Understanding Asset Liability Mismatch
Asset Liability Mismatch or ALM is considered to be a comprehensive and dynamical framework for measurement, monitoring and managing the market risk of the Banks. Asset Liability Mismatch arises in the following situation:
The Primary source of funds for the banks is deposits, and most deposts have a short- to medium-term maturities, thus need to be paid back to the investor in 3-5 years. In comparison, the banks usually provide loans for a longer period to borrowers. Out of them, the home loans and Infrastructure projects loans are of longest maturity. So when a bank provides the long term loans from much shorter maturity funds, the situation is called asset-liability mismatch.
ALM creates Risk and Risk has to be managed. This is called Asset Liability Management.
Consequences of the Asset Liability Mismatch
The Interest rate risks (due to fluctuation) and Liquidity Risk (due to long maturity of loans) are two typical consequences of Asset Liability Mismatch.
Interest Rate Risk: The banks would require to reprice the deposits faster than the loans and during this process if the bank has to pay a higher rate, the adjustment is difficult.
Liquidity Risk: The banks would have to repay the depositors when their funds mature. But when they repay, the cannot recall their loans. In this situation, bank would require the new deposits. This may create a acute situation if there are no deposits available. In some cases, the bank may also need to be paying higher interests on new deposits.