In the investopedia article on liability management, http://www.investopedia.com/terms/l/liability-management.asp
it says:
Liability management constitutes an important part of a bank’s bottom line
The way I udnerstand naively about liability is that liability is something that does not contribute to someone’s bottom line, as opposed to an asset. For example, a car is a liability.
So why would a bank want to manage liability?
Sorry, I am a newbie.
Well a bank is really just a long/short trade. Bank profit is the return on their assets less the cost of their liabilities. Banks invest in “long-term” assets and finance it with short term debt and deposits. So liability management, from a bank’s perspective, is about reducing cost (while managing risk).
Short-term debt will be lower cost, but as the mismatch in duration between assets and liabilities grow, so does your risk.
Also, liability management is a big deal in any company with sizeable debt obligations, like a utility for example. When I was in treasury at a utility we spent a lot of time concerned with duration versus our physical asset life and our exposure to rate movements, all while trying to reduce borrowing costs.
Sup little cubby.
In terms of a bank the asset is the mortgage loan. The liability is the savings account. Geo is hitting at net interest margin where you take the loan asset and subtract the savings account liability to get the ‘net’ interest the bank earns. Net interest margin has been squeezed hard in the last few years leaving banks to start generating revenue off other services, issueing more fees, and what not.
Asset is what you own. Liabilities are what you owe. The difference is your net worth (equity). Works for personal financial management as well as corp fin.
Liabilities are basically things that you owe to other people. Usually that’s some kind of debt, but it could be taxes or even equity that’s owned by someone else (minority interest).
(Incidentally, a car is an asset. The loan balance on the car, or, more accurately, the present value of the payments you will make to pay off the loan, is a liability.)
For banks, the main liabilities are deposits (money owed to depositors), regular bond-like debt, deferred taxes, and perhaps legal settlements. For things like pension funds or endowments, liabilities are expected payouts to plan participants or to the entity that the endowment supports.
Sometimes it’s easier to think of liabilities as if you are short a bond. If you owe a payment in X years, it’s like being short a zero coupon bond that matures in X years.
So what happens in banks is that they generally try to make money by lending over the long term at a high interest rate, and pay their depositors at a lower short-term rate. They can also try to do something similar with the bond liabilities where they argue that they lend out at high rates to risky projects, but bank bondholders get a more diversified portfolio that is safer and therefore get paid less. Banks make money on the spread, which is what the equity holders in banks get excited about.
Here’s the issue. If liabilities have a short duration (because deposits are more short term) and the assets tend to be long-duration, because they are being lent out long term at a spread. Then the assets can have a higher interest rate sensitivity than the liabilities. If interest rates rise, then both assets and liabilities are worth less than before, but the assets (i.e. loans to people who borrowed from the bank) take a bigger hit than the liabilities do.
If a bank hasn’t managed their assets and liabilities right, this means that a bank that used to be solvent, suddenly isn’t anymore, because assets that used to be worth more than the liabilities are suddenly worth less than the liabilities.
The other places where liability management is extra important are in pension funds, and corporate treasury. Usually, what one does is start by trying to set up fixed income portfolios that match the cash flows and timing (or at least the duration) of the liability streams, and then depart from that mix based on how much risk one is willing to take of not being able to meet liabilities (or how much of a cushion one has before not being able to meet them).
Thank you everybody for your responses.