Asset-Liability Management (ALM) in banks is a strategy used to balance the

bank’s assets (like loans) and liabilities (like deposits) to ensure financial stability
and profitability. It helps banks manage risks related to interest rates, liquidity,
and the timing of cash flows.
Business of banking involves the identifying, measuring, accepting and
managing the risk, the heart of bank financial management is risk management.
One of the most important risk-management functions in bank is Asset Liability
Management. Traditionally, administered interest rates were used to price the
assets and liabilities of banks. Asset Liability Management is concerned with
strategic balance sheet

management involving risks caused by changes in interest rates, exchange rate,

credit risk and the liquidity position of bank. With profit becoming a key- factor,
it has now become imperative for banks to move towards integrated balance
sheet management where components of balance sheet and its different
maturity mix will be looked at profit angle of the bank.

ALM is about management of Net Interest Margin(NIM) to ensure that its level
and riskiness are compatible with risk/return objectives of the bank.
It is more than just managing individual assets and liabilities. It is an integrated
approach to bank financial management requiring simultaneous decision about
types and amount of financial assets and liabilities it holds or its mix and volume.
In addition, ALM requires an understanding of the market area in which the bank
operates.

If 50% of the liabilities are maturing within 1 year but only 10% of the assets are
maturing within the same period. Though the financial institution has enough
assets, it may become temporarily insolvent due to a severe liquidity crisis.

Thus,ALM is required to match assets & liabilities and minimize liquidity as well
as market risk.

Reasons for growing significance of ALM

-Volatility

-Product Innovation

-Regulatory Framework

-Management Recognition

An effective Asset Liability Management technique aims to manage the volume

mix, maturity ,rate sensitivity, quality and liquidity of assets and liabilities as a
whole so as to attain a predetermined acceptable risk/reward ratio.
Here’s why ALM is used in banks:

1. **Interest Rate Management**: Banks borrow and lend money at different

interest rates. If interest rates suddenly change, it can impact the bank's profits.
ALM helps banks make adjustments to minimize losses.
2. **Liquidity Management**: Banks need enough cash or easily sellable assets
to meet deposit withdrawals or loan demands. ALM ensures the bank has the
right amount of liquidity to meet these needs without holding too much, which
could reduce profitability.
3. **Risk Management**: By monitoring the timing of assets and liabilities, ALM
helps banks avoid situations where they owe more than they can pay or can't
lend out money profitably.
Overall, ALM helps banks keep a balanced financial position, avoid losses, and
stay stable even when market conditions change.
 Purpose and objectives of asset liability management
1. Review the interest rate structure and compare the same to the
interest/product pricing of both assets and liabilities.
2. Examine the loan and investment portfolios in the light of the foreign
exchange risk and liquidity risk that might arise.
3. Examine the credit risk and contingency risk that may originate either due
to rate fluctuations or otherwise and assess the quality of assets.

Review, the actual performance against the projections made and analyze the
reasons for any effect on spreads.
Aim is to stabilize the short-term profits, long-term earningsand long-term
sustenance of the bank. The parameters that are selected for the purpose of
stabilizing asset liability management of banks are:
1. Net Interest Income(NII)
2. Net Interest Margin(NIM)
3. Economic Equity Ratio
Net Interest Income=Interest Income-Interest Expenses.
Net Interest Margin=Net Interest Income/Average Interest yielding Assets
Economic Equity Ratio=The ratio of the Shareholders’ funds / the total assets
measures the
shifts in the ratio of owned funds to total funds. The fact assesses the
sustenance capacity of the bank.
LIQUIDITY MANAGEMENT is how a bank makes sure it has enough cash
available to meet its day-to-day needs, like deposit withdrawals and loan
requests, without running out of money.
It involves planning and managing cash flow so the bank doesn’t hold too much
(which could limit profits) or too little (which could lead to financial trouble). This
helps the bank stay stable, reliable, and ready to handle customer needs
smoothly.
Banks need to keep enough cash, or liquidity, to cover withdrawals and meet
loan requests. This liquidity depends on changes in deposits and loan demands.
Having liquidity helps a bank:
1. Show it’s financially stable and can repay borrowings.
2. Meet its promises to lend money, whether promised formally or informally.
3. Avoid selling assets at a loss to raise cash.
4. Pay less on borrowing costs, as lenders see it as a safe, low-risk bank.
Essentially, liquidity ensures that a bank can smoothly handle customer needs
and maintain trust in the market.
 Types of liquidity risk:
1. Funding Risk
2. Time Risk
3. Call Risk.
Need to replace net outflows due to unanticipated withdrawal/non-renewal of
deposits arises due to
 Fraud causing substantial loss
 Systemic Risk
 Loss of confidence
 Liabilities in foreign currencied
TIME RISK:
Need to compensate for non-receipt of expected inflow of funds, arises due to,
 Severe deterioration in the asset quality
 Standard assets turning into non-performing assets
 Temporary problems in recovery
 Time involved in managing liquidity.

