Asset Liability management (ALM) is a tool to manage assets and investments based on liabilities of a firm including bank, insurance companies and other firms by managing interest rate risk and liquidity risk faced by them. This is done by managing risks which arises from mismatches between the assets and liabilities of the firm.
The risks of Asset-Liability mismatch are managed by insurance companies and banks by matching the assets and liabilities as per the maturity pattern or matching the duration, by hedging and securitization.
Key pillars of Asset Liability Management:
ALM Information Systems
Information is the key to the ALM process as several banks and non-banking financial companies have a fully computerized branch network and integrated systems for treasury, forex, and lending business segments etc.
Estimating the main sources of funds like core deposits, certificates of deposits, and call borrowings.
Reducing the duration difference between rate sensitive assets and rate sensitive liabilities.
Reducing the maturity mismatch between loans and deposits in order to avoid liquidity issues
Managing funds with respect to crucial factors like size and duration.
The size of ALCO depends on the size of the bank, its business mix and organizational complexity. The Asset – Liability Committee (ALCO) under direct supervision of top management would take a view on the interest rate movements and decides about investment patterns. It would also decide on the source and mix of liabilities – floating v/s fixed rate funds, retail v/s wholesale deposits, domestic v/s foreign currency funds and sale of assets.
The scope of ALM function can be described as bellows
Liquidity Risk Management – Bank management needs to measure the liquidity position of the bank using a maturity ladder on an ongoing basis and also examine the evolution of liquidity requirements under worst case scenarios when liquidity can dry up completely. The short-term mismatches are more critical to understand any potential liquidity issue in the near future.
nterest Rate Risk Management – Interest rate risk is an important risk associated with both assets and liabilities which is measured by Duration. In order to reduce overall risk, duration of asset should be almost equal to duration of liabilities so that any increase in liability due to adverse interest rate movement should be offset by almost similar increase in asset.
Cash Flow Risk Management – Future cash outflows are matched with the possible cash inflows from various investments in order to avoid any liquidity problem. Investment firms can use either bullet strategy or barbell strategy in order to achieve cash flow match.