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Bank Asset Liability Management (ALM) – Default ALM strategies.

In our last post we looked at a history of US Treasuries yield curve shifts between 1978 and 2010.

We now move to a simplified analysis of the maturity distribution of assets and liabilities on a bank balance sheet in anticipation of expected yield curve shifts. We use a stylzed template (shared below) to review the maturity distribution of assets or liabilities for a given interest rate scenario. Our objective is to review the tool kit of established ALM responses to common interest rate outlook changes.

Figure 1 A stylized template for analyzing Asset Liability Management challenges

We use nine asset classes ranging from maturities of 3 months to 10 years in our template. Each bucket in our stylized presentation is marked with the relevant balance sheet percentage allocation.

Figure 2 A stylized template for liabilities for answering ALM questions

The same template is used for the distribution of liabilities. The only difference is that we use six different liability classes with maturities spread between 3 months to 5 years.

Using the stylized ALM template.

How do we put the template to work? Here is an initial list of questions that we would like to answer:

a) How does varying maturity distributions across assets and liabilities change share holder value?

b) How does changing the same distribution impact future earnings.

c) Given an interest rate outlook is there an ideal fit (distribution) that a client bank can aim for. It would be interesting to examine how our allocation strategy would change based on our view of the interest rate environment.

An Ideal ALM maturity distribution for a given interest rate scenario?

We start with the last question first. If you know interest rates are going to rise, how would you change the maturity distribution of assets and liabilities? If you know interest rates were going to fall, what would you change?

Bank ALM Scenarios – Interest rates expected to rise.

If we expect rates to rise, the standard response is to extend the maturity of liabilities so that the cost of deposits is locked in for a longer duration of time using current (low) rates. Historically bank borrowing is focused and concentrated in the shorter tenors. The maturity extension strategy would focus on approaches and incentives that would allow deposits to be locked in at fixed rates for significantly longer period of time.

Once we lock in ourselves and rates rise a new question arises. If we managed to do a mark to market at fair value of liabilities, at the new rates, there should be a mark to market gain (loss) on the liability account. Even though regulatory frameworks do not allow us to mark down deposits to reflect interest rate changes, there is certainly an opportunity cost gain by paying lower than the average market rate for deposits.

Figure 3 Yield curve shifts – interest rates are expected to rise

Between 1978 and 1981, short term interest rates in the US rose from 7% all the way up to 21%. Longer term rates (yields on 10 year bonds) did not rise by as much but still moved from 7% to just under 13%. If in 1978 we had access to a interest rate oracle, our original deposit profile would shift from figure below to the figure that follows immediately after.

Figure 4 ALM default maturity distribution of liabilities

While a perfect fit would be to move all deposits to the 5 year bucket, realistically speaking that is not possible. Truly long term deposits are difficult to close and retain. Which is the reason why we end with a more gradual laddered maturity profile for longer term deposits.

Figure 5 ALM – Suggested distribution of liabilities for a rising rate environment

Sounds a little dated and unreal. Here is a snapshot from Goldman Sach’s published financial statements as at 31 December 2013.

Figure 6 Goldman Sach’s – Unsecured long term borrowing maturity profile as at 31-12-2013

If you can’t see the trend in the graph above, here is the same information presented in our stylized template for an easier comparison. The market certainly expects rates to rise and Goldman is no exception.

Figure 7 Goldman Sachs – Stylized template for maturity distribution of borrowings as at 31-12-2013

At the same time on the asset front rising rates will lead to a mark to market (MTM) loss on fixed rates assets. We should see a very different maturity profile. Asset maturities should shrink across the board with the largest chunk bucketed in the short term maturity buckets.

This is easier said than done. Restructuring asset maturities on a bank balance sheet over a six month to a yearlong window tends to be difficult. It is like making a super tanker (VLCC) take a u turn in the middle of Atlantic ocean.

Liquidity is an issue with long duration investments as well as with term loans. While as a bank we would love to switch maturity buckets at our whim 10, 15, 20 and 30 year bonds are significantly less liquid than treasury bills. Large positions take time to liquidate but they are still easier to switch than the advances portfolio. 5 year term loans cannot be called and refinanced within a few months. Even working capital and running finance lines need to be rolled over a few years in adjustment mode before they are paid down in full by clients.

Restructuring a fresh balance sheet is easier. Alternatively if you have been hoarding cash by restricting credit as reflected by your advances to deposit ratio, that too can work in your favor. But the decision to restrict credit and the implementation of this decision across your lending network can only be executed over a multiyear time frame. As clients pay down balances on loans, the freed up cash is not reinvested within the lending balance sheet but parked in liquid assets for future redeployment. When rate expectations are finally realized these liquid reserves are deployed at the new higher rates.

Figure 8 Maturity distribution of assets – rates are expected to rise

It is possible that by the time your transition to your idealized balance sheet profile is completed, the interest rate outlook changes again, requiring you to redo your asset allocation all over again.

Bank ALM scenarios. Interest rates expected to decline.

How does your strategy change if you expect interest rates to decline. Between 1982 and 1986 rates slowly gave up their gains and fell all the way down to 7% from their recent peaks touched in early 80’s.

Figure 9 The sky is falling – a decline in interest rates

Our approach to assets and liabilities reverses. We shorten our maturity exposure for liabilities and extend it for assets. Declining rates will lead to capital gains on investment securities. On the advances portfolio we would like to lock in longer dated loans at current high interest rates.

Figure 10 The ideal maturity distribution for liabilities in stable or declining interest rate environment

Compared to our earlier challenges with extending maturities, shortening maturities is relatively easier on the deposit side.

Figure 11 Maximizing interest rate mismatch – declining interest rate environment.

For a fully deployed balance sheet restructuring the advances portfolio however is still a challenge.

Bank ALM scenarios. Uncertain interest rate outlook?

When we are not sure about the direction of the interest rates, the best approach is to hedge our bets by using maturity ladders. A maturity ladders aims to distribute exposure evenly across maturity buckets. For liabilities as well as assets.

On the liability front this implies a decision to distribute deposits across maturity buckets. There is still a bias towards short term deposits because they are relatively easier to book.

Figure 12 A maturity ladder for liabilities

On the asset front this leads to an attempt for an even distribution across asset maturity buckets. However given the uncertain outlook, there may be a preference towards investment securities rather than lending since securities are easier to liquidate and re-allocate than loans.

Figure 13 A maturity ladder for assets – hedging bets in an uncertain interest rate outlook

More ALM questions?

So what happens if we don’t follow the standardized templates for rising or declining rate environments? If we flip and switch one of the above recommended profiles with alternates. Or we successfully manage to re-position our balance sheet but the interest rate outlook fails to oblige and goes in the opposite direction.

To answer these questions we need to take a closer look at the interaction of interest rate changes and maturity profiles with value and income. It’s a topic that we will cover in greater detail in our future posts on asset liability management.