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ALM 101: Introduction to asset liability management – Part 1: ALM goals & approaches

Zach Langley
January 11, 2022
Read Time: 0 min

Asset liability management basics

In part 1 of this "Introduction to ALM" blog series, learn the goals of asset liability management and how it can help financial institutions.

Read the full blog series here: "ALM 101 eBook: Introduction to asset/liability management"

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The ALM basics

4 Common questions about asset liability management

Financial institution leaders and decision-makers constantly face choices for how to effectively manage their institutions in the wake of changing economic landscapes, investment markets, interest rates, customer demand, mergers, acquisitions, and more recently, pandemics. The decisions made today have both short-term and long-term impacts on the institution’s financial performance, outlook, and strategy. With so much uncertainty, it can be easy to wonder how anyone musters the courage to make key decisions. But with a sound and robust ALM model, navigating the uncertainty can become manageable, and the path to the banking Promised Land can be paved.

An ALM model is a bank or credit union leader’s best friend when used and maintained properly. However, many institutions don’t take the opportunity to seriously manage and develop their ALM model. As a result, they could be leaving earnings and shareholder returns on the table. Financial institution leaders and management should consider ALM as a process for making institutions more profitable and more effective at managing risk simultaneously. This article kicks off a series intended to highlight how ALM can help financial institutions get the most profitability out of their balance sheets while managing their risk profiles.

ALM 101 blog series graphic

ALM 101: Introduction to Asset/Liability Management

The series, "ALM 101: Introduction to Asset/Liability Management," will explore topics like capital planning, interest rate risk, and others that highlight how ALM is an ongoing, useful process for banks and credit unions rather than simply a “check the box” report required by regulators.

Before getting into the nitty-gritty, laying the groundwork for what ALM is and why it’s performed in the first place is vital. 

This initial ALM 101 article is intended for the ALM rookie who wants to understand ALM basics: the process and its usefulness. An introduction to asset/liability management can best begin by re-visiting questions other ALM rookies often ask. Below are four common questions about asset/liability management that Abrigo's ALM consultants hear:

4 Common questions about asset/liability management

 

1. What is ALM?

2. What are financial institutions trying to accomplish with ALM?

3. Will ALM help financial institutions avoid risk?

4. What are the different approaches to ALM?

Top ALM questions

Defining ALM & ALM goals

What is ALM?

A textbook definition of ALM is managing the volume and timing of cash flows of assets and liabilities to increase profitability, manage risk, and maintain the safety and soundness of the financial institution.

One way to think about ALM is like a giant scale with multiple arms in all directions. Each arm represents a different interest of the institution (earnings, growth, capital, liquidity, etc.). Each of these arms is connected, however; when you add to or take away from one, there’s a reaction on some or all the others. For example, suppose an institution is looking to grow assets. In that case, the institution must be willing to either hold less capital or be able to generate enough earnings to have capital keep pace with asset growth. No one decision is completely independent of the other interests of the institution. ALM is a delicate balancing act between maximizing profitability while minimizing risk, between managing the needs of customers or members, regulators, and shareholders all at the same time.

When approached intentionally, ALM is a decision-making tool that allows the institution to make decisions about its assets and liabilities to generate sustainable earnings without compromising the other interests of the institution. Said another way, ALM manages the balance sheet to maximize income without having that income be too volatile (risky) in different market conditions.

Bank and credit union leaders must decide what products to offer and appropriate pricing. ALM is the litmus test to ensure these decisions are in the institution’s best interest both in the short- and long-term.

What are financial institutions trying to accomplish with ALM?

A broad goal of ALM, as noted earlier, is to help produce sustainable earnings without compromising the other interests of the institution. Breaking this goal of ALM down, this means accomplishing three key objectives:

  1. Meet financial goals
  2. Manage risks
  3. Maintain safety and soundness.

One objective of ALM is to meet financial goals.

A primary function of ALM is generating earnings. Financial institutions have very specific financial goals. Key profitability outputs ALM measures include net interest income, return on assets, and return on equity. Within those outputs are metrics like yield on earning assets, cost of funds, non-interest income, and non-interest expense that drive bottom-line profitability figures.

An effective ALM process will consider different strategies and approaches and measure the potential impact on profitability. For example, if an institution wants to venture into a different type of lending to try to increase yield on earning assets, it will want to measure the potential yield from those new products as well as the cost of funding those assets and all related costs of obtaining that new business in the first place. It will look at the cash flows in and out of the institution to determine whether certain approaches will help meet the desired margin, ROA, and most importantly, ROE, which is a measure of shareholder return or, for credit unions, a measure of the ability to provide continued or additional value to members.

A second ALM goal is to manage risks.

The idea of going into the marketplace and figuring out how to make more money is probably appealing to a lot of folks. Still, as we all know, where there’s potential return, there is always potential risk, and banking is no different. Risk in the context of ALM is the difference between expected cash flows versus and actual cash flows.

