What Is Asset/Liability Management?

Although it has evolved over time to reflect changing circumstances in

the economy and markets, in its simplest form, asset/liability
management entails managing assets and cash inflows to satisfy various
obligations. It is a form of risk management, whereby one endeavors to
mitigate or hedge the risk of failing to meet these obligations. Success in
the process may increase profitability to the organization, in addition to
managing risk.

Some practitioners prefer the phrase "surplus optimization" as better to
explain the need to maximize assets available to meet increasingly
complex liabilities. Alternatively, surplus is known as net worth, or the
difference between the market value of assets and the present value of
the liabilities and their relationship. The discipline is conducted from a
long-term perspective that manages risks arising from the interaction of
assets and liabilities; as such, it is more strategic than tactical.

A monthly mortgage is a common example of a liability that a consumer
has to fund out of his or her current cash inflow. Each month, the
individual faces the task of having sufficient assets to pay that mortgage.
Financial institutions have similar challenges, but on a much more
complex scale. For example, a pension plan must satisfy contractually
established benefit payments to retirees, while at the same time sustain
an asset base through prudent asset allocation and risk monitoring, from
which to generate these ongoing payments.

As you can assume, the liabilities of financial institutions can be quite
complex and varied. The challenge is to understand their characteristics
and structure assets in such a way as to be able to satisfy them. This
may result in an asset allocation that would appear suboptimal (if only
assets were being considered). Asset and liabilities need to be thought of
as intricately intertwined, rather than separate concepts. Here are some
examples of the asset/liability challenges of various financial institutions
and individuals.

A Banking Example
As financial intermediaries between the customer and the endeavor that
it is looking to fund, banks take in deposits on which they are obligated to
pay interest (liabilities) and make loans on which they receive interest
(assets). Besides loans, securities portfolios comprise the assets of
banks. Banks need to manage interest rate risk, which can lead to a
mismatch of assets and liabilities. Volatile interest rates and the abolition
of Regulation Q, which capped the rate banks could pay depositors, both
had a hand in this problem.

A banks net interest margin the difference between the rate that it
pays on deposits and the rate that it receives on its assets (loans and
securities) is a function of interest rate sensitivity and the volume and
mix of assets and liabilities. To the extent that a bank borrows short term
and lends long term, it has a mismatch that it needs to address through
restructuring of assets and liabilities or
using derivatives (swaps, swaptions, options and futures) to satisfy the
latter.

Insurance Examples
There are of two types of insurance companies: life and non-life (property
and casualty). Life insurers often have to meet a known liability with
unknown timing in the form of a lump sum payout. Life insurers also offer
annuities (reverse life insurance), that may be life or non-life contingent,
guaranteed rate accounts (GICs) and stable value funds
The Benefit Plan Example
The traditional defined benefit plan has to satisfy a promise to pay the
benefit formula specified in the plan document of the plan sponsor.
Accordingly, investment is long term in nature, with a view toward
maintaining or growing the asset base and providing retirement
payments. In the practice known as liability-driven investment (LDI),
gauging the liability entails estimating the duration of benefit payments
and their present value.

Funding a benefit plan involves matching variable rate assets with
variable rate liabilities (future retirement payments based upon salary
growth projections of active workers) and fixed-rate assets with fixed-
rate liabilities (income payments to retirees). As portfolios and liabilities
are sensitive to interest rates, strategies such as
portfolio immunization and duration matching may be employed to
protect them from rate fluctuations.

Foundations and Non-Profits
Institutions that make grants and are funded by gifts and investments
are foundations.Endowments are long-term funds owned by non-profit
organizations such as universities and hospitals; both tend to be
perpetual in design. Their liability is an annual spending commitment as a
percentage of the market value of assets, but may not be contractual,
making them different from a defined benefit pension plan. The long-term
nature of these arrangements often leads to a more aggressive
investment allocation meant to outpace inflation, grow the portfolio and
support and sustain a specific spending policy.

Wealth Management
With private wealth, the nature of individuals liabilities may be as varied
as the individuals themselves. These run the gamut from retirement
planning and education funding to home purchases and unique
circumstances. Taxes and risk preferences will frame the asset allocation
and risk management process that determines the appropriate asset
allocation to meet these liabilities. Techniques of asset/liability
management can approximate those used on an institutional level that
considers multi-period horizons.

Non-Financial Corporations
Finally, non-financial corporations use asset/liability management
techniques, of a sort, to hedge liquidity, foreign exchange, interest rate
and commodity risk. An example of the latter would be an airline hedging
its exposure to fluctuations in fuel prices.

The Bottom Line
Asset/liability management has become a complex endeavor. An
understanding of internal and external factors that bear upon this aspect
of risk management is critical to an appropriate solution. Prudent asset
allocation accounts not only for the growth of assets, but also specifically
addresses the nature of an organizations liabilities.

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