Asset and liability management


Asset and liability management is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.
ALM sits between risk management and strategic planning. It is focused on a long-term perspective rather than mitigating immediate risks and is a process of maximising assets to meet complex liabilities that may increase profitability.
ALM includes the allocation and management of assets, equity, interest rate and credit risk management including risk overlays, and the calibration of company-wide tools within these risk frameworks for optimisation and management in the local regulatory and capital environment.
Often an ALM approach passively matches assets against liabilities and leaves surplus to be actively managed.

History

Asset and liability management practices were initially pioneered by financial institutions during the 1970s as interest rates became increasingly volatile.

ALM objectives and scope

The exact roles and perimeter around ALM can vary significantly from one bank to another depending on the business model adopted and can encompass a broad area of risks.
The traditional ALM programs focus on interest rate risk and liquidity risk because they represent the most prominent risks affecting the organization balance-sheet.
But ALM also now seeks to broaden assignments such as foreign exchange risk and capital management.
According to the Balance sheet management benchmark survey conducted in 2009 by the audit and consulting company PricewaterhouseCoopers, 51% of the 43 leading financial institutions participants look at capital management in their ALM unit.
The scope of the ALM function to a larger extent covers the following processes:
  1. Liquidity risk: the current and prospective risk arising when the bank is unable to meet its obligations as they come due without adversely affecting the bank's financial conditions. From an ALM perspective, the focus is on the funding liquidity risk of the bank, meaning its ability to meet its current and future cash-flow obligations and collateral needs, both expected and unexpected. This mission thus includes the bank liquidity's benchmark price in the market.
  2. Interest rate risk: The risk of losses resulting from movements in interest rates and their impact on future cash-flows. Generally because a bank may have a disproportionate amount of fixed or variable rates instruments on either side of the balance-sheet. One of the primary causes are mismatches in terms of bank deposits and loans.
  3. Capital markets risk: The risk from movements in equity and/or credit on the balance sheet. An insurer may wish to harvest either risk or fee premia. Risk is then mitigated by options, futures, derivative overlays which may incorporate tactical or strategic views.
  4. Currency risk management: The risk of losses resulting from movements in exchanges rates. To the extent that cash-flow assets and liabilities are denominated in different currencies.
  5. Funding and capital management: As all the mechanism to ensure the maintenance of adequate capital on a continuous basis. It is a dynamic and ongoing process considering both short- and longer-term capital needs and is coordinated with a bank's overall strategy and planning cycles.
  6. Profit planning and growth.
  7. In addition, ALM deals with aspects related to credit risk as this function is also to manage the impact of the entire credit portfolio on the balance sheet. The credit risk, specifically in the loan portfolio, is handled by a separate risk management function and represents one of the main data contributors to the ALM team.
The ALM function scope covers both a prudential component and an optimization role, within the limits of compliance.
ALM intervenes in these issues of current business activities but is also consulted to organic development and external acquisition to analyse and validate the funding terms options, conditions of the projects and any risks.
Today, ALM techniques and processes have been extended and adopted by corporations other than financial institutions; e.g., insurance.

Treasury and ALM

For simplification treasury management can be covered and depicted from a corporate perspective looking at the management of liquidity, funding, and financial risk. On the other hand, ALM is a discipline relevant to banks and financial institutions whose balance sheets present different challenges and who must meet regulatory standards.
For banking institutions, treasury and ALM are strictly interrelated with each other and collaborate in managing both liquidity, interest rate, and currency risk at solo and group level: Where ALM focuses more on risk analysis and medium- and long-term financing needs, treasury manages short-term funding including intra-day liquidity management and cash clearing, crisis liquidity monitoring.

ALM governance

The responsibility for ALM is often divided between the treasury and Chief Financial Officer. In smaller organizations, the ALM process can be addressed by one or two key persons.
The vast majority of banks operate a centralised ALM model which enables oversight of the consolidated balance-sheet with lower-level ALM units focusing on business units or legal entities.
To assist and supervise the ALM unit an Asset Liability Committee, whether at the board or management level, is established. It has the central purpose of attaining goals defined by the short- and long-term strategic plans:
Relevant ALM legislation deals mainly with the management of interest rate risk and liquidity risk:

Building an ALM policy

As in all operational areas, ALM must be guided by a formal policy and must address:
Note that the ALM policy has not the objective to skip out the institution from elaborating a liquidity policy. In any case, the ALM and liquidity policies need to be correlated as decision on lending, investment, liabilities, equity are all interrelated.

