Asset liability mismatch
Encyclopedia
In finance, an asset–liability mismatch occurs when the financial terms of an institution's assets and liabilities do not correspond. Several types of mismatches are possible.
For example, a bank that chose to borrow entirely in US dollars and lend in Russian ruble
s would have a significant currency mismatch: if the value of the ruble were to fall dramatically, the bank would lose money. In extreme cases, such movements in the value of the assets and liabilities could lead to bankruptcy
, liquidity problems and wealth transfer.
As another example, a bank could have substantial long-term assets (such as fixed-rate mortgages) but short-term liabilities, such as deposits. This is sometimes called a maturity mismatch, which can be measured by the duration gap
. Alternatively, a bank could have all of its liabilities as floating interest rate
bonds, but assets in fixed rate instruments. Mismatches are handled by asset liability management
.
Asset–liability mismatches are important to insurance companies and various pension plans, which may have long-term liabilities (promises to pay the insured or pension plan participants) that must be backed by assets. Choosing assets that are appropriately matched to their financial obligations is therefore an important part of their long-term strategy.
Few companies or financial institutions have perfect matches between their assets and liabilities. In particular, the mismatch between the maturities of banks' deposits and loans makes banks susceptible to bank runs. On the other hand, 'controlled' mismatch, such as between short-term deposits and somewhat longer-term, higher-interest loans to customers is central to many financial institutions' business model.
Asset–liability mismatches can be controlled, mitigated or hedge
d.
For example, a bank that chose to borrow entirely in US dollars and lend in Russian ruble
Ruble
The ruble or rouble is a unit of currency. Currently, the currency units of Belarus, Russia, Abkhazia, South Ossetia and Transnistria, and, in the past, the currency units of several other countries, notably countries influenced by Russia and the Soviet Union, are named rubles, though they all are...
s would have a significant currency mismatch: if the value of the ruble were to fall dramatically, the bank would lose money. In extreme cases, such movements in the value of the assets and liabilities could lead to bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, liquidity problems and wealth transfer.
As another example, a bank could have substantial long-term assets (such as fixed-rate mortgages) but short-term liabilities, such as deposits. This is sometimes called a maturity mismatch, which can be measured by the duration gap
Duration gap
-Definition:The difference between the duration of assets and liabilities held by a financial entity.-Overview:The duration gap is a financial and accounting term and is typically used by banks, pension funds, or other financial institutions to measure their risk due to changes in the interest rate...
. Alternatively, a bank could have all of its liabilities as floating interest rate
Floating interest rate
A floating interest rate, also known as a variable rate or adjustable rate, refers to any type of debt instrument, such as a loan, bond, mortgage, or credit, that does not have a fixed rate of interest over the life of the instrument....
bonds, but assets in fixed rate instruments. Mismatches are handled by asset liability management
Asset liability management
In banking, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities of the bank. This can also be seen in insurance....
.
Asset–liability mismatches are important to insurance companies and various pension plans, which may have long-term liabilities (promises to pay the insured or pension plan participants) that must be backed by assets. Choosing assets that are appropriately matched to their financial obligations is therefore an important part of their long-term strategy.
Few companies or financial institutions have perfect matches between their assets and liabilities. In particular, the mismatch between the maturities of banks' deposits and loans makes banks susceptible to bank runs. On the other hand, 'controlled' mismatch, such as between short-term deposits and somewhat longer-term, higher-interest loans to customers is central to many financial institutions' business model.
Asset–liability mismatches can be controlled, mitigated or hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
d.
See also
- Diamond–Dybvig model
- Original Sin (economics)Original Sin (economics)Original sin is a commonly used metaphor in economics literature. It was proposed by Barry Eichengreen, Ricardo Hausmann, and in a series of papers to refer a situation in which "most countries are not able to borrow abroad in their domestic currency."...
- Domestic liability dollarizationDomestic liability dollarizationDomestic liability dollarization refers to the denomination of banking system deposits and lending in a currency other than that of the country in which they are held...