CHAPTER 7

ASSET-LIABILITY
MANAGEMENT

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 ASSET-LIABILITY MANAGEMENT
(ALM)
 One of the most useful analytical tools
developed in modern banking and financial-
services management.
 A series of management tools to help reduce
risk exposure (particularly to the probability of
loss from changing market interest rates) in
the banking system.
 Provides banking system with defensive
weapons to handle business cycles and
seasonal pressures and also helps to shape
portfolios of assets and liabilities to promote
bank’s goal.
 ALM STRATEGIES

1. Asset management strategy

2. Liability management strategy
3. Funds management strategy
 Asset Management Strategy
 This strategy views that the amount and
kinds of deposits a bank held and the
volume of other borrowed funds it was able
to attract were largely determined by its
customers.
 Under this view, the public determined the
relative amounts of checkable deposits,
savings accounts, and other sources of
funds available to depository institutions.
 The banker could exercise control only over
the allocation of incoming funds by
deciding who was to receive the quantity of
loans available.
 Liability Management Strategy

 The bankers can control over the price and

interest rate on their deposits and borrowings
to achieve volume, mix, and cost desired.
 Example: A bank faced with heavy loan
demand that exceeded its available funds
could simply raise the offer rate on its
deposits in order to get funds flow in.
 Funds Management Strategy
This strategy stresses several objectives:
1. Management should exercise as much
control as possible over the volume, mix,
and return or cost of both assets and
liabilities in order to achieve their goals.
2. Management’s control over assets must be
coordinated with its control over liabilities
so that asset management and liability
management are internally consistent and
do not pull against each other.
3. Revenues and costs arise from both sides
of balance sheet (from both assets and
liabilities).
 Interest rate risk: One of the
greatest ALM challenges
 When interest rates change in the financial
marketplace, interest income and interest
expenses must also change.
 Moreover, changing market interest rates
also change the market value of assets and
liabilities, thereby changing the financial
institution’s net worth (the value of the
owner’s investment in the firm).
 Thus, changing market interest rates impact
both the balance sheet and the statement of
income and expense of banks and other
financial institutions.
 INTEREST SENSITIVE GAP
MANAGEMENT
 The purpose of ALM is to control a bank’s
sensitivity to changes in interest rate risk
and limit its losses in its net income or
equity.
 Therefore, the most popular interest rate
hedging strategy in use today is called
interest-sensitive gap management.
 Gap management techniques require
management to perform an analysis of the
maturities and repricing opportunities
associated with interest-bearing assets and
deposits and other borrowings.
 If management feels its institution is excessively
exposed to interest rate risk, it will try to match as
closely as possible the volume of assets that can be
repriced as interest rate change with the volume of
deposits and other liabilities whose rates can also
be adjusted with market conditions during the same
period.

Dollar amount of repriceable = Dollar amount of repriceable

(interest-sensitive assets) (interest-sensitive liabilities)

 The revenue from earning assets will change in the

same direction and same proportion as the interest
cost of liabilities.
 Repriceable asset:
 short-term loans, short-term securities issued
by govt and private borrowers, and variable-
rate loans and securities.
 Repriceable liabilities:
 certificate of deposits, borrowings from the
money market, short-term savings account,
money market deposit.
 Nonrepriceable assets:
 cash in the vault and deposits at the Central
Bank, long-term loans made at a fixed interest
rate, long-term securities carrying fixed rates,
and buildings & equipment.
Cont…
 Nonrepriceable liabilities:
 Demand deposits (pay no rate), long-term
savings & retirement accounts, equity
capital.

