Definition, risks measured, indicators, customer behaviour and the role of ALM software. A short guide for those discovering the subject, or who have to explain it.
ALM, for Asset and Liability Management, is the discipline that measures and steers the maturity, rate and liquidity mismatches between what a bank or an insurer owns (its assets: loans, securities, investments) and what it owes (its liabilities: deposits, savings, borrowings, commitments to policyholders).
A bank lends long and borrows short. It promises its depositors to return their money at any time, and promises its borrowers not to ask for their money back for fifteen or twenty years. This mismatch is called maturity transformation. As long as rates and confidence stay stable, it earns money. When they move, it costs money. Asset and liability management exists to measure that mismatch before it shows up in the accounts.
ALM answers three questions: what will the balance sheet be tomorrow, what margin will it produce, and what interest-rate and liquidity risks does it carry, in each economic scenario.
The risk that the value of the balance sheet or net interest income falls when market rates change. A fixed-rate loan granted at 2% loses value if rates rise to 4%; a non-interest-bearing sight deposit becomes a valuable source of funding. Regulators call this interest-rate risk in the banking book, or IRRBB.
The risk of not being able to meet commitments as they fall due, for lack of available funds: massive deposit withdrawals, closure of the interbank market, simultaneous drawdown of credit lines. A bank can be solvent yet illiquid.
A contract does not run off as its schedule predicts. The borrower may prepay when rates fall, or renegotiate. The depositor may leave the money dormant for twenty years, or withdraw it tomorrow. The holder of a home savings plan closes it or keeps it depending on current rates.
Asset and liability management therefore rests on behavioural models: prepayment rate, renegotiation rate, conventional run-off of deposits with no maturity, stable and volatile portions, closure rate. These models turn a contractual balance sheet into an economic balance sheet, the only one that counts for measuring risks.
| Term | Definition |
|---|---|
| Reporting date | The date of the balance sheet being projected. All contracts are taken in their state at that date. |
| Balance | The outstanding principal of a contract or a portfolio at a given date. End-of-month balance and average-of-month balance are distinguished. |
| Run-off | The trajectory of the balance over time, contractual for a loan, conventional for a deposit with no maturity. |
| Liquidity view / interest-rate view | In the liquidity view, a contract stays on the balance sheet until it is repaid. In the interest-rate view, it leaves as soon as its rate resets. |
| Gap | The mismatch between assets and liabilities over a period, in liquidity terms (maturities) or in interest-rate terms (repricing dates). |
| Net interest income | The difference between the interest received on assets and the interest paid on liabilities, projected in each scenario. |
| Funds transfer pricing | The rate at which central treasury buys liquidity from, or sells it to, the business lines. It separates the commercial margin from the transformation margin. |
| New business | The contracts that do not yet exist at the reporting date and are assumed to be originated in the future, to project a complete balance sheet. |
| Scenario | A set of interest-rate, liquidity, inflation and behavioural assumptions. An ALM run calculates several: baseline, up, down, flattening, steepening. |
| EVE | Economic Value of Equity: the present value of all asset cash flows minus that of liability cash flows, and its change under shock. |
Both manage the matching of assets to liabilities, but the liabilities differ. For a bank, they are sight and term deposits and savings; for an insurer, commitments to policyholders, with rate-sensitive surrenders and premium inflows. An insurer's assets (bonds, swaps, options) are projected with the same tools as a bank's.
Interest Rate Risk in the Banking Book: the interest-rate risk of the banking book, defined by the Basel Committee and the European Banking Authority. It is measured by the sensitivity of EVE and net interest income to standardised rate shocks.
At least quarterly for regulatory reporting, monthly in most institutions for management purposes, and on demand to test an assumption or a hedging decision. Hence the importance of fast ALM software.
Because two loans in the same pool have neither the same date, nor the same rate, nor the same behaviour. Contract-by-contract projection avoids aggregation approximations and makes it possible to explain every figure down to the contract that carries it.
X-ALM is ALM software that projects a bank's balance sheet contract by contract, over twenty-five years, in every interest-rate and liquidity scenario, and reports the management and regulatory indicators in Power BI. It installs on an ordinary workstation, with no server and no database.
A one-hour demo on a sample balance sheet: from the contract to the gap, from the gap to EVE.
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