The complexities of asset liability portfolio management were covered in a talk by Adjunct Professor Philip Cheng of the Department of Finance, who urged portfolio managers to focus on balance sheets in addition to the easier option of looking at income.

“In the financial press we constantly see reports on earnings and return on equity because those are the easiest things to remember and to report. And most of us do care about the income. However, balance sheet management is equally important if not more so. 

“Company profitability can be managed by skewing and taking risk on the balance sheet without too many people noticing. Unless, that is, you have a sensitivity to know when a balance sheet is not managed well,” he said.

Balance sheets can reveal a company’s longer term direction and the five major risks it has to juggle in terms of interest rates, liquidity, credit, currencies and the market.

For instance, companies in less-developed countries need to consider more than their local currency because fluctuations in major currencies like the US dollar, Euro, yen, etc. could also affect their assets and liabilities.

Liquidity risk could arise in gaps between assets and liabilities, and could point to opportunities and dangers for portfolio managers.

“A mismatch is something that I pay a lot of attention to – don’t run away from a mismatch. You want the mismatch because there is no excitement in an over-clean balance sheet,” he said. “One is encouraged to pick one’s ‘poisons’, or pick the risks that are deemed to be least harmful and still achieve one’s corporate objectives!”

Interest rate risks may also be managed on balance sheets, a tactic that varies from place to place based on the country environment.

Professor Cheng said all risks can fluctuate over time, which makes it imperative for portfolio managers to stay on top of the situation. He suggested some pitfalls that managers should be beware of, using three case examples to illustrate his points.

For example, if one is dealing with a traditional financial institution based in New York or any developed countries, a common thing would be to try to fund the liabilities short term because this is cheaper and invest in longer term assets because the interest rate is generally higher. “But what about the yield curve impact if one keeps doing that? By nature, the longer the duration, the higher the risk. It could be credit risk, it could be liquidity or other risks. And there is competitive pressure, everyone wants a higher portfolio return,” he said.

Another example is a mass-merchandising company in an emerging economy. Here the risk could be high inflation diluting the values of asset, especially because of the generally lower profitability of these firms.

A third example would be an insurance company in an emerging country because insurance companies have very long-term liabilities and emerging economies do not have the maturity of assets to match the liabilities.

“My conclusions are that basically, you are constantly compared to others in terms of how good an asset liability manager you are. So you have to rank your poisons so to speak. Like juggling the five balls of risks in the air – if you drop one ball, your job or bonus is at stake.”

Managers should look outside to get the expertise they need, be aware of global risks and those specific to the places where they operate, be aware of the differences among rating agencies, and keep abreast of political changes. 

“And last but not least, there is a sixth risk,: Off Balance Sheet items. These are the contingent assets and contingent liabilities which have ruined so many people and so many companies,” he said.