Asset and liability management in financial crisis.

Abstract

Purpose--An efficient asset-liability management requires maximizing banks' profit as well as controlling and lowering various risks. This multi-objective decision problem aims to reach goals such as maximization of liquidity, revenue, capital adequacy, and market share subject to financial, legal requirements and institutional policies. This paper models asset and liability management (ALM) in order to show how different managerial strategies affect the financial wellbeing of banks during crisis.

Design/methodology/approach--A goal programming model is developed and applied to two medium-scale Turkish commercial banks with distinct risk-taking behavior. This article brings new evidence on the performance of emerging market banks with different managerial philosophies by comparing asset-liability management in crisis.

Findings--The study has shown how shifts in market perceptions can create trouble during crisis, even if objective conditions have not changed.

Originality/value--The proposed model can provide optimal forecasts of asset-liability components and banks' financial standing for different risk-taking strategies under various economic scenarios. This may facilitate the preparation of contingency plans and create a competitive advantage for bank decision makers.

Keywords Assets management, Liability, Financial management, Banking, Turkey

Paper type Case study

Introduction

Internationalization and financial integration and have increased the possibility of financial contagion among emerging and developed countries. The recent financial crises in Asia, Russia, Latin America, and Turkey demonstrated the extent of vulnerability in global financial markets to changes in emerging financial markets. The significance of the banking sector in the smooth and efficient functioning of the overall economy as well as the domestic financial system has become even more apparent during these crises. Therefore, developing appropriate bank management strategies seems crucial for lowering the devastating effects of crises.

A vital issue in strategic bank planning is asset and liability management (ALM), which is the assessment and management of endogenous--financial, operational, business--and exogenous risks. The objective of ALM is to maximize returns through efficient fund allocation given an acceptable risk structure. ALM is a multidimensional process, requiring simultaneous interactions among different dimensions. If the simultaneous nature of ALM is discarded then decreasing risk in one dimension may result in unexpected increases in other risks.

ALM has changed significantly in the past two decades with the growth and integration of financial institutions and the emergence of new financial products and services. New information-based activities and financial innovation increased types of endogenous and exogenous risks as well as the correlation between these. Consequently, the structure of balance sheet instruments has become more complex and the volatility in the banking system has increased. These developments necessitate the use of quantitative skills to manage risks more objectively and improve performance:

 
   Banking risk management is both a philosophical and operational 
   issue. As a philosophical issue, banking risk management is about 
   attitudes toward risk and the pay off associated with it, and 
   strategies in dealing with them. As an operational issue, risk 
   management is about the identification and classification of 
   banking risks, and methods and procedures to measure, monitor 
   and control them (Angelopoulos and Mourdoukoutas, 2001, p. 11). 

Diversity in bank decision makers' attitudes toward risk results in diverse ALM strategies. Risk taker decision makers are willing to accept higher risk for higher return whereas risk averse managers accept lower level of risks for lower return. Consequences of high risk taking strategies might be more devastating in unstable macroeconomic environments such as emerging financial markets, leading to systemic banking crises. On the other hand, financial risks may also increase a bank's overall risk. Since this type of interdependency has been observed during the recent crises in Turkey, it might be worthwhile to analyze ALM strategies with varying risk-taking attitudes during the crises period in order to demonstrate the sensitivity of banks' performance to different risk taking strategies.

The aim of the paper is to model ALM in order to show how different managerial strategies affect the financial well being of banks during crisis. The goal programming model is built on the managerial goals and policies of the bank along with financial and regulatory conditions. It manages different risks such as liquidity, capital, credit, currency, market and operational risks that comprise critical issues in emerging financial markets. Banks canting these risks and facing worsening economic conditions could benefit using the proposed model by analyzing the consequences of alternative options in asset-liability management. The model is applied to two medium scale Turkish commercial banks, one risk-averse and the other risk-taker, for the crisis year 2000 as a specific case of an emerging financial market.

The financial structure of the Turkish banking sector during crisis is discussed in the next section. Banking literature on multi-objective decision making; methodology and the model developed; empirical results and conclusion are discussed in consecutive sections.

The Turkish banking sector in the crises years

The Turkish banking sector has faced challenges calling for restructuring with new rules and regulations since 1980. During this period, Turkey experienced a number of financial crises that severely hit the economy and the banking sector. Among these crises, the recent twin crisis of November 2000 and February 2001 are the most severe ones leading to a systemic banking crisis, in combination with a currency and an economic crisis. Twin crises were due to a decade long macroeconomic problems such as high inflation, high public sector borrowing, credit rationing in the private sector, rapid growth of the banking sector without prudential regulatory institutions, foreign exchange open positions in the banking system, and dominance of inefficient large state banks (Ozkan-Gunay, 1998). At the end of 1999, the government announced an economic program, "Disinflation Program", based on a pre-determined exchange rate path as a nominal anchor, tight fiscal and monetary policies, and important structural reforms that were postponed for years. All economic agents demonstrated an optimistic approach and the public fully supported the announced program. However, the Economic Program failed in the last quarter of 2000 due to the political conflicts prevailing in the coalition government and the delay in structural reforms. Foreign investors transferred their funds abroad. The high foreign exchange demand and the control of liquidity by the Central Bank led to the collapse of the payment system in the banking sector. Especially the crash in large state banks had a chain effect in the overall economy as well as in the banking sector. Public loss of trust resulted in sharp declines in bond and stock prices and withdrawals from banks, triggering the twin crises. The impacts of the twin crises were severe enough to justify government take over, closing or partial intervention in 23 banks as of June 2002. In the real sector, many small size enterprises went bankrupt and many large firms faced liquidity problems.

Under the above circumstances, the structural composition of assets and liabilities changed in the balance sheets of the banks over the years. FX deposits became popular because economic agents expected that the pre-determined exchange rate path and the real appreciation of the Turkish Lira (TL) would lower costs of borrowing in FX liabilities. On the other hand, the high public …