Minimizing the Financial Risks to State and Local Governments Through Asset-Liability Management

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December 8, 2020

By Martin J. Luby

The Galbraith et. al piece in this Toolkit detailed how federal revenue sharing can promote the resilience of state and local governments during times of fiscal stress. With federal support, painful budget austerity measures, especially in the areas of personnel, programmatic, and capital maintenance spending, can be avoided, speeding the eventual recovery.

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However, one spending category in state and local government budgets can be reduced strategically in times of economic slowdowns without impeding recovery efforts: the interest expenditure on the debt that governments sell. Through a strategic program of asset-liability management (ALM), state and local governments can reduce their interest costs. Like revenue sharing, such a measure would reduce the need for counterproductive cuts in spending (though at a smaller scale). More holistically, an ALM program would reduce risks, while encouraging a more holistic approach to the management of assets and liabilities.

ALM was first developed in the 1970s and is used extensively by banks and insurance companies. The Society of Actuaries defines it as:

The ongoing process of formulating, implementing, monitoring and revising strategies related to assets and liabilities to achieve an organization's financial objectives, given the organization's risk tolerances and other constraints. ALM is relevant to, and critical for, the sound management of the finances of any organization that invests to meet its future cash flow needs and capital requirements.[1]

A common form of ALM seeks to mitigate risk to an organization from changes in interest rates by better matching its assets and liabilities in terms of maturity length and interest rate type (floating or fixed). Through ALM, an organization avoids making implicit bets on the future direction of interest rates, which improves its cash flow management by reducing the spread between asset earnings and liability costs.[2]

An ALM program would reduce risks while encouraging a more holistic approach to the management of assets and liabilities.

How does ALM apply to state and local governments and how can they use it to make their operating budgets more resilient? Depending on their size, these governments have sizeable amounts of assets and liabilities subject to interest rate risks that can impact their operating budgets. Assets typically include operating and reserve funds invested in short-term investments carrying a floating rate that changes regularly (daily, weekly, monthly, etc.) based on market conditions. The short-term investment horizon is appropriate, as it allows the governments to preserve the principal on their investment while maintaining liquidity, since the funds will either definitely be needed within the fiscal year (operating funds) or may be needed, depending on economic conditions (reserve funds).

Among their liabilities are long-term debt obligations used to fund capital projects. Most state and local governments sell these bonds with a fixed interest rate that does not change over time. This has the effect of locking in the borrowing cost, providing a benefit for future budgetary planning as the interest costs for the entire term of the bonds are known when they are sold. Politically speaking, this has the additional benefit of avoiding "headline risk," since fixed-rate debt is often viewed by taxpayers as the most financially conservative. However, from an interest rate forecasting perspective, by selling most (if not all) of their debt on a long-term fixed interest rate basis, these governments are implicitly making a bet that interest rates will rise. Such bets entail risks.

On the asset side, a decline in interest rates would reduce interest earnings and thus revenues for the operating budget. On the liabilities side, the interest rate risk is just the opposite. An increase in rates would raise the cost of debt and thus reduce budgetary resources. State and local governments typically have unmatched asset and liability portfolios, with short-term, floating-rate investments on the asset side and fixed-rate, long-term debt on the liabilities side. A declining interest rate environment would reduce their budgetary assets without changing the costs of their liabilities, while a rising interest rate environment would produce additional budgetary resources from assets but no change in costs from the government's liabilities. Under an unmatched asset-liability portfolio, as is typical for state and local governments, they are better off in a rising interest rate environment.

But this is problematic in two ways. First, over the last 20 years, the municipal bond market has experienced historically low interest rates. That means that governments lost their bet. They would have realized significantly lower interest costs if they had sold short-term, floating rate debt. Second, and perhaps more importantly for this Toolkit, a declining short-term interest rate environment is precisely what usually occurs during an economic recession.[3] So, precisely when state and local governments can least afford it, their unmatched asset-liability balance sheets produce a situation where they earn less on their assets, putting fiscal stress on their operating budgets, but do not realize a corresponding reduction in their interest costs since their debt is not in short-term, floating rate mode.

But what about in a rising interest rate environment? Yes, governments with unmatched asset and liability portfolios would be better off in that they would earn more on their short-term assets while seeing no change in their interest costs. But rising interest rate environments are usually associated with economic expansions, with increased tax revenues and other resources. Moreover, the point of ALM is to hedge the two sides of the government's balance sheet and avoid making implicit bets on the direction of interest rates. So, under an ALM strategy, when interest rates rise, the increased costs on the debt are offset by the increased earnings on the government's assets. When interest rates decline, the reduction in asset earnings is offset by the reduction in interest costs.

The policy implication of ALM in terms of budget resiliency is for state and local governments to add some floating rate debt to their bond portfolios. Given the size of many state and local governments' short-term assets and the limited amount of unhedged floating rate debt that is currently a part of their debt portfolios, adding a sizeable amount of floating rate debt over time may be appropriate. The use of floating rate debt in reasonable amounts is advocated by many financial experts, including the Government Finance Officers Association (GFOA). In fact, the GFOA explicitly identifies the potential benefits of floating rate debt in the ALM context while recommending that governments carefully evaluate its risks.[4]

One of the few state governments that has transparently adopted ALM is the Commonwealth of Massachusetts. Massachusetts estimated that its unmatched asset-liability portfolio cost it over $1 billion between 2004 and 2014.[5] While $1 billion in savings over 10 years will not have the kind of impact that federal revenue sharing does with respect to alleviating immediate budgetary stress, it is not an insignificant amount of money. To address this economic loss, Massachusetts planned to sell $3.6 billion in floating rate debt for capital projects between 2015 and 2018. Of course, the appropriate amount of floating rate debt for any government will be contingent on the amount of their short-term assets that need to be hedged.

Improving the resiliency of state and local governments requires more strategic financial thinking.

A few caveats should be noted. First, the use of floating rate debt requires additional credit support facilities from an outside bank, which increases the cost of the debt. This credit support can become more costly or scarcer over time, as was the case during the financial crisis of 2007/2008. Second, floating rate debt entails a greater administrative burden on the government, due to the periodic changes in interest rates that need to be tracked and monitored. Thus, any government considering an ALM approach should have a financial staff with considerable capacity and financial sophistication. Finally, this policy implication does not contemplate a wholesale change in capital finance strategy. More specifically, state and local governments should still sell most of their long-term bonds on a fixed rate basis given that their overall debt likely exceeds the amount of their short-term assets, with the floating rate portion of their debt only approximating the size of their floating rate assets over time.

Improving the resiliency of state and local governments requires more strategic financial thinking. It also requires an end to the siloing of the people who manage assets and the people who oversee liabilities that is all too common.[6] ALM provides a good example of the strategic advantage that can be gained from a holistic focus on both sides of a balance sheet. While there is some hope that the worst may be over in terms of COVID-19's budgetary impacts, there can be no doubt that another economic contraction will occur in the future. When it comes, state and local governments that adopted the strategic use of ALM will experience some budgetary relief which, in concert with other fiscal support, will ensure that the trajectory of their eventual recovery is both steeper and speedier.


Martin J. Luby is an associate professor at the Lyndon B. Johnson School of Public Affairs at the University of Texas-Austin. He is also a registered municipal advisor to state and local governments.

[3] In the 2007/2008 recession and during the onset of COVID-19 pandemic in March 2020, short-term floating interest rates did rise above fixed rates for a relatively short period of time. However, this was followed by an extensive period of lower short-term rates compared to the pre-recession and pre-pandemic market environments.

[4] Government Finance Officers Association. 2015. "Using Variable Rate Debt Instruments"


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