UNIT 5

ASSET-LIABILITY MANAGEMENT TECHNIQUES

5.1. General Principles of Bank Management

A bank has four primary concerns:

1. Liquidity management = making sure that the bank has enough cash to cover depositors’
requests for withdrawals (deposit outflows).
2. Asset management = acquiring assets with the highest return and the lowest risk.
 Managing credit risk
 Managing interest-rate risk
3. Liability management = acquiring funds at the lowest cost.
4. Capital adequacy management = maintaining sufficient capital while still providing
decent returns to shareholders.
5.1.1. Liquidity Management
Liquidity of bank may be defined as the ability to meet anticipated and contingent cash needs.
Cash needs arise from withdrawal of deposits, liability maturities and loan disbursals. The
requirement for cash is met by increase in deposits and borrowings, loan repayments, investment
maturities and the sale of assets. A minimum criterion of liquidity is the ability both to meet
commitments when due and to undertake new transactions when desirable.
The need for liquidity arises from
 Need to replace outflows of funds giving rise to funding risk
 Need to compensate for the non-receipt of expected inflows of funds giving rise to time
risk
 Need to find new funds when contingent liabilities become due
 Need to undertake new transactions when desirable giving rises to call risk.
Inadequate liquidity can lead to unexpected cash shortfalls that must be covered at inordinate
cost which reduces profitability. It can lead to liquidity insolvency of the bank without being
capital insolvent (negative net worth). A bank has also to avoid excessive liquidity since it results
in low asset yields and poor earnings.
 5.1.2. Asset Management

Asset Management refers to the attempt to earn the highest possible return on asset while
minimizing the risk. Banks must hold a mix of assets that provide the highest return with the
lowest risk. Thus, asset management involves four basic principles:

1) Get borrowers with low default risk, paying high interest rates
2) Buy securities with high return, low risk
3) Diversify: Diversifying the bank’s asset holdings to minimize risk: holding many types of
securities and making many types of loans offers protection when there are losses in one type
of security or one type of loan.
4) Manage liquidity: Holding some liquid assets, including excess reserves and Treasury bills
(“secondary reserves”), to protect against deposit outflows, even though the interest rate on
these assets may be lower.

5.2.3. Liability Management

Liability Management refers to managing the source of funds, from deposits, to certificates of
deposit (CDs), to other debt.

Checkable deposits are a bank’s lowest-cost source of funds because depositors want safety and
liquidity and will accept a lesser interest return from the bank in order to achieve such attributes.
But checkable deposits are unlikely to provide a bank with all of the funds that it needs. Thus,
the bank may obtain additional funds at higher costs by issuing CDs or by borrowing from other
banks (federal funds) or non-bank corporations (repurchase agreements).

Non-transaction deposits (includes like saving accounts and time deposits also called CDs) are
the overall primary source of bank liabilities and are accounts from which the depositors cannot
write checks. Non-transaction deposits are generally a bank’s highest cost funds because banks
want deposits which are more stable and predictable and will pay more to the depositors (funds
suppliers) in order to achieve such attributes.
5.2.4. Capital Adequacy Management

Banks hold capital to provide protection against unexpected losses. Banks have to make
decisions about the amount of capital they need to hold for three reasons. First, bank capital
helps prevents bank failure, a situation in which the bank cannot satisfy its obligations to pay its
depositors and other creditors and so goes out of business. Second, the amount of capital affects
returns for the owners (equity holders) of the bank. And third, a minimum amount of bank
capital (bank capital requirements) is required by regulatory authorities.

Since assets minus liabilities equals capital, capital is seen as protecting the liability suppliers
from asset devaluations or write-offs (capital is also called the balance sheet’s “shock absorber,”
thus capital levels are important). That is, bank capital is a cushion against a drop in the value of
its assets, which could force the bank into insolvency (having liabilities in excess of assets,
meaning that the bank can be forced into liquidation) if it owes more than it can repay.

