Bad debts and non-performing loans are not the only issues that Indian banks are grappling with at the moment. Many banks are also struggling with asset-liability mismatches. It was in 2010 that the Reserve Bank of India had first flagged its concern over the asset-liability mismatch in the banking system. It had identified lending to infrastructure projects as the source of the mismatch and suggested that banks should sit together and pinpoint the challenges and find solutions to them.
What is asset liability mismatch?
To put it in simple terms, mismatch occurs when the tenure of maturing loans (which are on the assets side of the balance sheet of a bank) do not match the tenure of the sources of funds on the liabilities side. The liabilities side of the balance sheet of a bank includes sources of funds and for a bank one of the main sources of funds are the deposits.
While infrastructure projects are taking longer to gestation, pegging interest on deposits to market-determined rates has resulted in a fall in the rates and deposits are now of shorter tenure. With the de-regulation of interest rates, most depositors are not looking beyond one or two years. Earlier higher interest rates on deposits with longer maturities ensured that banks had recourse to long-term funds.
Take this example: if as much as 90 percent of the assets of a bank are maturing in 10 to 15 years but about 50 percent of its liabilities are maturing in one or two years, the bank will face a severe crunch in terms of matching its outflows with its inflows in the short and medium term. If a bank tries to fund its long-term loans from short-term funds, it is setting itself up for serious problems in its profitability and margins.
Most infrastructure projects have a payback period of more than 10 years, at the least. Another category of loans, which are of long duration, is home loans, which have actually become longer with banks looking at 30-year mortgage periods.
What is causing the asset-liability mismatch?
In the aftermath of the global financial crisis of 2007/08 and the slowdown in decision-making that gripped the country from 2010 onwards, banks were looking at a scenario where they had sanctioned infrastructure loans to projects, which were yet to take off. When the economy revived, disbursements took place to all these projects (core sector projects pertaining to power, roads, etc.) majority of which had duration of between 10 and 15 years. However, deposit tenures were getting shorter and this huge disparity in tenures between assets and liabilities is creating the instability in banks’ balance sheets.
According to estimates within bank circles, close to 70 percent of incremental deposits received by banks after 2009, have been of short duration. Another type of instability occurs when a bank tries to pay down maturing short-term liabilities by raising high cost funds.
What are the repercussions of asset liability mismatch in the banking system?
The impact of asset-liability mismatches that persist for a long time in a bank are many. It poses interest rate risk; liquidity risk; exchange rate risk and credit rate risk.
The interest rate risk arises from the fact that the bank will have to re-price their deposits frequently, which have a faster turnover compared to the long-maturing loans. Banks are constrained by the fact that the deposit rates have to be in sync with the market rates. If the market rates were lower, it would become difficult to attract depositors, which means that sources of funds may well dry up. This poses liquidity risk as well because they have to repay the depositors faster but their funds are caught up in long-term assets. So though the bank might be asset-rich it does not have the necessarily liquidity, on the one hand, to repay its depositors and on the other hand even to lend for projects. Exchange rate risks and credit rate risks are natural corollaries of this process. The liabilities in a particular currency have to be matched by its assets in that currency, especially when exchange rates are volatile as they are currently, with the global economy still coming to terms with Britain’s exit from the EU and signals are mixed regarding changes in US interest rates.
According to various media reports, State Bank of India has a high level of asset liability mismatches as a significant proportion of its loans have been given on floating rates basis while its cash and savings accounts are all on fixed basis and they form a large chunk of its liabilities.
The ultimate impact of all this will be on the net interest margins of a bank. Banks with lower asset liability mismatches will have more room to manoeuvre with respect to their pricing of loans and deposits, while those with a high level of mismatches will find it difficult to reset their interest rates frequently and will have to face narrowing of margins.
How can asset liability mismatches be managed?
Banks have to put in place a robust asset liability management (ALM) system. The objective of an ALM is to safeguard the net interest margins, its short-term profits, long-term earnings and the sustained profitability of the bank. This can be achieved through