CHAPTER 7

ASSET-LIABILITY
MANAGEMENT

ASSET-LIABILITY
MANAGEMENT (ALM)

One of the most useful analytical tools

developed in modern banking and financialservices 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
banks goal.

ALM STRATEGIES
1.
2.
3.

Asset management strategy

Liability management strategy
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.
Managements 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
institutions net worth (the value of the
owners 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 banks

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 variablerate 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), longterm savings & retirement accounts,

equity capital.

11

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 interestsensitive assets of RM500 million and interestsensitive liabilities of RM400 million. So it has a
positive gap of RM100 million.
If interest rate rises, the banks 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 banks 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.
14

Liability-sensitive (negative)
gap

Example: A commercial bank has interestsensitive assets of RM150 million and interestsensitive liabilities of RM200 with a negative gap
of RM50 million.
If interest rate rises, the banks 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 banks NIM

and earnings will increase because
borrowing costs will decline by more
than interest revenues.

16

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.
ii.

Changes in the level of interest rate.

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)Dollargap

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)RelativeISGap=

Gap(RM)
banksize=totalassets

If relative IS Gap is greater than zero,

bank is asset sensitive.
3)Interestsensitivityratio(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
bank has:

A liability sensitive
bank has:

Positive Dollar IS GAP

Negative Dollar IS GAP

Positive Relative IS
GAP

Negative relative IS
GAP

Interest Sensitivity
ratio greater than 1

Interest Sensitivity
ratio less than 1

INTEREST SENSITIVE GAP

MANAGEMENT
Gap

Change in
interest
rate

Change in net
interest
income

Positive ISA > ISL

Increase

Increase

Decrease

Decrease

Negative ISA < ISL Increase

Zero ISA = ISL

Decrease

Decrease

Increase

Increase

No change

Decrease

No change

INTEREST SENSITIVE GAP

MANAGEMENT
With positive
gap
Asset sensitive
ISA > ISL

The risk

Possible
management
responses

Losses if interest
rate fall because
bank net interest
margin will be
reduced

Do

nothing (maybe
interest rate will
rise or stable)
Extend asset
maturities or
shorten liability
maturities
Increase ISL or
decrease ISA

With negative
gap

The risk

Possible
management
responses

Liability
sensitive
ISA < ISL

Losses if interest
rate rise
because the
banks net
interest margin
will be reduced

Do

nothing
(maybe interest
rate will fall or
stable)
Shorten asset
maturities or
lengthen liability
maturities
Decrease ISL or
increase ISA

How to Measure Interest Rate

Risk Exposure
1.
2.
3.

Cumulative gap
Aggressive gap management
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 interestsensitive liabilities to climb above interestsensitive 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 banks gap?
There is NO general optimal value for a
banks 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 banks
overall risk and return profile and
objectives.
The farther the banks gap from zero, the
greater the banks 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.
2.

3.

4.

5.

How to Calculate Duration.

How to Calculate Change in Net Worth if
Interest Rate Rises.
How to Calculate Dollar-Weighted Asset
Portfolio Duration.
How to Calculate Dollar-Weighted
Liability Portfolio Duration.
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 loans
current yield to maturity is 10%. What is
this loans duration?

How to Calculate
Duration
n

t*CFt

t
t 1 (1YTM)
D n
CFt

t
t 1 (1YTM)
39

t
5
RM
100

t
/(
1

.
10
)

RM
1
,
000

5
/(
1

0
.
10
)

D t 1

RM 1,000

RM4,169.87

RM1,000
4.17years

40

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
NW - D A *
*A
(1i)

i
- - D L *
*L
(1i)

42

0.02
NW -3*
*120
(1 0.10)

0.02
- - 2*
*100
(10.10)

RM 2.91million

43

How to Calculate Ringgit-Weighted

Asset Portfolio Duration
Example:
Assets Held
Asset durations
Treasury bonds
Commercial loans
Consumer loans
Real estate loans
Municipal bonds

Market Value (RM)

90 million
100 million
50 million
40 million
20 million

7.49 years
0.60 years
1.20 years
2.25 years
1.50 years

How to Calculate RinggitWeighted Asset Portfolio

Duration
n

D A w i *D Ai
i1

Where:
wi=thedollaramountoftheithassetdividedbytotalassets
DAi=thedurationoftheithassetintheportfolio
45

Durationof eachassetMarketvalueof eachasset

D A t 1

Total marketvalueof allassets

(7.4990)(0.60100)(1.2050)(2.2540)(1.520)
901005040 20

914.10

300
3.05years

46

How to Calculate Ringgit-Weighted

Liability Portfolio Duration
Example:
Liabilities Held Market Value (RM)
Deposit
78 million
Other non-deposit
60 million
borrowings

Durations
2.5 years
3.0 years

How to Calculate RinggitWeighted Liability

Portfolio Duration
n

D L w i *D Li
i 1

Where:
wi=thedollaramountoftheithliabilitydividedbytotalliabilities
DLi=thedurationoftheithliabilityintheportfolio
48

(2.578)(3.060)
D L
7860
375

138

2.72years

49

How to Calculate LeverageAdjusted Duration Gap

Formula:
Dollar-Weighted Asset Duration minus
Dollar-Weighted Liability Duration x Total
liabilities
Total
assets

How to Calculate LeverageAdjusted Duration Gap

TL
DD A -D L *
TA

51

Cont
138

D 3.05- 2.72

300

1.80years

52

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
53