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What is ALM ?
In banking, asset and liability management is the practice of managing risks that arise due to
mismatches between the assets and liabilities (debts and assets) of the bank. This can also be seen in
insurance.
Banks face several risks such as the liquidity risk, interest rate risk, credit risk and operational risk. Asset
Liability management (ALM) is astrategic management tool to manage interest rate risk and liquidity risk
faced by banks, other financial services companies andcorporations.
Banks manage the risks of Asset liability mismatch by matching the assets and liabilities according to the
maturity pattern or the matching the duration, by hedging and by securitization. Much of the techniques
for hedging stem from the delta hedging concepts introduced in theBlack-Scholes model and in the work
of Robert C. Merton and Robert A. Jarrow. The early origins of asset and liability management date to the
high interest rate periods of 1975-6 and the late 1970s and early 1980s in the United States. Van
Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail.
Modern risk management now takes place from an integrated approach to enterprise risk
management that reflects the fact that interest rate risk, credit risk, market risk, and liquidity risk are all
interrelated. The Jarrow-Turnbull model is an example of a risk management methodology that integrates
default and random interest rates. The earliest work in this regard was done by Robert C. Merton.
Increasing integrated risk management is done on a full mark to market basis rather than the accounting
basis that was at the heart of the first interest rate sensivity gap and duration calculations.
Asset and Liability Management (ALM) There are different organizational and governance models that guide the
management of bank asset and liability activities. The models reflect fundamentally different risk philosophies that
tend to evolve with the growing sophistication and depth of financial markets together with the position and
activities undertaken by a bank in the market. The terms ‘ALM unit’ and ‘treasury unit’, can be confusing as they are
often used by organizations who assign different responsibilities to them - this will be explained below.
1. The evolution of models is driven by differing philosophies about the role of the treasury or the ALM unit and banks
in markets at different stages of development often regard the treasury unit differently.
2. In emerging markets the treasury function is usually simplistic and a support function mainly focused on liquidity
management and basic foreign exchange activity. In these banks, it is not uncommon to have a prohibition on
involvement in more sophisticated capital markets transactions such as derivatives due to lack of knowledge and
suspicion about the instruments. Such markets can suffer from poorly developed capital markets that provide little
capacity to offset the risks assumed from the customer franchise. The result is often that these banks are slow to
evolve and run risks, without knowing it, which can threaten their very survival.
3. In developing markets the treasury function usually begins to take on more structure, more activities and a broader
mandate. At the simpler end of the spectrum it can assume full balance sheet management responsibility, involving
itself in more complex analytics and hedging activities. At the more complex end it can assume trading and market
making responsibilities for a range of capital market products that are used in hedging but also are provided to
customers. This can often be referred to as an ‘integrated treasury function’, with profit making as well as hedge
4. In developed markets the model usually evolves by separating out the trading and market making functions into a
more customer centric unit such as a capital markets or institutional banking division, with a subsequent refocusing
of the core ALM functions on more detailed analysis, and management of the banks’ assets, liabilities and capital
base. Treasury becomes more of a service centre in these banks, providing assistance and support with pricing and
analytics to customer facing divisions. The ALM or balance sheet can often be managed aggressively through the
use of derivative contracts. Funds transfer pricing mechanisms are used extensively to create economic
5. In all models the ALM function reports to either the CEO / CFO with the CFO generally having the day to day
responsibility for the ALM core functions. Under all models it is important to establish a clear understanding of
activities and risk thresholds in the Treasury function and ensure the risk framework is aligned to the operating
structure and market realities. Establishing a governance structure within which the board of the bank is fully informed
and cognisant of the risks being run is a critical and mandatory component.
6. It is in the more developed markets that the Chief Risk Officer function has developed and come to represent the
36. Successful ALM units create a properly aligned risk and return management process. The right mix between skills
and risk appetite must be identified, expected outcomes of activities known and appropriate metrics established. The
approach adopted needs to be aligned to the realities of the market the bank is operating within and to its desired risk
appetite.