ALM core functions

Managing gaps

The objective is to measure the direction and extent of asset-liability mismatch through the funding or maturity gap. This aspect of ALM stresses the importance of balancing maturities as well as cash-flows or interest rates for a particular set time horizon.
For the management of interest rate risk it may take the form of matching the maturities and interest rates of loans and investments with the maturities and interest rates of deposit, equity and external credit in order to maintain adequate profitability. In other words, it is the management of the spread between interest rate sensitive assets and interest rate sensitive liabilities..
Static/Dynamic gap measurement techniques
Gap analysis suffers from only covering future gap direction of current existing exposures and exercise of options at different point in time.
Dynamic gap analysis enlarges the perimeter for a specific asset by including 'what if' scenarios on making assumptions on new volumes,

Liquidity risk management

The role of the bank in the context of the maturity transformation that occurs in the banking book lets inherently the institution vulnerable to liquidity risk and can even conduct to the so-call risk of 'run of the bank' as depositors, investors or insurance policy holders can withdraw their funds/ seek for cash in their financial claims and thus impacting current and future cash-flow and collateral needs of the bank.
This aspect of liquidity risk is named funding liquidity risk and arises because of liquidity mismatch of assets and liabilities.
Even if market liquidity risk is not covered into the conventional techniques of ALM, these 2 liquidity risk types are closely interconnected. In fact, reasons for banking cash inflows are :
Measuring liquidity position via liquidity gap analysis is still one of the most common tool used and represents the foundation for scenario analysis and stress-testing.
To do so, ALM team is projecting future funding needs by tracking through maturity and cash-flow mismatches gap risk exposure. In that situation, the risk depends not only on the maturity of asset-liabilities but also on the maturity of each intermediate cash-flow, including prepayments of loans or unforeseen usage of credit lines.

Actions to perform

In dealing with the liquidity gap, the bank main concern is to deal with a surplus of long-term assets over short-term liabilities and thus continuously to finance the assets with the risk that required funds will not be available or into prohibitive level.
Before any remediation actions, the bank will ensure first to :
  1. Spread the liability maturity profile across many time intervals to avoid concentration of most of the funding in overnight to few days time buckets
  2. Plan any large size funding operation in advance
  3. Hold a significant productions of high liquid assets
  4. Put limits for each time bucket and monitor to stay within a comfortable level around these limits
    Non-maturing liabilities specificity
As these instruments do not have a contractual maturity, the bank needs to dispose of a clear understanding of their duration level within the banking books. This analysis for non-maturing liabilities such as non interest-bearing deposits consists of assessing the account holders behavior to determine the turnover level of the accounts or decay rate of deposits.
Calculation to define :
Various assessment approaches may be used:
  1. To place these funds in the longest-dated time bucket as deposits remain historically stable over time due to large numbers of depositors.
  2. To divide the total volume into 2 parts: a stable part and a floating part
  3. To assign maturities and re-pricing dates to the non-maturing liabilities by creating a portfolio of fixed income instruments that imitates the cash-flows of the liabilities positions.
The 2007 crisis however has evidence fiercely that the withdrawal of client deposits is driven by two major factors enhancing simplification in the new deposit run-off models.

