Bad debts are not the only issues that Indian banks are grappling with – As the stock markets have taught us quickly, the new demon is called an asset-liability mismatch!.
It was in 2010 that the Reserve Bank of India had first flagged its concern over the asset-liability mismatch in the banking system and brought in guidelines to control this phenomenon.
ASSET LIABILITY MISMATCH
To put it in simple terms, a mismatch occurs when the tenure of maturing loans (which are on the assets side of the balance sheet of a bank) do not match the tenure of the sources of funds on the liabilities side. The liabilities side of the balance sheet of a bank includes sources of funds and for a bank one of the main sources of funds are the deposits or short term papers.
It happens , say, ,when a bank lends say Rs.10 Crores as long term loan for 10 years to a sector for example but has obtained the Rs.10 Crores from short term deposits which has to be repaid back in 1–3 years then there exists a risk of asset liability mismatch.
In practice, banks and NBFCs can often run into liquidity issues as ILFS has in Q3CY2019, mainly because of asset-liability mismatches. That is, the entity’s loans and borrowings do not come up for payment at the same time. This liquidity crisis is often misinterpreted as a solvency issue and spreads across markets – causing Bank runs or stocks being mangled!
ASSET LIABILITY MANAGEMENT
This risk is a permanent feature in the financial services and policy finance space and has to be managed and the common term used for managing such risk is Asset Liability Management (ALM). In many banks, it is the responsibility of either the ALM Committee or in smaller ones, the treasury department that also has day to day responsibility for operationalizing the ALM strategy.
The crux of ALM is the art and science of managing mismatches or funding gaps at least cost.
ALM can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. Liquidity is an intuition ability to meet its liabilities either by borrowing or converting assets into liquidity.
In other words, ALM is all about managing three central risks:
- Interest Rate Risk
- Liquidity Risk
- Foreign currency risk
Through ALM , banks and NBFCs try to match the assets and liabilities in terms of Maturities and Interest Rates Sensitivities so as to minimize the interest rate risk and liquidity risk.
The objective of an ALM is to safeguard the net interest margins, its short-term profits, long-term earnings and the sustained profitability of the bank. This can be achieved through
- Managing the volume and mix of assets
- Managing the maturities on both the asset and liabilities side
- Managing quality and liquidity of assets
The Lehman crisis has ensured that the RBI and various credit rating agencies consider ALM as central to how they see the health of the financial system and regular guidelines and reviews are done to stress test the strength of the financial services system.
ALM is a company specific control mechanism within overall regulatory guidelines and definitions, and it is possible that several banks may employ similar ALM techniques or each bank may use its own unique system.
In a market-driven ecosystem, it is essential for banks, as a policy perspective to take a pragmatic call whether it can assume a relatively neutral approach to ALM risks or can manage and adopt a more vibrant approach, consciously allowing higher-funding gaps to take advantage of market movements to make money and target higher long term earnings.
The actual techniques used are fairly statistic-mathematical and based and include several components like Gap Analysis , Duration Gap Analysis , Scenario Analysis, Value at Risk and so on.
Irrespective of the organizational philosophy to determine risk appetite, a bank should keep in mind that the right level of skills and resources have to be committed to support such key function.
RISKS FROM POOR ALM
In a rising rate scenario, a bank will have to re-price its deposits frequently, which have a faster turnover compared to the long-maturing loans. Banks are constrained by the fact that the deposit rates have to be in sync with the market rates. If the market rates were lower, it would become difficult to attract depositors, which means that sources of funds may well dry up. This poses liquidity risk as well because they have to repay the depositors faster but their funds are caught up in long-term assets. So though the bank might be asset-rich it does not have the necessarily liquidity, on the one hand, to repay its depositors and on the other hand even to lend for projects. This can also happen similarly for assets and liabilities in foreign currencies causing a spiraling out of control of the situation.
The ultimate impact of all this will be on the net interest margins of a bank. Banks with lower asset liability mismatches will have more room to manoeuvre with respect to their pricing of loans and deposits, while those with a high level of mismatches will find it difficult to reset their interest rates frequently and will have to face narrowing of margins.
THE NBFC WARNING SIGNS
Way back in March 2018, ICRA had released a warning on the buildup of risk in the retail-focused non-banking financial companies (NBFCs) . It had said the sector would require Rs 3.8-4 trillion of fresh debt capital in FY19 to grow at 20 per cent in the current financial year while facing twin challenges in the form of narrowing options and increased borrowing cost for adequate debt raising. “Based on the asset liability mismatch (ALM) analysis of large retail-NBFCs, we note that the pricing related pressure is expected to be higher in the second half of FY19, as debt redemptions are expected to happen at a faster pace than their advance maturities and as incremental growth is expected to be more robust in the second half,” the report had then said. Depreciation in the rupee and hardening global yields are likely to further have an adverse effect on the overseas investor appetite, it had added.
This scenario has played out almost exactly the same way and we have seen collapses in the stocks in the listed NBFC space.
Few companies or financial institutions have perfect matches between their assets and liabilities. In particular, the mismatch between the maturities of banks’ deposits and loans makes banks susceptible to bank runs. On the other hand, ‘controlled’ mismatch, such as between short-term deposits and somewhat longer-term, higher-interest loans to customers is central to many financial institutions’ business model. . Therefore, in practice, the idea is to limit the mismatches rather than aim at zero mismatches.
Such is the umbilical link between ALM policy and stakeholder value. Hence, the mismatch management in funding operations need to be assumed as a critical function that decides the direction of growth of the organization.
With integration of more sophistical technology, the tools of ALM are fast transforming into risk more scientific statistical management modules that has the potentiality to provide synergy to enhance profitability. ALM as an integral part of risk management strategy needs more focus to enhance stakeholder value.
In an ideal world, each duration bucket / term assets should be financed by a similar tenure of funds. However, illiquid bond markets in India and unavailability of funds in longer tenures has meant the system is set up for disaster. In addition, the weakness in credit ratings has been exposed as entities are downgraded almost from Gilt to Junk in less than 24 hours! A collaborative improvement with regulatory oversight and international best practices therefore may lead to a more stable longer term financial services market that can help India attain its rightful place in the constellation of superpowers!