Asset-Liability Management of Banks

Activities or functions of banks can be divided into 2 broad categories:

1. Core Functions: Taking deposits & giving out loans
2. Ancillary Functions: Anything other than taking deposits & giving out loans. For
instance, financial advising, opening LCs, selling cricket match tickets, taking wasa bills
etc.it is
The core functions of the bank are reflected in the balance sheet. All the other activities do affect
the income statement (for instance revenue from financial services provided) but they arent
shown on balance sheet. So, the ancillary services of the bank are also called Off balance sheet
activities.
In the annual report, after the balance sheet we can see the off balance sheet report which reflects
the ancillary activities or services of a bank.
Bank management is often called balance sheet management as it reflects the core activities
(taking deposits & giving loans) or functions of a bank.

The Asset-Liability Structure of a Bank

The biggest liability on part of a bank is its liability & banking starts from its liability.
A simplified structure of a banks balance sheet is like this:

Balance Sheet of a Bank

Assets ( Assets are normally arranged Liabilities
in terms of liquidity)
1. Reserve (cash-held in hand, in other
1.Deposits
banks & central bank)
2. Call Money: At any moment of time,
2.Borrowings (from both central bank &
the lending bank can call it back
other banks)
3. Investments
3.Capital (it is banks liability to the
(As in Bangladesh, commercial banks shareholders or owners)
normally do not practice universal banking
that much. So, this investment part in the

asset segment is not that much significant.

In other words, low portion of investment
indicates that we do not practice universal
banking)
4. Loans, Advances ( The biggest item in the 4.Subordinated Bonds: This is a debt security
balance sheet)
which states that if the bank goes bankrupt,
bondholders claim will be subordinate to the
claims of the deposit holders.
OBSA: Off Balance Sheet Activities are also very much important as these can be important
revenue sources.

Asset Liability Management Strategies

Asset liability management comprises a number of strategies. With only one strategy, it cant be
managed. For instance, the way assets are managed, liabilities cant be managed the same way.
So, the existence of multiple asset liability management strategy is easy to understand.
Now, banks will be obviously trying to maximize their profits like any other organization. This is
their prime objective. Now,

So, broadly there are 2 asset-liability management strategies or in broader terms bank
management strategies:
# Liability management strategy

# Asset management strategy

# Liability Management Strategies:
So, these are different strategies based on the characteristic of the category in the balance sheet.
Now,
Deposits & Borrowings ---------- Outside liability on part of the banks

Capital -------------- Inside liability on part of the bank ( inside as this liability is to the
owners or shareholders)
*** Capital is known as inside liability of the bank. Shareholders or owners are insiders whilst
deposit holders are outsiders.
So, there should be at least 2 strategies in liability management strategiesa. Inside liability management strategies
b. Outside Liability management strategies

# Asset Management Strategies

In terms of asset structure also, all the asset items arent having same characteristicsIf broadly categorized:
Reserves = Non Earning Assets
Investment & Loans & Advances = Earning Assets
Banks will be trying to maximize revenue through these earning assets. However, non-earning
assets too have important functions.
So, in the category of asset management, there are at least 2 strategies:
a. Earning asset management strategy
b. Non-earning asset management strategy

1. Outside Liability Management Strategy:

Before formulating strategy, we should look at the mission, vision & objectives. Now, the
objective of managing outside liabilities is minimization of cost apparently.
Current accounts require lowest cost (for banks, cost means the interest Im paying out) as the
current account holders arent entitled to interests. So, if the sole objective of outside liability
management was to minimize costs, then banks would only be mobilizing current accounts. But
current accounts are very volatile as deposit withdrawals can be made at any time. So, with only
current accounts, even if it would ensure cost minimization, we cannot establish a stable asset
structure. (For instance, if bank wants to give a 10-year loan but all the accounts are current, then
there might be cash crisis if long term loans are given)
So, minimization of cost shouldnt be the sole objective of outside liability management.
Stability of asset structure should also be an objective.
Fixed deposits would ensure asset structure stability & current accounts will ensure cost
minimization; however, we mustnt go for any extreme end of having only fixed deposits or
current accounts for the above mentioned reasons.
So, there should be a tradeoff between the two objectives-cost minimization & ensuring asset
structure stability.

2. Capital\Inside Liability Management Strategy:

The most important function of capital for a bank is that it is a cushion against the bank business
loss. Losses from bank business should & must only be accommodated from capital, not from
the deposits.
So, owners or shareholders (In banking industry, the owners are refereed as sponsors as they
initiated the business. Also in practical scenario the depositors are the real owners as they
contribute most of the fund of a bank) will try to minimize capitals as it will accommodate
losses.
Now comes the central bank. CB will come & set a limit. They will decide how much funds
should banks keep under capitals. There are some international standards regarding capital
requirements of banks that are usually decided by the Basel Committee (G-20 Central Banking
Governing Committee; BIS is the association of central banks of countries, it is often refereed as
central bank of central banks & it is situated at Basel, Switzerland). These standard banking
practices are prescribed by the Basel Committee. If a banks which have international exposure

