Fund Management For Financial Institutions

Chapter – 2: An Overview of Asset and Liability Management (ALM)

Asset and liability management: Asset and liability management is coordinated and integrated
bank decisions regarding asset and liability portfolios, considering how the bank’s total portfolio
contributes to its broad goals of adequate profitability and acceptable risk. Charumathi (2008)
Asset and liability management is a dynamic process of planning, organizing, coordinating, and
controlling the assets and liabilities; their mixes, volume, maturities, yield, and costs in order to
achieve a specified net interest income (NII). In other words, it deals with the optimal investment
of assets in view of meeting current goals and future liabilities. Asset liability management
techniques provide the bank with the defensive weapons to handle business cycles and seasonal
pressures on its deposits & loans and with the offensive weapons to construct portfolios of assets
that promote the bank’s goal.
Purpose of asset-liability management: To formulate strategies and take actions that shape a
bank’s balance sheet and protect the value of its assets, equity and net income in a way that
contributes to the bank’s desired goals. The principle goals of asset-liability management are:
 To maximize or at least stabilize the bank’s margin or spread between interest revenues
and interest expenses and
 To maximize or at least protect, the value (stock price) of the bank, at an acceptable level
of risk.

Asset-liability management strategies:

 Asset management strategy: Control the portfolio or composition of a bank’s assets to
provide adequate liquidity and earnings as well as meet other goals.
 Liability management strategy: Due to increasing interest rate and intense competition
for funds, bankers began to devote greater attention to new sources of funding and
monitoring the mix and cost of their deposit and non-deposit liabilities which is called
liability management. Its goal is to control over the bank’s funds sources comparable to
the control over bank’s assets. The key control lever was price, the interest rate and
other terms banks could offer on their deposits and borrowings to achieve the volume,
mix and cost desired.

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 1

Fund Management For Financial Institutions

 Fund management strategy: The coordinated management of both a bank’s assets and
its liabilities to ensure an adequate level of liquidity and meet other goals. Fund
management strategy is a much more balanced approach to asset-liability management
that stresses several key objectives:
 Bank management should exercise as much control as possible over the volume,
mix, and return or cost of both assets and liabilities to achieve the bank’s goals.
 Management’s control over assets must be coordinated with its control over
liabilities so that asset and liability management are internally consistent and do
not pull against each other effective coordination in managing assets and
liabilities will help to maximize the spread between bank revenue and costs and
control the risk exposure.
 Revenues and costs arise from both sides of the bank’s balance sheet .bank
policies need to be developed that maximize return and minimize costs from
supplying services.

Interest rate risk: Interest rate risk refers to the danger that shifting interest rates could
adversely affect the bank’s net interest margin, assets or equity. When interest rates change in the
financial marketplace, bankers find that the change affects their most important source of
revenue interest income on loans & securities and their most important source of expenses
interest cost on deposits and other bank borrowings. Moreover changing the interest rate also
change the market value of a bank’s assets and liabilities, thereby changing the bank’s net worth
that is the value of the owner’s investment in the bank. As market interest rates move bankers
face at least two major kinds of risks such as price risk and reinvestment risk.
Price risk arises when markets interest rates rise causing the market values of most bond
& fixed rate loans as well as other financial instruments that a bank may hold fall. If the
bank wants to sell these financial instruments in a rising rate period, it must be prepared
to accept capital losses.
Reinvestment risk rears its head when market interest rates fall, forcing a bank to invest
incoming funds in lower yielding earning assets, lowering its expected future income.

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 2

Fund Management For Financial Institutions

Components of interest rate

Nominal rate = real rate + premium against different kinds of risks

Market interest rate on a risky loan or security = Risk-free interest rate (such as the inflation-
adjusted return on government bonds) + Risk premium to compensate lenders who accept risky
IOUs (An IOU stands for I owe you is usually an informal document acknowledging debt.) for
their default (credit) risk, inflation risk, term or maturity risk, marketability risk, call risk and so
on.
Measurement of interest rate
 Yield to maturity: The rate of discount that equalizes the current market value of a loan or
security with the expected stream of future income payments that the loan or security will
generate.
= Int + M - P0/n
.4 (P0) + .6(M)
 Discount rate: The rate of return on a financial instrument calculated using the
instrument’s face value and assuming 360 day year.
DR = ( 100- purchase price on loan or security)/ 100 * 360/ Number of days to maturity
Goals of interest rate Hedging: In case of interest rate risk, one important goal is to insulate the
bank’s profit i.e. net income after taxes and all other expenses from damaging effects of
fluctuating interest rates. To accomplish this particular goal, management must concentrate on
those elements of the bank’s portfolio of assets and liabilities that are most sensitive to interest
rate movements. This includes bank’s loan and investment on the asset side as well as interest
bearing deposits and money market borrowing on the liability side. In order to protect bank
profits against adverse interest rate changes, then management seeks to hold fixed the bank’s net
interest margin (NIM). NIM is the ratio of a bank’s total interest revenue less its interest
expenses divided by bank size.
NIM =
(Interest income from bank loans & investment – interest expenses on deposits and
other borrowed funds
Total earning assets

