Asset liability management is the process through which an association handles its financial risks that may come with changes in interest rate and which in turn would affect the liquidity scenario.
Banks and other financial associations supply services which present them to different kinds of risks. We have three types of risks — credit risk, interest risk, and liquidity risk. So, asset liability management is an approach or a step that assures banks and other financial institutions with protection that helps them manage these risks efficiently.
The model of asset liability management helps to measure, examine and monitor risks. It ensures appropriate strategies for their management. Thus, it is suitable for institutions like banks, finance companies, leasing companies, insurance companies, and other financing bodies.
Asset liability management is an initial step to be taken towards the long term strategic planning. This can also be considered as an outlining function for an intermediate term.
In particular, liability management also refers to the activities of purchasing money through cumulative deposits, federal funds and commercial papers so that the funds lead to profitable loan opportunities. But when there is an increase of volatility in interest rates, there is major recession damaging multiple economies. Banks begin to focus more on the management of both sides of the balance sheet that is assets as well as liabilities.
Asset liability management (ALM) can be stated as the comprehensive and dynamic layout for measuring, examining, analyzing, monitoring and managing the financial risks linked with varying interest rates, foreign exchange rates and other elements that can have an impact on the organization’s liquidity.
Asset liability management is a strategic approach of managing the balance sheet in such a way that the total earnings from interest are maximized within the overall risk-preference (present and future) of the institutions.
Thus, the ALM functions include the tools adopted to mitigate 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 handles the following three central risks −
Banks which facilitate forex functions also handles one more central risk — currency risk. With the support of ALM, banks try to meet the assets and liabilities in terms of maturities and interest rates and reduce the interest rate risk and liquidity risk.
Asset liability mismatches − The balance sheet of a bank’s assets and liabilities are the future cash inflows & outflows. Under asset liability management, the cash inflows & outflows are grouped into different time buckets. Further, each bucket of assets is balanced with the matching bucket of liability. The differences obtained in each bucket are known as mismatches.