# Asset Liability Management

Topics: Risk, Market risk, Zero-coupon bond Pages: 18 (4132 words) Published: December 14, 2009
ALM Implementation in Banks – an approach paper

Fundamentals of ALM3

Overview3
Structural Liquidity Risk3
Interest Rate Risk3
Non-term products4
Probabilistic cash flow products4
Options, Futures and derivatives4
Profitability4

Bank ALM policy5

Product5
Structural Liquidity5
Gap Measurement6
Cost to close gap6
Maximum Cumulative Outflow6
Scenario Analysis7
Interest rate risk7
Interest rate Gap7
Duration Gap7

A model for implementation9

ALM implementation – problems in banks9

Case study of ALM implementation in a large bank in Western Africa9

Fundamentals of ALM

Overview

ALM techniques are used to manage assets and liabilities by timeframe.

Objectives of ALM are:

• Maximize profitability
• Minimize use of capital
• Ensure structural liquidity
• Ensure robustness in market risk management
• ‘Just in time’ money

Risks addressed by ALM are described below.

Structural Liquidity Risk

Liquidity has often been defined as ‘Ability to raise money that is not required’ in a humorous vien, the argument being that the day you need this money, no one will be willing to lend to you. Liquidity risk is simple mathematics but complex finance.

Structural Liquidity risk is measured in multiple ways. Gap between inflows and outflows by timeframe is a measure. Cost to close gap may be used as a measure of liquidity risk. 7-day Maximum cumulative outflow is another method. One may use all of the above.

Interestingly, many trading strategies involving complex models make an assumption of infinite liquidity. Reality is liquidity is finite and this can only be ignored at one’s own peril.

Interest Rate Risk

Gap between interest rate sensitive assets and liabilities, spread over time is a measurement of market risk. This is a simplistic measure, a minimum that is required.

Sensitivity of Net Interest Income (NII) to interest rate change is another view. Basel recommends sensitivity to a 200 basis points parallel shift in yield curve as a standard measure. 200 basis points is a Basel guideline. Central banks of individual countries may impose different measures. This measure, when used over multiple scenarios can give a reasonable picture of sensitivity of interest rate income to movements in interest rates.

Traditionally, banks have a trading book and a banking book. For purposes of determining interest rate sensitivity, both books are mapped to zero coupon bonds, preserving market risk. Combined book represents bank’s interest rate risk profile. Traditional methods like modified or dollar duration gap and convexity gap analysis enable risk measurement of interest rate sensitivity.

ALM techniques are not meant to replace balance sheet techniques in any shape or form. It is a completely different technique. First of all, ALM addresses time bucket concept, whereas balance sheet ignores time element completely. Secondly, ALM demands inclusion of off-balance sheet items that have potential impact on ALM sheet – for example unutilized portion of cash credit i.e. options given to customers.

Non-term products

This is the complex finance part. Certain products, example savings bank have no contracted terms. Thus, they present conceptual difficulty in being mapped to zero coupon bonds as it is not possible to determine date when cash flows occur. Thus, such products are generally split into two or more Zero coupon bonds, maturing on different dates. These parts are termed volatile and core. Core is expected to mature in later time buckets. Volatile portion is expected to be in first bucket. This may change by nature of account and other dimensions. This is a study in itself.

Probabilistic cash flow products

Savings bank and current account are examples of banking book transactions of probabilistic cash flow...