What is “Asset and Liability Management”?
Asset and Liability Management (ALM) is a strategy that aims to reduce the risks arising from the mismatch of assets and liabilities. This technique combines aspects of financial risk management and financial planning and is commonly used by financial institutions to manage long-term risks. While the ultimate goal is to optimize returns by successfully matching assets against liabilities, the process requires consideration of various factors such as strategic asset allocation, interest rate risk, liquidity, and exchange rate risks, along with regulatory and capital requirements.
Key Learning Points
- Financial institutions use Asset and Liability Management to limit the risk of financial loss arising from the mismatch of assets and liabilities.
- The process of successfully matching assets against liabilities creates a surplus that can the utilized towards achieving higher profitability.
- The key concept of ALM is to make sure that, in any scenario, assets available are sufficient to appropriately cover liabilities when they are due or expected to be due.
- ALM could help to mitigate some of the major risks that financial institutions are exposed to, such as interest rate risk, currency risk, liquidity risk, and capital markets risk.
How Asset and Liability Management Works?
When establishing an ALM framework, financial institutions focus on maintaining long-term stability, ensuring the levels of operating capital are adequate to face the current and potential liabilities, and optimizing profits. Usually, the reason for a mismatch between assets and liabilities could be a change to the financial landscape, such as interest rates or liquidity requirements. While most traditional risk management strategies focus on separate factors, ALM is designed as a coordinated approach that oversees the entire balance sheet of an organization. It focuses on asset management and risk management on a macro level, with the aim of achieving optimal asset allocation and long-term mitigation of financial and regulatory risks.
Typically, the ALM is an ongoing process built to supervise and make sure the organization adheres to its risk tolerance, regulatory, and capital frameworks. Therefore, the areas of markets, credit, and liquidity are closely monitored. The existence of ALM frameworks is typical for financial institutions such as banks, insurance companies, asset managers, and pension funds.
Advantages and Disadvantages
By implementing ALM frameworks and processes, financial institutions could increase their efficiency and profitability. Quantifying and managing existing and potential risks that could arise from a mismatch of assets and liabilities also helps organizations to plan strategically and map potential areas that could be vulnerable to market uncertainty on their balance sheet.
The only downside of ALM is that there is no universal framework that all organizations can use. It needs to be designed to fit the various features of an organization and its goals, risk tolerance, and regulatory requirements.
What Type of Risks Can Be Managed?
The two key risks that ALM frameworks aim to mitigate are interest rate and liquidity risks. Financial institution’s assets and cash flows can be sensitive to changes in interest rates – for example, this may result in a potential mismatch between deposits and loans. In addition, it is also crucial for organizations to meet their financial commitments on time and, therefore, the implementation of a proper ALM strategy is needed to mitigate liquidity risks.