The Asset-Liability Mismatch

This term came in news as infrastructure funding by banks faced this problem. And it is haunting infrastructure funding

What is asset-liability mismatch? 

Banks’ primary source of funds is deposits, which typically have short- to medium-term maturities. They need to be paid back to the investor in 3-5 years. In contrast banks usually provide loans for a longer period to borrowers. Home loans, for instance, can have a tenure of up to 20 years. Providing such loans from much shorter maturity funds is called asset-liability mismatch. It creates risks for banks that need to be managed. 

What are the consequences of assetliability mismatch? 

The most serious consequences of asset-liability mismatch are interest rate risk and liquidity risk. Because deposits are of shorter maturity they are repriced faster than loans. Every time a deposit matures and is rebooked, if the interest rates have moved up bank will have to pay a higher rate on them. But the loans cannot be repriced that easily. Because of this faster adjusting of deposits to interest rates asset-liability mismatch affects net interest margin or the spread banks earn. Liquidity issues also arise when loans and deposits have different maturities. Depositors have to be repaid when their funds mature, but banks cannot recall their loans. They will have to find new deposits or roll over those maturing or else they will not be able to service their depositors. In an acute situation they may have to pay really high interests to raise funds. 

How do banks manage asset-liability mismatches? 

Most banks have elaborate institutional arrangement to manage asset-liability mismatches. The interest rate risk is usually managed by pricing a large percentage of loans at variable interest rates that move in tandem with market rates. Fixed rate loans are, therefore, usually priced at a huge mark up to variable rate loans to entice borrowers to opt for the latter. This takes care of interest rate risks as loans are linked to a benchmark and repriced when the benchmark rate moves up. Sophisticated derivatives are also used to manage interest rate risk. Liquidity risk involves a more hands on management. RBI requires banks to have dedicated asset-liability management committees to manage liquidity risks. A careful matching of cash inflows and outflows and gap funding are employed to manage liquidity risks.