Financial risk increases the probability of banks’ insolvency. Bank regulators are concerned
about the downside risk of banks and they focus on lower end of the distribution of bank
earnings. The variability of earnings from the regulators’ view point should not lead to
elimination of capital and insolvency of bank. Shareholders on the other hand are concerned with
the expected return and require higher earnings per share as bank profitability becomes more
variable. They have to be compensated for the bank risk.

The problem of financial risk is not solved by stipulating high capital requirement. High
requirement may inhibit the efficiency and competitiveness of the banking system and may act as
a constraint on the lending operations of the bank. Banks may not allocate funds in the most
efficient manner. Relatively high capital requirement for banks as compared to other providers of
financial services may also constrain the rate at which bank assets may be expanded impairing
their competitive strength.

5.2. Managing Credit Risk

Credit risk is inherent in banking. Banks are successful when the risks they take are reasonable,
controlled and within their financial resources and competence. Credit risk covers all risks
related to a borrower not fulfilling the obligations on time.
Credit risk management process begins with identifying the lending markets and proceeds
through a series of stages to loan repayment. A bank has to follow three key principles in its
credit risk management which are selection, limitation and diversification.
5.2.1. Selection

The first requirement is to whom to lend. This is usually based on customer’s request. A model
loan request would be in terms of filing all the information required in a printed loan application
form which elicits information an amount of loan, purpose of loan, repayment and collateral.
Information on the organization of the business (proprietorship, partnership, company (private or
public)), trade/industry area and other banking relationships would be required.

The 6 C’s of Credit

The evaluation of the loan request by the bank involves the 6 C’s of credit.
 Character (borrowers’ personal characteristics such as honesty, attitudes about
willingness and commitment to pay debts).
 Capacity (the success of business)
 Capital (financial condition).
 Collateral
 Conditions (economic).
 Compliance (laws and regulations).

5.2.2. Limitation

In view of the unforeseen changes in the financial conditions of companies, industries,

geographical areas or whole countries, a system of limits for different types and categories of
lending have to be set. While banks could adopt credit limits in different ways and at different
levels the essential requirement is to establish maximum amount that may be loaned to any one
borrower or group of connected borrowers and to any one industry or type of economic activity.
Loans may be classified by size and limits put on large loans in terms of their proportion to total
lending. The rationale of these limits is to limit the bank exposure to losses from loans to any one
borrower or to a group whose financial conditions are interrelated. A system of credit limit
restricts losses to a level which does not compromise bank’s solvency. Lending limits have to be
set taking into account bank capital and resources. Any limit on credit has to be accompanied by
a general limit on all risk assets. This would enable the bank to hold a minimum proportion of
assets such as cash and government securities whose risk of default is zero.
5.2.3. Diversification

Diversification involves the spread of lending over different types of borrowers, different
economic sectors and different geographical regions. To a certain extent credit limits which help
avoid concentration of lending ensures minimum diversification. The spread of lending is likely
to reduce serious credit problems.
Size however confers an advantage in diversification because large banks can diversify by
industry as well as region.
Lending to foreign governments, their agencies or to foreign private sector companies has added
a new dimension to credit risk. Country risk involving the assessment of the present and future
economic performance of countries and the stability and character of the government has to
supplement credit risk assessment or the creditworthiness of individual borrower. In line with the
basic principles of limitation and diversification of credit risk management, credit limit have to
be set for individual countries and particular regions of the world.

5.3. Managing Interest-rate Risk

Net interest income which is the difference between interest income and interest expense is the
principal determinant of the profitability of banks. Net interest income is determined by interest
rates on assets and paid for funds, volume of funds and mix of funds (portfolio composition).
Changes in interest rate affect the net interest income. Whenever rate of interest conditions
attaching to assets and liabilities diverge, then changes in market interest rates will affect bank
earning. If a bank attempts to structure its assets and liabilities to eliminate interest rate risk, the
profitability of the bank would be impaired.

