Asset liability mismatch

Asset liability mismatch

In finance, an asset-liability mismatch occurs when the financial terms of the assets and liabilities do not correspond. For example, a bank that chose to borrow entirely in U.S. dollars and lend in Russian rubles 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.

Asset-liability mismatches can occur in several different areas. A bank could have substantial long-term assets (such as fixed rate mortgages) but short-term liabilities (maturity mismatch), such as deposits, 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 also 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 has been offered as an explanation of 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 hedged by entering into derivative contracts like swaps.

ee also

*Diamond-Dybvig model

References

* [http://research.stlouisfed.org/publications/review/06/07/Bodie.pdf St. Louis Federal Reserve on asset-liability mismatch in context of federal deposit and pension insurance]
* [http://www.answers.com/topic/mismatch Definition of asset-liability mismatch]


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