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: Toward Enhancing Asset Liability Management
March 31, 2014
Financial System and Bank Examination Department
Bank of Japan
Financial institutions conduct asset liability management (ALM) in three steps. The first step is to gauge the degree of risks inherent in their assets and liabilities, including off-balance transactions. The second step is to reduce funding costs as well as streamline investment. The third step is to seek an optimal combination of assets and liabilities to maximize profits. One of the vital objectives of ALM is to manage interest rate risk caused by the mismatch in the structure of assets and liabilities, since this is a main profit source for financial institutions.
Financial institutions have long faced the challenge of effectively managing demand deposits through ALM. Demand deposits are deposits with indefinite maturities, and depositors can withdraw their money from the deposits. However, part of the demand deposits is thought to remain for a prolonged period (hereafter these are referred to as "core deposits"). In recent years, not only major banks but also regional banks have started to introduce core deposit modeling that estimates interest rate risk by gauging the effective maturities of demand deposits.
In a bank's interest rate risk management, core deposits are estimated by taking into account an interest rate rise. The modeling of core deposits is based on a range of assumptions, as a rise in interest rates was barely observed in Japan during the past decade. The number of types of modeling has grown, but a standard method of core deposit modeling has not been established yet. As the outstanding amount of demand deposits is large and on a rising trend, the amount of interest rate risk can vary significantly, depending on whether core deposit modeling is adopted and the particular modeling that is adopted. It is also uncertain whether an interest rate rise affects a bank's profits positively or negatively. In these circumstances, senior management and the departments in charge of planning and risk management should fully understand the characteristics and the problems regarding core deposit modeling, and continue to examine the appropriateness of such modeling.
Core deposit modeling can be used in a range of ALM, such as the analysis of prospective profits and costs in the overall balance sheets and of the profitability of deposit segments. Some financial institutions have already started to utilize core deposit modeling in such a way. However, such analysis requires financial institutions to accumulate detailed data, and many challenges remain to be resolved in this regard. We hope that discussions about enhancing interest rate risk management and ALM will become vigorous in the near future.
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