ASSETS LIABILITIES MANAGEMENT

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DEFINITION

Asset/liability management is the art and science of choosing the best mix of assets for the firms asset portfolio and the best mix of liabilities for the firms liability portfolio and firm object. INTRODUCTION

In the 1940s and the 1950s, there was an abundance of funds in banks in the form of demand and savings deposits because of the low cost of deposits, banks had to develop mechanisms by which they could make efficient use of these funds.

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Hence, the focus then was mainly on asset management but as the availability of low cost funds started to decline, liability management became the focus of bank management efforts Liability management essentially refers to the practice of buying money through cumulative deposits, federal funds and commercial paper in order to fund profitable loan opportunities but with an increase in volatility in interest rates and with a severe recession damaging several economies, banks started to concentrate more on the management of both sides of the balance sheet.

Business Characteristics of Asset4/14/12 Liability management

Keeping the credit union profitable Anticipating liquidity needs Addressing net worth requirements/objectives Minding the gap, simply defined as the difference between rate sensitive assets and rate sensitive liabilities for any given time period such as ,for the next month, for the next quarter, for 3-6 months, 6-12 months, greater than one year, greater than three years, greater than 5 years.(More on this below, including the

PROCESS

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FUNDAMENTAL STEPS OF AN ALM 4/14/12 PROCESS

The process consists of five fundamental steps :

ASSESS THE ENTITYS RISK/REWARD OBJECTIVES IDENTIFY RISKS QUANTIFY THE LEVEL OF RISK EXPOSURE FORMULATE AND IMPLEMENT STRATEGIES TO MODIFY EXISTING RISKS MONITOR RISK EXPOSURES AND REVISE ALM STRATEGIES AS APPROPRIATE

1.

2.

3.

4.

5.

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Asset/Liability-Strategies

Liquidity. Term structure. Interest-rate sensitivity. Maturity composition Default risk

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LIQUIDITY

Liquidity is loosely defined as the ease with which assets can be converted to cash. It is mainly important for deposit taking institutions. The first dimension of liquidity is maturity liquidity. The second dimension of liquidity is marketability.

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TERM STRUCTURE

The relationship between debt instrument yields and those instruments maturities play a important role in asset/liability managers expectations about the future of firm. The relationship can be explained by yield curve.

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INTEREST-RATE SENSITIVITY

It indicates the degree to which the instruments price change when instrument yields. Interest rate sensitivity focuses on floating rate of assets and liabilities. As markets rate rise, the return on interest sensitive assets and the cost of interest sensitive liabilities will also rise.

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MATURITY COMPOSITION

The maturity and interest rate sensitivity of an asset are matched, then the the institution has a spread lock on that portion of principles matched. DEFAULT RISK

It is a kind of risk when the debtor is unable to pay the loan principle or interest.

APPLICABILITY OF ALM

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Insurance companies, banks and thrifts, investment firms, and other financial services companies and trust funds

Pension

(Ex : endowments and foundations)

Governments Other

commercial or not-for-profit enterprises investors

Individual

ALM FOCUSES ON ECONOMIC VALUE

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Economic value represents the long-term inherent value of the portfolio. Economic value is based on future asset and liability cash flows. ALM uses these future cash flows to determine the risk exposure and achieve the financial objectives of an entity.

ALM IN BANKS : 4/14/12 Components of a Bank Balance sheet

Liabilities 1. 2. 3. 4. 5. Capital Reserve & Surplus Deposits Borrowings Other Liabilities Assets 1. 2. 3. 4. 5. 6. Cash & Balances with RBI Bal. With Banks & Money at Call and Short Notices Investments Advances Fixed Assets Other Assets

Purpose & Objective of ALM IN BANKS 4/14/12

An effective Asset Liability Management Technique aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of assets and liabilities as a whole so as to attain a predetermined acceptable risk/reward ration. It is aimed to stabilize short-term profits, long-term earnings and long-term substance of the bank.