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ASSET LIABILITY MISMATCH (ALM) - 'DEVIL AND THE DEEP SEA' SITUATION FOR BANKS.

Updated: Apr 5, 2023


If you are a student of finance studying ALM, the last few weeks must have been quite a perfect academic period to witness the SVB debacle unfold, as you mapped this use case to some of the written down textbook theories about ALM situations across balance sheets in general. While it's not entirely wrong to do so, however it's also pertinent to understand as why asset liability mismatches in financial institutions are not an exception but rather a rule. This article explains why it's so. As we critically examine here the developments which have led to the fall of some banks this year, it's also important to realize that ALM conditions in financial entities shall exist by design, till such time banks exist.


Post Silicon Valley Bank debacle in Feb this year, a lot has been written on ALM (Asset Liability Mismatch) conditions of banks, which have become a subject of intense public scrutiny. This short note is to emphasize on the fact that ALM conditions in banks are not an anomaly but is embedded in the design and revenue models of financial institutions. For banks, operating with asset liability mismatches in their balance sheets are a means to earn margin. It allows borrowing money at a lower interest rate and lending at higher. It's not a development that has shaped bank's balance sheets during the last few decades, but so has always been the case since banking has evolved.


Let's see how (in general) revenue generating models in financial entities are quite different from non-financial business, which in turn leads to the ALM conditions in banks.


WHY FOR NON-BANKING ENTITIES ALM IS AN ANOMALY?

Revenue streams of non-banking entities are not primarily linked with investments in financial assets, and as well margins are not primarily a function of lowering cost of borrowings. In other words, revenues to these organizations come from their core non-financial businesses and their effort to make higher margins is quite naturally derived from lowering their cost of operations. Infact a financially prudent balance sheet of a non-financial entity will be in having long term assets being financed out of long-term capital, while short-term assets financed through short term liabilities, so that liabilities can be met on demand, and there is no opportunity loss in having long term capital financing current assets.


WHEREAS FOR FINANCIAL ENTITIES ALM CONDITIONS ARE A BUILT IN FEATURE WITHIN THEIR REVENUE MODEL?

At the very foundation, business model of all financial entities rests on one fundamental, which is "lend long" & borrow short”. Lending long would mean - to make loans and invest in assets at interest rates that are fixed for some time. While borrowing short would mean financing such assets by issuing short-term debt - which can be taken out by lenders to the bank on demand. This means that the average duration of banks assets is much longer than bank liabilities. This is called the duration (or maturity) mismatch in banking.


Banks are therefore said to engage in maturity transformation, i.e., they transform long-term investments into short-term debt. This is an important feature of banks that distinguishes banking from non-financial firms. Non-financial firms usually avoid a duration mismatch, i.e., they finance long-term assets with long-term debt, and current assets with current liabilities.


HOW BANKS ACHIEVE THIS ANOMALY?

To achieve this, bank’s structure their assets and liabilities in a way that allows them to earn more interest on their loans than they pay on their deposits. One way they do this is by having shorter-term assets and longer-term liabilities. Short-term assets, such as loans and securities, generally have a maturity of less than one year and can be quickly converted into cash if needed. In contrast, long-term liabilities, such as bonds and mortgages, have maturities of several years or more and cannot be easily redeemed without incurring significant costs. By having shorter-term assets and longer-term liabilities, banks can take advantage of the yield curve, which typically slopes upward from short-term to long-term interest rates. This means that the interest rates paid on short-term deposits are generally lower than the interest rates charged on longer-term loans. As a result, banks can earn a profit on the spread between their borrowing and lending rates.


WHEN THINGS GO WRONG, AS THEY SOMETIMES WILL!

However, this strategy exposes banks to risks if short-term interest rates rises, or if there is a sudden demand for liquidity. If the interest rates on short-term deposits increase, banks may need to pay more to retain their deposits, which can decrease their profitability. If there is a sudden demand for liquidity, such as during a financial crisis, banks may need to sell their longer-term assets at a loss to meet their short-term obligations. This is exactly what led to the fall of SVB in Feb.


IN SUMMARY one of the fundamental premises based upon which banking survives is on short term depositors trust. Banks can't afford to go trust deficit. The perception that one is in trouble can create trouble and this is exactly where banks could be between the devil and the deep sea, meaning to be in a difficult situation where they have to choose between two equally unpleasant courses of action, that is meeting the withdrawal demands of short term depositors (at scale), which in turn needs to be funded by long term assets at a low realizable market value.


The role of "DEPOSITORS TRUST" in banks actually balances the pitfalls of ALM. When trust is in deficit, ALM self-destructs taking the banks along...

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