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 3

Fund Management For Financial Institutions

Net Interest income after expenses

Total earning assets
If the interest cost of borrowed funds rises faster than bank income from loans and securities, the
banks NIM will be squeezed, with adverse effects on bank profits. If interest rates fall and cause
income from loans and securities to decline faster than interest costs on borrowings, the bank’s
NIM will be again squeezed.

Interest sensitive assets: Interest sensitive assets are financial products whose features and
characteristics or their secondary market price are vulnerable to changes in interest rates. Bank
interest sensitive assets are:
• Short-Term Securities Issued by the Government and Private Borrowers
• Short-Term Loans Made by the Bank to Borrowing Customers
• Variable-Rate Loans Made by the Bank to Borrowing Customers

Interest-Sensitive Liabilities: Interest rate sensitive liabilities are bank liabilities, mainly
interest-bearing deposits and other liabilities, and the value of these liabilities is sensitive to
changes in interest rates; these liabilities are either repriced or revalued as interest rates change .
• Borrowings from Money Markets
• Short-Term Savings Accounts
• Money-Market Deposits
• Variable-Rate Deposits

Interest sensitive gap management:

One of the most popular interest rate hedging strategy today’s banking industry follows is the
interest sensitive gap management. Under this technique bank management requires to perform
an analysis of the maturities and repricing opportunities associated with the bank’s interest
bearing assets, deposits and money market borrowing. If bank management feels excessively
exposed to interest rate risk, it will try to match as closely as possible the volume of bank assets
that can be repriced as interest rates change with the volume of deposits and other liabilities

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 4

Fund Management For Financial Institutions

whose rates can also be adjusted with market conditions during the same time period. Thus a
bank can hedge itself against interest rate changes no matter which way rates move.
Amount of repriceable (interest sensitive) bank assets = Amount of repriceable (interest
sensitive) bank liabilities

Interest-Sensitive Gap Measurement techniques:

Interest sensitive gap: A gap exists between interest sensitive assets and interest sensitive
liabilities, if the amount of repricing assets does not equal to the amount of repricing liabilities.

Interest sensitive gap = interest sensitive assets - interest sensitive liabilities

If interest sensitive assets in each planning period exceed the volume of interest sensitive
liabilities subject to repricing the bank is said to have a positive gap and to be assets sensitive.

Assets sensitive (positive) gap = interest sensitive assets - interest sensitive liabilities > 0

In reverse situation, suppose - interest sensitive liabilities are larger than interest sensitive assets.
The bank then has a negative gap and is said to be liability sensitive. Thus
Liability sensitive (negative) gap = interest sensitive assets - interest sensitive liabilities < 0

Relative interest sensitive GAP: Simply it is the ratio between IS GAP and Bank size
(measured by total assets). A relative IS GAP greater than zero means the bank is asset sensitive,
while a negative relative IS GAP describes a liability-sensitive bank.
IS GAP (interest sensitive assets - interest sensitive liabilities)
= Bank size (Total assets)

Interest sensitive ratio: It is the ratio between interest sensitive assets and interest sensitive
liabilities. If an ISR less than 1 it tells us we are looking at a liability sensitive bank, while an
ISR greater than unity points to an asset sensitive bank.

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 5

Fund Management For Financial Institutions

Interest sensitive asset

= Interest sensitive liability

Decisions bank management must take to insult interest rate risk regarding IS gap
measurement techniques:
 Management must choose the time period during which the bank’s net interest margin
(NIM) is to be managed to achieve some desired value and the length of sub-periods into
which the planning period is to be divided.
 Management must choose a target level for the net interest margin that is whether to
freeze the margin roughly where it is or perhaps increase the NIM
 If the management wishes to increase the NIM, it must either develop a correct interest
rate forecast or find ways to reallocate earning assets and liabilities to increase the spread
between interest revenue and interest expenses
 Management must determine the dollar volume of interest sensitive assets and interest
sensitive liabilities it wants the bank to hold.

