How the corporate term of ‘Asset Liability Management’ affect you as an individual

Asset Liability Management (ALM) is a fundamental requirement for banks which face a myriad of risks – Interest Rate Risk, Liquidity Risk, Credit Risk, Market Risk, and Operational Risk.  ALM systems are used to manage these various risks on the bank’s capital by narrowing the difference between assets and liabilities.

A drastic reduction in Banks’ capital base weakens the fundamentals necessary for banks to have the ability to lend, and thus increases the liquidity issues of the economy.

But ALM does not only apply to Banking entities.

As an individual who has problems managing his assets and liabilities, it is likely that this person would face some debt repayment issues – which is the basis for the lender to charge a higher interest (because of the individual’s “risk premium”).  Consequently, it becomes “expensive” that individual to borrow money to do business, or to invest. So how can understanding ALM principles help the ordinary person?

Let’s take a look at an ordinary person’s story:

Ahmad is a mid-30s working professional with a family of two young children and a wife. He opines that investing in properties is the way to save sufficient money for his two young children (aged 10 and 8) to pursue their tertiary education in the next 10 years.

He uses RM20,000 of his bonus to buy a condominium (ASSET) worth RM200,000, by putting a 5% down payment of RM10,000 (his CAPITAL), and finance the balance through a mortgage of RM190,000 (LIABILITY).  Monthly mortgage is at RM1,800, with RM200 condo maintenance fees.  As this is Ahmad’s 2nd property, the bank is willing to extend a loan to him (he does not face LIQIUIDITY funding risk).  The total value of mortgage is 40% of his total income (his debt-income ratio is 40%). 

He rents his condo to Ali at RM2,100 per month for the next two years with a temporary waiver on the 2-month security deposit to Ali. Ahmad still has a balance of RM8,000 from his bonus and invests in physical gold.

Figure 1 – Ahmad’s Balance Sheet and Gap analysis

The net value of Assets minus Liabilities is RM18,000 (Equity).

12 months later…

The condo’s price increases by 20% and pegs the value at RM250,000 with RM50,000 worth of equity

All seems well until the Central Bank, in response to the overheating economy, raises interest rates (Ahmad is exposed to INTEREST RATE RISK). His mortgage payment is raised by RM200 to RM2,000 monthly but his rental is fixed (there is a MISMATCH here in the Asset-Liability equation), resulting in a deficit of RM100 monthly now.

The gold which Ahmad bought for RM8,000 has appreciated by 15% to RM9,200. The profit of RM1,200 helps to cover Ahmad’s shortfall on the condo’s rental.  He sells RM1,200 worth of gold.

Ahmad’s equity is RM75,200. The balance sheets shows that the value of Ahmad’s assets and liabilities are LARGE compared to his capital (equity and cash).

Figure 2 – Ahmad’s Balance Sheet and Gap analysis after 1 Year

6 months later…

The economy slows down.  Ahmad’s wage increment is frozen, inflation rate becomes higher and household expenses increase. His tenant, Ali has moved out and left Ahmad with about RM500 in unpaid utility bills and RM5,000 repair cost.

Ahmad has effectively lost 8 months of projected rental revenues. Rentals have gone down to RM1,500 a month for a similar

Ahmad considers selling the condo.  The best offer he can get is RM215,000 and needs 6 months to find a buyer. The cost to Ahmad for holding the property for the next six months would be RM24,400 as shown in the Gap Analysis below:

Figure 3 – How things went wrong for Ahmad

The solution and ending….

Ahmad decided to borrow the RM24,400 from his parents who will not charge him any interest.

At the end of 6 months, it is effectively No Gain, No Loss for Ahmad.  This is how it looks like: • He has made RM45,000 from selling the condo • After paying off his parents RM24,400 he is left with RM20,600 • Since he started with a savings of RM20,000 he effectively made RM600 (3%) over two years

Do you think Ahmad would have made more than 3% over two years if he had invested his RM20,000 elsewhere?

ALM was not popular in the 1960s when interest rates were stable.  But as interest rates became volatile in the 1970s and 1980s, people began to take note.  FSIs take on liabilities and invest them in revenue generating streams such as loans, bond, and real-estate.  The mismatch between long term liabilities and short term assets can be damaging to a bank, and it could quickly run out of liquidity

ALM also applies to Governments.  In this case, the stakes are even higher.  Assuming Country A, rich in commodities, does not have good income from its domestic sources like Income Taxes or GST but able to compensate the gap from high commodities prices.  Foreign investors lend money by purchasing Country A’s bonds (debt issuance).  The commodities market suddenly crashes and Country A’s income tax collections are not able to make up for the shortfall. 

Country A’s finances suffer due to mismatch of its Assets and Liabilities.  It needs to issue new bonds to pay the existing bondholders when its debt is due.  The Government’s failure to pay bondholders could result in high domestic interest rates as Governments need to pay higher rates for their bond (debt) issues.  The problem can escalate to a systemic risk when investors refuse to buy more of Country A’s debt, or ask for a ridiculously high return for the “risk premium.”   We saw these during currency crisis such as the Mexican Tequila Crisis, the Asian Currency Crisis, and the subsequent Argentina Peso crisis.

So as you can see, it’s all about managing risks.  As ordinary people, we do not have the means to use sophisticated system to manage our Assets and Liabilities.  However, a simple framework as explain goes a long way towards understanding the risks involved when we put our hard earned money to work.