Asset Liability Management – The overview

Definition of ALM

Asset and Liability Management (ALM) is a process of managing an organization’s assets and liabilities with the objective of earning an adequate return on capital employed.

First, since ALM is essentially a process, even having the best model and the resources to run it will not meet with much success unless the processes are streamlined. The whole process needs to be coordinated with sound long range planning and budgeting processes in place. Only a good mix of  resources working together as a team with good systems and techniques in place would derive the desired results.

Secondly, coordinating actions form an essential part of a good ALM process. For instance, let us assume that an evaluation of the current ALM risk factors reveals that your financial institution was currently doing fine and was within its ALM goals. This may provide the required confidence to your institution to proceed to accept deposits from members/customers, issue loans and purchase securities. As your financial institution proceeds in this manner unabated, quite unknowingly, the current rosy position might keep changing until it dawns on the management one day that it has slid into dangerous ground by pushing its future risk position outside the acceptable limits of its ALM policies. This shows us the need to be monitoring the ALM and having it under constant review and evaluation. Now that the organization has already treaded into the danger zone, the popular way out of it is to do a series of “What-if” searches and get the ALM back on track as quickly as possible. The main point I wish to stress through this example is the fact that not only should you be watching your present ALM, but should also be looking at the past, and most importantly, ensure the proper coordination of all necessary actions to have your future ALM within the institution’s policy limits.

Thirdly, being knowledgeable about the major risks your institution is exposed to will give you the proper ability to exercise a good control over the relevant risk factors. Take note that the required action is control and not, minimize.  Despite the popular belief, you should never be evaluating ALM with a view to minimizing risks, but only to control. If minimizing risks were to be the main criteria, then the Banks neither would be issuing loans nor invest  in treasury securities. Any attempts at acquiring assets with the slightest risk factor attached would be unacceptable as they only add to the risk. On the other hand, controlling risks really means striking a reasonable balance between the acquisition of assets  with different levels of risks (ranging from highly safe, but low yielding investments) to reasonably safe, with high yielding investments.

When analyzing a balance sheet, we may think of it as an inventory or store. The organization (bank) can be thought of as a large financial store with hundreds of products and services on offer to its customers on credit. Every product or service will serve a particular purpose and carry an interest rate, repayment pattern and term  period, which may differ for different types of loans / deposits.  External factors such as the state of the economy, prevailing competition and the current credit environment further complicate matters for the seller as well as the buyer. Eventually these external factors go to influence not only what products and services the bank / financial institution may offer its members, but also how it would be packaged. That is, the “financial package” in which the product or service will be wrapped spelling out the rate of interest payable and other terms and conditions applicable. Lot of coordination goes in to the making of such final decisions, and that is why ALM is so important – to coordinate. It is only with some well-coordinated efforts through ALM, a financial organization can continue to give the best of services to its customers while still keeping its own head above water.  With well-coordinated efforts on ALM, an organization can tide over periods of unfavorable economic conditions and hostile external environments, avoid taking  impulsive decisions or making mistakes while taking best advantage of available opportunities.

The ALM Process

Financial institutions or banks, depending on their individual magnitude and complexities of operations may hold their ALCO (Assets / Liabilities Committee) meetings for the assessment / reassessment, decision making and taking actions on their current ALM positions at intervals ranging from about one month to three months. Quarterly meetings are generally considered adequate for smaller and less complex institutions. However, if a bank finds its current ALM position is in a bad way, then it would become necessary to meet even several times during that month and even over the next couple of months until all the issues are resolved to their satisfaction. This would include a reasonable time period to be allowed to keep on monitoring and reassessing the latest positions after each new change is affected.

Responsibility for ALM

All activities connected with an organization have a bearing on the final outcome on the value of its assets and liabilities that finally determine its Net Worth. The ultimate responsibility for ALM rests with the Board of Directors, though usually a committee known as the Assets-Liabilities Committee ALCO comprising of officers drawn from the ranks of senior management within the organization take over the task of coordinating and assisting the Board by handling the day-to-day tightening of bolts and nuts and keeping the board informed and advised periodically. This may be on a monthly or a quarterly basis depending on the size of the organization.

Some Basics about ALM Measures

(i)      Financial Statements (Profit & Loss and Balance Sheet)

These statements in themselves are quite good ALM measurements and reflectors of financial strengths/weaknesses of an organization. The value of the information can be enhanced by comparing over time (past and present), and also with other comparable organizations.

