1.4 Assets Liability Management

In the system of financial management an important area is the effective management of assets and liabilities of the bank. Asset and liability management as a concept used in the banking industry began in the U.S. in the 60's of the last century, and refers to the regulation of the level of risk when interest rates rise and fall. Up to this time money managers have used some methods of management of assets, liabilities and spread (spread - the difference between the rates, prices. Difference between the weighted average deposit rate and the weighted average rate of their placement), as in the 1940s and 1950s, the banks were in abundance cheaper sources of funding in the form of demand deposits and savings deposits. The main management problem was this distribution of assets, which would ensure the liquidity of the commercial bank and the maximum income, therefore, based on the asset management. In this case, asset management has two main areas: the distribution of assets (pool of funds approach.) and the conversion of assets (assets allocation or conversion funds approach.).

Under the asset management understand the ways and procedures in own funds and borrowings. In relation to commercial banks - the distribution for cash, investments, loans and other assets. Particular attention is given to the allocation of resources in investments in securities and loan operations, including the composition of the securities portfolio and outstanding loans.

Fund management in commercial banks is complicated by several factors:

- Banks are the most regulated industry and business has been placing funds in strict accordance with the laws and regulations of control;

- The relationship between the bank and its customers on loans and deposits are based on trust and support;

- The holders of shares of a commercial bank, like all other investors expect the rate of return, the appropriate investment risk and comparable in magnitude to profit from those investments.

Most of the attracted funds are payable on customer's demand or with very short term of notice. Therefore, the first condition of good governance is to enable the bank to meet the demands of depositors. The second condition - it is the availability of funds, sufficient to meet the reasonable needs of a loan.

Commercial banks are private business entities, whose activities should be quite profitable with help of certain liquidity maintenance. Customers should not have a reason to doubt the solvency, liquidity and stability of the banking system, investors must have full confidence in any bank. In some way goals of depositors and holders of its shares are not compatible. This inconsistency is reflected in the inevitable conflict between the requirements of liquidity and desired profitability, which is exhibited in every financial transaction. The conflict between liquidity and profitability is a main problem to be solved by placing the pot of funds.

The main objectives of asset and liability management are: management of short-and long-term bank liquidity, maintaining and developing the profitability of the bank, management and adequacy of the capital structure of the bank, the bank's cost management, especially related to the payment of interest, management of asset quality, optimizing and reducing the tax burden, stabilization and an increase in the market value of the bank.

The purpose of asset and liability management - is preventing or correcting imbalances and avoiding of banking risks by analyzing the general strategy of the bank on the balance sheet structure and profitability.

Asset and liability management requires accurate and sufficient information from both internal and external sources. The external information is needed to predict the economic development and the formulation of the strategy, and internal - to monitor the implementation of policies to manage assets and liabilities, assessing the need for change in the policy and making new deals. All of the information used by the banks could be relevant, reliable and timely.

This information is necessary to ensure that the appropriate unit of the bank that manages assets and liabilities could:

- Set the current and future risks;

- Identify the quantity of the risk with help of sensitivity analysis of assets and liabilities to changes in interest rates, exchange rates, and inflation and growth rates;

- Analyze the results and determine the actions necessary to maintain the desired position on the balance sheet (positive, negative, neutral to the movement of interest rates);

- Develop further scenario to determine the value of the measure needed to maintain the desired position, i.e. assess the potential costs or losses and to take appropriate action, including changes in the strategies developed.

Thus, management of assets and liabilities is provided by all the financial policy and strategy of the bank, and the complexity of its activities, the rapid rise in interest rates and exchange rate changes have intensified the impact of market risk on the final results, which led to a special function of asset and liability management.

