CHAPTER 4

ASSET – LIABILITY
MANAGEMENT
DR. DINH THI PHUONG ANH
Asset – Liability Management
Evolution
 In the 1940s and the 1950s, there was an abundance of funds
in banks in the form of demand and savings deposits. Hence,
the focus then was mainly on asset management

 But as the availability of low cost funds started to decline,

liability management became the focus of bank management
efforts

 In the 1980s, volatility of interest rates in USA and Europe

caused the focus to broaden to include the issue of interest
rate risk. ALM began to extend beyond the bank treasury to
cover the loan and deposit functions

 Banks started to concentrate more on the management of

both sides of the balance sheet
Asset – Liability Management (ALM)
 Commercial banks manage their asset and
liability portfolio as an integrated decision

 ALM provide financial institutions with

both defensive and offensive weapon to
achieve objectives and minimize risks
Asset Management Strategy
Assets management controls the allocation
of incoming funds by deciding:
 Target borrower
 Terms of loans
Liability Management Strategy
 Liability management strategy monitors
the mix and cost of their deposit and
non-deposit liabilities
 The key control was PRICE, which are the
interest rate and other terms offered on
deposits and other borrowings
Raise the offer rate
Reduce the offer rate
ALM Strategy
This is a balanced approach to ALM that
stresses following objectives:
 Management should impose the highest
control over volume, mix, costs and return
of both assets and liability
 Consistent coordination between asset
management and liability management to
maximize profits and reduce risk exposure
 Revenues and costs arise from both sides of
the balance sheet
The Asset - Liability Committee
(ALCO)
 ALCO, consisting of the bank's senior management (including
CEO) should be responsible for ensuring adherence to the
limits set by the Board
 Is responsible for balance sheet planning from risk – return
perspective including the strategic management of interest rate
and liquidity risks
 The role of ALCO includes product pricing for both deposits
and advances, desired maturity profile of the incremental
assets and liabilities,
 It will have to develop a view on future direction of interest
rate movements and decide on a funding mix between fixed vs
floating rate funds, wholesale vs retail deposits, money market
vs capital market funding, domestic vs foreign currency funding
 It should review the results of and progress in implementation
of the decisions made in the previous meetings
Risks managed by ALM
 Interest Rate Risk: Interest Rate risk is
the exposure of a bank’s financial
conditions to adverse movements of
interest rates
 Liquidity Risk: arises from funding of
long term assets by short term
liabilities, thus making the liabilities
subject to refinancing
 Interest Rate Risk: One of The
Greatest ALM Challenges
 Refers to the potential variability in a bank's
net interest income and market value of
investments due to changes in the level of market
interest rates
 A rise in the rate of interest affects:
◦ banks’ funding costs, and also
◦ the market value of assets such as bonds
 But, not all assets/liabilities are subject to
interest rate risk,
◦ e.g. Fixed interest assets/liabilities;
◦ Some rate sensitive assets/liabilities re-priced;
◦ Some assets (e.g. cash) and liabilities (current accounts)
are not interest earning by default
 Refinancing Risk
 Usually, bank assets are of longer maturity than bank
liabilities
◦ Banks are ‘short funded’
 There is a risk that the cost of rolling over/re-borrowing
of funds may rise above the returns being earned on assets
 Example:
Interest rate

On Assets 9%

8% Profit margin

On
Liabilities 7%

Years
0 1 2
 Reinvestment Risk
 But, what if the bank is ‘long funded’, i.e. the maturities
of some liabilities are longer than that of assets
 Banks face the risk of re-investing their funds in the
second period
 Example:
Interest rate

On Assets 9%

8% Profit margin

On
Liabilities 7%

Years
0 1 2
Example: Bank A is planning to grant 2 loans:

- Loan 1:100 million dong, t = 1 year, fixed rate = 10% p.a

- Loan 2: 100 million dong, t = 2 year, fixed rate = 11% p.a

Bank A is seeking for the sources to fund above loans in the

interbank market. The rates are 6% p.a for 1-year loan and 7%
p.a for 2-year loan.

