Lecture: 5

Financial Risk Management

ASSET LIABILITY MANAGEMENT

WHAT IS ASSET/LIABILITY MANAGEMENT?

• Asset/liability management is the process of

managing the use of assets and cash flows to
reduce the firm’s risk of loss from not paying a
liability on time. Well-managed assets and
liabilities increase business profits. The
asset/liability management process is typically
applied to bank loan portfolios and
pension plans. It also involves the
economic value of equity
WHAT IS ASSET/LIABILITY MANAGEMENT?
• Understanding Asset/Liability Management
• The concept of asset/liability management
focuses on the timing of cash flows because
company managers must plan for the payment
of liabilities. The process must ensure that assets
are available to pay debts as they come due and
that assets or earnings can be converted into
cash. The asset/liability management process
applies to different categories of assets on the
balance sheet.
WHAT IS ASSET/LIABILITY MANAGEMENT?
• Factoring in Defined Benefit Pension Plans
• A defined benefit pension plan provides a
fixed, pre-established pension benefit for
employees upon retirement, and the
employer carries the risk that assets invested
in the pension plan may not be sufficient to
pay all benefits. Companies must forecast the
dollar amount of assets available to pay
benefits required by a defined benefit plan.
WHAT IS ASSET/LIABILITY MANAGEMENT?
• Factoring in Defined Benefit Pension Plans
• Assume, for example, that a group of
employees must receive a total of $1.5 million
in pension payments starting in 10 years. The
company must estimate a rate of return on
the dollars invested in the pension plan and
determine how much the firm must contribute
each year before the first payments begin in
10 years.
WHAT IS ASSET/LIABILITY MANAGEMENT?
• Examples of Interest Rate Risk
• Asset/liability management is also used in
banking. A bank must pay interest on deposits
and also charge a rate of interest on loans. To
manage these two variables, bankers track
the net interest margin or the difference
between the interest paid on deposits and
interest earned on loans.
WHAT IS ASSET/LIABILITY MANAGEMENT?
• Examples of Interest Rate Risk
• Assume, for example, that a bank earns an
average rate of 6% on three-year loans and
pays a 4% rate on three-year certificates of
deposit. The interest rate margin the bank
generates is 6% - 4% = 2%. Since banks are
subject to interest rate risk, or the risk that
interest rates increase, clients demand higher
interest rates on their deposits to keep assets
at the bank.
WHAT IS ASSET/LIABILITY MANAGEMENT?
• The Asset Coverage Ratio
• An important ratio used in managing assets and liabilities is the
asset coverage ratio which computes the value of assets
available to pay a firm’s debts. The ratio is calculated as follows:

• Asset Coverage Ratio = (BVTA−IA)−(CL−STDO)/ Total Debt

Outstanding

• ​ where:
• BVTA=book value of total assets
• IA=intangible assets
• CL=current liabilities
• STDO=short term debt obligations
WHAT IS ASSET/LIABILITY MANAGEMENT?
• The Asset Coverage Ratio
• Tangible assets, such as equipment and machinery, are stated at
their book value, which is the cost of the asset less accumulated
depreciation.
• Intangible assets, such as patents, are subtracted from the
formula because these assets are more difficult to value and sell.
• Debts payable in less than 12 months are considered short-term
debt, and those liabilities are also subtracted from the formula.
• The coverage ratio computes the assets available to pay debt
obligations, although the liquidation value of some assets, such
as real estate, may be difficult to calculate.
• There is no rule of thumb as to what constitutes a good or poor
ratio since calculations vary by industry.
WHAT IS ASSET/LIABILITY MANAGEMENT?
• Key Takeaways
• Asset/liability management reduces the risk that a
company may not meet its obligations in the future.
• The success of bank loan portfolios and pension plans
depend on asset/liability management processes.
• Banks track the difference between the interest paid
on deposits and interest earned on loans to ensure
that they can pay interest on deposits and to
determine what a rate of interest to charge on loans.
WHAT IS ASSET/LIABILITY MANAGEMENT?
• Fast Fact:
• Asset/liability management is a long-term
strategy to manage risks. For example, a
home-owner must ensure that they have
enough money to pay their mortgage each
month by managing their income and
expenses for the duration of the loan.
Asset Liability Management (ALM): Meaning, Tools and Factors

At the end of this presentation you will learn

about:-
1. Meaning of Asset Liability Management (ALM)
2. Tools of ALM
3. Factors Influencing ALM.
Asset Liability Management (ALM): Meaning, Tools and Factors

Meaning of Asset Liability Management (ALM):

Asset Liability Management in practical terms amounts to management
of total balance sheet items, its size and quality. It involves conscious
decisions with regard to asset liability structure in order to maximize
interest earnings within the frame work of perceived risk with
quantification of risk.

