Asset liability management: Strategic way-out for banks, FIs

An effective Asset Liability Management (ALM) demands adoption of strategic measures to manage the volume, mix, maturity, rate sensitivity, quality & liquidity of assets & liabilities in the right perspective. The main objective of this exercise is to make it possible to ensure acceptable risk reward trade-off.

Attainment of desired result out of ALM underpins the necessity to upgrade the asset quality through quantification of risk not only associated with the lending portfolio but also at the same time risk factors entangled with the liability portfolio should get due importance. Here it is noteworthy that liquidity risk stems from the mismanagement of risk assets, unabated expansion of lending portfolio in breach of prescribed lending deposit ratio ignoring the liquidity base having a seismic effect on the overall chain of ALM.

The proper process of ALM requires to follow the following raft of measures:

wReview of interest rate structure and making comparison of the same to the product pricing of both related to assets & liabilities.

wEvaluation of loan & investment portfolio in the right perspective as any failure or non-performance of the counterparty borrowers hinders the recycling of funds resulted in the liquidity problem for the lending institution.

wMaking review of the actual performance against the projection and identification of the reasons hindering the effort to churn out acceptable spread.

ALM practices should be synchronised to manage various risk factors in order to ensure stable earning streams/profitability both from short-term and long-term perspectives.

Predetermined interest rate(s) were used in the past for both assets and liabilities of banks and financial institutions (FIs) without absorbing the money market dynamics. But in the liberalised/deregulated environment, market forces are allowed to play their role in pricing both assets & liabilities and market competition has shrunk the spread of banks in the process of intermediation.

The changes in the profile of the sources & uses of fund are reflected in the borrowers' profile, industrial dynamics, sector-wise exposure limit, interest rate structure for both assets & liabilities.

ALM is concerned with strategic balance sheet management entailing risk emanated from changes in interest rate, exchange rate, credit risk and liquidity position of particular bank/lending institution.

It has become very much imperative for the banks & financial institutions to prioritise stable and sustainable earnings focusing on integrated balance sheet management where all the components of balance sheet and their respective maturity structure will get preponderance.

Measuring and managing liquidity are the primary tasks of the management of commercial banks. Bank's ability to meet the current, mid-term and long-term financial obligations as reflected in the liability profile should duly be monitored, measured and controlled to avert any situation of liquidity crunch. Failure on the part of any bank/financial institution to meet up the claim of their depositors and imposition of penalty due to failure to maintain prescribed CRR (Cash Reserve Ratio) will have systemic impact on the overall banking industry in so far as the confidence level of the depositors and other stakeholders is considered.

So, appreciating the aftermath effect of any liquidity crisis it has become also imperative not only to measure the liquidity position of banks on an ongoing basis but also to appraise how funding requirements are likely to come to the fore under a stressed situation.

There are two-pronged objectives of ALM as under - Ensuring Profitability and Ensuring Liquidity. So, striking the balance between the two diametrically opposite and at the same time complementary components is the critically important factor to reckon with.

In extreme cases, liquidity risk turns out to be the solvency risk. Generally, liquidity per se indicates the ability to accommodate decreases in liabilities and to funding increases mainly in risk assets (lending activities).

A bank possesses adequate liquidity base when it can source sufficient funds either by increasing liabilities or by converting assets promptly at reasonable cost.

If liquidity needs are not met through available liquid assets in that case the banks under compulsion are required to source deposits, i.e., liability even at an exorbitantly high interest rate having adverse impact on its cost of fund eroding the profitability.

In common parlance, bank's liquidity management is the articulated process of generating fund to meet contractual obligations at reasonable price at all times. The pressure on liquidity is created out of emerging loan demand, approved commitment and to meet the spree of deposit withdrawals.

Prudent liquidity management serves the following important purposes:

1. a) It epitomises that the bank is safe and capable to repay its borrowings within the due date of maturity.
2. b) It enables the bank to meet its prior loan commitments.
3. c) It lowers the size of the default risk premium that banks must pay for sourcing fund, i.e., the banks can arrange fund comparatively at the lower interest rate.
4. d) Banks with strong balance sheet will be perceived by the money market players in the industry as being liquid and safer one.

Banks with healthy balance sheet are well poised to mobilise fund at the comparatively lower risk premium calculated by the counter-party(ies) on the basis of perceived credit worthiness.

Assessment of adequacy of liquidity support mainly depends on the following factors:

1. a) Trend of fund requirements as experienced in the past.
2. b) Current liquidity base.
3. c) Forecasting of emerging fund requirements.
4. d) Sourcing of funds focusing on alternatives.
5. e) Option for reducing fund requirement by adopting conservative approach in lending.
6. f) Present and anticipated movement of asset quality.
7. g) Present and future earning capacity.

As all banks are affected by changes in the economic climate, the monitoring of economic and money market scenario is critically important factor for liquidity management.

Some of the factors as identified below generally affect the liquidity base of the banks:

1. a) Decline in earnings and increase in non-performing loan (NPL).
2. b) Concentration of corporate deposit.
3. c) Narrow base of retail and individual deposit(s).
4. d) Downgrading by rating agencies.
5. e) Unusual expansion of lending in breach of regulatory limit.

In case of emergency requirement, a bank has to generate fund by adopting following measures:

1. a) Dispose off liquid assets.
2. b) Increase of short-term borrowings.
3. c) Minimise the holdings of less liquid assets.
4. d) Increase of liabilities of long-term tenure.
5. e) Increase of capital base.

Sometimes crisis evolves as a result of a problem in a bank, such as severe deterioration of asset quality, unearthing of fraudulent acts, etc.  As a corollary effect this kind of crisis rattles the public confidence on banks/financial institutions at large.

Proper analysis of liquidity scenario entails the management not only to measure and forecast the liquidity status as a continuous process but also to conjure up how and on what scale funding requirements will come to the surface under a crisis-ridden situation.

Any financial transaction or commitment on the part of financial institutions has got an inherent liquidity risk. Sound liquidity risk management calls for setting a strategic road map by ensuring effective oversight of the Board and the senior Management. The strategy of this kind requires to be well communicated to all the operating units of banks/financial institutions and specially, of those units the operation of which has got direct impact on the liquidity base. Such units should operate under the approved Standardised Operating Procedure (SOP).

The writer is Managing Director & CEO, Bangladesh Finance and Investment Co. Limited and Member of the Executive Committee, BLFCA.

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