Home Banking Why Asset and Liability Management Should Be the Nerve Center of Modern Banks

Why Asset and Liability Management Should Be the Nerve Center of Modern Banks

by internationalbanker

By Sean Coyne, Solutions Consulting Principal, Treasury & Capital Markets, Finastra

 

After being awash with liquidity over the last decade, 2023 proved to be a tumultuous year for banks. Banking failures on both sides of the Atlantic Ocean have renewed focus on asset and liability management (ALM), bringing an often-overlooked discipline into the spotlight again. Bank runs, such as those at Silicon Valley Bank (SVB), are almost as old as fractional-reserve banking. Liquidity risk can be considered the original risk in banking, predating interest-rate risk by hundreds of years. However, in an era when focus is often drawn to a bank’s more glamorous areas, the collapse of SVB last year re-emphasized that effective management of liquidity and interest-rate risks is at the heart of the banking business model.

Having debated these issues with banking-industry experts, I’m sharing several opinions and best-practice recommendations on how to avoid such scenarios in the future.

The liquidity paradox

Addressing the collapse of Silicon Valley Bank, Professor Moorad Choudhry, non-executive director at Recognise Bank and Loughborough Building Society, has laid the blame for the failure on poor management and a lack of ALM discipline. He argued, “By simply doing what it should have done, which is to ensure that the balance sheet is always robust to meeting liquidity risk requirements. It’s not an intellectually challenging art. It requires discipline, but it also requires understanding the balance sheet’s exposure to changing market factors, like interest rates.”

Paradoxically, one factor that led to the failure of Silicon Valley Bank was excess liquidity, what Austin Elsey, chief credit officer at FMS Bank, has called an anti-stress event. He described it as: “When the financial institution finds itself dealing with a liquidity influx that’s pumped into the system. Naturally, as the cash sits on the balance sheet, it creates concern about how they could leverage and get a margin of return to maximize that profitability.” He added, “Having extra liquidity is a good thing, but if banks don’t prepare for that and properly plan for exiting that scenario, that’s where they start to feel that pressure.”

Liquidity was pumped into the system during the COVID crisis as financial authorities responded to the exogenous shock through large-scale asset purchases. SVB’s liability holders, Silicon Valley tech startups, also found themselves awash with increased COVID-related IT (information technology) spending, which ended up on SVB’s balance sheet.

Since the 2008 crisis, the high cost of funding in senior unsecured markets has seen banks increasingly turn to the deposit base as a low-cost source of funding. Deposits also receive favorable regulatory treatment, regarding them as high-quality funding sources.

However, surges in liquidity flows from the depositor base are expected to increase in the era of digitization and open banking. At the apex of the SVB crisis, customers withdrew a staggering $42 billion in a single day on March 9, 2023, which amounted to a quarter of the bank’s deposits. The following day, depositors withdrew 20 percent of total deposits from Signature Bank. Contrast this silent gutting of SVB and Signature Bank balance sheets by their depositors with the alarming scenes involving deposit holders of Northern Rock, a UK bank that collapsed during the 2007 financial crisis. Despite the panic, the maximum deposit outflow at Northern Rock on a single day was around 5 percent, nothing like the scale we witnessed during the bank runs of 2023.

Building a robust balance sheet to withstand economic tailwinds

A robust and profitable balance sheet is the aim of ALM, the ability to withstand different stresses to the economic environment and customers’ reactions. Professor Choudhry commented, “In a bank’s effort to increase NII, it invests in ten-year treasuries, ten-year mortgage bonds, and other securities,” which he said was understandable from a P&L (profit and loss) point of view in a low-rate environment. “However, banks should also recognize that this extends the duration risk.” The role of ALM is to uncover risks, which in SVB’s case was the susceptibility of its balance sheet to interest-rate rises. These stress tests are also increasingly embodied in regulatory requirements, including interest rate risk in the banking book (IRRBB), of which SVB, with a sizeable balance sheet of more than $200 billion, was infamously exempt.