Remediation actions

The liquidity measurement process consists of evaluating :
2 essential factors are to take into account :
But daily completeness of data for an internationally operating bank should not represent the forefront of its procupation as the seek for daily consolidation is a lengthy process that may put away the vital concern of quick availability of liquidity figures. So the main focus will be on material entities and business as well as off-balance sheet position
For the purposes of quantitative analysis, since no single indicator can define adequate liquidity, several financial ratios can assist in assessing the level of liquidity risk. Due to the large number of areas within the bank's business giving rise to liquidity risk, these ratios present the simpler measures covering the major institution concern. In order to cover short-term to long-term liquidity risk they are divided into 3 categories :
  1. Indicators of operating cash-flows
  2. Ratios of liquidity
  3. Financial strength
CategoryRatio nameObjective and significanceFormula

Cash-flow ratio
Cash and short term investment to total assets ratio
Indication of how much available cash the bank has to meet share withdrawals or additional loan demand
Cash + short term investment / total assets
Short term investment : part of the current assets section of investment that will expire within the year

Cash-flow ratio
Operating cash flow ratio
Help to gauge the bank's liquidity in the short-term as how well current liabilities are covered by the cash-flow generated by the bank
Cash-flow from operations / current liabilities

Ratio of liquidity
Current ratio
Estimation of whether the business can pay debts due within one year out of the current assets:
  • 1.7 to 2 : the business has enough cash to pay its debts
  • 1 to 1.5: potential problem to pay debts and raise extra finance
Current assets/ current liabilities
  • Current assets: cash, accounts receivable, inventory, marketable securities, prepaid expenses
  • Current liabilities : debt or obligation due within the year, short-term debt, account payable, accrued liabilities and other assets
Ratio of liquidity
Quick ratio
Adjustment of the current ratio to eliminate no-cash equivalent assets and indicate the size of the buffer of cash
Current assets / current liabilities

Ratio of liquidity
Non core funding dependence ratio
Measure of the bank's current position of how much long term earning assets are funded with non core funds net of short term investments. The lower the ratio the better
Non core liabilities / Long term assets

Ratio of liquidity
Core deposits to total assets
Measurement of the extent to which assets are funded through stable deposit base. Correct level : 55%
Core deposit : deposit accounts, withdrawals accounts, savings, money market accounts, retail certificates of deposits

Financial strength
Loans to deposit ratio
Simplified indication on the extent to which a bank is funding liquid assets by stable liabilities. A level of 85 to 95% indicating correct level.
Loans + advances to customer net of allowance for impairment losses / customer deposit

Financial strength
Loans to asset ratio
Indication that the bank can effectively meet the loan demand as well as other liquidity needs. Correct level : 70 to 80%

Setting limits

Setting risk limits still remain a key control tool in managing liquidity as they provide :
As an echo to the deficit of funds resulting from gaps between assets and liabilities the bank has also to address its funding requirement through an effective, robust and stable funding model.

Constraints to take into account

  1. Obtaining funds at reasonable costs
  2. Fostering funding diversification in the sources and tenor of funding in the short, medium to long-term
  3. Adapting the maturities of liabilities cash-flow in order to match with funds uses
  4. Gaining cushion of high liquid assets
Today, banking institutions within industrialized countries are facing structural challenges and remain still vulnerable to new market shocks or setbacks:
After 2007, financial groups have further improved the diversification of funding sources as the crisis has proven that limited mix of funds may turn out to be risky if these sources run dry all of a sudden.
2 forms to obtain funding for banks :

Asset-based funding sources

The asset contribution to funding requirement depends on the bank ability to convert easily its assets to cash without loss.
Retail funding
From customers and small businesses and seen as stable sources with poor sensitivity level to market interest rates and bank's financial conditions.
This plan needs to embrace all available funding sources and requires an integrated approach with the strategic business planning process. The objective is to provide realistic projection of funding future under various set of assumptions. This strategy includes :

Assessment of possible funding sources

Main characteristics :
Dependencies to endogenous / exogenous factors that will influence the bank ability to access one particular source.

Setting for each source an action plan and assessment of the bank's exposure to changes

Once the bank has established a list of potential sources based on their characteristics and risk/ reward analysis, it should monitor the link between its funding strategy and market conditions or systemic events.
For simplification, the diversify available sources are divided into 3 main time categories:
Key aspects to take into account :
  1. Assessment of the likehood of funding deficiencies or cost increase across time periods. In case for example, position on the wholesale funding, providers often require liquid assets as collateral. If that collaterals become less liquid or difficult to evaluate, wholesale funds providers may arbitrate no more funding extension maturity
  2. Explanation of the objective, purpose and strategy behind each funding source chosen : a bank may borrow on a long-term basis to fund real estate loans
  3. Monitoring of the bank capacity to raise each funds quickly and without bad cost effects as well as the monitoring of the dependence factors affecting its capacity to raise them
  4. Maintenance of a constant relation with funding market as market access is critical and affects the ability to both raise new funds and liquid assets. This access to market is expressed first by identification and building of strong relationships with current and potential key providers of funding
  5. As a prudent measure, the choice of any source has to be demonstrated with the effective ability to access the source for the bank. If the bank has never experienced to sold loans in the past or securitization program, it should not anticipate using such funding strategies as a primary source of liquidity