Explain the scenarios when the bank is experiencing refinancing

risk and reinvestment risk.
 Liquidity or Funding Risk
 Bank liquidity refers to ‘ the ability of the bank
to meet its liabilities when they fall due’
◦ E.g. banks need to meet depositors demand to
withdraw their money
 Funding risk usually refers to a bank’s ability
to fund its day-to-day operations
 Liquidity crisis occurs when depositors
demand larger withdrawals than usual
 Banks can acquire liquidity in two distinct
ways:
 1. By liquidation of assets
 2. By liquidation of liabilities.
Managing Interest Rate Risk
 ALM is a broad concept, but it has
generally come to refer to managing
the interest rate risk
 Interest rate risk arises from the
mismatching of banks’ assets and
liabilities
Managing Interest Rate Risk: the Gap Analysis
 The gap analysis is a popular tool to manage the
interest rate risk
 GAP models are commonly associated with net
interest income (margin) targeting
◦ Gap is the difference between rate-sensitive assets (RSA)
and rate-sensitive liabilities (RSL) over a specific time
horizon
 The basic gap analysis focuses on the maturity of
the RSA and the RSL
 GAP=RSA – RSL (2)
 Recall:
◦ NII= (Interest Income – Interest Expense) (3)
◦ NIM=NII/Total Earning Assets (4)
 Protecting the Net Interest Margin
◦ So, the GAP is the portion of the balance sheet
affected by interest rate risk
 GAP = £RSA – £RSL
◦ £ GAP = £RSA – £RSL = £150m – £200m = -£50m
 Positive GAP
◦ indicates a bank has more rate sensitive assets than
liabilities,
◦ and that NII will generally ↑ when interest rates
rise ↑
 Negative GAP
◦ indicates a bank has more rate sensitive liabilities
than rate sensitive assets,
◦ and that NII will generally ↓when interest rates ↑.
 Eliminating an Interest-Sensitive Gap

GAP Positive: The Risk: Possible Management Reponses:

RSA> RSL Losses if interest rates 1. Do nothing (things may improve)
fall because the net 2. Increase RSL or reduce
interest rate margin RSA
will be reduced

GAP Negative: The Risk: Possible Management Reponses:

RSA< RSL Losses if interest rates 1. Do nothing
rise because the net 2. Decrease RSL or increase
interest rate margin RSA
will be reduced
 Optimal Value for a Bank’s GAP?
 There is no general optimal value for a bank's GAP in all
environments.
 The best GAP for a bank can be determined only by
evaluating a bank's overall risk and return profile and
objectives.
 Generally, the farther a bank's GAP is from zero, the
greater is the bank's risk
 Many banks establish GAP policy targets to control
interest rate risk by specifying that
 GAP as a fraction of earning assets should be plus or
minus 15%, or
 the ratio of RSAs to RSLs should fall between 0.9
and 1.1
Bank A currently has the following interest-sensitive assets and liabilities on
its balance sheet with the interest-rate sensitivity weights noted
Interest-Sensitive Assets Index Interest-Sensitive Liabilities Index
(USD million) (USD million)
Federal fund loans 50 1.00
Security holdings 50 1.20 Interest-bearing deposits 250 .75

Loans and leases 310.8 1.45 Money-market borrowings 85 .95

a. What is the bank’s current interest-sensitive gap?

b. Adjusting for these various interest-rate sensitivity weights: what is the
bank’s weighted interest-sensitive gap?
c. Suppose the federal funds interest rate increases or decreases one
percentage point. How will the bank’s net interest income be affected:
c.1. Given its current balance sheet makeup;
c.2. Reflecting its weighted balance sheet adjusted for the foregoing
rate-sensitive indexes?
Some problems with Gap, and its
advantages and disadvantages
 Interest paid on liabilities tend to move faster
than that earned on assets
 The interest rates attached to bank assets and
liabilities do not move at the same speed as
market interest rates
 The point at which some assets and liabilities
are re-priced is not easy to identify
 The primary advantage of GAP analysis is its
simplicity.
 The primary weakness is that it ignores the
time value of money
Duration as a Risk-Management Tool
• Duration is a Value-weighted and Time-weighted measure
of maturity that considers the timing of all cash inflows
from earning assets and all cash outflows associated with
liabilities
▫ Measures the average maturity of a promised stream of future
cash payments
∑ (Ct*t)/(1+YTM)t
DA/L= -----------------------
∑ Ct/(1+YTM)t)

- DA/L : average maturity of an asset/liability

- t: time at which cashflow occurs

- Ct: amount of cashflow at time t

- YTM: yield to maturity

 Example 1:
The bank grants a 1 – year credit of VND
250 million with an interest rate of 10%
p.a. The principal is paid in 2 equal
installments in the middle and at the end of
the year. Interest is paid together with the
principal. Determine the average duration
of the above loan.
 Example 2:
The bank mobilizes capital through the
issuance of CD with par value of 250
million, term of 1 year, interest rate of 8%
per year, interest payment every 6 months,
current market interest rate is 8% per year.
Duration Gap

 The impact of changing market interest

rates on NET WORTH can be:
If a Bank’s Duration And if the Then, Bank’s Net
Gap is: Interest Rate: income Will:

