Asset and Liability Management: Definition & Example

KEY TAKEAWAYS

• Asset and liability management gets used by financial institutions to help mitigate potential financial risks. These risks are usually the result of a discrepancy between current assets and liabilities.
• A few of the most common risks that get addressed by asset and liability management include liquidity risk and interest rate risk.
• When assets and liabilities get matched properly, it leads to higher efficiency, increased profitability, and a reduction in risk for financial institutions.

What Is Asset and Liability Management?

Asset and liability management is a type of practice that financial institutions use to limit financial risks. In this case, the risks often come from an unbalanced level of assets and liabilities. Using an asset and liability management strategy usually works in combination with things like financial planning and risk management.

Businesses and organizations tend to use these strategies to help manage any potential long-term risks that could come from circumstances that change. For example, the overall practice of asset and liability management will include several different factors.

These can include risk mitigation, the strategic allocation of assets, and even adjusting capital and regulatory frameworks. When assets and current liabilities successfully get matched together, there can be a surplus for the financial institution. From here, the surplus can get managed to help increase profitability and maximize investment returns.

What Do You Need to Know About Asset and Liability Management?

To keep things as simple as possible, asset and liability management is designed to mitigate risks. It works by addressing the potential risks that come from a discrepancy or mismatch of assets and liabilities. Mismatches usually happen when there are distinct changes in the financial landscape.

For example, changes to interest rates or certain liquidity requirements can have an effect on assets and liabilities. When a financial institution puts together a strategic framework, it will often focus on things like profitability and long-term stability. This helps with asset allocation and asset growth.

They’re able to implement this by managing credit quality, maintaining liquidity requirements, and making sure there is enough operating capital. Other types of risk management practices can oftentimes be a little uncoordinated.

With asset and liability management, it’s a very coordinated process that is dedicated to looking after the balance sheet of an organization. When this happens, assets get invested in the most optimal way and liabilities get mitigated effectively long-term.

In the past, the majority of financial institutions managed their risks depending on the specific type of risk that was involved. However, the evolution of financial markets has allowed this approach to evolve and adapt. Now, asset and liability management primarily focuses on things like risk mitigation and asset management on a very macro level.

By evolving to this type of practice, financial institutions are now able to effectively address liquidity, market, and credit risks. But even with all of that said, asset and liability management is an ongoing process. It continues to monitor risks regularly to help make sure organizations are within their risk tolerance.

What Are the Advantages and Disadvantages of Asset and Liability Management?

Understanding how assets and liabilities are flowing is important to know for business operations. Implementing the asset and liability management frameworks helps to provide several different benefits for businesses and organizations.

One of the biggest advantages is that the practice allows a business to effectively manage the liabilities that they incur. This enables them to be able to strategically prepare for uncertainties that could happen in the future.

As well, the asset and liability management frameworks help organizations recognize present risks on their balance sheet. When they’re able to recognize these risks from a mismatch of assets and liabilities, they can then reduce them. When a business is able to strategically match its assets and liabilities, they can achieve higher efficiency. They can also increase overall profitability all while reducing the overall risk.

However, there are a few disadvantages that come with asset and liability management that are worth exploring. Since almost every organization is going to operate differently than others, there isn’t a single framework that can get adopted. So not implementing the proper type of framework and strategy can be detrimental.

To overcome this, you should try to design an asset and liability management framework that’s unique to your business. It should cover the most specific objectives, any regulatory constraints, and all of the risk levels.

Another challenge is that asset and liability management is a long-term strategy. This means it requires some strategic thinking and forward-looking datasets and projections. So once information becomes readily available to your business, you need to turn it into quantifiable measures.

The final challenge to overcome is that it’s an incredibly coordinated process that oversees the entire balance sheet of an organization. This means it’s going to involve lots of coordination between different departments. Not doing this effectively can make the process time-consuming and lead to additional, unexpected challenges.

What Are the Types of Risk Mitigated Through Asset and Liability Management?

It was mentioned above, but specific asset and liability management frameworks are going to differ from business to business. However, they’re all going to typically involve mitigating a similar range of risks. The most common of these are liquidity risk and interest rate risk.

Let’s take a closer look at the different types of risks that asset and liability management can help mitigate.

Liquidity Risk

Liquidity risk relates to how well a financial institution can facilitate its present and future cash-flow obligations. If they are unable to meet their obligations, the overall risk is going to affect their financial position. A good example of this is when a financial institution can’t meet its obligations because of a shortage of liquidity.

To help limit the liquidity risk, businesses implement asset and liability management procedures. This helps increase liquidity to fulfill any future cash-flow obligations that come from the liabilities they have.

Interest Rate Risk

Interest rate risk has to do with the risks that come from changing interest rates. When these rates change, they can affect the future cash flows of a business. So in this case, financial institutions will often hold their assets and liabilities that can get affected by changes in interest rates.

One of the most common examples of an asset being affected by interest rates changing is deposits. For liabilities, a common example is a loan. Both of these examples will be affected by any changes to interest rates. So when there is an environment where rates change, it can result in a mismatch of a business’s assets and liabilities.

Other Risks Worth Recognizing

Even though liquidity risk and interest rate risk are the most common, there are some other risks to know about. One of these is currency risk. In this case, the risk comes from any changes that happen with exchange rates. For example, if a business has foreign deposits in different currencies, the changes to exchange rates can cause a mismatch between the assets and liabilities.

Capital market risk is another example of a type of risk. This happens when there is a change in equity prices. But in this case, these risks can often get mitigated through things like derivatives, futures, and options.

Summary

The process of asset and liability management is designed to manage and mitigate the risks that come from a mismatch in assets and liabilities. This is important since having assets and liabilities that are well-managed will lead to an increase in business profits.

The main concept of asset/liability management is that it focuses on the timing of cash flows. This is since businesses are going to have to plan for the payment of liabilities. Implementing this process helps ensure that relevant assets are available to pay debts. Doing this as the assets come due helps ensure assets and earnings can get converted into cash.

Understanding asset and liability management can help with your current business process and you can maximize future investment returns.