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Understanding Asset-Liability Management

Asset-Liability Management (ALM) is a risk management technique used to earn a return while maintaining sufficient assets to cover liabilities. It considers interest rates, earnings, and willingness to take on debt. ALM was originally used by financial institutions but has expanded to other industries. The key is formulating, implementing, monitoring, and revising strategies to achieve financial goals within set risk tolerances. For example, a bank borrowing at 6% and lending at 7% for different terms faces interest rate risk if rates rise and it must refinance at a higher rate than its fixed loan earnings. Accrual accounting does not reflect this potential future loss.

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8 views1 page

Understanding Asset-Liability Management

Asset-Liability Management (ALM) is a risk management technique used to earn a return while maintaining sufficient assets to cover liabilities. It considers interest rates, earnings, and willingness to take on debt. ALM was originally used by financial institutions but has expanded to other industries. The key is formulating, implementing, monitoring, and revising strategies to achieve financial goals within set risk tolerances. For example, a bank borrowing at 6% and lending at 7% for different terms faces interest rate risk if rates rise and it must refinance at a higher rate than its fixed loan earnings. Accrual accounting does not reflect this potential future loss.

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gest
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ABSTRACT

Asset-Liability Management (ALM) can be termed as a risk management technique designed


to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It
takes into consideration interest rates, earning power, and degree of willingness to take on debt
and hence is also known as Surplus Management.

But in the last decade the meaning of ALM has evolved. It is now used in many different ways
under different contexts. ALM, which was actually pioneered by financial institutions and banks,
are now widely being used in industries too. The Society of Actuaries Task Force on ALM
Principles, Canada, offers the following definition for ALM: "Asset Liability Management is the
on-going process of formulating, implementing, monitoring, and revising strategies related to
assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances
and constraints."

Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the same money at
7 % to a highly rated borrower for 5 years. The net transaction appears profitable-the bank is
earning a 100 basis point spread - but it entails considerable risk. At the end of a year, the bank
will have to find new financing for the loan, which will have 4 more years before it matures. If
interest rates have risen, the bank may have to pay a higher rate of interest on the new financing
than the fixed 7 % it is earning on its loan.

Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in serious
trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its financing. Accrual
accounting does not recognize this problem. Based upon accrual accounting, the bank would
earn Rs 100,000 in the first year although in the preceding years it is going to incur a loss.

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