Challenges to ALM of a bank during new normal
Every business entity has its assets and liabilities. Even a person, as an individual, has his or her assets and liabilities. Individual assets are anything a person may own outright, such as a car, a house, or cash in a bank account. Individual liabilities are considered to be anything that a person makes payments on, such as rent, a mortgage, a car payment, or utilities. Asset-Liability Management (ALM) of a business entity is the process of managing the use of assets and cash flows to reduce the firm's risk of loss from not paying a liability on time.
Just like individuals or any other business entities Financial Institutions (FIs), such as banks have general assets and liabilities including physical assets, such as equipment, land and building. For example, cash, government securities, and profit/interest-earning investment/loan accounts, reserves, or holdings of deposits of the central bank and vault cash; and investments, or securities are all a part of a bank's assets. The liabilities of an FI are share capital, customer deposits, certificates of deposits bonds, derivatives and interbank market funding.
On the other hand, the term, 'New Normal', has been used concerning the financial crisis of 2007-2008, the aftermath of the 2008-2012 global recessions, and the COVID-19 pandemic. This is a state to which an economy, society, politics settles following a crisis when this differs from the situation that prevailed before the start of the crisis.
The twenty-first century's world has become very much unpredictable, highly volatile and vulnerable. Because, various unprecedented and unimaginable events, pandemics and disasters are appearing one after another for which even this hi-tech based world is not prepared.
In our everyday life, we purchase various durable goods, nondurable goods, and services which are the elements of measuring the volume of consumer spending of an economy. It creates various demands in the economy breeding multiple economic activities and opening the different scope of economic activities. It also encourages entrepreneurship and innovation. In this way economic productivity, mobilization of funds, cash flow, employment generation gain a huge pace. As a result, huge public spending on infrastructural development and government subsidies in various growing economic activities has become inevitable. FIs especially banks have direct or indirect insolvent in all of those financial activities.
Almost all development work of the world is financed by banks or other non-bank FIs. Human behaviour, purchasing power, lifestyle create a demand in the economy. That demand required various investments of financing on various infrastructural development and industries. But when demand is reduced to only basic needs then the whole economic cycles, cash flow, investment become slower. As a consequence, FIs, especially banks lose their business. Low demand in the economy also reduces international business, such as export, imports. A substantial portion of business income earned from foreign trading or foreign exchange business. During this corona pandemic, we witnessed a huge recession in the world's trade, finance and the overall economy.
As an inevitable consequence out of the Covid-19 pandemic, banks have been bound to depreciate their values of financial assets. Moreover, non-payment of credit due, banks are expected to face significant short-term liquidity gaps due to deterioration in asset quality and loss in the valuation of collaterals. At the same time, there has been a big change in sources of liquidity. Exceptional market volatility in the recent period led to an elevated level of Value-at-Risk (VAR) back-testing breaches across the banking industry.
Managing those risks is the core concern of ALM practice. Interest-rate risk has two elements. The first is the risk of changes in asset-liability value due to changes in interest rates. Such a change impacts the cash flows of assets and liabilities or their present value. Because the value of financial instruments largely depends on market profit or interest rates. The second element arises with products, such as early convertible loans. The other main type of risk that ALM seeks to manage its liquidity risk, which refers to both the liquidity of markets and the ease with which assets can be translated into cash easily.
As a result, banks are severely facing a mismatch between assets and liabilities because of illiquidity or changes in interest rates. Consequently, asset-liability management is also facing strong challenges to combat or mitigate such a risk of a mismatch. It requires a long-term strategy to manage risks. For example, a home-owner must ensure that they have enough money to pay their mortgage each month by managing their income and expenses for the duration of the loan.
Proper monetary policy has become a big challenge for the central bank in this new normal period. As a result, managing liquidity, upholding equilibrium of money supply and demand in the market, keeping inflation at a tolerable level has also become very much tough for the central bank as well as the commercial banks.
Fiscal policy is also under a big threat. The main target of fiscal policy is to keep the public spending and taxation as high as possible along with government subsidy or tax break simultaneously. The main target of these activities is to keep the unemployment rate at a lower level without triggering inflation. But Covid-19 has made everything very much uncertain, puzzled and confusing.
Banks do business with the depositor's money; they have to create a strong capital base collecting from various sources before the commencement of its business to manage any kind of core risks. Moreover, the BASEL committee on banking supervision is putting immense pressure on the banks worldwide to maintain minimum capital requirement, supervisory review and market discipline strictly under a framework, called International Convergence on Capital Measurement and Capital Standards.
When an investment of a bank, for any reason, becomes very much vulnerable and cannot generate any income or become classified then the bank is bound to maintain provision from its income that reduces its profitability. Even a single doubtful or bad and loss investment project could engulf the whole profitability and also could break down the whole capital base of an FI. In these circumstances that banks cannot endure those risks and embrace bankruptcy. Due to the Covid-19 pandemic, this scenario has become very common worldwide.
In a normal period, the ALM crisis and the problem can be mitigated through efficient management, enhancing capital base, strengthening capital base, rigorous marketing developing customer services, innovating products and services, enhancing equity base.
But during a disaster or pandemic period, most other above efforts might not be possible. As we know all economic activities are powered by human consumption patterns, lifestyle. But during this Corona pandemic, most of the economic activities have become stranded all over the world. Many thriving cities took a deserted look. The aviation and hospitality industry has been paralyzed. Peopled have changed and reduced their consumption pattern drastically. Whereas, consumer spending is the key driving force of the economic cycle in today's world.
So, in this New Normal Period, we have to live with this pandemic considering it as normal. We should not scare about it. Economic activities can never remain stopped forever. If lockdown continues and people remain scared for long then the economic disaster might bring severe consequences inhuman life which could be more severe than a big pandemic.
To mitigate this liquidity, market and interest rate risks as much as possible, the central bank or regulatory authority should plan to offset liquidity crunch through discounting and liquidity tap. The authority should also rethink with new dimension about the open market operation, reserve requirement, rate of the 'repo' and 'reverserepo' for saving the economy from huge fall, keeping local currency as strong as possible, facilitating commercial banks in the proper management of their liquidity, fund and above all asset-liability. Above all the BASEL Committee should be more logical and realistic in putting pressure on banks for maintaining capital measurement and capital standards based on realities of the new normal period.
The writer is banker and
freelance column writer