The cornerstone of the banking business model is the practice of maturity transformation, which refers to the fundamental banking activity of borrowing short-term and lending long-term. This practice, while essential, can lead to what is known as an asset-liability mismatch (ALM).
In the context of the Nepalese banking industry, this issue has been growingly significant due to their predominant holding of short-term 6-12 months Fixed Deposits (FDs), while concurrently financing long-term loans.
To better understand the issue of asset-liability mismatch (ALM), let’s break it down into two simple parts.
Assets (loans) are long-term, bearing an interest rate risk due to their lengthy maturity periods. Meanwhile, liabilities (deposits) are short-term, often needing to be rolled over at current market rates, making them more susceptible to liquidity risk. If an institution is caught amidst rising interest rates, it may find its cost of liabilities outpacing the income from its assets, thereby narrowing the Net Interest Margin (NIM).
The situation could become even more challenging in a country like Nepal where banking discipline is not strongly enforced and there exists no ‘gentleman’s agreement’ to fix interest rates among banks.
Drawing from Nepal’s banking practices, one bank could easily break ranks, raise deposit rates and thereby attract a significant inflow of deposits, often referred to as a ‘hot money’ scenario. The competitive landscape would alter drastically, leaving other banks scrambling for liquidity and facing substantial funding pressure.
Such a circumstance could trigger a domino effect, causing an increase in interest rates across the market, culminating in a tighter liquidity condition, and potentially a destabilized financial ecosystem. The repercussions would be far-reaching, possibly prompting higher loan default rates, which would further compound the asset quality issues for banks.
While ALM is a persistent issue in banking, it is manageable with the right strategies and regulatory oversight. The Nepalese banking system, while faced with this concern, also holds the potential to turn it into an opportunity for improving its risk management practices and fostering sustainable growth.