Asset Liability Management (ALM)

Asset liability management (ALM) is a process through which a bank manages its balance sheet. It is basically a tool of liquidity management. So, Asset Liability Management is a process of planning, organizing and controlling asset and liability volumes. Information system and organizational structure are the key factors in asset liability management. Banks need information regarding assets and liabilities in different branches. Moreover, it is easier to collect information in case of foreign exchange, investment portfolio and money market operations because these functions are centralized. 

Further, asset liability management is a process by which banks measure and monitor risks and also provides suitable strategies to manage risk. As mentioned above, ALM basically includes liquidity management. It also covers currency risk management and interest rate risk management. 

On the advice of RBI in February 1999, banks have to set up internal asset liability management committees (ALCO). The task of the committee is to decide the risk management policy of the bank and 

set limits for liquidity, interest rate, foreign exchange and equity price risks. The responsibilities of ALCO are as follows: 

(i) Pricing of deposits and advances i.e. fixing the rate of exchange. 

(ii) Supervising the risk levels of the bank. 

(iii) Review the progress made in the implementation of decisions made in the previous meetings. 

(iv) Decide on sources and mix of assets and liabilities. 

The Objectives or Scope of ALM 

(i) Liquidity Risk Management– Measuring and managing liquidity needs are important for the survival of a commercial bank. Bank’s liquidity management not only includes measuring the liquidity position of a bank on a continuous basis but also assessing how liquidity requirements will evolve under different situations. Further, it is a myth that Government securities and money market instruments are always liquid. They can be illiquid when the market and the market players are moving in only one direction.Therefore, liquidity can be tracked through maturity and cash flow mismatches. 

What is a liquidity risk? 

The term ‘liquidity’ in banks basically refers to the ability of a bank to funds its asset and any increase in its assets and able to meet its obligations as they come without incurring any major loss. So, liquidity risk is a risk that banks may not be able to meet its obligations in time without affecting the financial conditions of a bank in a major way. Therefore, effective liquidity management refers to meeting the obligations in time and reduces the chances of occurring any adverse situation. 

Factors leading to liquidity risk management 

• Heavy reliance of banks on short term corporate deposits 

• Gaps in the maturity dates of assets and liabilities 

• Heavy increase in banks asset which surpasses its liabilities by a fair margin 

• Sudden and heavy withdrawals from the depositors 

• Slow economic growth also perpetuates liquidity problems 

• Measurement, governance and management of liquidity management 

• Banks should maintain a cushion of non-mortgaged/non-pledged high quality liquid assets to ward off a series of stress events. 

• A bank should also put in place a risk tolerance system. 

• Senior management should on continuous basis review information on the bank’s liquidity developments and report to the board of directors on a regular basis.

• A bank should have a sound process for identifying, measuring, monitoring and controlling liquidity risk. This process should include a good technique forecasting cash flows arising from assets, liabilities and off-balance sheet items over a period of time. 

• A bank should form a funding strategy that provides effective diversification in the sources and tenure of funding. It should maintain a continuous presence in already existing markets and also maintain good relationships with providers of fund to have a mix of various forms of funding sources. 

• A bank should have the ability to access funds quickly from each source as mentioned above. 

• A bank should manage its intraday liquidity positions and risks to meet payment and settlement obligations on a timely basis. 

• A bank should manage collateral in an efficient manner. 

(i) Currency Risk– Managing currency risk is a big task of Banks. Currency risk includes changes in one currency in relation to another currency. Floating exchange rate movements has brought in its fold new dimension to the risk profile of banks’ balance sheets. Large flows of foreign capital from different countries have rendered the banks’ balance sheet exposed to exchange rate movements. 

(ii) Interest Rate Risk(IRR)– Interest risk is the change in prices of bonds that could occur because of change in interest rates. It also considers change in impact on interest income due to changes in the rate of interest. In other words, price as well as reinvestment risks require focus. In so far as the terms for which interest rates were fixed on deposits differed from those for which they fixed on assets, banks incurred interest rate risk i.e., they stood to make gains or losses with every change in the level of interest rates. 

Techniques to manage IRR - 

a) Maturity gap analysis: (to measure the interest rate sensitivity of earnings) 

Gap is a static report showing Balance Sheet and off Balance Sheet position on a particular day. It determines number of time buckets and the length of each time bucket. It means putting every asset, liabilities and off balance sheet item into a time bucket. For instance, one year loan that shows price changes every three months should be put in a three month bucket. 

b) Duration (to measure the interest rate sensitivity of capital) – is a measure of % change in economic value of a position that may happen if there is a small change in level of interest rate. 

c) Simulation–It attempts to remove the disadvantages of Gap and Duration approach by Computer Modeling the bank’s interest rate sensitivity. Modeling assumes future path of interest rate charges in business activity, pricing and hedging strategies. 

d) Value at Risk - As per Wikipedia, VAR is a measure of risk of investment. Given the normal market condition in a set of period, say, one day it estimates how much an investment might lose. This investment can be a portfolio, capital investment or foreign exchange etc., VAR answers two basic questions –

(i) What is worst case scenario? 

(ii) What will be loss? 

It was first applied in 1922 in New York Stock Exchange. It entered the financial world in 1990s and become world’s most widely used measure of financial risk. 

The role of securitization in ALM 

With the help of securitization, financial institutions and banks can convert mortgaged backed assets into securities which would have otherwise been held till maturity. It acts as an alternative route for asset/liability restructuring. Securitization can also be viewed as a direct form of financing in which investors directly lend to the borrowers. 

The process of Securitization also has the additional advantage of balance sheet cleaning by converting highly complex and illiquid assets into marketable securities. Another benefit of securitization is that it transfers risk such as interest rate risk, credit risk and pre-payment risk to the ultimate investors of the securitized assets. Further, Securitization increases the liquidity (because money is coming to the financial institution in form of issuance of securities with the help of mortgaged backed assets) and diversification (because securities offer various options to the investors) of the loan portfolio. Also, it allows a financial institution to regain some part of the profits of lending and reduction of cost in intermediation (i.e. in the process of converting the illiquid assets into marketable securities).