Mismatch between Asset & Liability and the

Techniques for Reducing the Mismatch

 Introduction: nature of bank business
• A typical strategy of a bank to generate revenue is to
run mismatch, i.e. borrow short term and lend longer
term.
• Maturity mismatch is the basis of profitability
• Mismatches are handled by asset-liability management.
• Asset-liability mismatches can be controlled, mitigated
or hedged.
 What is Asset-Liability Mismatch?
• In general, Asset-Liability mismatch means mismatch
between asset and liability which in not correct
• Asset-liability mismatch occurs when the financial terms
of a Financial Institution’s assets and liabilities do not
correspond.
• In banking business, a mismatch occurs when assets that
earn interest do not balance with liabilities upon which
interest must be paid.
• For example, an asset that is funded by a liability with a
different maturity creates a mismatch (maturity
mismatch).
 The problem of mismatch
• Mismatches in maturity
• Mismatch of the nature of A & L (fixed or floating)
• Mismatches in interest rate
• Risk management does not eliminate mismatch – merely
manages them
• Interest Rate Risk  Affects profitability
• Liquidity Risk  May lead to liquidation
• General Strategy
– Eliminate Liquidity Risk (not the mismatch)
– Manage Interest Rate Risk
• Consciously create gaps
 Liquidity Risk:
• It is the risk that bank will be unable to meet it’s
commitment as they fall due leading to bankruptcy or
rise in funding cost.
• Banks traditionally use the Statutory Liquidity Reserve
and their borrowing capacity in the volatile inter-bank
money market as the source of liquidity.
• Asset liability mismatch is accompanied by liquidity risk
and excessive longer tenor lending against shorter-term
borrowing would put a bank’s balance sheet in a very
critical and risky position.
 Liquidity risk management
• Liquidity risk management is the management of Gap
• What is Gap management?
 It is simply, maturity mismatches of Financial Assets &
Liabilities
 If not prudently managed, can cause liquidity problems
to Banks
 Can result in enormous financial losses
Gap Management
• To address this risk and to make sure a bank does not
expose itself in excessive mismatch, a bucket-wise
(e.g. next day, 2-7 days, 7 days-1 month, 1-3 months,
3-6 months, 6 months-1 year, 1-2 year, 2-3 years, 3-4
years, 4-5 years, over 5 year) maturity profile of the
assets and liabilities is to be prepared to understand
mismatch in every bucket.
• However, as most deposits and investments of a bank
matures next day (call, savings, current, overdraft etc.),
bucket-wise assets and liabilities based on actual
maturity reflects huge mismatch;
• although we know that all of the shorter tenor assets
and liabilities will not come in or go out of the bank’s
balance sheet. 7
• As a result, banks prepare a forecasted balance sheet
where the assets and liabilities of the nature of current,
overdraft etc. are divided into
‘core and non-core’ balances, where
core is defined as the portion that is expected to be stable
and will stay with the bank; and non-core to be less
stable.
• The distribution of core and non-core is determined
through historical trend, customer behavior, statistical
forecasts and managerial judgment; the core balance can
be put into over 1 year bucket whereas non-core can be
in 2-7 days or 3 months bucket.

8
 Total CALL 2-7D 8D-1M 1-3M 3M-1Y 1-5Y 5Y+

Islamic Bonds 750 250 --- 250 250 --- --- ---

Investment Assets 5,000 500 550 1,400 300 250 1,500 500

Other Assets 500 200 --- --- --- --- 300

Total Assets 6,250 950 550 1,650 550 250 1,800 500

Customers Deposits (5,500) (1,950) (1,000) (1,450) (100) (200) (800) ---

Capital & Reserves (500) --- --- --- --- (100) (400) ---

Other Liabilities (250) (250) --- --- --- --- --- ---

Total Liabilities (6,250) (2,200) (1,000) (1,450) (100) (300) (1,200) (0)

NET MISMATCH 0 (1,250) (350) 250 400 (1,900) 600 500

CUMULATIVE NET (1,250) (1,600) (1,350) (950) (2,850) (2,250) (1,750)

MISMATCH

9
 Problems of Asset - Liability mismatch in
volatile interest rate Environment
• Decrease of NIM
• Liquidity problems
• Decrease in Net Worth
• Bankruptcy
Techniques to measure the exposure/risks arising
from Asset-Liability Mismatch