CALL RISK: Crystallisation of contingent liabilities and inabilite to undertake

profitable business opportunities when desirable,arises due to,
 Conversion of non-fund based limit into fund based.
 Swaps and options.
Measuring and Managing Liquidity Risk
Developing a structure for managing liquidity risk.
Setting tolerance level and limit for liquidity risk.
Measuring and managing liquidity risk.
 Setting tolerance level for a bank:
To manage the mismatch levels so as to avert wide liquidity gaps-The residual
maturity profile of assets and liabilities will be such that mismatch level for time
bucket of 1-14 days and 15-28 days remain around 20% of cash outflows in each
time bucket.
To manage liquidity and remain solvent by maintaining short-term cumulative
gap up to one year(short term liabilities-short term assets) at 15% of total
outflow of funds.
Measuring and Managing Liquidity Risk
Stock Approach
Flow Approach
Stock Approach is based on the level of assets and liabilities as well as off
balance sheet exposures on a particular date.
The following ratios are calculated to assess the liquidity position of the bank:
Ratio of core deposits to total assets
Net loans to total deposits ratio
Ratio of time deposits to total deposits
FLOW APPROACH
Measuring and managing net funding requirements.
Managing Market Access
Contingency Planning
Measuring and Managing net funding requirements:
Flow method is the basic approach followed by Indian Banks. It is called as gap
method of measuring and managing liquidity. It requires the preparation of
structural liquidity gap report. In this method net funding requirement is
calculated on the basis of residual maturities of assets & liabilities. These
residual maturities represent net cash flows i.e. difference between cash outflow
& cash inflow in future time buckets
These calculations are based on the past behavior pattern of assets and liabilities
as well as off balance sheet exposures. Cumulative gap is calculated at various
time buckets. In case gap is negative bank has to manage the shortfall.
The analysis of net funding requirements involves the construction of a maturity
ladder and the calculation of a cumulative net excess or deficit of funds at
selected maturity dates.

A bank’s net funding requirements are determined by analyzing its futurecash

flows based on assumptions of the future behavior of assets ,liabilities and off –
balance sheet items and then calculating the cumulativenet excess over the time
frame for liquidity assessment. These aspects willbe elaborated under following
heads:

The maturity Ladder

Alternative scenarios
Measuring Liquidity over the chosen time –frame
Assumption used in determining cash flows

The Maturity Ladder

A maturity ladder should be used to compare a bank’s future cash inflows to its
future cash outflows over series of specified time periods. Cash inflows arise from
maturing assets, saleable non-maturing assets and established credit lines that
can be tapped. Cash outflow include liabilities falling due and contingent
liabilities, especially committed lines of credit that can be drawn down.
The difference between cash inflows and cash outflows in each period becomes
the starting point for a measure of a banks future liquidity excess or shortfall at a
series of points in time.

Statement of Structural Liquidity

All Assets & Liabilities to be reported as per their maturity profile into 8 maturity
Buckets:

1 to 14 days
15 to 28 days
29 days and up to 3 months
Over 3 months and up to 6 months
Over 6 months and up to 1 year
Over 1 year and up to 3 years
Over 3 years and up to 5 years
Over 5 years

Statement of structural liquidity

Places all cash inflows and outflows in the maturity ladder as per residual
maturity
Maturing Liability: cash outflow
Maturing Assets : Cash Inflow
Classified in to 8 time buckets
Mismatches in the first two buckets not to exceed 20% of outflows
Shows the structure as of a particular date
Banks can fix higher tolerance level for other maturity buckets.

Interest rate risk is the volatility in net interest income(NII) or in variations in net
interest margin(NIM).
Interest rate risk is broadly classified into following category:
Gap or Mismatch Risk
Basis Risk
Net Interest position risk
Embedded option risk
Yield curve risk
Price risk
Reinvestment risk
Gap or Mismatch risk:
A gap or mismatch risk arises from holding assets and liabilities with different
principal amounts, maturity dates or repricing dates, there by creating exposure
to changes in level of interest rate. The gap is the difference between the
amount of assets and liabilities on which the interest rates are reset during a
given period. In other word, when assets and liabilities fall due to repricing in
different periods, they can create amismatch. Such a mismatch or gap may lead
to gain or loss depending upon how interest rate in market tend to move.
Basis risk: The risk that the interest rate of different assets and liabilities may
change in different magnitudes is called basis risk.
Embedded option:
Prepayment of loans and bonds and/or premature withdrawal of deposits before
their stated maturity dates
Yield Curve Risk:
An yield curve is a line on graph plotting the yield of all maturities of a particular
instrument. Yield curve changes its slop and shape from time to time depending
upon repricing and various other factors. This change cause change in the gap
between assets & liabilities.
Price risk:
Price risk occurs when assets are sold before their maturity dates. In the financial
market ,bond prices and yield are inversely related .
Yield curve: It is a line on a graph plotting the yield of all maturities of a
particular instrument.
Management of Exchange Rate Risk

Foreign exchange risk-Risk arising out of adverse exchange rate movements

during a period in which it has open position in an individual foreign currency.
Transaction exposure: Change in the foreign exchange rate between the time the
transaction is executed and the time it is settled.
Forwards-Agreement to buy or sell forex for a predetermined amount, at a
predetermined rate on a predetermined date.
Open position: The extent to which outstanding contracts to purchase a currency
exceed liabilities plus outstanding contracts to sell the currency &vice versa.
Overnight position-A limit on the maximum open position left overnight, inall
major currencies.
Day-light position-A limit on maximum open position in all major currencies at
any point of time during day. Such limits are generally larger than overnight
positions.
Options: It is a contract for future delivery of a currency in exchange for another,
where the holder of the option has the right, without obligation to buy or sell the
currency at an agreed price, the strike price or exercise price, on a specified
future date.
Call option; The right to buy under an option
Put option:The right to sell under an option.
Futures are forward contracts with standardized size, standardised maturity date
governed by a set of guidelines stipulated by exchange concerned for
settlements and payments.