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Section 7. Asset Liability Management (ALM)

Much before VaR appeared as a central concept, asset liability management (ALM) developed and provided tools for capturing liquidity and interest rate risk at the global balance sheet level. It extends to the definition of economic transfer prices, serving as benchmarks for pricing and for allocating revenues. Note that there is no capital charge for mismatch risk that ALM addresses.

ALM is neither a subset of market risk, as sometimes suggested, nor a trivial technique that can be bypassed by addressing the more sophisticated techniques of market risk and credit risk modeling. There are not so many extensive publications on ALM1. The financial crisis will presumably enhance and reinforce the role of ALM as a critical function because of its major role of mismatch risk. ALM addresses mismatch risk in its two dimensions, liquidity risk and interest rate risk. ALM provides the very first picture of the liquidity position of a bank, through the time profiles of excesses of deficits of funds in all currencies. ALM also tracks interest income fluctuations by relating them to interest rates. It applies to retail banking, commercial banking, and merchant banking.

The ALM Committee, or "ALCO," decides all related policies with respect to balance sheet structure, funding, regulatory constraints, and relate those with interest income.


The goal of ALM is to provide measures of the exposure to mismatch risk, and to maintain it within bounds, while optimizing the risk-return profile of the balance sheet, both through unbalance sheet actions (business policy) and off-balance sheet instruments (derivatives).

The target variables of mismatch risk include the liquidity position plus target variables subject to interest rate risk (IRR).

ALM risks, liquidity and interest rate, are not subject to capital charges under Basel 2. Basel 2 considers supervision of ALM risks only under pillar 2 ("market discipline"):

§762 The Committee remains convinced that interest rate risk in the banking book is a potentially significant risk which merits support from capital ...

§763 The revised guidance on interest rate risk recognizes banks' internal systems as the principal tool for the measurement of interest rate risk in the banking book and the supervisory response. To facilitate supervisors' monitoring of interest rate risk exposures across institutions, banks would have to provide the results of their internal measurement systems, expressed in terms of economic value relative to capital, using standardized interest rate shocks.

Basel 2 did not allocate any risk-based capital to ALM risks which played a major role in the 2008 financial crisis. Today, regulations rightly consider minimum simple measures for addressing both financial firm and financial system risks (macro-prudential monitoring), which compensates the relative lack of attention on ALM risks.

FTP systems link global risk management to business units and transactions. As such, they are an important block of bank-wide risk management systems and are generally within the broad scope of ALM.

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