Asset Liability Management In Financial Institutions

The recent incidents in the financial services sector, especially in non-banking financial services (NBFCs) have brought to the fore, the importance of a sound Asset Liability Management (ALM) system. In simple terms, ALM is the management of mismatches between the profiles of assets and liabilities. However, a sound ALM process requires a deep understanding of the structure and behaviour of all assets and liabilities in a dynamic state of the world. Let us understand this in more detail. 

Objective of ALM: A financial institution (FI, i.e. a bank or an NBFC) is principally engaged in sourcing of funds and deployment of the same in a profitable manner. The job of an FI is to:

* Unbundle the risks and returns related to the funds, as applicable to the providers and users of funds;

* Match the sub-sets of funds with similar risk-return profiles at the two ends of providers and users of funds and receive a compensation for the job;

* Assume some risk for the unmatched sub-sets of funds, and earn a commensurate return for the risk.

Each of the above steps requires some expertise in identification, measurement, and management of the risks. The ALM process is a multi-level process within an FI to ensure that the above steps are conducted appropriately. The objective of the ALM process is to guide the management of the FI to undertake and manage the asset-liability mismatch risks in line with the broad objectives of the firm. 

Process of ALM

The properties of each individual asset and liability in an FI need to be understood and analysed. These properties include tenor, rate behaviour (fixed/ variable), price, embedded optionality, volatility, and liquidity. Ideally, all assets and liabilities need to be mapped based on each of these dimensions. In reality, however, it can be a humongous task to deeply study and map the assets and liabilities on all dimensions. Therefore, FIs focus predominantly on a few chosen dimensions. In most cases, these dimensions are limited to tenor, and rate behaviour. The regulatory guidelines on ALM are also limited to these dimensions.  

In practice, FIs monitor their ALM risks on the basis of two key ALM reports:

* Liquidity report (LR) – This report categorises all assets and liabilities in multiple time buckets based on their residual maturity. The gap between the amounts of assets and liabilities maturing in a given time bucket is known as the asset liability mismatch in the said bucket. The cumulative mismatch over any given time horizon is a simple indicator of the liquidity risk incurred in that time period by the FI. The wider the negative mismatch, the higher is the liquidity risk.

The liquidity report can be short term, i.e., focussed on measuring liquidity risks over a limited time horizon (say, up to 6 months) or can be long term in nature. 

* Interest rate sensitivity (IRS) – This report slots all assets and liabilities in future time buckets, based on their residual maturity or next repricing dates, whichever may be earlier. The purpose of this report is to capture the repricing risks on all assets and liabilities.  

Apart from preparing the above-mentioned two reports, FIs also compute several ratios which are indicators of specific dimensions of their liquidity risk. For example, a liquidity coverage ratio (LCR) measures the liquidity risk over a 1 year time horizon, and net stable funding ratio (NSFR) measures the structural liquidity risk for an FI. 

The top management of an FI uses the above mentioned reports, prepared regularly, to draw conclusions on the liquidity and interest rate risks and also work on plans to address such risks.

Assumptions and Risks

As mentioned above, the ALM statements need to be prepared to convey the real state of liquidity and interest rate risks in an FI. They provide the fundamental guidance to the Management for their decision making. It is therefore important to note that these statements need to be prepared to reflect the real expected behaviour of the assets and liabilities. This could often be very different from the behaviour as per contracts or books of the FI.    

This is a serious task and requires:

* Appreciation by the management of the nuances of the behaviour of various assets and liabilities;

* Deep understanding of the characteristics of depositors, investors, borrowers, and the financial markets;

* Sound tools and techniques for simulating the real behaviour in future;

* Integration and interaction between the ALM monitoring team and the business teams representing the various assets and liabilities;

* Regular and sincere review by the top management of the key underlying assumptions in the ALM statements.

In the absence of the above, the ALM process in an FI can be reduced to being merely an exercise in compliance of regulatory requirements. This leaves the risks unaddressed or even unknown at many times.  

In addition to the above, the Board of an FI must clearly specify the nature and extent of ALM risks that the Management can take in the course of regular business. The Board should approve an ALM Policy, comprehensively covering the various dimensions of the ALM framework, for the FI. 

To illustrate, an FI may be carrying a certain level of mismatch in its assets and liabilities, over a period of 6 months, in line with its approved ALM Policy. However, certain liabilities (like demand deposits) may, in reality, come up for a faster repayment than contracted or assumed in the ALM statements. This could be because of an option with the credit/ depositor, not explicitly recognised in the books and ALM reports. Another contentious issue is often the assumed period of liquidation of an investment like a commercial paper (CP) against a sudden decline in liquidity in the money markets for all CPs or just the given issuer. 

Conflicts

An important risk in the ALM process is the sub optimal resolution of conflicts between business imperatives and risk management. It is most common, and quite justified, for an FI to borrow, up to a certain limit, short term funds and lend the same for longer maturity. This helps improve the profit margin of the FI. However, the determination of, and adherence to, a prudent set of limits that are in consonance with the risk appetite of the FI, is of utmost importance. 

The relaxation of limits, based on either greed of higher profits, or ignorance of the ensuing risks, can be a highly risky proposition for an FI. 

Conclusion:

A sound ALM framework is critical for the financial health of an FI. The Boards and Managements of FIs should review their internal ALM processes, limits, tools and techniques, models, and expertise and take appropriate corrective steps wherever required. 

The stakeholders like the creditors, shareholders, analysts, and even regulators, need to pay closer attention to the ALM process. 

The regulators should also appraise the level of disclosure, by the FIs, of the ALM risks. This is currently at a very minimal level, limited to a high level time bucket gaps on annual basis. The disclosures need to be reviewed and significantly expanded. At the same time, they should refrain from micro management issues like stipulation of limits for the FIs.