Factors influence net interest margin:

• Changes in Interest Rates Up or Down
• Changes in the Spread Between Assets and Liabilities
• Changes in the Volume of Interest-Sensitive Assets and Liabilities
• Changes in the Mix of Assets and Liabilities

Net interest income

= Total interest income – Total interest cost
= interest yield on rate sensitive assets × Volume of rate sensitive assets + Interest yield on
fixed ( non-rate sensitive) assets × Volume of fixed assets – Interest cost on rate sensitive
liabilities × Volume of rate sensitive liabilities – Interest cost on fixed ( non-rate sensitive)
liabilities × Volume of fixed (non-rate sensitive) liabilities

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 6

Fund Management For Financial Institutions

2001= A200- L150 =50 =

2002= A170-L195= -25 = 25
2003 = A250-L180 =70 = 95
2001 10%
2003 14%

Cumulative gap: Cumulative gap is a useful overall measure of bank’s interest rate risk
exposure which is the total difference in dollars between those bank assets and liabilities that can
be repriced over designated period of time. The cumulative gap is useful because given any
specific change in market interest rates; we calculate approximately how the bank’s net interest
income will be affected by the interest rate change.
Changes in the bank’s net interest income
= Overall change in interest rate × Size of the cumulative gap
In general banks with a negative cumulative gap will benefit from falling interest rates but lose
net interest income when interest rates rise. Banks with positive cumulative gap will benefit if
interest rates rise, but lose net interest income if interest rate decline.

Problems with Interest-Sensitive Gap Management

• Interest Paid on Liabilities Tend to Move Faster than Interest Rates Earned on Assets
• Interest Rate Attached to Bank Assets and Liabilities Do Not Move at the Same Speed as
Market Interest Rates
• Point at Which Some Assets and Liabilities are Repriced is Not Easy to Identify
• Interest-Sensitive Gap Does Not Consider the Impact of Changing Interest Rates on
Equity Position

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 7

Fund Management For Financial Institutions

Mathematical issues:

Problem-4: The First state bank of Ashfork reports a net interest margin of 3.25% in its most
recent financial report, with total interest revenues of $88 million and total interest cost of $72
million. What volume of earning assets must the bank hold? Suppose the bank’s interest
revenues rise by 8% and its interest costs and earnings assets increase 10%. What will happen to
bank’s net interest margin?
Given that,
Net interest margin = 3.25%
Total interest revenue = $ 88 million
Total interest costs = $ 72 million

We know,
Net interest margin = (Total interest revenue- Total interest costs)
Total earning assets

3.25% = $ (88 - 72) million / Total earning assets

Total earning assets = $16 million / 3.25%
= $ 492.3077 million

88 + 88 * .08 = 88 (1 + .08)
88 * (1.08)
After increasing revenue by 8% increasing cost and total earning assets by 10%
Total interest revenue = $ 88 million × (1.08) = $ 95.04 million
Total interest costs = $ 72 million × (1.10) = $ 79.2 million
Total earning assets = $ 492.3077 million × (1.10) = $ 541.5385 million

Again,
Net interest margin = (Total interest revenue- Total interest costs)
Total earning assets

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 8

Fund Management For Financial Institutions

= $ (95.04 – 79.2) million / $ 541.5385 million

= 2.93%
3.25%
0.32% decreases
Problem -6:
(-$35) + (-$35) = -$70
Cumulative gap = - $ 70 million
Initial interest rate = 6%
Interest rate fall 25% from initial rate
Changes in interest rate = - 1.5%

We know,
Changes in the bank’s net interest income
= Overall change in interest rate × Size of the cumulative gap
= -1.5% × - $ 70 million
= $1.05 million

Problem: McGraw Bank and Trust has interest-sensitive assets of $225 million and interest
sensitive liabilities of $168 million. What is the bank’s dollar interest-sensitive gap? What is
McGraw’s relative interest sensitive gap? What is the value of its interest sensitivity ratio? Is the
bank asset sensitive or liability sensitive? Under what scenario for market interest rates will the
bank experience a gain in net interest income? A loss in net interest income?

Solution:
Given that,
Interest-sensitive assets of $225 million
Interest sensitive liabilities of $168 million

The bank’s dollar interest-sensitive gap = Interest-sensitive assets - Interest sensitive liabilities
= $225 million- $168 million
= $57 million

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 9

Fund Management For Financial Institutions

Relative interest sensitive gap = IS GAP (interest sensitive assets - interest sensitive liabilities)
Bank size (Total assets)

$57 million
$225 million

= 0.253

Interest sensitivity ratio

Interest sensitive asset
= Interest sensitive liability

$225 million
= $168 million
= 1.34

Md. Ariful Hoque, Assistant Professor, DBA, IIUC 10