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Asset and liability management (often abbreviated ALM) is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting.
ALM sits between risk management and strategic planning. It is focused on a long-term perspective rather than mitigating immediate risks and is a process of maximising assets to meet complex liabilities that may increase profitability.
ALM includes the allocation and management of assets, equity, interest rate and credit risk management including risk overlays, and the calibration of company-wide tools within these risk frameworks for optimisation and management in the local regulatory and capital environment.
Often an ALM approach passively matches assets against liabilities (fully hedged) and leaves surplus to be actively managed.
Asset and liability management practices were initially pioneered by financial institutions during the 1970s as interest rates became increasingly volatile.
The exact roles and perimeter around ALM can vary significantly from one bank (or other financial institutions) to another depending on the business model adopted and can encompass a broad area of risks.
The traditional ALM programs focus on interest rate risk and liquidity risk because they represent the most prominent risks affecting the organization balance-sheet (as they require coordination between assets and liabilities). [1]
But ALM also now seeks to broaden assignments such as foreign exchange risk and capital management. According to the Balance sheet management benchmark survey conducted in 2009 by the audit and consulting company PricewaterhouseCoopers (PwC), 51% of the 43 leading financial institutions participants look at capital management in their ALM unit.
The scope of the ALM function to a larger extent covers the following processes:
The ALM function scope covers both a prudential component (management of all possible risks and rules and regulation) and an optimization role (management of funding costs, generating results on balance sheet position), within the limits of compliance (implementation and monitoring with internal rules and regulatory set of rules). ALM intervenes in these issues of current business activities but is also consulted to organic development and external acquisition to analyse and validate the funding terms options, conditions of the projects and any risks (i.e., funding issues in local currencies).
Today, ALM techniques and processes have been extended and adopted by corporations other than financial institutions; e.g., insurance.
For simplification treasury management can be covered and depicted from a corporate perspective looking at the management of liquidity, funding, and financial risk; see Corporate finance § Financial risk management. On the other hand, ALM is a discipline relevant to banks and financial institutions whose balance sheets present different challenges and who must meet regulatory standards.
For banking institutions, treasury and ALM are strictly interrelated with each other and collaborate in managing both liquidity, interest rate, and currency risk at solo and group level: Where ALM focuses more on risk analysis and medium- and long-term financing needs, treasury manages short-term funding (mainly up to one year) including intra-day liquidity management and cash clearing, crisis liquidity monitoring.
The responsibility for ALM is often divided between the treasury and Chief Financial Officer (CFO). In smaller organizations, the ALM process can be addressed by one or two key persons (Chief Executive Officer, such as the CFO or treasurer).
The vast majority of banks operate a centralised ALM model which enables oversight of the consolidated balance-sheet with lower-level ALM units focusing on business units or legal entities.
To assist and supervise the ALM unit an Asset Liability Committee (ALCO), whether at the board or management level, is established. It has the central purpose of attaining goals defined by the short- and long-term strategic plans:
Relevant ALM legislation deals mainly with the management of interest rate risk and liquidity risk:
As in all operational areas, ALM must be guided by a formal policy and must address:
Note that the ALM policy has not the objective to skip out the institution from elaborating a liquidity policy. In any case, the ALM and liquidity policies need to be correlated as decision on lending, investment, liabilities, equity are all interrelated.
The objective of this aspect of ALM, is to measure and then manage the direction and extent of any asset-liability mismatch, so as to maintain adequate profitability. The result will be expressed as a funding or "maturity gap" (see duration gap for discussion).
This exercise will have the joint objectives of balancing maturities, cash-flows and / or interest rates, for a particular time horizon. The management thus takes the form of:
The above "static" gap analysis considers any future gaps due to current, i.e. existing, exposures, and any related exercise of (embedded) options - usually prepayments - at different points in time.
"Dynamic gap analysis" enlarges the scope by including "what if" scenarios, testing potential changes in business activity (new volumes, additional prepayment transactions, potential hedging transactions), and considering unusual interest rate scenarios, with their associated shape of the yield curve and resultant changes in pricing.
Depending on deal-stage and likelihood, analysts will incorporate expected capital investments and their required funding under either approach, as appropriate.