1. Repricing (or Funding Gap) model

2. Maturity model

3. Duration model
 Repricing or Funding Gap Model
• The repricing or funding gap model is a book value
accounting cash flow analysis model which focuses on
the repricing gap between the interest revenue
earned on assets and the interest paid on its
liabilities (or its NII) over a particular period of time.
 Repricing or Funding Gap Model
• Commercial banks need to report to central bank the
repricing gaps for assets and liabilities with the
following maturities:
i) 1 day to 30/31 days (one month)
ii) Over one month and upto two months
iii) Over two months and upto three months
iv) Over three months and upto six months
v) Over sixth months and upto one year
vi) Over one year and upto three years
vii) Over three years and upto five years
viii) Over five years and upto seven years
ix) Over seven years and upto ten years
x) Over ten years
xi) Non-sensitive
 Repricing or Funding Gap Model
• Under the repricing approach, a bank reports the gaps in
each maturity bucket by calculating the value of rate
sensitivity asset (RSA) and rate sensitivity liability
(RSL) on its balance sheet.
• All investments, advances, deposits, borrowings,
purchased funds, principal repayments, assets/liabilities
carrying floating interest rate etc. that mature/re-price
within a specified time-frame are interest rate sensitive
• Rate Sensitivity calculation means that the asset or
liability is repriced at or near current market interest rate
within a certain time horizon (or maturity bucket)
 Mismatch between RSA & RSL and
interest rate exposure
• Mismatch between RSA and RSL will lead a bank/FI to Net
Interest Margin (NIM) exposure to interest rate changes in
different maturity buckets.
• Mismatch or Gap is the difference between Rate Sensitive Assets
(RSA) and Rate Sensitive Liabilities (RSL) for each time bucket.
- If RSA > RSL, positive Gap
- If RSL>RSA, negative Gap
• GAP reports indicate whether an FI is in a position to benefit
from rising interest rates by having a positive Gap (RSA>RSL) or
whether it is in a position to benefit from declining interest rates
by a negative Gap (RSL>RSA).
• Gap can be used as a measure of interest rate sensitivity.
Funding Mismatch and Interest Rate Exposure to FI
• FI will face risks regarding NIM –
1. If there is negative gap (RSA<RSL), or
2. Spread difference
 Funding Mismatch and Interest Rate Exposure to
FI – Example (TK in mil)
1 2 3 4

Assets Liabilities Gaps Cumulati

ve Gap

1. 1 day to 30/31 days 20 30 -10 -10

2. More than 1months to 2-months 30 40 -10 -20

3. More than 2- months to 3-months 70 85 -15 -35

4. More than 3- months to 6-months 90 70 +20 -15

More than 6 moths to 1 year 40 30 +10 -5

6. Over 1 years 10 5 +5 0

Total 260 260

 Funding Mismatch and Interest Rate Exposure to
FI – Example (contd.)
• ΔNII = (GAP) x ΔR
= (RSA – RSL) x ΔR
• If short-term interest rate rises by 1%, then
For one day to 30/31 days bucket
ΔNII = (- Tk. 10 million x .01)
= -Tk. 100,000
For 3-moths to 6-months cumulative gap
ΔNII = (- Tk. 15 million x .01)
= -Tk. 150,000
 Impact of Spread Effect on NIM - Example
• Suppose the RSA and RSL are equal to Tk. 200 million. But
the interest rate increases by 1.5% on RSA and 1% on RSL.
• The Effect of changes in interest rate at different manner
will hurt the NIM.
ΔNII = (RSA x ΔRRSA) - (RSL x ΔRRSL)
= Δ Interest Revenue - Δ Interest Expense
= (Tk. 200 million x 1.5%) – (Tk. 200 million x 1%)
= Tk. 200 million (1.5% - 1%)
= Tk. 10,00,000
 Maturity Mismatch and Maturity Model
• Market Value Accounting: The assets and liabilities of
the FIs are revalued according to the current level of
interest rates.
• Marking to Market: The practice of valuing securities
at their current market price.
• Change in interest rate would affect the market value of
fixed-income securities
• Maturity Mismatch/Gap: Difference between the
weighted-average maturity of the FI’s assets and
liabilities.
Maturity Gap = MA – ML
This gap may be positive, negative or zero.
 Effect of Maturity Mismatch on Market Value of
FI’s Assets and Liabilities
Market Value Balance Sheet of an FI

Assets Liabilities
Long-term assets (A) Short-term Liabilities
(L)
Net Worth (E)

E=A–L
ΔE = ΔA - ΔL
I.e. changes the net worth
 Technique to Reduce Maturity Mismatch Risk
• Constructing balance sheet in such a way that
maturity gap is zero. That is, MA – ML =0, which is
not practically possible.

• However, will zero maturity gap protect the FI from

interest rate risk?
• Full immunization requires to take into accounts of –
– The degree of leverage in the FI’s balance sheet, i.e.
proportion of assets funded by liabilities (such as deposits)
rather than equity
– The duration analysis of the asset or liability cash flows
rather than the maturity of assets and liabilities &
equalization of duration of cash flow in another way-out.
– However, Finding assets and liabilities of the same
duration can be difficult.
Management Strategy to Hedge the Risk
GAP Risk Possible Management Response
position
Positive Losses if 1. Do nothing with the expectation
(RSA>RSL) interest rates that interest rate will rise or be
fall because stable
the net interest 2. Extend asset maturities or shorten
margin will be liability maturities
reduced 3. Increase interest-sensitive
liabilities or reduce interest-
sensitive assets
 Management Strategy to Hedge the Risk

GAP Risk Possible Management Response

position
Negative Losses if 1. Do nothing with the expectation
(RSA< RSL) interest rates that interest rate will fall or be
rise because stable
the net 2. Shorten asset maturities or
interest lengthen liability maturities
margin will 3. Decrease interest-sensitive
be reduced liabilities or increase interest-
sensitive assets
?