ALM encompasses the process of managing Net interest Margin (NIM),

within the overall risk. It calls for an integrated approach to decision
making with regard to type (demand/time maturities) and size
(portfolios) of financial assets and liabilities and their mix and volumes
(turnover). The success of ALM hinges on matching of assets and
liabilities in terms of Rate and maturity to optimize the yield and
maintain/improve the NIM.
Asset Liability Management (ALM): Meaning, Tools and Factors

Meaning of Asset Liability Management (ALM):

In practice, assets and liabilities of a bank are continuously
changing which affect interest cost and interest income. Since
Micro level management of assets and liabilities is not
possible, through ALM, the bank groups the assets and
liabilities according to the maturity, rate, risk, and size so as to
control mismatches.
While elimination of gaps arising due to mismatches is not
possible, the ALM aims at minimizing the gaps as they are risk-
prone and directly affect the NIM. Thus ALM will enable the
bank to protect and if possible improve the Net Interest
Margin through conscious strategies and decisions.
Asset Liability Management (ALM): Meaning, Tools and Factors

Meaning of Asset Liability Management (ALM):

A sound ALM system for the bank should include:
1. Interest rate movement and outlook,
2. Pricing of assets and liabilities,
3. Review of investment portfolio and credit risk
management,
4. Review of investment of foreign exchange operations,
5. Management of liquidity Risk,
6. Management of NIM and of balance sheet ratios, and
7. Formulation of budgets and operational planning.
Asset Liability Management (ALM): Meaning, Tools and Factors

Tools of ALM:
There are different tools for Asset and Liability
Management. Some of which are:
1. Gap Analysis,
2. Duration Analysis,
3. Value-at-risk method, and
4. Risk management.
Asset Liability Management (ALM): Meaning, Tools and Factors

1. Gap Analysis:
• Basically Assets and Liabilities both are rate sensitive in different
degree. It is therefore necessary to identify the rate sensitivity
among different groups of assets and liabilities and match identical
groups of assets with liabilities. In the ALM process, Gap is
generally used for quantifying the rate sensitive groups only (as
compared to rate insensitive groups of liabilities like current
deposits, float funds etc.)

• In other words, GAP is the “excess” of interest sensitive assets over

interest sensitive liabilities or vice – versa> If Risk sensitive liabilities
and Risk sensitive Assets are equal when difference of two (GAP
RSA-RSL) becomes NIL, Net Interest Margin (NIM) is free from any
effect of interest rates movements.
Asset Liability Management (ALM): Meaning, Tools and Factors

2. Duration Method:
Under this method, impact of changes in interest
rate on the market value of assets and liabilities is
considered. Duration analysis is carried out with
respect to cash flows and average maturity.
Asset Liability Management (ALM): Meaning, Tools and Factors

3. Value-at-risk (VAR) method:

This method is variant of the practice of ‘Market-to
Market’ approved securities based on Yield- to
Maturity.
Asset Liability Management (ALM): Meaning, Tools and Factors

4. Risk Management:
Under this process, the risk profiles of assets and liabilities are
evaluated to ensure that they are within the acceptable levels of
risk. The availability of hedging mechanisms (e.g. derivative
instruments) would facilitate risk management.
The Reserve Bank of India issues specific guidelines to be
followed by banks for managing their respective. Asset and
Liability Management. Although the principles of managing
assets and liability based on Basel committee have been given
above some important points of the guidelines issued by RBI
(these are reviewed periodically to suit the changing atmosphere
of the monetary and economic policies of the government)
Asset Liability Management (ALM): Meaning, Tools and Factors

Factors Influencing ALM:

For asset-liability management (ALM) system the broad
guidelines of RBI specify three important factors to be
looked into by each bank:
1) ALM information system,
2) ALM Organisation, and
3) ALM process.
Under the Information system banks are required to ensure
development of information procuring system for
measuring, monitoring, controlling and reporting the risks.
Asset Liability Management (ALM): Meaning, Tools and Factors

Factors Influencing ALM:

The method is used to analyze the behavior of assets and
liability products to assess in which way the assets and liability
would behave in the business of banking. The ALM
Organisation guidelines insist that each bank at the top
management level and Board of Directors should on the
ongoing basis review the situation to ensure appropriate
policies and procedures are adopted and implemented to
timely arrest the prospective risks.
The ALM process is meant to create parameters for managing
the risks like, identification of risk, measurement of risk,
management of risk, planning to mitigate the risk etc..
THE END