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Interest-sensitive gap = interest-sensitive assets
– interest sensitive
liabilities

1. Asset-sensitive (positive) gap =

Interest-sensitive assets – interest-sensitive
liabilities > 0

2. Liability-sensitive (negative) gap =

Interest-sensitive assets – interest-sensitive
liabilities < 0
 Asset-sensitive (positive)Gap

Example: A commercial bank has interest-

sensitive assets of RM500 million and interest-
sensitive liabilities of RM400 million. So it has a
positive gap of RM100 million.
 If interest rate rises, the bank’s net interest
margin (NIM) will increase because the interest
revenue generated by assets will increase more
than the cost of borrowed funds
 Interest rate rises – interest on loan will
generate more income than interest on
deposits
Cont…
 If interest rate falls, the bank’s NIM will decline
as interest revenues from assets drop by more
than interest expenses associated with liabilities.
 The bank with a positive gap will lose net
interest income if interest rates fall.

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 Liability-sensitive (negative) gap

Example: A commercial bank has interest-

sensitive assets of RM150 million and interest-
sensitive liabilities of RM200 with a negative gap
of RM50 million.
 If interest rate rises, the bank’s net interest
margin (NIM) will decrease because the rising cost
associated with interest-sensitive liabilities will
exceed the increase in interest revenue.
 Interest rate increase- increase in deposits –
NIM decrease as bank has to pay more
interest on deposits
Cont…
 In interest rate falls, the bank’s NIM and
earnings will increase because borrowing costs
will decline by more than interest revenues.

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 INTEREST SENSITIVE GAP
MANAGEMENT
 Bank can hedge against interest rate risk
by making:

Interest-sensitive assets = interest sensitive liabilities

Factors affecting Net Interest Margin:

i. Changes in the level of interest rate.

ii. Changes in the slope of the yield curve
or the relationship between assets yields
and liability cost of funds.
iii. Changes in the volume of assets and
liabilities.
iv. Changes in the composition of assets and
liabilities.
 INTEREST SENSITIVE GAP
MANAGEMENT
To measure interest sensitive gap (IS GAP):

1) Dollar gap
GAP (RM) = ISA (RM) - ISL (RM)
 ISA = Interest Sensitive Assets
 ISL = Interest Sensitive Liabilities
 If dollar gap is positive, bank is asset
sensitive, and vice versa.
2) Relative IS Gap = Gap (RM)
bank size = total assets

 If relative IS Gap is greater than zero, bank

is asset sensitive.

3) Interest sensitivity ratio (ISR)

= ISA (RM)
ISL (RM)
 If ISR is greater than 1, bank is asset
sensitive.
 Only if interest-sensitive assets and liabilities are
equal is a bank relatively insulated from interest
rate risk.
 In reality, a zero gap does not eliminate all
interest rate risk because the interest rates
attached to assets and liabilities are not perfectly
correlated.
 Example, loan interest rates tend to lag behind
interest rates on money market borrowings.
 So, interest revenues often tend to grow more
slowly than expenses during economic
expansions, while interest expenses tend to fall
more rapidly than revenues during economic
downturns.
 INTEREST SENSITIVE GAP
MANAGEMENT

An asset sensitive A liability sensitive

bank has: bank has:

Positive Dollar IS GAP Negative Dollar IS GAP

Positive Relative IS GAP Negative relative IS GAP

Interest Sensitivity ratio Interest Sensitivity ratio

greater than 1 less than 1
 INTEREST SENSITIVE GAP
MANAGEMENT
Gap Change in Change in net
interest rate interest income
Positive ISA > ISL Increase Increase

Decrease Decrease

Negative ISA < ISL Increase Decrease

Decrease Increase

Zero ISA = ISL Increase No change

Decrease No change
 INTEREST SENSITIVE GAP
MANAGEMENT

With positive gap The risk Possible

management
responses
Asset sensitive Losses if interest Do nothing (maybe
rate fall because interest rate will rise
ISA > ISL bank net interest or stable)
margin will be Extend asset
reduced maturities or shorten
liability maturities
Increase ISL or
decrease ISA
With negative The risk Possible
gap management
responses
Liability sensitive Losses if interest Do nothing
ISA < ISL rate rise because (maybe interest
the bank’s net rate will fall or
interest margin stable)
will be reduced Shorten asset
maturities or
lengthen liability
maturities
Decrease ISL or
increase ISA
 How to Measure Interest Rate
Risk Exposure