The role of the bank in the context of the maturity transformation that occurs in the banking book (as traditional activity of the bank is to borrow short and lend long) lets inherently the institution vulnerable to liquidity risk and can even conduct to the so-call risk of 'run of the bank' as depositors, investors or insurance policy holders can withdraw their funds/ seek for cash in their financial claims and thus impacting current and future cash-flow and collateral needs of the bank (risk appeared if the bank is unable to meet in good conditions these obligations as they come due). This aspect of liquidity risk is named funding liquidity risk and arises because of liquidity mismatch of assets and liabilities (unbalance in the maturity term creating liquidity gap). Even if market liquidity risk is not covered into the conventional techniques of ALM (market liquidity risk as the risk to not easily offset or eliminate a position at the prevailing market price because of inadequate market depth or market disruption), these 2 liquidity risk types are closely interconnected. In fact, reasons for banking cash inflows are :
Measuring liquidity position via liquidity gap analysis is still one of the most common tool used and represents the foundation for scenario analysis and stress-testing.
To do so, ALM team is projecting future funding needs by tracking through maturity and cash-flow mismatches gap risk exposure (or matching schedule). In that situation, the risk depends not only on the maturity of asset-liabilities but also on the maturity of each intermediate cash-flow, including prepayments of loans or unforeseen usage of credit lines.
In dealing with the liquidity gap, the bank main concern is to deal with a surplus of long-term assets over short-term liabilities and thus continuously to finance the assets with the risk that required funds will not be available or into prohibitive level.
Before any remediation actions, the bank will ensure first to :
As these instruments do not have a contractual maturity, the bank needs to dispose of a clear understanding of their duration level within the banking books. This analysis for non-maturing liabilities such as non interest-bearing deposits (savings accounts and deposits) consists of assessing the account holders behavior to determine the turnover level of the accounts or decay rate of deposits (speed at which the accounts 'decay', the retention rate is representing the inverse of a decay rate).
Calculation to define (example):
Various assessment approaches may be used:
The 2007 crisis however has evidence fiercely that the withdrawal of client deposits is driven by two major factors (level of sophistication of the counterparty: high-net-worth clients withdraw their funds quicker than retail ones, the absolute deposit size: large corporate clients are leaving faster than SMEs) enhancing simplification in the new deposit run-off models.
The liquidity measurement process consists of evaluating :
2 essential factors are to take into account :
But daily completeness of data for an internationally operating bank should not represent the forefront of its procupation as the seek for daily consolidation is a lengthy process that may put away the vital concern of quick availability of liquidity figures. So the main focus will be on material entities and business as well as off-balance sheet position (commitments given, movements of collateral posted...)
For the purposes of quantitative analysis, since no single indicator can define adequate liquidity, several financial ratios can assist in assessing the level of liquidity risk. Due to the large number of areas within the bank's business giving rise to liquidity risk, these ratios present the simpler measures covering the major institution concern. In order to cover short-term to long-term liquidity risk they are divided into 3 categories :
Category | Ratio name | Objective and significance | Formula |
---|---|---|---|
Cash-flow ratio | Cash and short term investment to total assets ratio | Indication of how much available cash the bank has to meet share withdrawals or additional loan demand | Cash + short term investment / total assets Short term investment : part of the current assets section of investment that will expire within the year (most part as stocks and bonds that can be liquidated quickly) |
Cash-flow ratio | Operating cash flow ratio | Help to gauge the bank's liquidity in the short-term as how well current liabilities are covered by the cash-flow generated by the bank (thus shows its ability to meet near future expenses without to sell assets) | Cash-flow from operations / current liabilities |
Ratio of liquidity | Current ratio | Estimation of whether the business can pay debts due within one year out of the current assets:
| Current assets/ current liabilities
|
Ratio of liquidity | Quick ratio (acid test ratio) | Adjustment of the current ratio to eliminate no-cash equivalent assets (inventory) and indicate the size of the buffer of cash | Current assets (-stock) / current liabilities |
Ratio of liquidity | Non core funding dependence ratio | Measure of the bank's current position of how much long term earning assets (more than one year) are funded with non core funds (net short term funds: repo,CDs, foreign deposits and other borrowings maturing within one-year) net of short term investments. The lower the ratio the better | Non core liabilities (-Short term investments) / Long term assets |
Ratio of liquidity | Core deposits to total assets | Measurement of the extent to which assets are funded through stable deposit base. Correct level : 55% | Core deposit : deposit accounts, withdrawals accounts, savings, money market accounts, retail certificates of deposits |
Financial strength | Loans to deposit ratio | Simplified indication on the extent to which a bank is funding liquid assets by stable liabilities. A level of 85 to 95% indicating correct level. | Loans + advances to customer net of allowance for impairment losses (-reverse repo) / customer deposit (-repo) |
Financial strength | Loans to asset ratio | Indication that the bank can effectively meet the loan demand as well as other liquidity needs. Correct level : 70 to 80% |
Setting risk limits still remain a key control tool in managing liquidity as they provide :
As an echo to the deficit of funds resulting from gaps between assets and liabilities the bank has also to address its funding requirement through an effective, robust and stable funding model.