Addressing this, Professor Choudhry remarked, “I think we are getting into a little more sophisticated model of understanding what that true investment curve looks like. Is there a prepayment risk on the backside? Are we going to be exposed to losing funds quickly in a stress if this rate environment shifts really quickly?”

As the interest-rate crisis at SVB evolved into a liquidity crisis, Professor Choudhry highlighted the impacts of behavioral risk by commenting, “The vast majority of their funding was overnight tenor. A disciplined ALM process would prepare the bank better by terming out some of the funding, to mitigate when there are sudden changes in market factors.”

The fact that ALM is at the locus of many different areas within the bank—risk, regulatory, finance and hedging—creates many demands on the Asset-Liability Committee (ALCO), and it is the committee’s job to balance these forces. Internal stakeholders may have finance, trading, quantitative or management backgrounds and view the balance sheet through different lenses. However, it is important that the ALCO is a big tent, encompassing a multi-dimensional approach, and that ALM reflects the different views across the organization.

For Professor Choudhry, addressing external stakeholder concerns under the board’s oversight is key to a well-functioning ALCO. He remarked, “The ultimate balance sheet is a mixture of loan and deposit products that most efficiently meet the needs of different stakeholders that move in different directions—the regulator wants lots of capital and liquidity that drag on the balance sheet, which opposes what the shareholder wants. Meanwhile, the customer wants good service and good interest rates. The ALCO’s role is critical in this three-dimensional optimization if banks wish to move away from the traditional approach. Setting budgets and targets need[s] to be bank-wide and overseen by the ALCO. More importantly, everyone needs to know what everyone else is doing.”

The intersection of risks and the role of regulation

Silicon Valley Bank’s problems stemmed from the confluence of interest rate and liquidity risks, a reminder that balance-sheet risks must be considered holistically. Referring to Silicon Valley Bank’s build-up in interest-rate exposure that followed the influx of liquidity, Professor Choudhry stated, “A cardinal sin for me by any bank anywhere is to assume that just because something’s been the same for the last ten years, it will continue to be the same for the next ten years. That’s the cardinal error if one is to take a risk to get rid of profit and loss because of the surplus.” He added, “If one is to take the higher risk option, then one should really understand the additional risks associated with that and manage accordingly.”

Regulation’s role has expanded over the years to cover credit, market, operational and liquidity risks, as well as the capital and liquidity constraints imposed by regulators, while improving financial stability and positively impacting earnings. However, the regulatory cadence should not set the tone for the bank. Mehdi Bouasria, product general manager at Finastra, has emphasized the need for the ALCO to react to an uncertain financial environment. “The need for doing ALM just for the ALCO or to meet regulatory requirements is no longer sufficient. The ALCO should not meet quarterly or semi-annually and expect to catch up with the market changes happening swiftly. Banks must ramp up their monthly or weekly monitoring to ensure a robust balance sheet.”

This observation is especially true for smaller banks that sometimes lack the risk infrastructures found at larger institutions and often face more concentrated risks due to their limited geographies or targeted market segments. Focusing on the community-bank segment in the United States, Mr. Bouasria continued, “Despite their small size, community banks still face various risks, and they need to effectively manage their balance sheet to ensure profitability, stability, etc.”

The 2008 financial crisis prompted regulators to strengthen banks’ high-quality liquid assets to meet funding requirements under stressed conditions. However, the 2023 liquidity crisis raised other concerns, particularly around a bank’s access to cash to meet unsecured liability outflows, a scenario to which SVB was particularly vulnerable.

ALM is more relevant than ever; sometimes, a crisis is needed to prompt us to remember this fact. Each new era has its own unique challenges—for example, social media’s role in the demise of SVB. ALM, too, is evolving and increasingly draws in professionals from other areas of the bank, such as trading risk, who bring their own toolsets. Asset and liability management may contain eternal risks, but as markets evolve, they can be seen through a different prism.

 

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