Asset and liability management (ALM), also referred to as Balance Sheet Management, is the process financial institutions use to manage risks from cashflow and/or value mismatches between assets and liabilities. Specific risks commonly include interest rate risk, liquidity risk, and maturity mismatch risk. A strong ALM ecosystem allows banks to improve forecasting, remain compliant with regulatory expectations, and provide an analytic framework for strategic financial decision-making.
Running a profitable bank involves optimizing the transition of deposits into loans and investments, while also maintaining sufficient liquidity to meet operational obligations and withdrawal requests.
Given market condition fluctuations, contractual and behavioral elements of financial instruments on the balance sheet can create inherent risk unless multi-scenario simulations are strategically considered. Finance leaders must understand the process and intricacies of ALM in full.
To be effective, an ALM process must address three main risks:
- Interest Rate Risk, the sensitivity of net interest income and market value of equity to changes in levels and shapes of market yield curves.
- Liquidity Risk, the impact of stressed demands or unexpected market conditions on cash levels or access to funding.
- Maturity Mismatch Risk, where short-term and long-term assets aren’t aligned with liabilities.
To manage these types of risks, several techniques and tools exist, including scenario planning and “what-if” simulations. Finance leaders can use these to test strategies and form a plan of action for different circumstances.
Ultimately, finance leaders who master ALM can ensure long-term resilience in constantly fluctuating markets.
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Key Risks ALM Helps You Manage
A strong ALM framework allows finance leaders visibility into potential risks that can slowly chip away at profitability and stability.
By accounting for risks and having a plan of action for changing market conditions, ALM can help banks be better prepared for market downturns. This can improve investor confidence, minimize compliance issues, and ensure streamlined operations and long-term viability.
Whether it’s shifting rates, liquidity or funding stressors, or cash flow gaps, ALM helps identify and manage these threats to an organization.
Interest Rate Risk
Interest rate risk is the possibility that a change in rates will adversely affect a bank’s earnings or asset valuation. ALM tools can model and simulate repricing gaps and rate shocks to allow banks the opportunity to take appropriate action in anticipating and managing exposure before it’s too late.
Liquidity Risk
Liquidity risk means potentially having an insufficient amount of funds or assets to cover withdrawals, obligations, or other funding needs.
ALM provides a greater level of visibility into potential liquidity shortfalls. This allows banks and finance leaders adequate time to determine how much buffer is needed, as well as the need for contingency plans.
Learn more on monitoring deposit risk.
Maturity Mismatch Risk
Maturity mismatch risk is the misalignment in the timing of when assets generate inflows of cash and the outflow of cash as a result of liabilities.
ALM helps hone in on the maturity dates of these items to determine what needs to be shifted or rebalanced to avoid any strain on cash flows.
Traditional ALM Approaches vs. Modern Expectations
One of the issues with traditional ALM management is that many banking institutions have it isolated from the people who could benefit from its visibility — namely, finance leaders. Rather, it’s often only considered a treasury responsibility, with crucial details tucked away in spreadsheets or other legacy tools.
While this is certainly better than not having anyone have eyes on the data, it provides only a basic view of rate and exposure risks due to the limitations of fragmented data, siloed ownership, and reliance on manual processes.
To better manage present-day risks and strict compliance and regulatory requirements, modern ALM must allow for the integration of departments like treasury, finance, and the asset-liability committee (ALCO), so there’s a single, centralized view of balance sheet risk.
Workflows should also be linked with ALM models, as this can further allow banks to operate more efficiently and provide more accurate “what-if” scenario testing.
How a bank handles governance is just as important. Enhanced ALM processes can do more than just measure risks. They can help with regulatory issues and compliance items — a great way of demonstrating accountability and transparency to investors, board members, auditors, and bank examiners.
More than ever before, market conditions are now asking for clear documentation, independent review, and strong model risk management as typical expectations — something that’s also covered in our model validations webinar.
The change in times has made it clear. Traditional ALM is insufficient with its siloed and reactive approach to risk. Modern ALM is more proactive in strategic planning, risk analysis, and data-driven among multiple teams.
Benefits of a Strong ALM Framework
Although ALM is often seen as more of a regulatory compliance item for checking off boxes, it’s much more than that. A robust ALM framework can help drive financial performance by mitigating risk and increasing operational efficiency.
This effectively bridges the gap between budgeting and balance sheet resiliency, as it can ensure forecasts are accurate; risk models hold up under stress testing; and contingency plans remain credible with auditors, investors, and bank examiners.
Some of the key benefits of a strong ALM framework include the following:
- Improved forecasting accuracy: Enhance financial planning by forecasting outcomes given multiple interest rate and liquidity scenarios. This helps determine the level of adaptability possible.
