Definition: Asset Liability Management (ALM) is a strategic framework that emphasizes on settling the liabilities through the company’s cash flow and assets to avoid any sort of penalty or interest on delayed payments or non-repayments of such debts. It ensures stability, higher gain, liquidity, better return to shareholders, proper fund allocation and lower risk of default.
Moreover, the company’s reputation among the public i.e., the customers, investors, partners, associates, employees, financial institutions, government and all others depends upon its ability to clear debts on time and a healthy financial position which is possible through ALM implementation.
Content: Asset Liability Management (ALM)
Need
Strategies
Tools and Techniques
Process
Limitations
Example
Need for Asset Liability Management
What is the need for an asset liability management framework?
ALM is not only applied widely by financial institutions but also adopted as a financial tool by companies around the world.
Some of the major reasons for adopting ALM framework are discussed below:
- Competitiveness: When the company is financially stable and holds superior goodwill in the market, its competitiveness automatically upgrades.
- Market Integration: Due to low financial risk and higher profitability, the company can scale up the production which in return provides market consolidation.
- Interest Rates Deregulation: ALM practice essentially takes care of deregulating the rate of interest on assets, since as the interest rates rise, the return on assets automatically upsurges.
- Multi-Currency Balance Sheet: To handle the transactions in different currencies, banks and other financial institutions adopt asset liability management.
- Financial Market Globalization: The financial institutions bridges the gap between the lenders and the borrowers located across different countries through a well-designed ALM framework.
- NII/NIM Narrowing: When the net interest income shrinks due to the decreasing difference between the interest earned and interest paid, the banks need to go for ALM practice.
- ALM Products’ Diversification: To develop innovative products, financial institutions move forward with various asset liability management techniques and strategies.
Strategies of Asset Liability Management
There are different ways through which a company or a financial institution practice asset liability management. Given below are the crucial strategies of ALM:
Currency Risk Management: Exchange rate fluctuation is a major issue while a company deals in foreign currency. Therefore, to hedge the business from such adversities, currency risk management plays a key role.
Liquidity Risk Management: The banks are prone to liquidity risk where their inability to pay off dues detriments their financial position. Thus, a smart liquidity risk management ability can save these financial institutions from such unfavourable situations.
Profit Planning and Growth: Another profound strategy is the anticipation of possible gain and growth opportunities for the annual period, to maintain resources and set a course of action for the attainment of the same.
Interest Rate Risk Management: You may have heard that the returns on a certain asset have not met the expectations, hence interest rate risk management becomes crucial to be secured from interest rate fluctuations.
Credit Risk Management: When financial institutions offer loans and advances to their clients, there are chances of not able to recover this amount. To handle the risk of such bad debts credit risk management strategy is undertaken.
Funding and Capital Management: Funds are inevitable to run a business, therefore, the companies and financial institutions carefully plan its sources of fund, capital allocation and cash flow through funding and capital management.
Capital Market Risk Management: For corporate investors, capital markets are always a fruitful idea for short-term gains. However, such securities, derivatives, bonds and foreign currency borne risk and requires a systematic approach.
Spread Management: Any difference between the bid and the ask prices of a particular asset is considered as a spread. While proper spread management, the investor can yield profits from stock investment.
Tools and Techniques of Asset Liability Management
Analyzing the financial whereabouts involves statistical and interpretative approach. The most common tools applied in this context are as follows:
- Asset Coverage Ratio: The company’s competency to pay off its liabilities from the firm’s assets can be determined through an asset coverage ratio.
- GAP Analysis: To measure the business efficiency by evaluating the difference between the actual and the set goals of an organization, GAP analysis is carried out.
- Duration Analysis: While identifying the impact of interest rate changes over a certain debt instrument’s price, the companies adopt the duration analysis technique.
- Value-at-Risk Approach: The risk appetite of any asset or investment and its possibility of loss can be analyzed by the VaR method.
- Scenario Analysis: This technique takes into consideration all possible favourable and unfavourable events affecting the expected value of a particular investment portfolio.
- Simulation Technique: The simulation method tries to figure out the in and outs of an actual situation by creating its dummy.
- Risk Management: One of the most robust techniques is to anticipate, analyze and develop measures to deal with the possible danger to the company’s viability and income.
Process of Asset Liability Management
How to go about designing a suitable asset liability management framework?
The answer is described in the following five-step process of ALM:
- Setting Risk Parameters: As we proceed with ALM implementation, the foremost step is to set limits of bearing financial risk.
- Risk Identification: Next is to ascertain the risk that may highly impact the organization, its working, finances or investment.
- Risk Measurement: Various methods like value at risk, standard deviation, correlation are adopted for risk assessment.
- Risk Management: Risk mitigation is another essential phase in the process where the efforts are made to minimize the impact of any such loss.
- Risk Policies and Tolerance Level: Lastly, the guidelines for risk management as well as level of tolerance is entrenched for future reference.
Asset Liability Management Limitations
While a financial institution or an organization undertake asset liability management practice, it has to face a number of hurdles:
- Inaccurate At Times: Since it is just an assumption and trial that may prove to be fruitful in the long-term, however, there is no assurance of such possibilities.
- Doesn’t Work Alone: For risk management, ALM cannot perform solely instead the other financial measures need to be applied simultaneously for obtaining the desired results.
- Difficult to Implement: Every organization requires a unique ALM framework since they face different challenges and have varying objectives. Thus, it becomes difficult to implement this strategy for every company.
- Time-Consuming: As it is seen as a coordinated effort, the organization’s resources need to work in synchronization which is a complicated and time-consuming process.
- Restrict Higher Returns: Asset liability management may draw boundaries for the investments resulting in limited profits or returns.
- Long-Term Strategy: It is not a quick fix, rather the ALM results can be observed in a future period. Therefore, it becomes difficult to analyze the viability of such a framework.
Asset Liability Management (ALM) Example
The multinational companies selling products across the geographical boundaries have to provide credit many times. Therefore, to wave off any loss on currency fluctuation at the time of realizing payments, they design an ALM framework inclusive of a proper currency risk management strategy.