    Liquidity reserve or highly liquid assets stock

This reserve can also referred to liquidity buffer and represents as the first line of defense in a liquidity crisis before intervention of any measures of the contingency funding plan. It consists of a stock of highly liquid assets without legal, regulatory constraints. They can include :
Key actions to undertake :
  1. To maintain a central data repository of these unencumbered liquid assets
  2. To invest in liquid assets for purely precautionary motives during normal time of business and not during first signs of market turbulence
  3. To apply, if possible, both an economic and regulatory liquidity assets holding position. The LCR, one of the new Basel III ratios in that context can represent an excellent 'warning indicator' for monitoring the dedicated level and evolution of the dedicated stock of liquid assets. Indeed, the LCR addresses the sufficiency of a stock of high quality liquid assets to meet short-term liquidity needs under a specified acute stress scenario. It identifies the amount of unencumbered, high quality liquid assets an institution holds that can be used to offset the net cash outflows it would encounter under an acute 30-days stress scenario specified by supervisors. In light of the stricter LCR eligible assets definition, the economic approach could include a larger bulk of other liquid assets
  4. To adapt the stock of the cushion of liquid assets according to stress scenarios. As an example, a bank may decide to use high liquid sovereign debt instruments in entering into repurchase transaction in response to one severe stress scenario
  5. To evaluate the cost of maintening dedicated stock of liquid assets portfolio as the negative carry between the yield of this portfolio and its penalty rate. This negative carry of this high liquid portfolio assets will be then allocated to the respective business lines that are creating the need for such liquidity reserve

    Contingency funding plan

As the bank should not assume that business will always continue as it is the current business process, the institution needs to explore emergency sources of funds and formalise a contingency plan. The purpose is to find alternative backup sources of funding to those that occur within the normal course of operations.
Dealing with Contingency Funding Plan is to find adequate actions as regard to low-probability and high-impact events as opposed to high-probability and low-impact into the day-to-day management of funding sources and their usage within the bank.
To do so, the bank needs to perform the hereafter tasks :

Identification of plausible stress events

Bank specific events : generally linked to bank's business activities and arising from credit, market, operational, reputation or strategic risk. These aspects can be expressed as the inability :
External events :
This assessment is realised in accordance with the bank current funding structure to establish a clear view on their impacts on the 'normal' funding plan and therefore evaluate the need for extra funding.
This quantitative estimation of additional funding resources under stress events is declined for:
In addition, analysis are conducted to evaluate the threat of those stress events on the bank earnings, capital level, business activities as well as the balance sheet composition.
The bank need, in accordance, to develop a monitoring process to :
Such inventory includes :
The last key aspect of an effective Contingency Funding Plan relates to the management of potential crisis with a dedicated team in charge to provide :
The objective is to settle an approach of the asset-liabilitiy profile of the bank in accordance with its funding requirement. In fact, how effectively balancing the funding sources and uses with regard to liquidity, interest rate management, funding diversification and the type of business-model the bank is conducting or the type of activities of the respective business lines

ALM report

Funding report summarises the total funding needs and sources with the objective to dispose of a global view where the forward funding requirement lies at the time of the snapshot. The report breakdown is at business line level to a consolidatedone on the firm-wide level. As a widespread standard, a 20% gap tolerance level is applied in each time bucket meaning that gap within each time period defined can support no more than 20% of total funding.
The effect of terming out funding is to produce a cost of funds, the objective is to :
This is the concept of Fund Transfer Pricing a process within ALM context to ensure that business lines are funded with adequate tenors and that are charged and accountable in adequation to their current or future estimated situation.