- Liquidity resilience: Level up liquidity planning and avoid funding shortfalls by monitoring for early warning signals and real-time tracking of inflows and outflows of cash.
- Better balance sheet visibility: Get better visibility into mismatches between assets and liabilities that could impact earnings, capital adequacy, and long-term stability.
- Faster decision-making with scenario planning: Be better prepared and have more time to create contingency plans by analyzing various what-if scenarios in the event that market conditions shift.
- Cross-team alignment: Unify data across multiple teams, such as treasury, finance, and risk, to create better visibility, streamlined workflows, and reduction of redundant work.
- Regulatory confidence: Pinpoint weak areas from stress testing, allowing for easier compliance maintenance and reduced time responding to or managing bank examiner inquiries.
- Board-ready reporting: Give investors, board members, and other stakeholders timely, relevant, and transparent reporting in the context of risks and strategic planning.
With a strong ALM framework, finance leaders can consider potential future risks with forecasting and risk planning, which can help build a foundation for better strategic decision-making.
Combined with something like profitability analytics, the insights gained from ALM can drive profitable growth and safer, more streamlined operations.
Start Your ALM Journey With Empyrean Solutions
Getting started on the right foot with asset and liability management begins with understanding whether your bank’s current processes give an adequate level of visibility to confidently plan for the future.
For finance directors, being cognizant of this can provide the opportunity to begin the process of improvement and get the conversations started with treasury, risk, and other key stakeholders.
A few questions you can ask yourself and your teams:
- Are existing ALM models fast, and do they provide enough transparency? Or are they still tied to time-consuming, manual processes?
- Do key stakeholders, such as treasury and finance, share data from the same system, or are they isolated from one another?
- Is it easy to run what-if scenarios with interest rates, liquidity, and capital?
- What is our confidence level that our current level of reporting is sufficient to keep auditors, our board members, investors, and regulators satisfied?
If the answers to these questions leave you feeling uneasy, rest assured that you’re not alone. Many banks nationwide are rethinking their approach to ALM, moving from siloed legacy platforms to integrated systems instead.
If you’re looking for ideas on how ALM can help with your budgeting and planning, you can watch our budgeting and ALM webinar.
Are you ready to take the next step?
Discover how Empyrean ALM can provide fast, easy-to-use, integrated modeling functionality, so you can step into the modern age of ALM, move past just basic compliance, and utilize it as a tool to give your bank a strategic advantage.
FAQ: Asset and Liability Management
ALM is incredibly complex, and even those with a good understanding of the basics can have practical questions about how it fits into the day-to-day. Below are answers to some of the most commonly asked questions.
What Is Asset and Liability Management in Banks?
Asset and liability management in banks is the process in which long-term asset growth is balanced with short-term obligations. Examples of long-term assets can include loans and investments, whereas short-term obligations can be deposits and other forms of borrowed money.
ALM ensures the bank maintains an adequate level of liquidity while simultaneously focusing on profitability and regulatory compliance. A bank’s treasury, finance, and risk departments all play a role in evaluating any such risks, including forecasting possible scenarios and taking appropriate action, such as forming contingency plans.
Ultimately, ALM is key in ensuring banks find the right balance of stability and growth.
How Does Asset and Liability Management Reduce Risk and Optimize Return?
ALM helps banks reduce risk exposure by modeling interest rate risk, liquidity risk, and maturity mismatches. Modeling these risks involves scenario analysis — something that can show the outcome of various funding strategies.
This, then, allows finance leaders to make the necessary adjustments in order to optimize costs and fortify balance sheet efficiency. In other words, ALM is not just a reactive or defensive tool. It can proactively inform of the best strategic plan to implement to support profitable growth.
What’s the Difference Between Gap Analysis and Duration Analysis?
In the context of asset and liability management, gap analysis and duration analysis both measure risk but tackle it from different angles:
- Gap analysis can help identify timing mismatches between when assets and liabilities mature or are repriced. In other words, it can reveal whether there could be a cash flow or liquidity issue in the event liabilities mature faster than assets might be available.
- Duration analysis looks more so at the level of sensitivity assets and liabilities could be should interest rates fluctuate.
Banks typically utilize both approaches in addition to scenario modeling, something that brings more flexibility than using only gap or duration analysis alone.
Can a Finance Team Lead ALM Without Deep Risk Expertise?
Asset and liability management has typically been kept under the umbrella of Treasury or ALCO. However, modern ALM platforms make information obtained from modeling and scenario planning far more accessible to other teams.
This enables finance leaders to take a more active co-ownership role, which makes sense considering it also drives budgeting, forecasting, and board reporting. Easy entry points include joining ALCO discussions, working with risk and treasury, and taking the lead on scenario planning.