1. A bank needs to decide whether it wants to take a relatively neutral approach to ALM risks or is prepared to take a
more aggressive approach and target higher long term earnings and an increase in economic value. Irrespective of
the choice made, a bank needs to realise that the right level of skills and resources need to be committed to support
the function. Failure to do this can result in a poorly managed operation characterised by volatility in; core
Assuming a single portfolio without hedges, a large and well diversified bank, with transactions weighted broadly
across all market segments, will find that its balance sheet will naturally take on countercyclical characteristics as
the business environment consolidates through the economic cycle. This makes sense as the bank is effectively
providing customers with solutions they are demanding as they operate in the external environment. The market
itself will also provide limitations and one of the areas where this can manifest strongly is on the liability side of the
balance sheet. Various techniques are used to examine the mismatch in a bank’s balance sheet and it can be a
difficult process if not supported with adequate systems. Depending on systems and analytical support the ALM
process will undertake a number of analysis designed to identify; static and dynamic mismatch; sensitivity of net
interest income; and, market value under multiple scenarios -including under high stress.
3. The majority of banks set net interest income (NII) limits as a main measure of performance with the more
advanced banks also using market or economic value as a secondary measure. NII has become the industry
benchmark simulation tool because; it is relatively easy to understand and implement; it’s a single period measure
that does not require many assumptions, and; it is easy for investors to relate to because it is directly linked to
reported financial results. On the negative side, it is limited as it does not provide a full view of the risks run by a
bank or reflect fully the economic impact of interest rate movements. Market value or economic value simulations on
the other hand, offer a more complete assessment of the risk being run but require significantly more detailed
analysis which is out of reach of many banks at this point. The process requires multiple assumptions that are
difficult to form in some cases and is less intuitive and more difficult to understand. Notwithstanding the difficulties of
the latter, both metrics are important in the measurement and management of embedded risk in banks. In less
developed ALM units, the time it takes to collect and analyse information can render much of it useless for active
management as by the time it is available markets have moved making hedging ineffective.
4. Access to timely and accurate data is critical in support of any form of ALM activity.
1. The funds transfer pricing system has become a fundamental ALM tool in a bank. It creates the ability to immunize
business units from risk and provides the basis for economic and product transparency.
2. The process of FTP is designed to identify interest margins and remove interest rate and funding or liquidity risk.
Looking at it from the business unit perspective, it effectively locks in the margin on loans and deposits by assigning
a transfer rate that reflects the repricing and cash flow profile of each balance sheet item – it is applied to both
assets and liabilities. From the ALM unit’s perspective, it isolates business performance into discrete portfolios that
can be assigned individualised metrics and facilitates the centralisation and management of interest rate
mismatches. A by-product is that it effectively allocates responsibilities between the organizational business units
balance sheet structure with FTP rates adjusted to either encourage or discourage product and customer flows. The
associated analytical process leads to greater understanding of a bank’s competitive advantage, assisting with asset
allocation and protection of the franchise. Similarly, in smaller and/or less developed banks it is of equal value as
4. The methods used by banks are generally consistent - FTP rates are structured to include both interest rate and
funding liquidity risks with the derived transfer yield curve constructed to include appropriate premiums. Such
premiums should capture all elements associated with the banks funding cost. These should include the cost of
items such as; holding liquidity reserves; optionality costs, where pre-payment rights exist; term funding program
Liquidity Management
1. The main liquidity concern of the ALM unit is the funding liquidity risk embedded in the balance sheet. The funding
of long term mortgages and other securitised assets with short term liabilities (the maturity transformation process),
has moved to centre stage with the contagion effect of the sub-prime debacle. Both industry and regulators failed to
recognise the importance of funding and liquidity as contributors to the crisis and the dependence on short term
funding created intrinsic flaws in the business model. Banks must assess the buoyancy of funding and liquidity
2. Banks are in the business of maturity transformation to meet their customers’ requirements and these result in
liquidity, interest rate and currency mismatches which need to be managed. ALM units have traditionally analysed
and ‘managed’ liquidity within pre set limits; however it is only the recent crises that have brought its true importance
into focus. Failure to manage effectively can have dire results but the events of recent times have demonstrated that
3. Like all areas of risk management, it is necessary to put a workable framework in place to manage liquidity risk. It
needs to look at two aspects: 1) Managing liquidity under the business as usual scenario, and 2) Managing liquidity
under stress conditions. It also needs to include a number of liquidity measurement tools and establish limits against
them.
