We all deal with money in everyday life. We earn salaries, we buy things, and we invest it or just keep it. Sometimes we forget our wallet and our friends pay for us at tea stalls. Some other times we pay for them because they paid for us the last time.
How would it be if we start recording all these transactions? The same kind of transaction recorded together and kept away from other types. This record of transactions is called as an 'account.' The money that you have or you will get eventually is called an 'asset.' The money you have to give back to others is called a 'liability.'
Asset and liability are the basic terms of accounting. If you know someone who is an aspiring chartered accountant, his entire life revolves around balancing this asset with liability. What would happen if they do not balance? Let's find out.
The Commerce Lecture
An asset is something you have, or you might get someday. Suppose you have Rs. 100 in cash. You paid Rs. 10 for your friend’s tea at tea stall using an e-wallet. So today, you have Rs. 100 cash, and you will get back Rs. 10 from your friend tomorrow. Your asset sums up to Rs. 110.
You see, that amount lent is basically an asset. It is something you don't have right now, but you still own it. On the other hand, your friend has a liability of Rs. 10. The amount he owes or he has borrowed from you. Though he has those Rs. 10 right now, someday he will have to return it to you. So, a loan taken is a liability.
In the case of banks, the money you deposit is their liability because they will have to return it to you when you ask them. The loan you took from them is an asset to them because they will get back that money, and additional interest.
Once we get the meaning of assets and liabilities, we see how enterprises see this. An enterprise needs money to produce goods. It receives money on selling those products. Sometimes it sells its shares, some other times it just borrows. For successful and sound functioning, an enterprise would want that it possess more amount than it has to repay. In accounting words, the assets should balance the liabilities.
It is simple to understand. If liabilities become more than assets, how will the company repay? How would people trust the company that it would repay its debts?However, sometimes things are not so simple to implement
The Asset-Liability Mismatch
There are innumerable scenarios in finance. There may be cases when assets and liabilities do not correspond, even if everything is fine. Suppose US banks buy Indian Masala Bonds. The day they buy the bonds, one dollar values Rs. 50. They buy the bonds worth $100 and hence, give you Rs. 5000. 10 years later, the rupee devalues and one dollar becomes Rs. 100. Now though, you return them their Rs. 5000, but it is actually $50.
In this case, US banks have lost half their amount. Despite everything being the same, the assets have lost their value. This kind of asset-liability mismatch is called 'currency mismatch.' There is another case. Banks borrow money on the floating interest rate (it keeps changing after a certain period) and lends that money to people at a fixed interest rate. Say today bank borrows at 5% and lends people at 8%. What would happen if the floating interest rate jumps to 10%?
Bank has to pay more money to its lenders but earns less money from customers. Despite everything else being the same, the liabilities of the banks have increased. This kind of asset-liability mismatch is called as 'interest rate mismatch.'
There is a third kind too. Say you borrow Rs. 100 from a friend and promise to return him next week. Meanwhile, you see an advertisement for a scheme that would give you Rs. 200 at the end of the year for Rs. 100 invested today. You are lured and use the amount from your friend to take advantage of this scheme.
What would happen when your friend turns up next week asking for money? You will not have anything to return to him. Though you would have enough by the end of the year, you promised to return him next week, not next year. The assets and liabilities are all in place, but not in the same duration.
This kind of asset-liability mismatch is called 'maturity mismatch.' Not just that, it is seen widespread, it accounts for most company defaults. IL&FS management blamed the default on this and wiped its handoff.
As explained, it starts when a financial institution borrows money for the short term but lends it further for a longer-term. The banks take deposits from you and then provide loans to people. The savings can be cashed any day while most fixed deposits tenure 1 year to 3 years. The money is lent to housing, infrastructure and commercial loans that are repaid over more than 10 years.
This kind of scenario causes an asset-liability mismatch due to the maturity of both. While the assets (loans) return in the long term, liabilities (deposits) have to be satisfied in the short term. This causes liquidity risk.
The Way Out
Although this is a problem, financial institutions like banks, and most importantly, the NBFCs deliberately create asset-liability mismatch. The NBFCs have relatively lesser sources of funds. They have to raise the money to lend from various sources. It is quite logical to understand that short-term funds are cheaper and long term funds are expensive. Long-term funds are charged at a higher interest rate because of risk increases. You might be certain about what is going to happen in two months, but not for about 10 years.
In an ideal scenario, selling equity helps in raising funds for the long-term. An institution would have to keep selling its equity and arrange money to lend people for the long-term, but then how will they do business?
Hence, NBFCs (and other financial institutions) have no other option but to attract short-term deposits and then lend it long term. They manage their business using a mix of long-term and short-term fundraising.
The asset-liability mismatch is a double-edged sword. It brings along liquidity risk and might cause 'bank runs' (banks have no money to repay depositors as all money has been lent out as loans). Nevertheless, we have seen how several financial institutions like NBFCs have successfully pulled off this model.
The key lies in managing the funds. One way is to have a proper mix of long-term and short-term funds. Other ways these companies use are investing in hedge funds. These funds help companies address interest rate mismatches.
Pension funds face a reverse problem. They receive money in the short-term but they have to return it after a long time. Hence, these funds need places to park money, both short term, and long term. Such funds are a huge source of capital for such mismatch facing institutions and help keep their business running and ensure easy availability of loans to all of us.
Another aspect that has gained much emphasis, especially post-2008 'subprime crisis', is 'risk management.' Institutions have become particular about risk management and with the coming of various standards like 'Basel norms' have prevented such risks.
At the end of the day, especially for countries like India, where banks enjoy immense trust, it all narrows down to perspective. Since Indians find banks more trustworthy than NBFCs, a bank would face these problems much later than an NBFC in a similar situation. Although the phenomenon sounds scary, it has helped create capital for the entire world.