1. Cumulative gap
2. Aggressive gap management
3. Weighted interest-sensitive gap
 Cumulative gap
 The total difference in dollars between those
assets and liabilities that can be repriced
over a designated period of time.
 Example: The bank has RM100 million in
earning assets and RM200 million in
liabilities subject to an interest rate change
each month over the next 6 months.
 The cumulative gap:
(RM100 million per month x 6) – (RM200
million per month x 6) = - RM600 million.
 The cumulative gap is useful because,
given any specific change in market
interest rates, we can calculate
approximately how net interest income will
be affected by an interest rate change.

Change in net interest income = Overall change

in interest rate (in percentage points) x size of
the cumulative gap (in dollars).
Example: Suppose market interest rate rises by
1 percentage point. The loss of net interest
income will be:
0.01 x –RM600 million = -RM6 million
 Aggressive Gap Management
 Some banks shade their interest-sensitive gaps
toward either asset sensitivity or liability
sensitivity, depending on their degree of
confidence in their own interest rate forecast.
 Example: If management believes interest rates
are going to fall over the current situation, it will
probably allow interest-sensitive liabilities to
climb above interest-sensitive assets.
 If interest rates do fall as predicted, liability
costs will drop by more than revenues and the
NIM will increase.
 Weighted Interest-Sensitive Gap

 This approach takes into account the

tendency of interest rates to vary in speed
and magnitude relative to each other and
with the up and down cycle of business
activity.
 The interest rates on assets often change by
different amounts and by different speeds
than interest rates on liabilities.
 Under this approach, all interest-sensitive
assets and liabilities are given weight based
on their speed (sensitivity) relative to some
market interest rate.
 For example, federal funds loans generally carry
interest rates set in the open market, so these
loans have an interest rate sensitivity weight of
1.0.
 On the other way, loans and leases are the most
rate-volatile so its weight is estimated to be 1.5.
 On the liability side, the bank can assume
deposits have a rate-sensitive weight of 0.86
because deposits rate may change more slowly
than market interest rates.
 To determine the interest-sensitive gap, the
dollar amount of each type of assets or liability
would be multiplied by its weight and added to
the rest of the interest-sensitive assets or
liabilities.
 More rate-volatile assets and liabilities will
weigh more heavily in the refigured balance
sheet.
 This weighted interest-sensitive gap should
be more accurate than the unweighted
interest-sensitive gap.
 The interest-sensitive gap may change from
negative to positive or vice versa and may
change significantly the interest rate strategy
pursued by the bank.
 INTEREST SENSITIVE GAP
MANAGEMENT
Optimal value for a bank’s gap?
 There is NO general optimal value for a
bank’s gap in all environment.
 Gap is a measure of interest rate risk.
 The best gap for a bank can be determined
only by evaluating a bank’s overall risk and
return profile and objectives.
 The farther the bank’s gap from zero, the
greater the bank’s risk.
 Bank managers try to adjust the interest rate
exposure in anticipation of changes in interest
rates.
 Speculating on the gap:
* Difficult to vary the gap and win (requires
accurate interest rate forecast on a
consistent basis).
* Usually only look short term.
* Limited flexibility in adjusting the gap,
customers and depositors.
* No adjustment for timing of cash flows or
dynamics of the changing gap position.
Problems with IS gap management:
i. Interest paid on liabilities tend to
move faster than interest rates
earned on assets.
ii. Interest rate attached to bank assets
and liabilities do not move at the
same speed as market interest rates.
iii. Point at which some assets and
liabilities are repriced is not easy to
identify.
iv. Interest sensitive gap does not
consider the impact of changing
interest rates in equity position.
 DURATION GAP MANAGEMENT
 Duration is a value and time-weighted
measure of maturity that considers the
timing of all cash inflows from earning
assets and all cash outflows associated
with liabilities.
 It measures the average maturity of a
promised stream of future cash payments.
 In effect, duration measures the average
time needed to recover the funds
committed to an investment.
 CONCEPT OF DURATION:
1. How to Calculate Duration.
2. How to Calculate Change in Net Worth if
Interest Rate Rises.
3. How to Calculate Dollar-Weighted Asset
Portfolio Duration.
4. How to Calculate Dollar-Weighted Liability
Portfolio Duration.
5. How to Calculate Duration Gap.
 How to Calculate Duration