 (ii)      CAMEL Ratios:

CAMEL stands for Capital, Assets Quality, Management, Earnings and asset/Liabilities. Under Management, there no ratios usually associated with, as it is more or less dependent on somewhat subjective measurements. With regard to the other 4 balance sheets items Capital, Assets, Earnings and Liabilities, there are several ratios popularly known as accounting ratios that can be applied on many sub categories of assets and liabilities grouped under each of the above main categories to test their respective strengths or weaknesses. All these ratios too are comparable over the relevant past and present balance sheets and also with other comparable organizations. Two distinctive advantages with CAMEL ratios is that they are comparatively easy to compute, and the possibility to run “what-ifs” to assess the potential future effects on CAMEL ratios if some specified strategies were to be introduced. Thus CAMEL ratios can be considered a very useful and convenient tool that would enable any organization to take advantage of opportunities and avoid costly mistakes.

 (iii)  Gap:

It should be noted that this is not GAAP (Generally Accepted Accounting Principles), but simply Gap which is an ALM technique for measuring some balance sheet items. It is essentially a technique of asset-liability management, but specially considered good for assessing interest risk rate which is sometimes also called  liquidity risk. This measurement gives fair to good results depending on the type of risk being measured. There are many types of Gap of which the main two are Maturity Gap and Re-pricing Gap.

(a)     Maturity Gap:

It is the Gap of assets and liabilities that mature over time. In calculating the liquidity risk factors of this class of assets and liabilities, Gap analyzes an organizations relevant cash flow statements.

 (b)     Re-pricing Gap:

This too is a another liquidity ratio that looks at particularly the timing aspect of interest rates applicable on loans/deposits found on both sides of a balance sheet with a view to seeing when they could change them. Take for example the money market checking where it is subject to change every month. But Auto Loans (found on the opposite side of the balance sheet) which are also fixed interest rate bearing loans cannot be re-priced until the loan is paid off in full and a new loan is granted. Consequently a re-pricing gap arises due to the potential rate timing difference between the two sides of the balance sheet.

 It should be noted that the Re-pricing Gap returns a fair measure of the ratio between interest rate risk and earnings.

 (iv)      NEV (Net Economic Value) or EVE (Economic Value of Equity)

Economic Value is sometimes also referred to as Market Value of Equity. NEV is an indicator of the ratio that interest rate risk bears to capital.

 This ratio is considered as rather controversial by certain sections of financial circles mainly because of the introduction of a concept called the “Economic Value of Equity” that could be sometimes way different from the corresponding book value.

 This dispute of opinions arises from the fact that it is the “Economic Value of Equity” that NEV takes for the calculation of the Net Economic Value in place of its corresponding book value. The critics of the method adopted for the calculation of this ratio point out that the “Economic Value” brought into the equation is highly theoretical, could be biased, and hence open to debate. However, financial pundits who are in favor of taking the economic value in place of its relevant book value accept that the new technique can range from a very poor estimate to a very good estimate of the net realizable value of the asset; and that all depends on how and from what sources the economic value is derived from.

 NEV focuses on the change in net worth taken as a fair valued balance sheet ignoring the relevant book values. As already stated earlier, fair, or economic values could differ dramatically from their corresponding book values as per the balance sheet, so much so, that for example, at a given point of time when interest rates are on an upward trend, an investment of $1 million may be fair valued as worth only $925,000. whereas under conditions of falling interest rates at any given point of time, the fair value of an asset would increase.

NEV uses discounted cash flows in arriving at a fairly approximate value of the assets and liabilities. We cannot give it a better title than calling it “approximate” because the exact fair value at best is only an and a matter of opinion, and uncertain since market values are liable to change on a daily basis.  As such, it is viewed as a rather controversial ratio by many financial circles.

(v)   Income Simulations:

Income Simulations is an excellent tool for measuring interest rate risk to earnings and for the evaluation of future strategies for a bank / financial institution for the quantification of potential risks attached to the proposed future strategies.

 As its name implies, it simulates future income statements with changes in certain components including –

  • Interest Rates
  • Growth, and
  • Any changes in the mix, or the composition of assets and liabilities, and also some income and expense items like charges, fees, and changes in certain other non-interest incomes and expenses.

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