Required for management of Financial Institutions for the Asset Liability model

1. Bcom MFI
Unit 7
Asset Liability Management
Elvis Khisa

2. 2
Course Content
By the end of the section students should be able to:
• Explain the various bank classifications
• Identify the 5 major concerns of a Bank Manager
• Identify the main assets and liabilities of banks.
• List the main sources of revenue for banks.
• Describe the basics of asset-liability management.
• Explain the various types of risks banks face.
• Discuss the importance of risk management

3. 3
Forms of Bank Classification
A. Traditional Vs Modern Banking
Traditional Modern Banking
1. Products
Loans & Deposits Insurance,
Securities, pensions,
Others financial services
2. Income sources
Net interest income Fee & Commission
income
3. Strategic Focus
Asset size & Growth ROS/H, Creating SH
Value (ROE, Greater
than cost of capital)
4. Other Areas
• Customer Focus-Supply led Dd led
Based on value creation
for customers
• Competitive environment- High
Restricted till 1990s Non banking fin. Insts.

4. 4
• Service normally offered to individuals are usually small
scale in nature depending on magnitude the services can
also be offered to corporations.
• Services include:
-Payment services; Current account with cheque
facilities, credit transfers, standing orders,
direct debits and plastic cards)
-Savings
-Loans
-Mortgages
-Insurance
-Pensions
• Other banks also offer these personal services
(Commercial banks, Savings banks, Co-operative banks,
Building societies, Credit Unions, Finance Houses).

5. 5
Introduction
• Banks have a unique model in that they manage
their assets concurrently with their liabilities
• In a bid to maximize its profits, a bank must
simultaneously seek the highest returns possible
on loans and securities, reduce risk and make
adequate provisions for liquidity by holding liquid
assets.
• ALM is the simultaneous management of both
the asset and liability side of a bank’s balance
sheet.

6. 6
Asset Liability Management
Bank Managers have 5 major concerns:
• Asset Management: The portfolio of assets must include low-risk
assets and is well diversified.
• Liability Management: Acquire funds at the lowest possible cost
• Liquidity Management: Predict daily withdrawals and other payments
by customers in order to keep enough cash and other liquid assets
readily available.
• Capital Management: Keep adequate amounts of capital in order to
comply with regulatory requirements in order to maintain the
appropriate level of solvency.
• OBS management: Must control and limit the level of exposures
derived from OBS transactions.
Modern banks use a combined management on both sides of the
balance sheet involving a wide range of sophisticated risk
management instruments and procedures. The co-coordinated and
simultaneous decision on financing and investing is the essence ALM.

7. 7
ALM
• The Bank Manager’s objective of achieving higher levels
of profitability and safety have induced them to engage in
OBS activities. These are transactions that are not
recorded on the bank’s BS, such as derivative activities,
loan commitments and securitization, LCs, guarantees
and overdrafts.
• These activities are normally fee based and involve no
booking of assets nor collection of deposits.
• This implies that the bank’s BS looks healthy and yet the
bank be could be over exposed.
• This has been one of the major causes of the banking
crisis since managers are taking on more risks for
bonuses given their discretionary powers.
• AM involves; maximizing return on loans, minimizing risk,
adequate liquidity.
• LM involves; maximizing return on the inter bank market,
minimizing costs on deposits (interest).

8. 8
ALM
• Capital Adequacy management is a very
important balance sheet item because; it
helps prevent bank failure, affects returns
on owner’s equity and a minimum amount
is required by the bank regulators.
• Capital adequacy measures to what extent
the bank is safe and sound i.e solvent.
• In bank liquidity there is a trade off
between safety and return. Most of the
Bank’s capital is held in very safe assets.

