Business firms use a financial analysis technique called asset vs. liability management (ALM) to mitigate risk due to a mismatch in their assets and liabilities. A mismatch occurs when assets and liabilities do not correspond to each other properly. A financial analyst will look at the firm’s balance sheet to find where the mismatches, and increased financial risk, occur. Mismatches between asset and liability accounts may significantly increase the risk of the firm. A financial advisor can do the same for you by looking at your balance sheet’s assets and liabilities and trying to improve the way they relate to each other.
What Is Asset vs. Liability Management?
Asset vs. liability management is one of many financial analysis techniques used to align risk and return. It is used primarily by banks, large pension funds, life insurance companies and wealth management firms, although other types of corporations may use it too. It is also appropriate for individuals.
There are several types of risk that can be managed by asset vs. liability management. Assets and cash flows are used to hedge against the risk of firms’ failing to meet their liability obligations due to one of the many types of financial risk that occurs due to mismatches as occur with interest rate risk.
Individuals all face risk and mismatches in their own personal portfolios and on their balance sheets. They, too, must coordinate their assets and liabilities to meet their debt obligations. A financial planner can help you manage your assets and liabilities through proper asset allocation.
What Is Risk Management?
Risk management strives to lessen the risk of a project or investment while earning the highest return possible. The technique’s goal is to solve the mismatches between assets and liabilities. Asset vs. liability management is one financial analysis technique available to risk managers to accomplish this function.
Financial risk is the risk a business must bear to complete a project or invest successfully while earning an acceptable return for the firm’s shareholders. The financial analyst’s goal is to keep that risk from being so excessive that it falls outside the firm’s risk tolerance and investment objectives. There is a positive or direct relationship between the riskiness of a project and its potential return. You must take on more risk to potentially increase your return.
What Are Mismatches?
A mismatch occurs when assets and liabilities are incorrectly matched regarding their interest rate profiles. Assets must be growing and available to meet the payment of a firm’s liabilities. For example, look at a business that administers pensions. The pension deposits must correspond appropriately to the withdrawal of pension funds, or you have a mismatch, and you might not be able to meet your pension requirements.
In a bank, you must have enough deposits on hand to meet your loan requirements and the withdrawal of funds. In a corporation, you must have enough growing assets and cash flow to pay the debts of your company on time. In an insurance company, you must have enough cash on hand from policy premiums to meet the cash outflows needed if there is an accident or natural disaster. In all these types of organizations, assets must be growing to match liabilities when they come due. If they do not, the business could have big financial losses or even bankruptcy.
As an individual, you want to match the maturities of your assets and liabilities to be able to meet your debt obligations.
Types of Risk-Affecting Assets and Liabilities
There are three main types of risks that impact the asset and liability comparison. It’s important to understand each so that you know where the mismatches could occur and how it could impact your situation. There are three main types of risk:
- Interest Rate Risk: Interest rate risk is the most significant of all the risks associated with asset and liability management. Interest rate risk is the unexpected change in interest rates as you have in an inflationary environment. The risk arises from holding assets of different principal amounts and liabilities with varying maturity dates.
- Liquidity Risk: Liquidity risk is also significant for ALM. Liquidity and profitability have an inverse relationship, so too much liquidity will negatively impact profitability. However, enough asset liquidity is essential to meet debt obligations and it becomes a balancing act.
- Investment Risk: Investment risk is relevant to ALM since it is a collection of other types of risk impacting the expected value of the assets and liabilities held by the firm. There is volatility risk, inflation risk, business risk and others. All are part of the financial risk of a business firm or an individual retail investor.
Assets and liabilities are particularly sensitive to interest rate risk and liquidity risk. In an environment of inflation and rapidly changing interest rates, ALM can be quite challenging. Financial managers usually attempt some form of gap management, which refers to managing the gap between the interest rates they are earning on their assets compared to the interest rates they are paying on their liabilities.
Mismatches may occur since prices may be rising faster than the interest paid on assets. Gap management in this case would require a more active role by the financial manager to be sure there is enough cash flow from assets to meet the amounts due on liabilities. The asset composition of the firm may need to be adjusted along with ever-increasing operating expenses. This is an integrated asset-liability approach where the appropriate asset allocation can be determined to hedge the liabilities and jointly optimize the assets and liabilities.
A more recent form of an ALM strategy is “surplus optimization,” which indicates the gap between assets and liabilities. The surplus return on assets is compared to the surplus variance on the liabilities using a mean-variance approach. This technique is helpful to determine which assets are available to hedge the liabilities.
A two-portfolio technique may also be useful. Assets are divided between a growth portfolio used to increase return and a conservative portfolio used to hedge the liabilities.
The Bottom Line
ALM is one technique of lowering the impact of the ever-changing financial environment on the balance sheet or net worth of the business firm or an individual’s balance sheet. Financial analysts use a variety of strategies to perform asset allocation that assures that the obligations of liabilities are met by the market value of the assets while preserving a reasonable market return.
Tips on Asset Allocation
- Determining what assets to invest to meet your financial goals can be a struggle. A financial advisor can help you weigh the risks and advantages before investing in a stock for your portfolio, and help you find the right mix. Finding a financial advisor doesn’t have to be difficult. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Do you need some help choosing stocks for your portfolio? If so, take a look at SmartAsset’s asset allocation tool that helps you choose stocks in the proper proportion for your portfolio.
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