What is Asset Liability Management?
Asset Liability Management is a technique of managing the maturities, rate structure, and risk in the asset and liability portfolios in accordance with interest rate changes. This service is concerned with banks and financial institutions.
Table of Contents
- 1 What is Asset Liability Management?
- 2 Asset Liability Management Definition
- 3 Functions of Asset Liability Management
- 4 Objectives of Asset Liability Management Service
- 5 Applicability of ALM Principles
- 6 Steps of Asset Liability Management Process
Management of Asset is concerned with a trade-off between profitability and liquidity. To trade-off between risk and return is called Liability management. Interest rate sensitivity is highly influenced in the bank funds and its impact reflects on the profitability & liquidity and risk & returns of the bank funds. Hence, the handling of funds should be with efficiency and effectiveness.
Asset Liability Management Definition
“Asset Liability Management is the ongoing process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities to achieve financial objectives, for a given set of risk tolerances and constraints”.
“ALM is critical for the sound financial management of any entity that invests to meet future cash flow needs within constraints. ALM is broader than risk mitigation and is inextricably linked to the liability and investment management functions”.
Normally, it is covered under the framework of Risk Management of an enterprise and it is managed by the fund manager of the company itself.
Asset Liability management services are offered by outsiders and the services are used by some companies to optimize their risk/reward profile. The circumstances and preferences are different from entity to entity. Hence, the application of the ALM process is different for each entity. The service of ALM is very important to an entity because it focuses on managing risks for maximizing profit.
Functions of Asset Liability Management
- To evaluate the interest rate structure and compare it with the interest/product pricing of assets and liabilities
- To scrutinize the loan and investment portfolios which may involve foreign exchange risk and liquidity risk
- To examine the credit risk and contingency risk which may be created due to interest/exchange rate fluctuations, the quality of assets and others
- To assess and compare the actual performance with their estimations and to analyze the reasons for its effect if any on spreads
- To maintain the stability of the short-term profits, long-term earnings and long-term substance of the bank
Objectives of Asset Liability Management Service
- To coordinate the bank’s portfolios
- To manage the risk of Interest Rate Risk and Currency Risks
- To facilitate bank in maximizing profitability
- To increase the stockholders’ returns in the long run i.e. wealth maximization of shareholders
- To maintain the liquidity of the bank fund Asset-Liability Management Service provides proper planning to meet liquidity needs and to reduce interest rate risk on the maturities of assets and liabilities.
The parameters that are selected for the purpose of stabilizing asset liability management of banks are:
- Net Interest Income (NII)
- Net Interest Margin (NIM)
- Economic Equity Ratio
Applicability of ALM Principles
The ALM principles are applicable to the following institutions and funds:
- Insurance companies, banks, investment firms, and other financial services companies
- Pension and trust funds (e.g., endowments and foundations) of Governments
- Commercial entities
- Non-profit enterprises
- Individual investors
Steps of Asset Liability Management Process
The steps of the asset-liability management process:
- Assess the Entity Risk Objectives
- Identify Risks
- Quantify the Level of Risk Exposure
- Formulate and Implement Strategies to Modify Existing Risk
- Monitor Risk Exposures and Revise Alm Strategies as Appropriate
Assess the Entity Risk Objectives
The nature of risk is different for different companies. The determining financial objectives and risk bearings are to be reorganized.
Identification of risk on each and every asset and liability is the prime function. ALM has to evaluate various types of risks. It has to find the causes of each type and establish the relationship of internal and external sources of risk.
Quantify the Level of Risk Exposure
Risk exposure can be quantified in the following ways:
- Relatively to changes in the risk component,
- at the maximum expected loss for a certain confidence interval in a specified set of circumstances, or
- by the allocation of outcomes for agreed set of pretentious circumstances for the risk component over a period of time Regular measurement and monitoring of the risk exposure is mandatory.
Formulate and Implement Strategies to Modify Existing Risk
ALM has to formulate and implement some strategies like diversification, hedging, portfolio management etc., to reduce the risk and optimize the risk/reward tradeoff after measuring the risk. Professional judgement is an important part of the process.
Monitor Risk Exposures and Revise Alm Strategies as Appropriate
ALM has to monitor and report to the top management from time to time about all identified and quantified risk exposures. The corrective measures must be taken whenever the risk exposure exceeds the limit.
The following ALM statements are to be submitted to RBI:
- Statement of Structural Liquidity – Rupee
- Statement of Interest Rate Sensitivity – Rupee
- Statement of Dynamic Liquidity – Rupee
- Statement of Maturity and Position (MAP) – Forex
- Statement of Sensitivity to Interest Rate – Forex