DRIVING THE RIGHT ASSET MIX: A BALANCING ART

WHAT’S THE MOTIVE FOR BANKS TO DRIVE A HIGHER QUOTIENT ON INVESTMENT BOOKS AS COMPARED TO THEIR LOANS OR TO HAVE A LIQUID PROFILE WITH A HIGHER SHARE IN THE MONEY MARKET? THIS ARTICLE INVESTIGATES WHAT CONSTITUTES THE RIGHT ASSET MIX FOR BANK CFOS

Increased competition and pressure on credit off-take implies that the assets reflected in the balance sheet are not only demonstrating progress with year on year growth, but also strike a better balance in terms of their mix. More importantly, with the increased focus on driving the bottom-line, it becomes somewhat imperative that every dollar deployed earns the bank a better return. The construct of the balance sheet, and the appropriate deployment of funds therefore assume far more significance, and deserve much higher attention than before.

Of the four kinds of asset class, loans and advances, which is the primary focus of a commercial bank, typically takes the lions share. Middle East banks have this in the range of 65 to 75 per cent whereas emerging economies tend to have this even higher. Interestingly markets such as Egypt still have it to be less than 50 per cent. While investments including securities, equity, derivatives, etc usually tend to be 10 to 15 per cent of the asset book of a commercial bank, the cash and balances are in the range of five to 10 per cent. The rest sit in the other asset category.

While the above reflect the broad range of asset mix, it is quite obvious that banks need to play their asset deployment game aligned to that of their liability book. Easier said than done. There are three core objectives that any commercial bank would face in addressing the above, and even more so with increased thrust on the margin

  • Ensuring the right risk profile – this is not only about the overall risk weighted asset mix and the related capital adequacy requirement, but also about the profile of risk that is associated with each asset class. These could be both credit risk and market risk.
  • Driving the right returns – even while the loan portfolio drives a higher return than investments that of course is still better than call money deployment, it is not that the banker gets a choice of all of them everyday! It is a continuous process of realignment. More on this later.
  • Aligning the maturity profiles and liquidity: The banker’s paradigm as they say! It’s not just the lending and borrowing rates that is the hallmark of a successful bank, but also aligning the maturity profile of the asset and liability book. The right level of liquidity is key – not too high, not too low.

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Considering that the above are the key levers for structuring the right asset mix, and they ought to be balanced appropriately, the art of doing so becomes the new mantra for driving the balance sheet strategy. Obviously, these are quite relative to whether the bank is more corporate or retail oriented, conventional or Islamic, and also whether it is a new bank where the capital needs to be deployed, or an established entity.

So what are the principles to driving the right balance? How does one determine if the asset mix is appropriate and when does it become necessary to make a correction, if at all? And more importantly, what are the tenets that help determine the right course of action should there be a realignment that is necessary?

Firstly, a core lending portfolio and its composition determine the primary outlook of the bank and demonstrate the key focus of the bank across multiple dimensions – corporate, commercial and retail business segments, the industry and customer segmentation, kind of lending – be it term or working capital financing and of course the concentration risk built around it. While this is primarily driven by the credit function, the exposure value and asset book constitution would also be influenced by the LDR, risk weights and the capital adequacy norms that need to be adhered to.

The investment portfolio, while is driven by the treasury and investment strategy of the bank, also serves as the semi-liquid asset class that facilitates parking of funds in both debt and equity instruments. Investments in properties and other asset classes including in real estate are typically not considered to be part of the core investment strategy, although they still represent the nonfinancial investments of the bank. Again, the class of financial assets invested in – such as government bonds or Sukuk, greatly influence the risk weighted asset profile and the resultant capital adequacy requirements. Investment in T-bills and Zero Coupon Bonds are seen in many developing economies as levers to managing the statutory liquidity ratio of the banks as well.

The real juggle i.e. where that ‘extra dollar’ is protected, is correlated to the ability of the bank in managing the call borrowing and lending effectively. While four to five per cent of the asset portfolio is generally acceptable and is essential to manage the surplus or quick need of liquidity, it gets to become a significant leakage of income where this tends to be consistently above five per cent. There are banks that have this go even up to 10 per cent, and that can be quite an opportunity to focus upon. Call lending hardly earns 50 to 100 basis points of return, as compared to Sukuk or other debt instruments, whose yields tend to be at least three to five times higher. The key here is to be on the constant lookout for those mostly-liquid debt instruments where short-term funds could be parked, and effective leverage of that investment avenue.

INVESTMENTS IN PROPERTIES AND OTHER ASSET CLASSES INCLUDING IN REAL ESTATE ARE TYPICALLY NOT CONSIDERED TO BE PART OF THE CORE INVESTMENT STRATEGY

As they say, it’s a science when things are black and white, but gets to be called as an art when you ought to operate in shades of grey. The mastery of this ‘balancing art’ is not only to strike the right asset mix, but in ensuring its consistency as an ongoing process as well!

Author | V. Ramkumar

For a further conversation on this subject of Cedar View or how we may be able to help please email V. Ramkumar, Senior Partner, Cedar at V.Ramkumar@cedar-consulting.com


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