Asset liability management (ALM) can be defined as the comprehensive and dynamic framework for measuring, monitoring and managing the financial risks associated with changing interest rates, foreign exchange rates and other factors that can affect the organisation’s liquidity.
ALM relates to management of structure of balance sheet (liabilities and assets) in such a way that the net earning from interest is maximised within the overall risk-preference (present and future) of the institutions.
Thus the ALM functions includes the tools adopted to mitigating liquidly risk, management of interest rate risk / market risk and trading risk management. In short, ALM is the sum of the financial risk management of any financial institution.
In other words, ALM is all about managing three central risks:
- Interest Rate Risk
- Liquidity Risk
- Foreign currency risk
For banks with forex operations, it also includes managing
Through ALM banks try to match the assets and liabilities in terms of Maturities and Interest Rates Sensitivities so as to minimize the interest rate risk and liquidity risk.
Overview of what are asset liability mismatches :
The Assets and Liabilities of the bank’s B/Sheet are nothing but future cash inflows & outflows. Under Asset Liability Management i.e. ALM, these inflows & outflows are grouped into different time buckets. Then each bucket of assets is matched with the corresponding bucket of liability.
The differences in each bucket are known as mismatches.
Is complete matching of Assets & Liabilities in the Balance sheet necessary?
No, because banks can even make money as a result of such mismatches sometimes. Alam Greenspan, ex-Chairman of US Federal Reserve has once observed “risk taking is necessary condition for wealth creation”. However, it is a risky proposition to keep large mismatches as it can lead to massive losses in a volatile market. Therefore, in practice, the idea is to limit the mismatches rather than aim at zero mismatches.