Copyright

Asset Liability Management: Definition & Example

Instructor: LEROY (Bill) RANDS

Bill has taught college undergraduate and MBA classes in finance, economics & management, 40 years of finance experience and has a MBA degree.

Banks and commercial companies all face problems of liquidity. The basic issue is to ensure that the assets are producing enough income at the right times for the companies to pay their creditors.

Asset Liability Management

Remember the 2008 depression? That was caused by banks having a liquidity crises. So, what is a liquidity crisis and how does it occur?

Banks raise money by borrowing it from other people. They use that money to make loans to its customers. Say Everytown Bank pays Karen 2% on $10,000 she has put into a savings account. Everytown Bank uses that $10,000 to loan money to Mike at 4% interest. The 2% difference is bank's profit margin. But all of sudden, Mike stops making loan payments. Everytown Bank has a liquidity problem if it doesn't have money coming from other sources to be able to pay interest on Karen's savings account.

Asset liability management is a process of matching the interest paid for raising funds against the payments received from loans to ensure the bank is liquid.

When interest rates increase or economic conditions change, financial institutions can have problems if it is costing them more to raise money or the cash flows from their loans start to decline.

Banking

Banks raise money from several sources that they use to make loans. Some of these sources are:

  • money deposited by customers in checking accounts
  • money customers put in savings accounts
  • CDs purchased.
  • borrowing funds from other financial institutions

The difference between the average rate paid to borrow money and the interest rate that is charged on loans is called the interest rate spread. That is the profit margin for the bank. Asset liability management is the management process to ensure that the timing on the payments from loans is enough to pay the interest on the money borrowed or used.

During the 2008 depression, there were significant defaults on mortgages for many banks. People lost jobs or took on mortgages they couldn't afford. Many banks had write-offs and did not have the cash to pay its creditors.

Say Everytown Bank has an interest rate spread of 2%. However, most of its loan portfolio is 30-year mortgages. Because of changes in the economy, interest rates increased 1.5% on what Everytown Bank had to pay for money. Mike, the president of the bank, is concerned. If the default rate on its mortgages increased only slightly, the bank will not have enough money coming in to meet its interest payments.

Mitigating Banking Risk

Besides careful asset liability management, banks can lessen the liquidity risk by using a number of financial products, such as:

  • doing interest rate swaps
  • buying financial futures
  • using financial options
  • securitizing loan packages

These investment tools allow for passing off liabilities to a third party, locking in interest rates, or lessening the risks of interest rate increases. Securitization is a process of a bank selling some of its mortgages to an investment bank who then converts the loan package into a security to sell to investors.

Because of the pending liquidity issue, Mike talked to his investment bank about taking $100 MM of his 30-year mortgages and putting them into a security package. The investment bank would pay Everytown Bank $95 million for the package and Everytown Bank could use the money to either make other loans or Mike could use it ensure the bank is liquid.

Commercial Asset Liability Management

Companies are usually pretty good at managing assets and liabilities to make sure they have enough cash flow to pay all the liabilities. However, asset liability management is used in one area.

Some large companies offer defined benefit retirements plans to its employees. These plans require the company to put money away to pay the expected retirement benefit to retirees. Companies can invest the money contributed to the plan to earn interest to help offset what they have to contribute to the plan. The amount needed is determined by three factors:

  • how much cash the company is contributing
  • how much interest/income they expect to make from invested the cash
  • how long retired employees will live.

Asset liability problems occur in defined benefit plans often because:

  • the plan has overestimated the interest income the plan would earn; or
  • the retired employees are living longer than the plan estimated they would live.

To unlock this lesson you must be a Study.com Member.
Create your account

Register to view this lesson

Are you a student or a teacher?

Unlock Your Education

See for yourself why 30 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back
What teachers are saying about Study.com
Try it risk-free for 30 days

Earning College Credit

Did you know… We have over 200 college courses that prepare you to earn credit by exam that is accepted by over 1,500 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Transferring credit to the school of your choice

Not sure what college you want to attend yet? Study.com has thousands of articles about every imaginable degree, area of study and career path that can help you find the school that's right for you.

Create an account to start this course today
Try it risk-free for 30 days!
Create an account
Support