With the right choice of strategy asset and liability management is an integral part of the financial and banking management used to minimize the financial risk of credit institutions, optimizing the structure of balance in order to ensure a high level of efficiency of banking operations and reducing costs./18, p.199/

Historically there are following strategies in the management of assets and liabilities:

a) Asset management strategy (60's.) - This strategy has prevailed in international banking practice in the 60s of this century. In this approach, the bankers perceived sources of resources - equity and liabilities which are not dependent on banking, but determined mainly by opportunities and needs of customers and shareholders. It was assumed that the size, type and structure of liabilities, that the bank might attract, were attributed to the population. If the latter is itself determined the quantitative relationship between deposits and checking account. The advantages of asset management strategy is relatively easy to use, because decisions are made only on one aspect of the banking business - asset allocation, and for the management of liquidity it apply simple techniques that do not require significant resource costs. The bank does not make sense to attract highly qualified staff, which helps reduce the cost of training and labor experts. This approach does not maximize profit. Indeed, on the one hand, the bank refuses liability management, and consequently, on the impact on their value. On the other hand, a significant part of bank assets must be in the form of highly liquid to maintain a sufficient level of liquidity, which leads to a decrease in revenue.

b) Liability management strategy (in the 60's and 70's.) - liability management strategy was developed in the international banking business in the 60 - 70 years of this century. During this period, banks are faced with the rapid growth of interest rates and intense competition in the field of fundraising. Bankers began to focus the search for new sources of funding, as well as control over the structure and the cost of deposits and deposit liabilities, which gave impetus to the formation of the strategy through the management of the bank liability management. Bank liability management strategy does not preclude parallel asset management, but the problem is the delimitation and autonomy of each of these approaches. In this case, the structural units of the bank which are responsible for raising funds are separated from lending and investment divisions and have no information on possible areas of resources. The main drawback of liability management strategy is that it is usually applied on the principle of "more is better", the funds are raised without effective lines of their placement. During the recovery period, when the demand for credit increases, this approach may be appropriate and useful. But during a recession, when demand for loans is limited, unbalanced approach to the management of the bank's assets and liabilities may lead to a significant reduction in profits and even cause damage. The advantage of this approach to the management of the bank is the ability to increase revenues, controlling operating costs and accurately predicting the bank needs for liquidity.

c) Asset and liability management strategy (modern approach) - The main feature of the international financial markets in the 80's was the volatility of interest rates and, consequently, an increase in the interest rate risk of banks. Before this time the main risk banks was a credit risk, starting with the 80's the number one risk in the banking sector was interest rate risk. This led to the development of a balanced approach to the simultaneous management of assets and liabilities, which is prevalent now in the global banking practice. The essence of a balanced management strategy is that banks consider their portfolios of assets and liabilities integrally, defining the role of the aggregate portfolio of high returns for an acceptable level of risk. Joint management of assets and liabilities gives the bank the tools to create the optimal balance sheet structure and a protection against the risks caused by extreme changes the parameters of the financial markets. The main idea of a balanced strategy is to understand that both revenues and expenses relate to both sides of the bank balance. The price of each transaction or service should cover the costs of the bank for its provision.

Commercial banks have to allocate funds raised to various types of active operations. The banks may be guided by the two following methods of placement:

1. Pool of funds approach. The basis of the method is the idea of combining all of the resources. Then the total funds are allocated among the types of assets (loans, government securities, cash balances, etc.) that are considered appropriate. In the pool of funds approach it does not matter from what source funds are received for a particular active operation, as long as their placement help achieve the objectives of the bank.

This method requires management to the principles of equal liquidity and profitability. Therefore, funds are placed in these types of active operations, which fully comply with these principles. At the same time, this method does not contain clear criteria for the allocation of funds by category of assets, does not solve the dilemma of "liquidity-profitability" and depends on the experience and intuition of bank management.

2. Assets allocation or conversion funds approach. In managing the assets by the pool of funds approach too much attention is given to liquidity and are not considered different liquidity requirements with respect to demand deposits, savings deposits, time deposits and fixed assets. According to many bankers this deficiency is the cause of the increasing reduction in the rate of profit. Over time, time and savings deposits require less liquidity than demand deposits, and are growing more rapidly. The approach of assets allocation, known as well as the approach of conversion funds can overcome the limitations of the pool of funds approach./17, p.201/

The main advantage of this method is to reduce the share of liquid assets and investing additional funds into loans and investments, thus increasing profit margins. This model involves the creation of several "profit centers" (or "liquidity facilities") within the bank because placement of each of these centers is realized independently of the location of other centers.

