ALM Basics: What is Asset Liability Management?
This post is part of a series on the basics of asset liability management.
Asset Liability Management, often referred to as ALM, is an integral part of the daily function of every bank. However, because it covers such a wide range of topics and concepts, it is often misunderstood. In short, ALM is defined as the practice of measuring and managing three types of financial risk on bank balance sheets:
Interest Rate Risk: the risk that a bank’s earnings and/or capital will be negatively impacted by changes in interest rates
Liquidity Risk: the risk that liabilities cannot be met when they are due
Credit Risk: the risk of default (note – asset liability management’s role in credit risk is as a view of overall credit risk on the entire balance sheet, including cash, investments, and loans. The credit risk specifically in the loan portfolio is generally handled by a separate risk management function/loan committee)
In practice, ALM is the process by which banks price assets and liabilities in order to maximize net interest income within the institution’s risk parameters. In the normal course of business, banks book assets (primarily loans and securities) and fund it with liabilities (deposits and borrowings). These assets and liabilities have differing maturity dates, cash flows, and overall structures, and natural mismatches in structure occur. Banks use various measurement methodologies to determine if earnings or capital will be impacted by movements in interest rates (interest rate risk) or changes in market prices and conditions (liquidity risk). Subsequent posts will define the terminology and general methods used by banks to meet these objectives.