Example: Suppose a commercial bank

grants a loan to one of its customers for a
term of 5 years. The customer promises
the bank an annual interest payment of
10%. The par value of the loan is
RM1,000, which is also its current market
value (price) because the loan’s current
yield to maturity is 10%. What is this
loan’s duration?
How to Calculate Duration

n
t * CFt
t 1 (1  YTM)
t
D n
CFt
t 1 (1  YTM)
t

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 5

 RM 100  t /(1  .10) t

 RM 1,000  5 /(1  0.10) 5

D t 1
RM 1,000

RM4,169.87

RM1,000

 4.17 years

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 How to Calculate Change
in Net Worth if Interest
Rate Rises
Example: Suppose a commercial bank has
an average duration in its assets of 3
years, an average liability duration of 2
years, total liabilities of RM100 million,
and total assets of RM120 million. Interest
rate was originally 10%, but suddenly they
rise to 12%. Find the change in the value
of net worth.
 How to Calculate Change in
Net Worth if Interest Rate
Rises

 i   i 
NW  - D A * * A  - - D L * * L
 (1  i)   (1  i) 

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  0.02   0.02 
NW  - 3 * *120 - - 2 * *100
 (1  0.10)   (1  0.10) 

  RM 2.91 million

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 How to Calculate Ringgit-Weighted
Asset Portfolio Duration

Example:
Assets Held Market Value (RM) Asset durations
Treasury bonds 90 million 7.49 years
Commercial loans 100 million 0.60 years
Consumer loans 50 million 1.20 years
Real estate loans 40 million 2.25 years
Municipal bonds 20 million 1.50 years
How to Calculate Ringgit-Weighted
Asset Portfolio Duration

n
D A   w i * D Ai
i 1

Where:
wi = the dollar amount of the ith asset divided by total assets
DAi = the duration of the ith asset in the portfolio
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 n

 Duration of each asset  Market val ue of each asset

DA  t 1
Total market val ue of all assets

(7.49  90)  (0.60  100)  (1.20  50)  (2.25  40)  (1.5  20)

90  100  50  40  20

914.10

300

 3.05 years

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 How to Calculate Ringgit-Weighted
Liability Portfolio Duration

Example:
Liabilities Held Market Value (RM) Durations
Deposit 78 million 2.5 years
Other non-deposit 60 million 3.0 years
borrowings
How to Calculate Ringgit-Weighted
Liability Portfolio Duration

n
D L   w i * D Li
i 1

Where:
wi = the dollar amount of the ith liability divided by total liabilities
DLi = the duration of the ith liability in the portfolio
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 (2.5  78)  (3.0  60)
DL 
78  60

375

138

 2.72 years

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How to Calculate Leverage-Adjusted
Duration Gap

Formula:
Dollar-Weighted Asset Duration minus

Dollar-Weighted Liability Duration x Total liabilities

Total assets
How to Calculate Leverage-Adjusted
Duration Gap

TL
D  DA - DL *
TA

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Cont…

 138 
D  3.05 - 2.72  
 300 

 1.80 years

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 Limitations of Duration Gap
Management
 Finding Assets and Liabilities of the Same
Duration Can be Difficult
 Some Assets and Liabilities May Have Patterns of
Cash Flows that are Not Well Defined
 Customer Prepayments May Distort the Expected
Cash Flows in Duration
 Customer Defaults May Distort the Expected
Cash Flows in Duration
 Convexity Can Cause Problems

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