Ahead of the Yield Curve: A Roundup of What You Need to Know about Business and Interest-Rate Cycles, the Gap, Risk, Asset Sensitivity and Other Asset-Liability Management Issues That Are of Critical Importance to Marketing

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Before you can figure out how marketing fits in to the asset-liability committee (ALCO) process, you first have to understand asset-liability management. In this article, I'll review file history and basic principles of asset-liability management. Then, I'll add a few observations about marketing's role in this area.

A century ago, pricing for bankers was simple. Like any business, they bought their raw material, money, at a low price, added value, and then sold it at a higher price. Hopefully, this price covered their costs and left a little for the owners. Interest rates rarely changed, inflation was not fully understood, and there was no Federal Reserve in place to smooth out the normal boom-bust cycles through the manipulation of rates and, thereby, people's perceptions of the future.

Things began to change, though, as we learned about the business cycle and its cousin, the interest-rate cycle. It seems that economies do not grow in a linear upward-trending fashion. Rather, like the mood swings of the people they reflect, businesses and economies grow in cycles. They start small, gain some success, add resources, and then really start to grow. This process attracts more and more resources until, eventually, too many are competing. This leads to severe price competition, lower profits, and a decline in volumes as the less capable resources are forced out.

This cycle, as depicted on the accompanying chart ("The Business and Interest-Rate Cycle"), applies to anything bought or sold in a free, or relatively free, market. It would apply to wheat, coal, corn, computer chips, farm laborers, skilled machinists, airline pilots, doctors, call-center operators, houses, apartments, or just about anything bought or sold. It also applies to money, the price of which we call interest.

The business of banking is mostly about the buying and selling of money. Though recent regulatory changes allow banks to expand their product lines somewhat, these new businesses relate largely to the needs people and businesses have to either buy or sell money. As a bank looks at its raw materials, it calls these categories of money liabilities because it is obligated to eventually give them back to their owners. These liabilities include deposits, borrowings and capital. This is the money the bank owes to people.

On the other side of the balance sheet are the assets. These are the loans of various types that banks make to customers to grow their businesses, buy new homes, send kids to school, or whatever is desired to build a better future.

To a bank, deposits are liabilities and loans are assets. This is just the opposite of the way consumers would look at their balance sheet. A bank buys deposits (liabilities) and sells loans (assets). The prices we pay to buy deposits and the prices we get for loans are interest rates. Generally, the higher the degree of risk associated with both, the higher the interest rate. Risk exists because borrowers might not pay their loans back; or depositors might lose their money if the bank makes too many bad loans and fails.

Another form of risk affecting the price of money is opportunity costs, that is, the chance that you might wish to borrow money (or lend money) for a long period of time during which rates might either go up or down and foreclose a better opportunity. For example, if you borrow $200,000 to buy a new home today at 6 percent for 30 years, and rates drop to 3 percent, you will have lost the opportunity for a cheaper loan. And if you refinance at 3 percent, your lender will have lost the opportunity to have your 6 percent loan, which it may have financed with 4 percent certificates of deposit (CDs).

So, as rates gyrate through the business/interest-rate cycle, risks are evaluated and mitigated, products are marketed, and shrewd bankers and their marketers harvest profits (or, if they not so shrewd, losses). All of this is done within the crucible of today's incredibly high competition. …