Asset-liability mismatch explained

I have noted in Indian Current Affairs blog on 7^th October that banks are battling a liquidity crunch and an asset liability mismatch in their books. Further that they want the RBI to relax the norms to help them lend and borrow more in the inter-bank money market.

Let’s look at what exactly does this asset-liability mismatch mean.

If banks mobilize short term deposits to provide short-term loans or long term deposits to provide long-term loans, it is an ideal situation. But if banks mobilize short-term deposits and lend loans on longer terms, that results in an asset-liability mismatch situation.

Ideally banks should borrow short and lend long, and keep the margin. Usually banks’ deposits are mobilized (that is they are borrowing) for periods of up to 5 years only. But their loan portfolios (they are lending) – specially those relating to auto loans and housing – have a far longer duration. This borrow short and lend long means that they have to roll over their liabilities (deposits) faster than their assets (loans). This works fine as long as the there is a reasonable spread between the long-term and short-term rates. But when the spread narrows down, as is the case now (the benchmark 10 year paper in the secondary market is being traded at 7.38% whereas the one year T-Bill is at 6.95% -- a spread of only 43 basis points!) a serious asset-liability mismatch could expose the banks to interest rate risk and could affect their profitability – especially if the rolled over funds come at a higher cost than lent funds.

According to the latest statistics on banking from RBI, the share of short-term deposits in total time deposits of banks has increased from 43.8% at the end of March 2000 to 58.2% at the end of March 2006. On the other hand the tenure of banks’ advances or loans has been getting longer. As at the end of March 2006, of the total loans and advances of new private sector banks, those with over 5 year tenure had a 17.9% share. In contrast, in their deposits, the share of deposits of 5 years plus maturity was only 1.4%. The situation with foreign banks and old private sector banks is only marginally better. The situation with PSU banks though at present is stated to be even, with banks going for home loan lending aggressively, the asset-liability mismatch is going to be worse. This could pose systemic problems and hence the concern.