Bankers primarily involved in making loans, but they also engage in buying and selling securities. Therefore, their day-to-day decisions are concerned with lending and investment activities, and financing of these activities. In making these decisions, bankers should analyze the direction of future movement in market interest rate. Besides, they should also consider the composition of assets and liabilities in their investment and financing portfolios, and the level of risk they are interested to undertake. These decisions particularly have a greater impact on the net interest income of the bank and its asset and liability values. Simply, asset-liability management (ALM) is the process of deciding the appropriate composition of a bank’s assets and liabilities inconsistent with the expected level of risk the bank management is going to undertake. In a broader perspective, ALM is defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities resulted from the change in liquidity and market interest rates. ALM activities are carried out by the asset-liability management committee of the bank to manage sources and uses of funds on the balance sheet and off-balance sheet activities with respect to liquidity and interest rate risk. The primary purpose of ALM is to control the size of the bank’s net interest income. This issue is addressed by managing the dollar gap. Similarly, ALM also focuses on the impact of change in market interest rates on the value of balance sheet items. This is addressed by managing the duration gap. We will discuss shortly the concept of dollar gap and duration gap in the later section. At this point, we illustrate the ALM of a bank with an example.

Also Read:- Meaning of a Bank.

Suppose, a commercial bank has Rs 1,000 million in total assets that only consists of a 7-year, 10 percent fixed interest rate loan. The funding of these loans has been satisfied by 60-day deposits worth Rs 900 million carrying 6 percent interest and the rest Rs 100 million by equity. The balance sheet of the bank appears as follows:

Given these assets and liabilities, the net interest income (NII) of the bank is the difference between interest income and interest expenses worked out as follows:

In our example, the interest income is 10 percent of Rs 1,000 million fixed rate loan (that is, 0.1 * Rs 1,000 million = Rs 100 million) and the interest expense is 6 percent of Rs 900 million in deposits (that is, 0.06 * Rs 900 million = Rs 54 million). Thus, net interest income is :

NII = Rs 100 million – Rs 54 million = Rs 46 million

Similarly, net interest margin (NIM) is defined net interest income as a fraction of a bank’s earning assets. It is worked out as follows:

In our example, the net interest margin is given by:

NIM = Rs 46 million/Rs 1000 million

= 0.046 or 4.6%

Note that the bank, in our example, has used 60-day deposits (liabilities) to finance a 7-year fixed-rate loan (assets). So the maturity of assets does not match the maturity of liabilities. The deposits mature in 60 days. Therefore, if the market interest rate increases in 60 days, the cost of short-term liabilities will also increase, but the interest income remains the same as the asset is the fixed-rate loan. This results in a decline in net interest income and net interest margin of the bank. For example, suppose the market interest rate on short-term deposits increased from 6 percent to 7 percent. when the deposits mature in 60 days, the bank has to use new deposits at a 7 percent interest rate. The interest expense on new deposits will increase from Rs 54 million to 63 million (that is, 0.07 * Rs 900 million), while the interest income remains at Rs 100 million. Thus, the net interest income of the bank will decline to Rs 37 million (that is, Rs 100 million – Rs 63 million). Similarly, the net interest margin will also decline to 3.7 percent (that is, Rs 37 million/Rs 1,000 million). If the loan made by the bank were floating rate loans, the interest income would also increase with the rise in the market interest rate. As a result, net interest income and net interest margin would also be higher.

In particular, banks make loans with different maturities and also use deposits with many different maturities. Therefore, the net interest income of banks depends on the interest income on loans, interest paid on deposits, the number of loans and deposits, and the earnings mix of loans and deposits. Higher the interest earned on assets, higher will be the NII, and higher the interest paid on liabilities, lower will be the NII. Similarly, the higher the number of funds raised and invested, the higher will be the NII. Finally, by investing more in higher-yielding assets and using more the lower-cost funds, banks can increase net interest income.