Asset Liability Management – Why do we need it? How do we use it?
Banks make money in a variety of ways.
The simplest of ways is to act as an intermediary on transactions (such as buying and selling foreign exchange, equities, bonds and other financial securities) and take a small cut on both ends of the transaction (buying and selling). So if we buy or sell 1000 Euros from our bank, the bank will keep a small margin on the trade and add that margin to its income from dealing in foreign currencies. Note that this is different from income generated by trading in foreign currencies for the bank’s account using bank capital (proprietary trading).
The next stream of revenues is charging for services provided to customers who are part of the bank’s network (for checks issued and processed, account statements, processing loan applications, pay orders and bank drafts, using the ATM network, paying bills, etc). These items get tagged under the fee income accounting head in the earning section of the bank’s financial statements.
But the biggest component of a bank’s earnings is driven by what we call core banking operations – the business of borrowing and lending money. Depending on how the bank’s franchise adds value, this third and final head may represent as much as 60% – 80% of the total earnings generated by the bank.
Under this head banks make money by borrowing in the short term (through daily, weekly and monthly deposits or interbank borrowing) and lending it out for the long term (via fixed maturity loans to business customers, revolving balances on credit cards or short term personal loans, longer terms auto and mortgage loans to individual customers.)
Since there is a clear difference in rates (the spread) between long term (higher) and short term rates (lower), such a strategy allows a bank to earn an interest rate spread. The source of the spread is the intentional maturity mismatch between assets and liabilities. In order to benefit from the maturity mismatch bank assume:
a) The spread between long term and short term rates will remain positive over the duration of the borrowing and lending terms.
b) They will be able to rollover (renew) short term deposit base (contractual liabilities) at the end of the original borrowing tenor. Thet will not have an issue continuing funding for longer duration assets by using such rollovers.
c) Any interim liquidity shortfall can be temporarily financed by borrowing from the Interbank market.
d) The practice of maturity mismatch is an accepted part of the banking business model and does not lead to compliance issues raised by bank board of directors or regulators.
As interest rate change over a period of time, the interest rate spread widens (increases) or tightens (decreases). Even with little volatility in rates, spreads can still change significantly if interest rates move in different directions for assets and liabilities or across maturity tenors and buckets.
Figure 1 The Asset Liability Management discussion summarized
Changes in interest rate spread have a direct and significant impact on bank earnings. Which is the reason why bank boards, regulators and industry analysts are interested in financial disclosures that clearly show earning sensitivity to expected interest rate changes in the near term. Combined with an interest rate outlook for the next few quarters, most boards can get an indication of earnings direction and use that to manage analyst and shareholder expectations.
Over the years the industry has fine tuned the usage of reporting tools that focus on the impact of interest rate changes on earnings. While Asset Liability Management (ALM) has a much broader mandate, earning sensitivity reporting is now a core part of the monthly ALM discussion during executive committee meetings.
In addition to earning sensitivity Asset Liability Management reporting also looks at funding (financing), refinancing and liquidity and contractual maturity mismatch risk. To understand these reporting tools we need to get comfortable with three key drivers of the ALM function.
a) The shift and changes in interest rates,
b) The structure of a typical bank balance sheet, and
c) The interaction of (a) and (b) above and its impact on both earnings and shareholder value.
Figure 2 Bringing it all together – Asset Liability Management and testing the business model
The challenge within the ALM world is that while the framework appears to be basic, things get complicated very quickly. There are assumptions that need to be tweaked as well as understood. A set of neat reports that come with their own readability convention. Scenarios that need to be explained to board members before meaningful discussion could begin on Asset Liability Management strategies specific to those scenarios. Results that need to be interpreted carefully given the assumptions and models used. There is an even mix of the hypothetical, the make believe and real world used in generating the reports but the impact of decisions taken on the basis of the same reports is all real world. The last thing board and shareholders want to hear is “But I thought….”
As the Cheshire cat said to Alice, it all depends on where you want to go…