Balance Sheet Type | Asset Liability Management [Video]

Financial instruments can be fixed or floating and short-term or long-term. Floating instruments can also reset at different intervals. These details are important because they determine how interest rate shocks affect the bank’s net interest income (NII).

Due to the different terms and rate settings of financial instruments, a bank’s balance sheet can be asset-sensitive or liability-sensitive.

Asset-sensitive means an increase in interest rates would increase NII, whereas a decrease in increase interest rates would decrease NII.

Liability-sensitive means an increase in interest rates would decrease NII, whereas a decrease in increase interest rates would increase NII.

How can you tell whether a bank’s balance sheet is asset-sensitive or liability-sensitive?

The first step is to quantify the impact on NII from various interest rate scenarios. For example, a bank could examine how an increase of 100 basis points would affect its NII.

The next step is to take action to mitigate the interest rate gap risk and reduce the earning gap. Banks can do this with matched maturity funding and/or matched rate funding.

Matched maturity funding means funding short-term assets with short-term liabilities, and funding long-term assets with long-term liabilities.

Matched rate funding means funding fixed-rate assets with fixed-rate liabilities and funding floating-rate assets with floating-rate liabilities.

It’s not easy to match the maturities and rates of assets and liabilities. Thus, banks also use interest rate swaps and basis swaps to manage risk.
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