A bank may borrow short and lend long. The mismatch of assets and liabilities gives rise to
interest rate risk. In such a case a rise in interest rates can result in losses for the bank. A bank
has also to take into account the preferences of its constituents. They may want long-term
deposits when the bank wants to issue short-term deposits; and loan customers may want fixed
interest loans when the bank wants to increase the amount of interest sensitive assets.
Each bank through its choice from different types of assets and liabilities can alter the structure
of its balance sheet in order to increase or decrease interest rate exposure. In order to limit
interest rate risk banks in US and Eurodollar market have substituted during the last three
decades variable interest rates for fixed interest rates across much of their lending. Lending at
variable rates which varies in line with short-term market rate helped in aligning them closely
with rates paid by the bank on the bulk of liabilities. The objective of interest rate risk
management is to insulate net interest margin (interest income divided by average interest
earning assets).

5.4. Measuring Bank Performance

To understand how well a bank is doing, we need to start by looking at a bank’s income
statement, the description of the sources of income and expenses that affect the bank’s
profitability.

Much like any business, measuring bank performance requires a look at the income statement.
For banks, this is separated into three parts:
 Operating income
 Operating expenses
 Net operating income

Operating Income
Operating income is the income that comes from a bank’s ongoing operations. Most of a bank’s
operating income is generated by interest on its assets, particularly loans. Interest income
fluctuates with the level of interest rates, and so its percentage of operating income is highest
when interest rates are at peak levels.

Operating Expenses
Operating expenses are the expenses incurred in conducting the bank’s ongoing operations. An
important component of a bank’s operating expenses is the interest payments that it must make
on its liabilities, particularly on its deposits. Just as interest income varies with the level of
interest rates, so do interest expenses. Noninterest expenses include the costs of running a
banking business: salaries for tellers and officers, rent on bank buildings, purchases of equipment
such as desks and vaults, and servicing costs of equipment such as computers, etc.

Net Operating Income

Subtracting the operating expenses from the operating income yields net operating income. Net
operating income is closely watched by bank managers, bank shareholders, and bank regulators
because it indicates how well the bank is doing on an ongoing basis.
Net income, more commonly referred to as profits after taxes, is the figure that tells us most
directly how well the bank is doing because it is the amount that the bank has available to keep
as retained earnings or to pay out to stockholders as dividends.

Although net income gives us an idea of how well a bank is doing, it suffers from one major
drawback: It does not adjust for the bank’s size, thus making it hard to compare how well one
bank is doing relative to another.
Hence, as much like any firm, ratio analysis is useful to measure performance and compare
performance among banks.
i) Return on Assets (ROA)
A basic measure of bank profitability that corrects for the size of the bank is the return on assets
(ROA) which divides the net income of the bank by the amount of its assets. ROA is a useful
measure of how well a bank manager is doing on the job because it indicates how well a bank’s
assets are being used to generate profits.
ROA = Net Income
Assets
ii) Return on Equity (ROE)
Although ROA provides useful information about bank profitability, we have already seen that it
is not what the bank’s owners (equity holders) care about most. Bank’s owners are more
concerned about how much the bank is earning on their equity investment, an amount that is
measured by the return on equity (ROE), the net income per dollar of equity capital.
ROE = Net Income
Capital
iii) Net Interest Margin (NIM)
Another commonly watched measure of bank performance is called the net interest margin
(NIM), the difference between interest income and interest expenses as a percentage of total
assets:
Net Interest Margin (NIM) = Interest Income – Interest Expenses
Assets
One of a bank’s primary intermediation functions is to issue liabilities and use the proceeds to
purchase income-earning assets. If a bank manager has done a good job of asset and liability
management such that the bank earns substantial income on its assets and has low costs on its
liabilities, profits will be high. How well a bank manages its assets and liabilities is affected by
the spread between the interest earned on the bank’s assets and the interest costs on its liabilities.
This spread is exactly what the net interest margin measures. If the bank is able to raise funds
with liabilities that have low interest costs and is able to acquire assets with high interest income,
the net interest margin will be high, and the bank is likely to be highly profitable. If the interest
cost of its liabilities rises relative to the interest earned on its assets, the net interest margin will
fall, and bank profitability will suffer.