ALM is a comprehensive and dynamic framework for measuring, monitoring and managing the
market risk of a bank. It is the management of structure of balance sheet (liabilities and assets) in
such a way that the net earning from interest is maximised within the overall risk-preference
(present and future) of the institutions. The ALM functions extend to liquidly risk management,
management of market risk, trading risk management, funding and capital planning and profit
planning and growth projection.
Benefits of ALM - It is a tool that enables bank managements to take business decisions in a
more informed framework with an eye on the risks that bank is exposed to. It is an integrated
approach to financial management, requiring simultaneous decisions about the types of amounts
of financial assets and liabilities - both mix and volume - with the complexities of the financial
markets in which the institution operates
The concept of ALM is of recent origin in India. It has been introduced in Indian Banking
industry w.e.f. 1st April, 1999. ALM is concerned with risk management and provides a
comprehensive and dynamic framework for measuring, monitoring and managing liquidity,
interest rate, foreign exchange and equity and commodity price risks of a bank that needs to be
closely integrated with the banks’ business strategy.
Therefore, ALM is considered as an important tool for monitoring, measuring and managing the
market risk of a bank. With the deregulation of interest regime in India, the Banking industry
has been exposed to the market risks. To manage such risks, ALM is used so that the
management is able to assess the risks and cover some of these by taking appropriate decisions.
The assets and liabilities of the bank’s balance sheet are nothing but future cash inflows or
outflows. With a view to measure the liquidity and interest rate risk, banks use of maturity ladder
and then calculate cumulative surplus or deficit of funds in different time slots on the basis of
statutory reserve cycle, which are termed as time buckets.
After such an exercise, each bucket of assets is matched with the corresponding bucket of
the liabililty. When in a particular maturity bucket, the amount of maturing liabilities or assets
does not match, such position is called a mismatch position, which creates liquidity surplus or
liquidity crunch position and depending upon the interest rate movement, such situation may
turnout to be risky for the bank. Banks are required to monitor such mismatches and take
appropriate steps so that bank is not exposed to risks due to the interest rate movements
during that period.
• (b) The net cumulative negative mismatches during the Next day, 2-7 days, 8-14 days and 15-28
days buckets should not exceed 5 % ,10%, 15 % and 20 % of the cumulative cash outflows in the
respective time buckets in order to recognise the cumulative impact on liquidity.
The Board’s of the Banks have been entrusted with the overall responsibility for the
management of risks and is required to decide the risk management policy and set limits
for liquidity, interest rate, foreign exchange and equity price risks.
Rate Sensitive Assets & Liabilities : An asset or liability is termed as rate sensitive
when
(a) Within the time interval under consideration, there is a cash flow,
(c) RBI changes interest rates where rates are administered and,
Assets and liabilities which receive / pay interest that vary with a benchmark rate are
re-priced at pre-determined intervals and are rate sensitive at the time of re-pricing.
INTEREST RISK :
The phased deregulation of interest rates and the operational flexibility given to banks in
pricing most of the assets and liabilities imply the need for the banking system to hedge the
Interest-Rate Risk. Interest Rate Risk is the risk where changes in market interest rates
might adversely affect the Bank’s Net Interest Income. The gap report should be generated
by grouping interest rate sensitive liabilities, assets and off balance sheet positions into time
buckets according to residual maturity or next repricing period, whichever is earlier. Interest
rates on term deposits are fixed during their currency while the advance interest rates are
floating rates. The gaps on the assets and liabilities are to be identified on different time
buckets from 1–28 days, 29 days upto 3 months and so on. The interest changes should be
studied vis-a-vis the impact on profitability on different time buckets to assess the interest
rate risk.
GAP ANALYSIS :
The various items of rate sensitive assets and liabilities and off-balance sheet items
are classified into time buckets such as 1-28 days, 29 days and upto 3 months etc. and
items non-sensitive to interest based on the probable date for change in interest.
The gap is the difference between Rate Sensitive Assets (RSA) and Rate Sensitive
Liabilities (RSL) in various time buckets. The positive gap indicates that it has more
RSAS than RSLS whereas the negative gap indicates that it has more RSLS. The gap
reports indicate whether the institution is in a position to benefit from rising interest
rates by having a Positive Gap (RSA > RSL) or whether it is a position to benefit from
declining interest rate by a negative Gap (RSL > RSA).
REPORTS :
http://www.allbankingsolutions.com
http://en.wikipedia.org
http://www.adb.org
http://rbidocs.rbi.org.in