February 16 2016

A brief history of asset and liability management

Senior Lecturer in the Accounting and Finance Department at Middlesex University, Dr Edward Bace, charts the history of asset and liability management ahead of the inaugural Bank Treasury Risk Management conference in Dubai.

Asset and liability management (ALM) is an essential risk-mitigation tool, not only for banks, but also for other commercial institutions. The objective of many enterprises with assets to invest is to fund a liability, for example, banks, insurance companies and pension funds. It follows that ALM should be the investment focus and basis for selecting a core portfolio, as in asset management for pensions.

Insurance companies have long been practitioners of ALM, in part because of regulations imposed on them. Proper ALM should be a coordinated effort based on improving the pension plan’s funded ratio (assets/liabilities), with no other goal or interference, such as market indices, peer comparisons or inflation. In sum, ALM can be defined as the process that deals with interest rate risk management, whether it is applied to banks, insurers, pensions or other enterprises.

Cash matching

An early form of ALM for pensions (sometimes called liability-driven investment, or LDI) was called dedication, or cash matching. It required the exact matching of a stream of cash inflows (assets) to a stream of cash outflows (liabilities). This necessitated a sophisticated computer programme to perform the numerous iterations required to achieve effective cash flow matching by leaving the smallest amount of cash flow uninvested or unmatched. The model assumed a 100 per cent bond portfolio held to maturity or to the liability payment dates (termination dates). The goal was to find the least expensive mix of bonds to perform this future value matching. Dedication had the advantages of:

• Certain or predictable cash flows (when held to maturity)
• Risk reduction (market, reinvestment, inflation, default and liquidity)
• Specificity (asset cash flows must match liability cash flows)
• Simple asset allocation (100 per cent bonds)
• Passive investment management (more certain returns with lower fees)

Along with these came several disadvantages:

• A model that was not easy to build
• Difficulty of understanding the complicated mathematical model
• The model depends on accurate projected liability payments, which may not always be predictable
• The model is designed to capture future values, not present values. This gives rise to potential volatility in funded ratios (which are based on present values or market values) if asset market values do not move in tandem with liability market values.
• The model minimises, or even eliminates, the role of active bond managers and pension consultants for asset allocation
• The transaction cost of dedication was very interest rate sensitive (inversely correlated), so with trends to lower interest rates, dedication became increasingly more expensive.

Dedication thus gave way to immunisation, designed to match the present value growth of liabilities because that is how the accounting rules measured the funded ratio of a pension plan. Immunisation involved matching the interest rate sensitivity of liabilities in present values. Thus it focused on duration (or modified duration) in conjunction with horizon analysis. Duration measures the average life of a security (asset or liability) in present values.  When it is modified (negative of duration/(1+yield to maturity)), duration is a good approximation for price return movement given an interest rate movement.

Serious obstacles

As interest rates began to fall, call risk became a serious obstacle to immunisation and dedication models. This prepayment risk altered cash flows and maturity structures, damaging the integrity of immunisation and dedication models dependent on certain cash flows and maturity dates.

A new accounting rule in the 1980s allowed corporations to use a return on asset (ROA) assumption to offset liability expense. As a result, if the growth in assets based on the ROA rate exceeded the liability expense, this expense would become income (or credit), which would directly enhance earnings.  Because corporations are earnings per share (EPS) driven and not liability driven, the ROA, instead of matching and funding liabilities, became the hurdle rate or objective return.

ALM began to be promoted as a proper asset management style on an economic basis

When interest rates fell below the ROA assumption in the late 1980s, dedication and immunisation strategies were replaced by surplus optimisation strategies, which aimed for growth in assets to outpace liability growth, creating a surplus that reduced or even eliminated pension contributions.

During the 1990s, asset allocation models favoured equities over bonds because the ROA was the growth benchmark. Equities enjoyed several good years of double-digit returns, resulting in surpluses which enhanced EPS. But this focus on ROA rather than relative and volatile liability growth would soon come back to haunt.

Back to basics

The equity correction of 2000-2002 was a tidal wave that hit financial statements with unexpected, damaging force. It caused an EPS drain because the assets underperformed the ROA. After this correction, the stage was set to return to the basic concept of asset/liability management. This environment opened up asset allocation to many new asset classes and strategies. ALM began to be promoted as a proper asset management style on an economic basis (i.e. market value) and not on an accounting basis. This is rightly where we are today.

Dr Edward Bace is speaking on ALM and related topics at the BTRM conference in Dubai, which is taking place between 21 and 23 February 2016.  He is also acting as guest co-editor for a special issue of the Journal of Risk Management in Financial Institutions (JRMFI), for which papers of 2,000-5,000 words on the topic of ALM are being sought from practitioners and researchers. The deadline for these is 14 April 2016, with successful submissions published in the 29 August edition. Please contact Dr Bace, or alternatively email Julie Kerry, the publisher. Further guidance on manuscript submissions is available on the journal website.

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Tags: accounting, Asset management, banking, cash flow, economics, finance, investment, liability, pensions, risk