Asset and liability management: form and function of the committee

Federal Home Loan Bank Board Journal, April, 1984 by William C. Handorf, Michael P. McCarthy

There is little doubt that the future strength of the savings and loan industry is directly related to the willingness of individual associations to utilize the expanded authority provided by legislation passed in the early 1980s. Management is presently able to evaluate a broader spectrum of actions designed to improve their institution's interest margin (interest income less interest expense)--the major factor precipitating profitable or deficit operations. Prior to the broader authority granted by the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St Germain Depository Institutions Act of 1982, thrifts could either increase institution size (volume) or improve the interest spread (rate) to achieve higher earnings. Now, thrifts may also manage the asset/liability mix in order to enhance the interest margin.

The convergence of financial service groups in the industry, stratification of traditional customers, segmentation of products by competitors, and almost complete deregulation of interest rates paid for savings are causing thrift institutions to re-evaluate their approach to funds management. Asset/liability management must identify those investments, credits, deposits, and purchased money alternatives capable of increasing and/or stabilizing the interest margin. The mix of funds between and within open financial markets and customer-dominated markets reflect strategic issues central to the planning process.

In response to the more permissive regulatory environment, volatile economy, intense competitive pressures and rapidly emerging technological innovations, numerous associations have appointed asset/liability committees to grapple with the related issues. Early experience shows that these organizational reactions sometimes have not lived up to expectations or are destined to consume unnecessarily large amounts of managerial time and institutional expense. In short, uncertainties exist regarding the form and function of asset/liability management.

This article addresses organizational and structural questions associated with the management of funds. The article suggests answers to the following questions regarding the asset/liability committee:

* Who should serve?

* What is the purpose?

* When should the participants meet?

* Why is the committee important?

* How does the committee operate?

The current market position and financial condition of most thrifts largely reflect past regulatory impediments and unprecedented economic volatility. Continued survival and a profit turnaround will reflect the willingness of each institution's board of directors to establish reasonable goals and of management to achieve these goals by implementing appropriate strategies. The asset/liability committee provides the organizational structure by which to affect strategic choices. Strategic Perspective

As thrift institutions compare their own organization's existing strengths and weaknesses with likely industry opportunities and threats, the strategic planning process provides insight into four fundamental questions:

* Who business will we be in?

* What markets will we serve?

* Who will our principle customers and competitors be?

* What relative priorities exist for profit, growth, and service goals?

The precise mix of funds and the growth rate of total assets will likely follow general role models anticipated within the environment of a deregulated industry, i.e.: (1) nationally recognized institution; (2) low-cost producer; and (3) specialty financial institution. Because the financial services industry is becoming less homogeneous, management will find it increasingly meaningless to compare itself merely with another, even if geographically close and similar in asset size. Corporate missions will differ and precipitate varying degrees of liquidity, asset quality, capital, and earnings among industry participants. Asset/liability management must reflect the individual operations of each institution rather than an industry norm.

Nevertheless, the empirical record shows that defaulting financial institutions operate with less liquidity, lend more aggressively to lower quality debtors, rely on less capital, maintain little control over operating expenses, and significantly mismatch the yield sensitivity of assets with liabilities. Asset/liability management must identify and determine an optimal risk/return trade-off. Risk should not be avoided--it must be managed with a size limited to what can be absorbed in normal annual earnings. The flavor of the risk/return trade-off is next suggested prior to developing the organizational structure of an asset/liability committee.

Growth. Since limited scale economies exist in providing financial services, larger size operations can contribute more toward income than is taken away by expenses. For the thrift industry, growth also shrinks the relative importance of lower rate mortgage loans which, otherwise, drags down the resultant interest margin and precipitates grave yield sensitivity imbalances. One of the easiest ways to grow internally is to pay more for funds and charge less for loans than the competitor. The strategy increases the volume of funds but reduces the spread. Whether the action is appropriate depends on the association's elasticity of demand and supply for customer funds and the adequacy of the capital ratio which falls with additional financial leverage.