However, this method has drawbacks reducing its effectiveness. The basis of allocation of the various "profit centers" put the velocity of the different types of deposits, but it may not be a close link between the rate of treatment of contributions of a group and fluctuations in the total deposits of the group.

Other deficiencies relate to the both methods: the pool of funds approach and the method of assets allocation. Both methods have focused on the liquidity reserve requirements and the possible seizure of deposits, paying less attention to the need to meet the demands of customers for credit. But it is well known that as both deposits and loans grow.

From the position of interest rate risk management method of assets allocation is cautious. In this case, the passive side is still considered to be constant and to avoid interest rate risk is provided by linking more closely the terms of asset allocation with their funding on terms, i.e. liabilities. With fast variability of interest rates using the method of assets allocation does not help optimize profits.

Since banks are considered as subjects who buy funds and lend them on the basis of percentage difference between the interest rates of purchase and sale, the term "management spread" is becoming more popular in banking practice.

In order to manage interest rate risk asset allocation method is most useful in a stable environment, as its successful use depends on three things:

- A relatively small variation in interest rates;

- The composition of liabilities is quite stable and easy to predict;

- Most of the raised funds consist of interest bearing demand deposits, i.e. balances on the settlement and current accounts of enterprises, organizations and individuals.

With realizing of both of these conditions the bank's managers could consider the passive side of the balance as a stable specified value and give more value to assets. In the method of asset allocation increase in liquidity is ensured by adjusting the structure of assets and the level of profitability of the bank is maintained at a given level of control over the spread.

Disadvantages of the method of asset allocation revealed a more frequent fluctuation in interest rates, so that the value of assets is potential subject to change. This situation led to the loss of revenues from lower asset prices and the emergence of liquidity risk.

Theory of liability management, developing and complementing the policy of liquidity management of commercial banks, based on the following two statements: The first - a commercial bank can solve the problem of liquidity by attracting new money by buying them in the capital market. The second - a commercial bank can provide its liquidity by resorting to extensive borrowing of funds from the Central Bank or a correspondent bank, as well as to loans obtained on the Eurocurrency market.

In the 60 years of the last century, funding sources have become less stable, the amount of free cash flow decreased with an increase in the demand for loans. In these circumstances, bank managers have to save on cash balances, i.e. maximize their cut, and in order to meet the growing demand for credit banks appealed to the management of its obligations, i.e. liabilities.

However, in the 1970s, due to rising inflation and the decline in production banks have started to pay more attention to the management of both sides of the balance sheet.

Technology co-regulatory assets and liabilities is called asset and liability management (ALM). The meaning of ALM is that it combines used for decades certain management practices (assets, liabilities and spread) in a single coordinated process. Thus, the main task of ALM - is coordinated management of all bank statements, and not its individual parts./14/

Also the following two methods should be noted:

1) A balanced approach of the asset-liability management. In recent years, many banks have moved to an integrated strategy that includes methods of separating and combining sources of funds to provide more flexibility. This approach combines the advantages of the previously mentioned methods, while smoothing out a number of shortcomings.

The methods considered are the verbal model. They provide an understanding of the problems of planning, relationship factors, portfolios and their parameters (indicators), but do not provide the computational procedure that allows the planner to calculate indicators of the plan portfolios: The total of investments, risk, liquidity, income, expenses, etc. But these models are useful in one way, it provides material and contains a statement of the problem for the development of constructive econometric models and computer programs as tools for managers.

3. Management with scientific methods and operations research. This method involves a scientific approach to solving management problems using advanced mathematical methods and computers to study the interaction of elements in complex models. This approach requires setting goals, establishing links between different elements of the problem, identify the variables under and beyond the control of management, evaluation of possible behavior of uncontrollable variables and identifying the internal and external constraints that govern the actions of management. The method of scientific management attempts to answer three questions: "what is the problem?", "What are the options to solve it?", "What is the best option?".

Bank management should consider this method as a way of improving decision-making, which brings the management of assets and liabilities to a new, more efficient level.

We should note that the high efficiency of the chosen strategy is only achieved in the way of proper selection of method of the asset and liability management.