One of the most challenging aspects of banking is the interconnected risks that must be managed. Bank leaders must weight changing economic conditions, interest rates, liquidity risks, customer demand, and the list goes on and on. All of these risks and decisions make up what we refer to asset and liability management (ALM). With ALM being a noted concern of regulators as we enter 2024, we thought a brief refresher was in store.
ALM is at a basic level the process of managing the risks that result when assets do not match liabilities. Interest rate changes and illiquidity can cause a mismatch between assets and liabilities that hinders the ability to pay debts as they become due. ALM helps to ensure that this does not occur. While it sounds simple enough we’ve all witnessed the havoc that poor interest rate management and deposit concentration and other liquidity risks can bring over the past year.
As an example of ALM, consider interest rates. As we have previously detailed, interest rate management is critical because rate changes are at risk of changing for a multitude of reasons. When interest rates vary, the present value of assets and cash flows change as well. Interest rate risk management is thus critical to bank stability.
Secondly, consider how customer behavior impacts operations. Usually customers will prepay their loans or withdraw their deposits without much advance notice, if any. These conveniences can inadvertently cause unpleasant surprises for the bank because at a large enough scale it can result in interest rate and liquidity risks. For this reason, it is important for banks to monitor customer behavior to react quickly.
So, how do banks manage all these interconnected risks? It’s probably too complex to fully summarize here but there are a few common elements of ALM approaches. First, banks need liquidity buffers to offset risks, such as unexpected withdrawals. Buffers typically consist of cash and dependable assets, like government bonds. Next, banks must understand customer behavior and the effects of any changes to their behavior. This can involve modeling assets, such as prepayment of loans, and liabilities, like customer withdrawals. Lastly, performing scenario analyses and stress testing will keep the bank abreast of its risk profile and that should be combined with regular monitoring.
ALM plays a crucial role in the industry as a framework for managing risks and ensuring long-term financial stability and maintaining safe and sound banking. Through responsibly managing assets and liabilities, it’s possible to mitigate interest rate and liquidity risk, while optimizing profitability. As you think about your ALM entering 2024 you may find our asset & liability management toolkit useful, including our ALM policy, and as always please reach out to our Hotline team for assistance.