dont conform to these standards, no one will find the bank reliable enough to accept their LC or
guarantees. These international standards are prescribed but not mandatory, yet all banks accept
these standards for the above mentioned reasons.
Now, the capital requirement is set to be 8% by the Basel Committee but it is the minimum
requirement. In Bangladesh, Bangladesh bank has set it to 10% of total RWA (risk weighted
assets) or 400 crore Taka, whichever is higher. Basically, the 400 crore taka requirement is for
new banks. So, only with 400 Crore taka, you can charter a bank in Bangladesh!
So, the objective of inside liability management is to ensure that this 10% of RWA or 400 crore
taka requirement of capital is being met.
If losses are incurred, then it will be accommodated from the capital or from the 10% of RWA.
So, rebalancing will be required to again meet the 10% limit.

3. Non-Earning Asset Management Strategy:

Banks must maintain a fund in hand in the form of cash to meet short term liquidity necessities &
the deposit withdrawals. Now, these non-earning assets dont generate any revenue or interest
income on part of the bank, so banks will be trying to keep the cash or reserve level at minimum.
But central bank wants to ensure that whenever depositors come with a check to a bank, they are
honored in terms of encashing their funds. So, again central bank would perform a regulatory or
supervisory role by deciding a limit of reserves.
SLR- Statutory Liquidity Requirement: 19.5% of total demand & time liabilities
(Total demand & time liabilities= all deposits + borrowings)
Of this 19.5%, 6.5% is to be kept at Central bank in the form of Cash which is the Cash Reserve
Ratio (CRR).
So,
Non-Earning Asset Management
|
Liquidity Management
|

CRR= 6.5% (to be kept at central bank in form of cash)

|
Other 13% is to be kept in form of cash to themselves or in form of eligible security papers

So, conceptually & academically & by definition,

SLR= CRR of 6.5% + Other 13%
However, in Bangladesh, in practice, by SLR people mean the 13% & by CRR the 6.5%
But conceptually the CRR is also part of SLR.
So, maintaining this CRR & SLR is the objective of liquidity management or non-earning asset
management.

4. Earning Assets (EA) Management Strategy:

The objective of Earning assets management should be to maximize revenues as EA is the only
source of funds from which banks generate revenues. However, high return means high risks. So,
maximization of revenues will be coupled with maximization of risks. So, maximization of
revenues shouldnt be the sole
objective or concern.
Banks should also be concerned These 2 should constitute earning with
risk
minimization. So, again, prudent asset management
bank management
will try to make a tradeoff
between the two
&
these
2
are
business
decisions
objectives.
So,
Maximization of Revenue
Minimization of risk

Whilst, the two decisions (maintain

10% of RWA & maintain the CRR
& SLR) are regulatory decisions.

5. Matching Strategy:

If the liabilities are short term, meaning if the deposits are only short term, we cannot create any
long term assets. But if banks only mobilize high yield deposits, then there will be problem in
maintaining the SLR, CRR in liquidity management.
So, banks actually-

Takes deposits at different rates &

different terms from different
parties

Gives loans to different parties at

different rates, different terms &
different forms

So, matching is necessary. This matching refers to matching

between interest rates, matching between maturity & matching between asset & liability
management. So, there is another strategy called matching strategy in bank management.
So, banks are actually changing the shape of financial resources. So, banking is actually financial
engineering. Civil engineers change the shape of physical resources & bankers-the financial
engineers change the shape of financial resources.

6. Pricing Strategy:
The pricing of the financial products the banks are offering needs to be formulated. In practical
life, generally the sellers quote the price first. In the liability market (deposit market), bankers are
the buyers as they buy deposits from the surplus units at the cost of interest. As they are buyers
in the liability market, they dont have much say in this case.
But in the earning assets market (loan market), they are the sellers. So, banks have the say here
& banks fix up the loan price.

Generally, the price of anything is determined by the interplay between demand & supply. But
the bankers have their own technology of determining the price of any kind of financial products
based on:

a. Cost of Fund
b. Cost of administration
c. Cost of capital

The 3 basic element of foundation

of pricing technology of any
financial products by bankers

So, in the 6 bank management or balance sheet management, there are 6 strategies we came
across so far,

2 are regulatory driven---- Inside Liability Management strategy, non-earning asset

management strategy
4 are business driven ------- The other 4 strategies- Outside liability management,
Earning assets management, pricing strategy, matching strategy

Now, the 7th strategy is about Off Balance Sheet Activity (OBSA)

7. Off Balance Sheet Activity (OBSA) Management Strategy:

The non-fund business or ancillary business of the banks generates revenue like service fees,
commissions.
So, one objective of OBSA management would be to maximize the fees\commissions.
But with maximization of fees, there will be higher degree of risks. For instance, if the bank
starts to open up LC for everyone who wants to generate maximum fee revenue, then if unknown
or new clients do not abide by conditions the banks credibility will be harmed.

So again there should be a trade of between the two objectives of OBSA management:

Tradeoff between ------------- Maximization of fees & Minimization of fees

So, to conclude, banks profitability will depend on these 7 strategies.