Rise Decrease
Positive
Fall Increase

Rise Increase
Negative
Fall Decrease
Example:
 The outstanding loan and deposit of a
bank are both 100 billion VND. The
current interest rates applied for lending
and deposit are 15% and 11%
respectively.
DA = 1.2 year
DL = 1 year.
 In case the market rates for deposit and
lending increase by 2% in year 2, what
happen to the net interest income of the
bank?
Guidance on interest rate
management
 Forecast interest rates to have a
reasonable interest rate policy
 Maintain balance between assets and
liabilities that are sensitive to interest
rate
 Maintain balance of maturity of assets
and liabilities
 Choose an appropriate interest rate
risk management strategy
 Use tools to hedge interest rate risk
Managing Liquidity Risk
THE DEMAND FOR AND SUPPLY OF BANK
LIQUIDITY
Demand for spendable funds come from two sources:
 (1) Customer withdrawing money from bank’s deposits
 (2) Credit requests from customers the bank wishes to keep,
either in the form of new loan request, renewals of expiring
loan agreements, or drawing upon existing credit lines
Important element in the supply of bank liquidity is
 (1) Receipt of new customers deposits, both from newly
opened
 accounts and from new deposits placed in existing accounts
 (2) Customers repaying their loans
 27

Managing Liquidity Risk

These various sources of liquidity demand and supply come
together to determine each bank’s net liquidity position at any
moment in time. That net liquidity position at time is as
follows:
 28

Managing Liquidity Risk

Suppose that a bank faces the following cash inflows and
outflows during the coming week: (a) deposit withdrawals are
expected to total $33 million, (b) customer loan repayments are
expected to amount to $108 million, (c ) operating expenses
demanding cash payment will probably approach $51 million, (d)
acceptable new loan requests should reach $294 million, (e) sales
of bank assets are projected to be $18 million, (f) new deposits
should total $670 million, (g) borrowing from the money market
are expected to be amount $43 m, (h) non deposit service fee
should amount to %27 m, (i) previous bank borrowings totaling
$23m are scheduled to be repaid, and (j) a dividend payment to
bank stockholders of $140 m is scheduled.
What is this bank’s projected net liquidity position for the
coming week?
 29

ESTIMATING A BANK’S LIQUIDITY NEED

Liquidity gap = Sources of liquidity (1) − Uses of

liquidity (2)
- When (1) < (2), the bank faces a negative liquidity gap,
or liquidity deficit. It now must raise funds from the
cheapest and most timely sources available.
- When (1) > (2), the bank will have a positive liquidity
gap. Its surplus liquid funds must be quickly invested in
earning assets until they are needed to cover future cash
needs.
 30

Managing Liquidity Risk

- When the bank’s total demand for liquid exceeds
its total supply of liquid (Lt < 0), management must
prepare for a liquidity deficit, deciding when and
where to raise additional liquid funds.
- On the other hand, if any point in time the total
supply of liquid to the bank exceeds all of its liquidity
demands (Lt>0), management must prepare for a
liquidity surplus, deciding when and where to
profitably invest surplus liquid funds until they are
needed to cover future liquidity demands.
 31

Managing Liquidity Risk

The essence of the liquidity management problem for a
bank may be described in two succinct statements:
1. Rarely are the demands for bank liquidity equal to the
supply of liquidity at any particular moment in time. The
bank must continually deal with either a liquidity deficit or
a liquid surplus.
2. There are trade-off between bank liquidity and
profitability. The more bank resources are tied up in
readiness to meet demands for liquidity, the lower is that
bank’s expected profitability (other factor held constant).
 32

ESTIMATING A BANK’S LIQUIDITY NEED

Assets Balance Liabilities Balance

Cash 160 Demand deposit 1.600
Short-term saving
Balance at State Bank 570 deposit 2.400
Balances from other Medium and long-
banks 400 term saving deposit 3.400
Treasury bill 700 Short-term borrowings 400
Medium and long-term
Short-term loans 2.300 borrowings 600
Medium-term loans 1.870 Equity 400
Long-term loans 2.700
Other assets 100
 33
Estimate the liquidity demand and supply for quarter
I/N+1 and propose a solution for the liquidity gap:
Items Increase Decrease
1. Liabilities

Demand deposit 800 300

Short-term saving deposit 1.080 620

Medium and long-term saving 820 1.240
deposit
[Link]
Short-term loans 800 1.000

Medium-term loans 1.440 1.280

Long-term loans 320 280

Considering:
The payment reserve ratio to demand deposits is 5%, the required
reserve ratio for deposits <12 months is 11%, for deposits of 12 months
or more is 5%. Payment reserve is managed at the bank’s cash items,
required reserve is managed at State Bank.