9. Liquidity Mgt & Importance of reserves
• Two key issues under this; Liquidity vs Profitability
tradeoff and bank reserves (required & excess) are a
form of insurance against costs associated with
deposit outflows
• Bank can obtain liquidity from; borrowing from other
banks, selling some of its securities or loans,
borrowing from the central bank
• A bank with liquidity issues will require a co-
ordinated ALM strategy by acting quickly and
discreetly to meet the shortfall. Otherwise it could
create a run on the bank and possibly lead to
insolvency. Therefore liquidity and solvency are
strongly linked
9

10. Loan sales & Securitization Process
• Loans are sold with or without recourse to mainly financial
intermediaries. A recourse debt (loan) holds the borrower
personally liable.
• Loan sales can be done through participation, Assignment or
Loan strips
• Selling loans will; allow replacement of lower-yielding assets
with higher yielding ones, increases bank liquidity, help in the
management of credit & interest rate risk, help in diversifying
bank’s assets and lower cost of capital
• Securitization is a relatively new process whereby loans,
receivables and other financial assets are pooled together,
with their cash flows or economic values redirected to support
payments on related securities (ABS) which are issued and
sold to investors by issuers who utilize securitization to finance
their business activities
10

11. 11
Bank Balance Sheet Structure
• It’s a financial statement listing all the stock
values of sources and uses of funds
• Bank fund Sources are;
- Deposits (Retail and Corporate)
- Other bank deposits (Inter bank)
- Equity issues (Owners)
- Debt issues (Bond issues and loans)
- Saving past profits (Retained Earnings)
• The above 5 items are broadly classified as bank
liabilities (debt) and Capital (equity)

12. 12
Balance sheet items
• The above items are then transformed into financial
assets and to a lesser extent real assets such as;
- Cash
- Liquid assets
- Short term money market instruments (TBs).
- Loans
- Other investments
- Fixed assets
• Generally bank liabilities tend to have shorter maturities
than bank assets. This mismatch arises from the different
requirements of depositors and borrowers.
• This is where banks derive their cardinal role of
intermediation- Asset transformers.
• Generally: A-L=NW

13. Most common risks faced by Banks
• With increased pressure on banks to increase SH returns they
have had to assume higher risks and at the same time
manage these risks to avoid losses.
• Changing environment (deregulation, globalization,
conglomeration) have posed serious risk challenges to banks
bringing in several risks modern banks have to face and
manage in order to improve on their performance (ROE, ROA)
• Credit risk, interest rate risk, refinancing and reinvestment risk,
liquidity (funding) risk, foreign exchange risk, market (trading)
risk, country (sovereign) risk, operational risk, Off-balance
sheet risk,
• Other risks: inflation, settlement (both credit and liquidity risk),
regulatory, competitive, legal, reputation, portfolio,
call(redeemable), capital, 13

14. 14
Credit Risk Mgt
1.Asses how other similar banks and groups of banks have
made their risk/return decisions.
2. Compare the bank’s performance measure to those of similar
banks.
3. Set reasonable objective against the backdrop of the bank’s
historic performance.
• The above steps are followed after analyzing stock market
expectations, trade analysis of past performance, trend and
comparative analysis of peers’ performance.
• The biggest risk faced by banks is credit risk given that the
nature of their business is over 80% loan portfolios.
• Credit risk derives from the possibility of a loan not being paid
fully or partly and also through holding a bond or securities.
Bank managers can minimize this by building a portfolio of
assets that diversifies the degree of risk.

15. 15
Credit risk cont…
• In order to mitigate risk, Managers must continually screen and
monitor borrowers’ abilities to pay, introduce long term customer
relationships, loan commitments, collateral and compensating
balances and credit rationing.
• All banks have their own credit philosophy and credit culture so are
affected differently by credit risk and the management of risk is
handled differently across banks.
• The bank can monitor credit risk by using traditional proxies i.e total
loans/total assets, non-performing loans/total loans, loan losses/total
loans, loan loss reserves/total assets. These ratios can be calculated
accord to the various kinds of loans on the bank’s balance sheet.
• The above could be lagging factors. Hence they could be combined
with other factors like loan concentration in terms of geographical
area or sector or individual, rapid loan growth, high lending rates
• We could also look at loan loss reserves/non-performing loans or
total loans/total deposits. Other bank risks handled by Derivatives.