The short-term liquid deposits from savers and putting

The asset and
liability structure is important for banks in order to maximise profitability,
increase effectiveness and stability and minimise risk. With a faulty structure
the banks may be in a vulnerable position when there are changes in interest rates,
inflation, banking legislations and global economy.

Asset/liability
management has become a complex endeavour. Knowledge of the different
factors that take upon this aspect of risk management is crucial to find
appropriate solution. Accurate asset allocation accounts not only for the growth of
assets, but also addresses the nature of an organization’s liabilities. Macroeconomic
conditions, sovereign and financial market tensions and monetary policies can
change rapidly, as shown by the 2008 financial crisis, and it is important to ensure
asset quality and profitability in response to the changing environment.  

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In the case of commercial banks,
they make their profits by taking small, short-term liquid deposits from savers
and putting these into larger, longer maturity loans e.g. mortgages or business
loans. But in order to minimise risk, banks have to diversify their assets,
since they can’t put all their funds into long-term loans, as that would put
them into a weak position if the loans went bad. Thus, banks diversify their
assets, putting funds into long-term and short-term loans, offshore securities,
gold, cash etc., and they effectively reduce risk, improve their liquidity, and
in the situation that there is a market downturn they will have a better chance
of survival.

 

As
for investment and universal banks, they generally have more assets in trading,
reverse repo finance and less in loans. The same distinction is on the
liability side, where commercial banks tend to have mostly deposits, universal
and investment banks typically have mostly repo finance, trading and other
debt.

 

 

As we can see, the liabilities and assets of financial
institutions can be quite complex. To manage risks that arise because of
mismatches between assets and liabilities the Asset-liability management (ALM) strategies
are used. They minimise risk, loss of profit and help banks increase their
asset value. These include the use of interest rate risk management and
hedging, using financial futures, swaps, options and the use of derivatives. Using
these techniques banks can understand asset and liability structures better,
operate with less risk, more efficiency and profitability.

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