Today, banking institutions within industrialized countries are facing structural challenges and remain still vulnerable to new market shocks or setbacks:
After 2007, financial groups have further improved the diversification of funding sources as the crisis has proven that limited mix of funds may turn out to be risky if these sources run dry all of a sudden.
2 forms to obtain funding for banks :
The asset contribution to funding requirement depends on the bank ability to convert easily its assets to cash without loss.
From customers and small businesses and seen as stable sources with poor sensitivity level to market interest rates and bank's financial conditions.
This plan needs to embrace all available funding sources and requires an integrated approach with the strategic business planning process. The objective is to provide realistic projection of funding future under various set of assumptions. This strategy includes :
Main characteristics :
Dependencies to endogenous (bank specific events such as formulas, asset allocation, funding methods...) / exogenous (investment returns, market volatility, inflation, bank ratings...) factors that will influence the bank ability to access one particular source.
Once the bank has established a list of potential sources based on their characteristics and risk/ reward analysis, it should monitor the link between its funding strategy and market conditions or systemic events.
For simplification, the diversify available sources are divided into 3 main time categories:
Key aspects to take into account :
This reserve can also referred to liquidity buffer and represents as the first line of defense in a liquidity crisis before intervention of any measures of the contingency funding plan. It consists of a stock of highly liquid assets without legal, regulatory constraints (the assets need to be readily available and not pledged to payments or clearing houses, we call them cashlike assets). They can include :
Key actions to undertake :
As the bank should not assume that business will always continue as it is the current business process, the institution needs to explore emergency sources of funds and formalise a contingency plan. The purpose is to find alternative backup sources of funding to those that occur within the normal course of operations.
Dealing with Contingency Funding Plan (CFP) is to find adequate actions as regard to low-probability and high-impact events as opposed to high-probability and low-impact into the day-to-day management of funding sources and their usage within the bank.
To do so, the bank needs to perform the hereafter tasks :
Bank specific events : generally linked to bank's business activities and arising from credit, market, operational, reputation or strategic risk. These aspects can be expressed as the inability :
External events :
This assessment is realised in accordance with the bank current funding structure to establish a clear view on their impacts on the 'normal' funding plan and therefore evaluate the need for extra funding.
This quantitative estimation of additional funding resources under stress events is declined for:
In addition, analysis are conducted to evaluate the threat of those stress events on the bank earnings, capital level, business activities as well as the balance sheet composition.
The bank need, in accordance, to develop a monitoring process to :
Such inventory includes :
The last key aspect of an effective Contingency Funding Plan relates to the management of potential crisis with a dedicated team in charge to provide :
The objective is to settle an approach of the asset-liability profile of the bank in accordance with its funding requirement. In fact, how effectively balancing the funding sources and uses with regard to liquidity, interest rate management, funding diversification and the type of business-model the bank is conducting (for example business based on a majority of short-term movements with high frequency changement of the asset profile) or the type of activities of the respective business lines (market making business is requiring more flexible liquidity profile than traditional bank activities)
Funding report summarises the total funding needs and sources with the objective to dispose of a global view where the forward funding requirement lies at the time of the snapshot. The report breakdown is at business line level to a consolidatedone on the firm-wide level. As a widespread standard, a 20% gap tolerance level is applied in each time bucket meaning that gap within each time period defined can support no more than 20% of total funding.
The effect of terming out funding is to produce a cost of funds, the objective is to :
This is the concept of Fund Transfer Pricing (FTP) a process within ALM context to ensure that business lines are funded with adequate tenors and that are charged and accountable in adequation to their current or future estimated situation.
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