An Asset Liability Mismatch, or ALM, is what led to the downfall of IL&FS. More recently, it has been discussed with relation to PMC Bank.
Which begs the question: Why do Financial Institutions (FIs) use short-term funds to give long-term loans? This asset-liability mismatch does not bode well for the company and increases insolvency risk.
Maintaining continuously effective ALM operations is challenging and requires a dynamic paradigm. FIs have to account for cash flow streams, liquidity management, credit risk, market risk, interest rate risk, balance sheet profitability, and capital planning.
(FI = banks, non-banking financial companies (NBFCs), micro-finance institutions).
Dr Vijay Malik explains by addressing four pertinent questions.
1. Why does an asset-liability mismatch happen?
To lend for the long term, a FI should ideally have long-term sources of funds.
In situations where a FI has to give out long-term loans by using money raised from short-term sources like commercial paper (CP) or current and savings account (CASA), exposes itself to risk.
The risk is that the counterparties that lent it the money in the first place (short-term funds) may demand it back anytime. Money may be pulled out of savings accounts. Bank deposits mature and the money has to be returned. In such a situation, the FI may not have the funds to do so, as they are all locked up in long-term loans.
This is the scenario which has played out for many NBFCs including IL&FS and is called an asset-liability mismatch.
2. How should the asset-liability mismatch be tackled?
- Use equity as the long-term source.
In an ideal situation, FIs should fund their long-term loans with long-term sources of money. This would eliminate an asset-liability mismatch. If this is implemented, all the long-term loans would be funded by equity. Using 100% equity for giving out long-term loans limits its growth prospects. Raising equity whenever a long-term loan has to be sanctioned is inconvenient, costly and time-consuming. In doing so, the FI will lose out on the business when compared to its competitors. This is because the competitors would give out loans faster and cheaper using money raised from debt rather than equity.
- Use long-term debt as the long-term source.
Long-term sources of funds are costlier than short-term sources. This is simply because the probability of anything going wrong with the FI is greater over the longer term. As a result, the providers of money will ask for a higher return than they would for short-term debt. Giving loans to its customer by using long-term debt/long-term sources would be costlier than giving loans using short-term sources of funds.
3. How do financial institutions balance the above?
The stability/risk-lessness in giving out long-term loans and the cost of these long-term loans varies on a spectrum but moves in the opposite direction.
- To have the highest level of stability, FIs should fund all the long-term loans by equity/long term sources. However, this makes lending a very costly affair as long-term sources of money are costlier than short-term sources. This, in turn, decreases the profits.
- If the FI uses cheaper short-term funds to give out long-term loans, then it increases returns/profits because the short-term sources of money are cheaper than the long-term sources of money. However, when the FI uses short-term sources of money to give long-term loans to its client, it exposes itself to the risk where providers of short-term money may ask their money back and it will not be able to repay them. This is called asset-liability mismatch or solvency/liquidity risk.
Therefore, the final decision is a tricky one. And, they end up using a mix of long-term and short-term funds, depending upon their ability to convince the short-term fund (CPs and CASA) providers to give them cheaper money and keep rolling it over and over again. This rolling-over facility provides an opportunity to the FI to give long-term loans at a lower cost and in turn, increase its profits.
However, if a FI is unable to instill confidence in short-term fund providers about its ability to repay them whenever they call their money back, then these short-term fund lenders will stay away. As a result, the FI will have to rely on costlier long-term funds and give loans at lower profits.
As the aim of all the FIs is to generate maximum profit, they tend to use cheaper short-term funds as much as possible whether by way of CP or CASA. However, they also need to give the assurance that they are financially stable and can repay the amount whenever asked. The ability of best performing banks to repay the short-term fund providers (CASA) at any time, is reflected in their ability to improve the stickiness of such customers.
This best performing image for high CASA banks is not permanent and if there is any doubt on the ability of the bank to repay CASA at short notice, then banks also face the same fate as that of IL&FS. It is called “Run on the Bank”.
4. How must investors view this?
Instead of looking it as a bank vs. NBFC prism, investors should look at it from the confidence level provided to the short-term fund providers. If any FI provides high confidence to CP/CASA providers, then it will want to and it will be able to fund its long-term loans from short-term funds and in turn, generate high profits for itself/its shareholders. If this confidence ceases to exist, the FI, will eventually face a run on it and eventually bankruptcy.
It is the market perception of the stability of a FI that lets it use short-term funds to fund long-term loans. The sources of money are cheaper, which increases profits. However, whenever any FI overuses short-term funds, then it faces stability (liquidity) risk and results in its bankruptcy.
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Disclosure: Dr Vijay Malik is registered with SEBI as a Research Analyst. He does not own any financial interest in any of the companies mentioned in this article.