What Is Liability Management?
Liability management is the practice by banks of maintaining a balance between the maturities of their assets and their liabilities in order to maintain liquidity and to facilitate lending while also maintaining healthy balance sheets. In this context, liabilities include depositors’ money as well as funds borrowed from other financial institutions.
A bank practicing liability management looks after these funds and also hedges against changes in interest rates. A bank can face a mismatch between assets and liabilities because of illiquidity or changes in interest rates; and liability management reduces the likelihood of a mismatch.
- Liability management 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.
- Well-managed assets and liabilities involve a process of matching offsetting items that can increase business profits.
- The asset-liability management process is typically applied to bank loan portfolios that may offer fixed-term products such as CDs and loans but also demand deposits and lines of credit.
- Defined-benefit pension plans may also use liability management to ensure it does not experience a cash shortfall for paying its future and current obligations.
Understanding Liability Management
A bank must pay interest on deposits and also charge a rate of interest on loans. To manage these two variables, bankers track the net interest margin or the difference between the interest paid on deposits and interest earned on loans.
Banks began to actively manage assets vs. liabilities in the 1960s by issuing negotiable CDs. These could be sold prior to maturity in the secondary market in order to raise additional capital in the money market. Also known as asset/liability management, this strategy plays an important in the health of a bank's bottom line. During the run-up to the 2007–08 financial crisis, some banks mismanaged liabilities by relying on short-maturity debt borrowed from other banks to fund long-maturity mortgages, a practice that contributed to the failure of U.K. mortgage lender Northern Rock, according to a government report on the crisis.
An asset-liability committee (ALCO), also known as a bank's surplus management team, is a supervisory group that coordinates the management of assets and liabilities with a goal of earning adequate returns. By managing a company's liabilities effectively, the ALCO provides oversight for better evaluating on- and off-balance-sheet risk for an institution. Members incorporate interest rate risk and liquidity consideration into a bank’s operating model.
The Banking Industry
As a financial intermediary, banks accept deposits for which they are obligated to pay interest (liabilities) and offer loans for which they receive interest (assets). In addition to loans, security portfolios also compose bank assets. Banks must manage interest rate risk, which can lead to a mismatch of assets and liabilities. Volatile interest rates and the abolition of Regulation Q, which capped the rate at which banks could pay depositors, contributed to this problem.
A bank’s net interest margin—the difference between the rate that it pays on deposits and the rate that it receives on its assets (loans and securities)—is a function of interest rate sensitivity and the volume and mix of assets and liabilities. To the extent that a bank borrows in the short term and lends for the long term, there is often a mismatch that the bank must address through the structuring of its assets and liabilities or with the use of derivatives (e.g., swaps, swaptions, options, and futures) to ensure it satisfies all of its liabilities.
Liability Management in Pension Plans
A defined benefit (DB) pension plan provides a fixed, pre-established pension benefit for employees upon retirement, and the employer carries the risk that assets invested in the pension plan may not be sufficient to pay all benefits. Companies must forecast the dollar amount of assets available to pay benefits required by a defined benefit plan.
Assume, for example, that a group of employees must receive a total of $1.5 million in pension payments starting in 10 years. The company must estimate a rate of return on the dollars invested in the pension plan and determine how much the firm must contribute each year before the first payments begin in 10 years.