What is Asset Liability Management?

Techniques Used for Asset Liability Management

1) Gap Analysis in Asset and Liability

A gap is defined as the difference between rate-sensitive assets and rate-sensitive liabilities.

GAP = Rate Sensitive Asset – Rate Sensitive Liabilities

GAP Ratio = Rate Sensitive Asset/ Rate Sensitive Liabilities

2) Asset Coverage Ratio

Another important ratio to manage the asset and liabilities is the asset coverage ratioAsset Coverage RatioAsset Coverage Ratio is a risk analysis multiple that depicts the company’s ability to repay the debt by selling off the assets and outlines how much of the monetary and tangible assets are available against the debt. It helps an investor to predict the future earnings and gauge the risk involved in the investment.read more, which determines the number of assets available to pay off the debts.

Asset Coverage Ratio = ((Total asset- intangible asset) – (current liabilities- short term debt))/total debt

The higher the asset coverage ratio, the more assets the company has to pay off its debt. Companies should at least have this ratio as more than 1.

Examples of Asset Liability Management in Different Industries

The following are examples of different industries.

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#1 – Banking Industry

Banks are the financial intermediaryFinancial IntermediaryA financial intermediary refers to a third-party, forming environment for conducting financial transactions between different parties.read more between their customers and future endeavors. Banks take a deposit from their customers for which they are obliged to pay interest. From these deposits, they provide loans for which they receive interest income. Therefore, banks need to implement strong asset-liability management to ensure net interest income and ensure that they can pay off their customer deposits at any given time.

#2 – Insurance Companies

Insurance companies provide two types of insurance: life and non-life. Non-life insurance is property and vehicle insurance. Insurance companies receive payment from other parties, but they are liable to pay some lump sum amount as and when required. So they will have to make sure that they have the funds available to pay off these liabilities at any time.

#3 – Benefit Plan

Benefit Plans such as future retirement plans take some funds out of employees’ salaries and then, in the future, pay this amount with the applicable rate at the time of retirement. Therefore, these groups need to ensure that they have funds to meet these liabilities.

Benefits

Following are the benefits:

  • It helps in risk measurement and management for companies.Effective asset-liability management ensures liquidity riskLiquidity RiskLiquidity risk refers to ‘Cash Crunch’ for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more management.Effective ALM protects and enhances the profit and net worth of a company.It increases the net interest incomeInterest IncomeInterest Income is the amount of revenue generated by interest-yielding investments like certificates of deposit, savings accounts, or other investments & it is reported in the Company’s income statement. read more of the banking institution.ALM is used to quantify the various kinds of risks in the company.It helps in finalizing the short-term and long-term planning for a company.It helps in strategizing the introduction of new products in the market.

Limitation

Below point is the limitation:

  • Other criteria need to be looked upon to check the risks of a company apart from asset-liability management.It can be misleading sometimes.Sometimes having risk is better because high risk gives higher returns.

Important Points to Note

  • Its objective is to manage risk, not to eliminate risk.It is the process of deciding to control risks and stabilizing the system by balancing assets and liabilities.Companies should have adequate assets to pay off their liabilities whenever due.Companies can use the Gap analysisGap AnalysisIn Gap Analysis, the actual performance of a company is compared to the desired goals.read more and Asset Coverage Ratio to quantify this management.In the banking industry, it addresses the risk of asset-liability mismatch because of either interest rate or liquidity risk.

Conclusion

Asset liability management is an important concept used in various industries, primarily in the banking and insurance industry. For example, an effective asset management policy framework can increase banks’ profitabilityProfitabilityProfitability refers to a company’s ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company’s performance.read more by increasing net interest income.

A better view can be seen as a coordinated process of combining balance sheet itemsBalance Sheet ItemsAssets such as cash, inventories, accounts receivable, investments, prepaid expenses, and fixed assets; liabilities such as long-term debt, short-term debt, Accounts payable, and so on are all included in the balance sheet.read more into the right mix. The gist of the technique is that companies should have adequate assets to pay off their liabilities. Asset liability management is a systematic approach that can protect against the risks arising from the asset-liability mismatch.

This has been a guide to what is asset-liability management. Here we discuss techniques and examples of industries in asset-liability management and benefits and limitations. You can learn more about financing from the following articles –

  • Compare – Assets vs LiabilitiesFormula of Coverage RatioAsset Based FinancingNon-Interest Income of Banks