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ALM – Asset Liability Management

ALM – Asset Liability Management in Banks

When dealing with ALM or asset liability management banks are faced with a difficult situation. They take deposits that are payable on demand – these are short term liabilities and make loans that are of longer duration – long term assets. Hence there is a mismatch between their assets and liabilities and therefore a liquidity mismatch. So far we have discussed excess reserves as a solution to the liquidity mismatch issue.

However there are other solutions available to Bank of Metrocity than simply losing money on excess reserves – managing secondary reserves.

The basic issue with excess reserves is that it generally doesn’t generate any yield, hence the opportunity cost of holding reserves is large. In asset management, the alternative to holding reserves in cash is to hold them in highly liquid securities.

Assets such as loans are highly illiquid. Banks cannot ask their customers to repay loans whenever there is a liquidity issue. Banks therefore buy and sell securities with other banks depending on whether they have excess cash or a cash deficit on an overnight basis. This market is the money market, which we shall look at in greater depth later. The point to note here is that banks use government securities to manage their liquidity now rather than parking idle funds at the central bank.

Liability management is simply the reverse. Banks borrow overnight funds as they require it. For new loans or deposit withdrawals banks manage liquidity by borrowing overnight funds or initiating repo transactions that we will see later.

Once we move excess reserves to securities we see that the profitability of the bank increases

The balance sheet would now look something like

Debit

Credit

Assets

Deposit at Central Bank

2

Loans

25

Securities

3

Liabilities and Equity

Checking Deposit

20

Capital

10

profitability

= (loans x realised yield) + (yield on securities) – (deposits x deposit cost) – FC

= (25 x 13.25) + (3 x 6%) – (20 x 6%) – 0.5

= 3.3125 + 0.18 – 1.2 – 0.5 = $1.7925 million

The bank’s return on equity would therefore be =

profit/equity = 1.7925/10 x 100 = 17.925%

Lets summarise what we are trying to establish here. We can see that bank reserves are essential for banks to manage their liquidity requirements and they are also a regulatory requirement by central banks. The lower the reserves gives banks opportunities to increase their asset portfolio specifically their loan portfolio thereby improving profitability. Too low the reserves is a risk for banks to default on their commitments.

However excess bank reserves are expensive since they are idle funds that have an opportunity cost. The excess reserves deployed in government securities yield a risk free rate of interest. Banks utilise asset liability management techniques to best manage excess reserves. Therefore it is in the bank’s best interest to keep reserves at an optimal level. We will further see the importance of reserves as a tool utilised by central banks in their monetary policy implementation.

There are many other ways by which BOM can improve profitability such as – lowering its equity, using leverage by borrowing, reducing fixed costs and more. 

Liquidity Management in Depth

Lets build on our framework further by studying liquidity management in more depth since it is essential to understanding how the monetary policy works.

The current banking system in the US has evolved a long way from the 1920s and 1930s. In the 1920s large profits were made by banks by mixing the traditional business of banking of accepting deposits and sanctioning loans to underwriting securities, trading commodities, investing in capital markets.

This period saw an emergence of a new type of banking that combined commercial banking with investment banking business. Asset liability management was proving to be an issue. From the collapse of the financial system in the US, the Crash of the 1929 and the Great Depression that followed, strong regulations on banking emerged.

The most famous one was the Glass-Steagall Act of 1933 that basically segmented commercial banking activity and investment banking activity. The Act imposed interest rate caps on deposits and Section 11 of the Act further restricted any interest payment on demand deposits.

The Fed also had authority to regulate time deposits under regulation Q. These regulations spawned many innovations in the financial markets that make an interesting read. However for our purpose we will only look at what is relevant.

Lets revisit the asset and liabilities to understand how central banks influence the banking sector in the current day scenario.

With the growth in the industrial sector over the years the bank’s assets grew steadily to include mortgage lending, consumer lending, lending to different industries, and interbank lending. Bank’s also invest in securities and place cash reserves with the central bank. Due to this increased scope of lending the requirement for funds increased. Banks needed to come up with innovative sources of funds to circumvent the banking regulations placed on the terms of the usual liabilities.

We have already discussed checking and time deposits earlier. In many countries small local banks were good in mobilising deposits but poor in getting good loan opportunities as compared to their city counterparts. An interbank deposit was a good way for local banks to earn on surplus funds and was a good source of funds for the larger banks.

Next we understand how bank use repos or repurchase agreements to manage their liquidity.

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