Asset-Liability Management

3 March 2017

Asset-Liability Management “Asset-Liability Management (ALM) can be defined as the ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve an organization’s financial objectives, given the organization’s risk tolerances and other constraints”[1]. ALM also is known as balance sheet management. In banking activity the gap between assets and liabilities can bring some consequences where the following risks are arose. And as a whole it influences badly on the bank’s functioning.

Solving that problem is the primary goal of ALM. The good balance sheet management means that the return on loans and securities as the highest as possible, risks are minimized and liquid assets are in adequate amount (See Appendix 1 and 2). For these reasons bank staff when managing assets and debts should follow four main strategies which include liquidity, asset, liability and capital adequacy management[2] (See Appendix 3). Traditionally, ALM has focused primarily on the interest rates risk[3] which is arose when the maturity of assets and debts and their volume are not the same.

For example, commercial bank is viewed as ‘short-funded’ when the maturity of its assets is longer than the liability maturity. On the contrary, bank can be called ‘long-funded’ when the maturity of debt is bigger. Both situations are risky and maybe not much profitable because in both cases bank has to refinance or reinvest funds at a rate that can be unfavorable. However, today in addition to interest rate risk, the control of a much broader range of risks such as equity, liquidity, currency, credit, operational risks etc. is engaged by balance sheet management.

Also there are some methods commercial banks use to manage the risks: by matching the assets and liabilities according to the maturity pattern or the matching the duration, by hedging and by securitization. Asset securitization ‘Asset securitization is a process of packaging illiquid individual loans and other debt instruments into liquid securities with credit enhancement to further their sale in the capital market’[4]. There are different types of asset which can be securitized: mortgages, auto loans, credit card receivables, high-yield bonds and loans and equipment lease and so on.

Even future royalties from record sales can be a type of securitized asset. However, the mainstream examples of ABS are mortgage-backed securities (MBS) and secured credit card receivables. The process of asset securitization The process of securitization you can find in Appendix 4. First of all, the borrower comes to a bank and asks for a loan. Then, the bank or the originator provides that loan. After that, homogeneous assets are put together in different tranches and passed to an organization which is created by the bank and calls a special purpose vehicle (SPV).

It issues securities backed by these assets (ABS) and spreads them among a wild range of institutional investors such as banks, insurance companies and pension funds. The key aim of creation of SPV is to demarcate originator’s risks of bankruptcy from the securities which are issued by the SPV. That’s why this vehicle also calls a bankruptcy-remote entity[5]. So, investors in ABS issued by SPV do not have to worry about bank’s solvency position and its credit rating because the securities are not affected by the parent company rating.

As a consequence, rating agency evaluates ABS by analyzing a securitization program but not look at a bank’s rating. Asset-backed securities have several levels of credit enhancement. It is necessary for reducing losses which can be arose from the underlying assets credit risks. Usually credit enhancement depends on the issuer rating. So, SPV can archive a high credit rating through overcollateralization, excess spread, letter of credit or an insurance. Another member of the process involved in the ABS creation is an underwriter. It is an intermediary between SPV and investors.

The main functions of the underwriter are securities evaluation and holding their prices in an appropriate level. Also it is involved in structuring the transaction. At the same time the underwriter provides consultations in marketing and law. Benefits and drawbacks of asset securitization Before asset securitization was created, banks lent money to households and companies and these loans existed in the banks’ balance sheets until they mature or are paid off. This creates a mismatching of assets and liabilities because typically banks use deposits and issuance of debts as a provision of loans.

And both of them have shorter period of maturity then banks’ lending especially cars and mortgages loans. Since the bank started to use securities backed by assets or in other words it started to transfer the ownership of the assets to SPVs, the great opportunities have began widely available for the bank. And the main of that fee income and additional trading opportunities are providing. Securitization is the process of transforming illiquid assts into marketable securities. This helps banks to maintain or even increase their liquidity because long-term loans are replaced to SPVs.

As a consequence, the gap between balance sheet sides also is diminished. And as a result the position of the bank becomes more stable and it frees up capital to provide new loans. In other words, the opportunity for bank to lend additional funds to the consumers appears. Moreover, securitization provides quick access to funds that would be unavailable for several years because of the long period of maturity. And banks can raise additional capital without incurring balance sheet liabilities. These facts are also the important evidence of liquidity growth.

In addition of securitization attraction is that it helps banks to diversify their assets by allowing the replacement of lower-yielding assets with higher-yielding assets. Also, the process of managing credit and interest rate risk becomes easier. The exposure of risks is reduced because illiquid assets are replaced from originator’s balance sheet (See Appendix 5). After securitization the balance sheet becomes more liquid than it was when the bank holding long-term mortgages. This fact makes ROE (return-on-equity) better.

Mr. Jose Manuel Gonzalez-Paramo in his speech at a Global ABS Conference 2008 argued that one of the main reasons why banks have adopted securitization model is that ‘banks have often in the past economized on costly capital requirements’[6] such as Basel I which sets a minimal capital requirements and Basel II which provides recommendations on laws and regulations of banks. Also Mr. Gonzalez-Paramo said that ‘the securitization of loans could reduce a secular source of vulnerability of the economies’.

Bank removes its illiquid assets from balance sheet and spreads it more broadly in the sector. He argues that it can decrease the probability of the credit crises. In addition, geographical and regional discrepancies in the availability and cost of credit can be diminished in liquid and efficient secondary securitization markets by linking local credit extension activities to national capital markets systems. Securitization can help to achieve some social and economic benefits. It can be a stimulator of the growth of affordable housing.

Also it helps to increase the availability and lowering the cost of consumer credit; promote efficient market structures and institutions; facilitate the efficient use and rational allocation of capital; and facilitate the achievement of governmental fiscal, economic and regulatory policy goals[7]. However, asset securitization has some drawbacks. First of all, investors and rating agencies require the information disclosure of assets data. Also, servicing reports the assets condition on the regular basis. Nevertheless, it can be the disadvantages only for originator or issuer of securities.

For investors it is good when the assets, where the money is put in, are regularly monitored. From the bank or issuer point of view, there are other disadvantages. First, it is that the up-front expenses required for the first time securitization are bigger than the bank borrowings expenses. Next, there are costs to issuers for securitizing assets such as investment-banking fees, fees to rating agencies, fees associated with the trustee of the asset pool, and credit enhancement costs. Securitization may sometimes be harmful because it cheats the law and demands banks’ minimum capital requirements.

How to cite Asset-Liability Management essay

Choose cite format:
Asset-Liability Management. (2017, Mar 28). Retrieved February 21, 2020, from
A limited
time offer!
Save Time On Research and Writing. Hire a Professional to Get Your 100% Plagiarism Free Paper