Asset liability management
Encyclopedia
In banking, asset and liability management is the practice of managing risk
s that arise due to mismatches between the assets and liabilities (debts and assets) of the bank. This can also be seen in insurance.
Banks face several risks such as the liquidity risk
, interest rate risk
, credit risk
and operational risk
. Asset liability management (ALM) is a strategic management
tool to manage interest rate risk and liquidity risk faced by bank
s, other financial services companies and corporation
s.
Banks manage the risks of asset liability mismatch
by matching the asset
s and liabilities according to the maturity pattern or the matching the duration, by hedging and by securitization
. Much of the techniques for hedging
stem from the delta hedging concepts introduced in the Black–Scholes model and in the work of Robert C. Merton
and Robert A. Jarrow
. The early origins of asset and liability management date to the high interest rate periods of 1975-6 and the late 1970s and early 1980s in the United States
. Van Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail.
Modern risk management now takes place from an integrated approach to enterprise risk management
that reflects the fact that interest rate risk
, credit risk
, market risk
, and liquidity risk
are all interrelated. The Jarrow-Turnbull model is an example of a risk management methodology that integrates default and random interest rates. The earliest work in this regard was done by Robert C. Merton
. Increasing integrated risk management
is done on a full mark to market basis rather than the accounting basis that was at the heart of the first interest rate sensivity gap and duration calculations.
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
s that arise due to mismatches between the assets and liabilities (debts and assets) of the bank. This can also be seen in insurance.
Banks face several risks such as the liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
, interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
, credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
and operational risk
Operational risk
An operational risk is, as the name suggests, a risk arising from execution of a company's business functions. It is a very broad concept which focuses on the risks arising from the people, systems and processes through which a company operates...
. Asset liability management (ALM) is a strategic management
Strategic management
Strategic management is a field that deals with the major intended and emergent initiatives taken by general managers on behalf of owners, involving utilization of resources, to enhance the performance of firms in their external environments...
tool to manage interest rate risk and liquidity risk faced by bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s, other financial services companies and corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
s.
Banks manage the risks of asset liability mismatch
Asset liability mismatch
In finance, an asset–liability mismatch occurs when the financial terms of an institution's assets and liabilities do not correspond. Several types of mismatches are possible....
by matching the asset
Asset
In financial accounting, assets are economic resources. Anything tangible or intangible that is capable of being owned or controlled to produce value and that is held to have positive economic value is considered an asset...
s and liabilities according to the maturity pattern or the matching the duration, by hedging and by securitization
Securitization
Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or Collateralized mortgage obligation , to...
. Much of the techniques for hedging
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...
stem from the delta hedging concepts introduced in the Black–Scholes model and in the work of Robert C. Merton
Robert C. Merton
Robert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:...
and Robert A. Jarrow
Robert A. Jarrow
Robert Alan Jarrow is the Ronald P. and Susan E. Lynch Professor of Investment Management at the Johnson Graduate School of Management, Cornell University...
. The early origins of asset and liability management date to the high interest rate periods of 1975-6 and the late 1970s and early 1980s in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
. Van Deventer, Imai and Mesler (2004), chapter 2, outline this history in detail.
Modern risk management now takes place from an integrated approach to enterprise risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
that reflects the fact that interest rate risk
Interest rate risk
Interest rate risk is the risk borne by an interest-bearing asset, such as a loan or a bond, due to variability of interest rates. In general, as rates rise, the price of a fixed rate bond will fall, and vice versa...
, credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....
, market risk
Market risk
Market risk is the risk that the value of a portfolio, either an investment portfolio or a trading portfolio, will decrease due to the change in value of the market risk factors. The four standard market risk factors are stock prices, interest rates, foreign exchange rates, and commodity prices...
, and liquidity risk
Liquidity risk
In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss .-Types of Liquidity Risk:...
are all interrelated. The Jarrow-Turnbull model is an example of a risk management methodology that integrates default and random interest rates. The earliest work in this regard was done by Robert C. Merton
Robert C. Merton
Robert Carhart Merton is an American economist, Nobel laureate in Economics, and professor at the MIT Sloan School of Management.-Biography:...
. Increasing integrated risk management
Risk management
Risk management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities...
is done on a full mark to market basis rather than the accounting basis that was at the heart of the first interest rate sensivity gap and duration calculations.
External links
- Society of Actuaries Professional Actuarial Specialty Guide describing Asset Liability Management
- Asset-Liability Management by riskglossary.com
- Asset Liability Management in Risk Framework by CoolAvenues.com
- Asset - Liability Management System in banks - Guidelines Reserve Bank of IndiaReserve Bank of IndiaThe Reserve Bank of India is the central banking institution of India and controls the monetary policy of the rupee as well as US$300.21 billion of currency reserves. The institution was established on 1 April 1935 during the British Raj in accordance with the provisions of the Reserve Bank of...
- Asset-liability Management: Issues and trends, R. Vaidyanathan, ASCI Journal of Management 29(1). 39-48