1. Mismatch occurs when the tenure of maturing loans do not match the tenure of the sources of funds on the liabilities side. The liabilities side of the balance sheet of a bank includes sources of funds and for a bank one of the main sources of funds are the deposits.
2. From 2010 onwards with the economy recovered, disbursements of infrastructure loans were sanctioned by banks to projects such as power and roads had duration between 10 and 15 years. However, deposit tenures were getting shorter and this huge disparity in tenures between assets and liabilities created the instability in banks’ balance sheets.
3. Countries pegging interest on deposits to market-determined rates has resulted in a fall in the rates and deposits are now of shorter tenure. With the de-regulation of interest rates, most depositors are not looking beyond one or two years.
2. From 2010 onwards with the economy recovered, disbursements of infrastructure loans were sanctioned by banks to projects such as power and roads had duration between 10 and 15 years. However, deposit tenures were getting shorter and this huge disparity in tenures between assets and liabilities created the instability in banks’ balance sheets.
3. Countries pegging interest on deposits to market-determined rates has resulted in a fall in the rates and deposits are now of shorter tenure. With the de-regulation of interest rates, most depositors are not looking beyond one or two years.
4. Constant monitoring and periodic evaluation of its investment portfolio is important for a bank as many of its short-term liabilities are met through this resource.
IMPACT OF ASSET LIABILITY MISMATCH
1. The interest rate risk arises as banks will have to re-price their deposits frequently, which have a faster turnover compared to the long-maturing loans. Banks are constrained as deposit rates have to be in sync with the market rates. If the market rates were lower, it would become difficult to attract depositors, which means that sources of funds may well dry up.
2. Banks face liquidity risk as they have to repay the depositors faster but funds are caught up in long-term assets. So although the bank might be asset-rich it does not have the necessarily liquidity to repay its depositors at the same time lend for projects.
2. Banks face liquidity risk as they have to repay the depositors faster but funds are caught up in long-term assets. So although the bank might be asset-rich it does not have the necessarily liquidity to repay its depositors at the same time lend for projects.
3. Exchange rate risks and credit rate risks are natural corollaries of this process. The liabilities in a particular currency have to be matched by its assets in that currency, especially when exchange rates are volatile as they are currently, with the global economy still coming to terms with Britain’s exit from the EU and signals are mixed regarding changes in US interest rates.
MANAGING ASSET LIABILITY MISMATCH
1. Banks have to put in place a robust asset liability management (ALM) system. The objective of an ALM is to safeguard the net interest margins, its short-term profits, long-term earnings and the sustained profitability of the bank. The system would manage the volume & mix of assets, the maturities on both the asset & liabilities side, and the quality & liquidity of assets.
2. The majority of banks set net interest income (NII) limits as a main measure of performance with the more advanced banks also using market or economic value as a secondary measure. NII is limited as it does not provide a full view of the risks run by a bank or reflect fully the economic impact of interest rate movements. Market value or economic value simulations offer a more complete assessment of the risk being run but require significantly more detailed analysis.
3. The process of Funds Transfer Pricing (FTP) is designed to identify interest margins and remove interest rate and funding or liquidity risk. Looking at it from the business unit perspective, it effectively locks in the margin on loans and deposits by assigning a transfer rate that reflects the repricing and cash flow profile of each balance sheet item – it is applied to both assets and liabilities. It isolates business performance into discrete portfolios that can be assigned individualised metrics and facilitates the centralisation and management of interest rate mismatches.
4. FTP rates are structured to include both interest rate and funding liquidity risks with the derived transfer yield curve constructed to include appropriate premiums. Such premiums should capture all elements associated with the banks funding cost such as; holding liquidity reserves; optionality costs, where pre-payment rights exist; term funding program costs; and, items such as basis risk.
2. The majority of banks set net interest income (NII) limits as a main measure of performance with the more advanced banks also using market or economic value as a secondary measure. NII is limited as it does not provide a full view of the risks run by a bank or reflect fully the economic impact of interest rate movements. Market value or economic value simulations offer a more complete assessment of the risk being run but require significantly more detailed analysis.
3. The process of Funds Transfer Pricing (FTP) is designed to identify interest margins and remove interest rate and funding or liquidity risk. Looking at it from the business unit perspective, it effectively locks in the margin on loans and deposits by assigning a transfer rate that reflects the repricing and cash flow profile of each balance sheet item – it is applied to both assets and liabilities. It isolates business performance into discrete portfolios that can be assigned individualised metrics and facilitates the centralisation and management of interest rate mismatches.
4. FTP rates are structured to include both interest rate and funding liquidity risks with the derived transfer yield curve constructed to include appropriate premiums. Such premiums should capture all elements associated with the banks funding cost such as; holding liquidity reserves; optionality costs, where pre-payment rights exist; term funding program costs; and, items such as basis risk.
5. Like all areas of risk management, it is necessary to put a workable framework in place to manage liquidity risk. It needs to look at two aspects:
i) Managing liquidity under the business as usual scenario, and
ii) Managing liquidity under stress conditions. It also needs to include a number of liquidity measurement tools and establish limits against them.
6. At the governance level, boards need to recognise liquidity risk and to clearly articulate the risk tolerance of the organization and subject the balance sheet to regular scrutiny. Guiding principles need to be included as part of this process. The following 5 principles are valuable:
i) Diversify sources and term of funding – concentration and contagion were the killers in the recent crisis.
ii) Identify, measure, monitor and control – it is still surprising that many banks do not fully understand the composition of their balance sheet to a sufficient level of detail to allow for management of the risks.
iii) Understand the interaction between liquidity and other risks – e.g. basis risk – the flow on impact of an event in one area can be devastating to others.
iv) Establish both tactical and strategic liquidity management platforms – keep a focus on both the forest and the trees.
v) Establish detailed contingency plans and stress test under multiple scenarios regularly.
KEY AUDIT PROCESS FOR ALM
1. Periodic audits of ALM function should at least address the following:
2. Review cash-flow analysis of current product obligations; ensure analysis has properly assess the potential cash-flow impact of interest-rate fluctuations, and verify analysis tested cash flows associated with projected future product obligations.
3. Evaluate the degree of match between assets and liabilities.
4. Review cash-flow testing practices. Verify routine liquidity studies apply an appropriate set of economic scenarios.
5. Review company's investment segmentation plan. Ensure proper groupings of products having similar interest-rate sensitivity; assess whether the number and size of the segments is reasonable; and verify that aggregate of segments is consistent with balance sheet amounts.
7. Verify each transaction was assigned to the appropriate segment for a sample of investment transactions.
8. For each product group or segment, verify accuracy of calculation of net liability. Trace significant liabilities to the source documentation. The total of financial values used in calculating net liability should be consistent with values found in other financing reporting.
9. For investment activity reports, investment portfolio performance reviews, and asset reports, follow source documentation to test for accuracy.
10. sample the company's in-force products to verify that all products were analysed for interest-rate sensitivity.
11. Review the models used for ALM analysis and the appropriateness of any assumptions used in modeling, similarly, review the completeness of scenario modeling as a whole.
12. Review interest coverage ratio calculation
13. Verify corporate business recovery plan incorporates ALM as an aspect of recovery.
(Source: Indiainfonline, Asian Development Bank)
