Asset Liability Management (ALM): Meaning, Tools and Factors

After reading this article you will learn about:- 1. Meaning of Asset Liability Management (ALM) 2. Tools of ALM 3. Factors.

Meaning of Asset Liability Management (ALM):

Asset Liability Management in practical terms amounts to management of total balance sheet items, its size and quality. It involves conscious decisions with regard to asset liability structure in order to maximize interest earnings within the frame work of perceived risk with quantification of risk.

ALM encompasses the process of managing Net interest Margin (NIM), within the overall risk. It calls for an integrated approach to decision making with regard to type (demand/time maturities) and size (portfolios) of financial assets and liabilities and their mix and volumes (turnover). The success of ALM hinges on matching of assets and liabilities in terms of Rate and maturity to optimize the yield and maintain/improve the NIM.

In practice, assets and liabilities of a bank are continuously changing which affect interest cost and interest income. Since Micro level management of assets and liabilities is not possible, through ALM, the bank groups the assets and liabilities according to the maturity, rate, risk, and size so as to control mismatches.

While elimination of gaps arising due to mismatches is not possible, the ALM aims at minimizing the gaps as they are risk-prone and directly affect the NIM. Thus ALM will enable the bank to protect and if possible improve the Net Interest Margin through conscious strategies and decisions.

A sound ALM system for the bank should include:

1. Interest rate movement and outlook,

2. Pricing of assets and liabilities,

3. Review of investment portfolio and credit risk management,

4. Review of investment of foreign exchange operations,

5. Management of liquidity Risk,

6. Management of NIM and of balance sheet ratios, and 

7. Formulation of budgets and operational planning.

Tools of ALM:

There are different tools for Asset and Liability Management.

Some of which are:

1. Gap Analysis,

2. Duration Analysis,

3. Value-at-risk method, and 

4. Risk management.

1. Gap Analysis:

Basically Assets and Liabilities both are rate sensitive in different degree. It is therefore necessary to identify the rate sensitivity among different groups of assets and liabilities and match identical groups of assets with liabilities. In the ALM process, Gap is generally used for quantifying the rate sensitive groups only (as compared to rate insensitive groups of liabilities like current deposits, float funds etc.)

In other words, GAP is the “excess” of interest sensitive assets over interest sensitive liabilities or vice – versa> If Risk sensitive liabilities and Risk sensitive Assets are equal when difference of two (GAP RSA-RSL) becomes NIL, Net Interest Margin (NIM) is free from any effect of interest rates movements.

2. Duration Method:

Under this method, impact of changes in interest rate on the market value of assets and liabilities is considered. Duration analysis is carried out with respect to cash flows and average maturity.

3. Value-at-risk (VAR) method:

This method is variant of the practice of ‘Market-to Market’ approved securities based on Yield- to Maturity.

4. Risk Management:

Under this process, the risk profiles of assets and liabilities are evaluated to ensure that they are within the acceptable levels of risk. The availability of hedging mechanisms (e.g. derivative instruments) would facilitate risk management.

The Reserve Bank of India issues specific guidelines to be followed by banks for managing their respective. Asset and Liability Management. Although the principles of managing assets and liability based on Basel committee have been given above some important points of the guidelines issued by RBI (these are reviewed periodically to suit the changing atmosphere of the monetary and economic policies of the government)

Factors Influencing ALM:

For asset-liability management (ALM) system the broad guidelines of RBI specify three important factors to be looked into by each bank:

1) ALM information system,

2) ALM Organisation, and

3) ALM process.

Under the Information system banks are required to ensure development of information procuring system for measuring, monitoring, controlling and reporting the risks.

The method is used to analyze the behavior of assets and liability products to assess in which way the assets and liability would behave in the business of banking. The ALM Organisation guidelines insist that each bank at the top management level and Board of Directors should on the ongoing basis review the situation to ensure appropriate policies and procedures are adopted and implemented to timely arrest the prospective risks.

The ALM process is meant to create parameters for managing the risks like, identification of risk, measurement of risk, management of risk, planning to mitigate the risk etc..