Bank Asset-liability Management

Banks` assets comprise mostly of loans, mortgages and investments in money market securities.

Banks` liabilities consist mostly of deposits (both retail and wholesale), as well as borrowings.

The problem banks faces is that the duration of their assets far exceeds that of their liabilities. For instance, the loans provided by banks (i.e., their assets) tend to be long term, while the customer deposits used to fund those loans (i.e., their liabilities) tend to be short term. Thus, a bank is prone to run out of liquidity (i.e., cash) regularly.

To avoid falling low on liquidity, many banks attempt to match the durations of their assets and liabilities, i.e., long-term funds are used to finance long-term assets like loans and short-term funds are used to finance investments in short-term assets.

Banks have also increased their holdings of money market securities, which are short-term investments that retain their value well and are easily convertible into cash, i.e., they are highly liquid securities. Nonetheless, investments in money market securities bring little income to the banks.

On certain assets, banks are able to adjust the interest rates they demand following a change in interest rates. These assets are referred to as rate sensitive assets (RSAs). Conversely, there are other assets where the rates remain unaltered following interest rate changes. These are fixed-rate assets.

Similarly, a bank`s liabilities can be decomposed into rate-sensitive liabilities (i.e., those with floating rates (RSLs)) and fixed-rate ones (i.e., those with fixed interest rates).

Under asset-liability management, banks calculate the difference between RSAs and RSLs and determine the Gap between the two. In formula terms, Gap refers to the difference between RSAs and RSLs.

Following an interest rate increase, banks can reset their rates on RSAs while they will pay a higher rate on their RSLs. However, banks with positive Gap have more RSAs than RSLs. These banks will expect more income from their RSAs than interest payments on their RSLs following an interest rate increase. Thus, a bank with positive Gap will experience an increase in its net interest income following an increase in interest rates.

Conversely, and following an interest rate decrease, the banks will earn less from their RSAs and will pay a lower rate on their RSLs. However, banks with positive Gap have more RSAs than RSLs. The drop in income from their assets will exceed the lower interest payments on their rate-sensitive liabilities. Thus, a bank with positive Gap will experience a decrease in its net interest income following a decrease in interest rates.

Asset-Liability management entails the calculation of Gap by banks. The Gap is a reflection of the interest rate risk that exists in the bank`s books. For instance, in the current low interest rate environment, if interest rates were to change, they will, in most likelihood, increase. It puts banks with negative Gap at risk. Since these banks have more rate-sensitive liabilities than assets, these banks will be faced with higher interest payments on their liabilities following an interest rate increase.