The logical example here is credit risk. When making an auto loan with an 8% interest rate, an institution expects to collect all the cash flows from principal and interest, but that isn’t always what happens. Sometimes the borrower defaults, and the institution never collects all that it’s owed and expected to collect. That loss of yield on earning assets has an impact on financial goals like margin, ROA, and ROE.

While credit risk is probably the most intuitive example of risk that institutions face, there are many types of risks that need to be considered. Three main risks institutions face:

It’s this reality that forces institutions to make smart and measured decisions on how to generate earnings. No institution is putting all its eggs in the highly volatile commercial real estate (CRE) basket due to the potential volatility of the cash flows in those products. Institutions are constantly walking a tightrope of generating enough return without exposing themselves to excessive risk. An effective ALM model will help measure the level of potential risk in different market conditions to help decision-makers discern which strategies show the opportunity to create enough return to meet desired goals while also actively managing risks that could jeopardize the safety and soundness of the institution.

A third goal of ALM is to maintain safety and soundness.

Bank and credit union leaders are also acutely aware of regulatory expectations in terms of providing assurances of the long-term viability and solvency of the institution. Usually expressed in the form of regulatory capital ratios, these ratios ensure institutions have enough capital to withstand adverse financial or economic scenarios. After the great recession in the late 2000s, regulatory expectations of capital levels are higher than ever, which can lead institutions to be conservative in terms of risk-taking.

ALM combined with an effective capital planning process can help ensure that an institution’s strategies don’t jeopardize capital levels and lead to regulatory pressure that can further constrain the institution’s operations.

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Will ALM help financial institutions avoid risk?

Sure, a financial institution could use its ALM model to avoid risk. However, as noted earlier, where there’s potential return, there is also potential risk. With that in mind, you can reason that where there is no potential risk, there is probably no potential return, and if a financial institution is not earning, then it likely isn’t growing or surviving. It’s certainly not thriving in a way that provides the most flexibility to meet the wants and needs of stakeholders like customers or members, shareholders, and the community.

One of the goals of ALM is to manage risk, not actively avoid risk. It’s inevitable that an institution must take some level of risk to survive. It is just a matter of what types of risk and how much of those risks an institution is willing to take. Like personal investors, institutions all have different risk appetites. The sooner an institution’s management can define how much risk is tolerable to them, the sooner they’ll be able to make the decisions that make money.

Risk tolerances are reflected in a financial institution’s written policy limits. Once established, these policy limits act as a roadmap for the level of risk that can be undertaken while maximizing profitability. A function of ALM is to monitor these board-established policy limits in terms of volatility to earnings/equity, profitability, credit quality, and liquidity in different rate environments. A financial institution’s balance sheet and income statement can be “tested” through different scenarios that measure the impact of different decisions to make sure the exposures represent reasonable levels of risk that are in line with risk policy limits. If the board finds the results indicate they’re a little too vulnerable to their liking, a tweak, change or abandonment of the strategy may be required. It’s this process, performed repeatedly, that allows institutions to manage their risk levels while still being able to produce the return needed to meet their financial goals.

What are the different approaches to ALM?

As one could probably imagine, the complexity and sophistication of ALM models vary from institution to institution. However, most banks and credit unions typically steer toward one of two main approaches to the ALM function: a regulatory approach or a management approach. Again, each institution is going to have its own take on ALM modeling, and often, it’s some combination of these two approaches, but at a high level, here’s what each process looks like:

Regulatory approach – This approach to ALM aims to “check the (regulatory) box.” It is called the regulatory approach because there is regulatory expectation for the measurement and management of risk on an institution’s balance sheet and income statement. This approach is geared toward meeting those expectations, at least minimally.

This approach usually includes conducting an analysis on a static (no growth) balance sheet, which does not consider any future changes in the institution’s growth, strategy, pricing, or business plan. As a result, this approach includes no future risk/return analysis because it only considers what the institution is currently doing, not how it plans to make money down the road. While it may pass a regulatory “smell test,” it is not giving institution leaders the full picture of current and future balance sheet performance and risk levels, which could lead to riskier or less profitable decisions or both. Furthermore, the minimalist analysis in a regulatory approach often examines what might happen in the unlikely event of a sudden and indefinite extreme spike in interest rates. That type of information is far less useful for managing an institution's performance than weighing more realistic "what-if" scenarios a bank or credit union might encounter.

Management approach – A management approach to ALM, on the other hand, makes it much easier to assess the risk/return trade-off in proposed strategies and make decisions that benefit the institution both in the short term and the long term. This approach leverages all the analyses typically performed in the regulatory approach, and so meets examiner requirements. But it also considers dynamic modeling of the balance sheet, which means that future growth plans and strategies are analyzed as well, giving management a realistic look at the outlook of the institution today and tomorrow. This more impactful approach informs decisions related to both risk and strategy and enables boards and management to make good decisions in different rate environments.

Conclusion

Later in this "Introduction to Asset/Liability Management" series, additional articles will tackle other aspects of ALM in more detail. By the end, you’ll have a detailed understanding of how ALM can help meet the short-term and long-term goals of a financial institution.

Read Part 2 of the ALM 101 Series: Interest Rate Risk - Earnings at Risk

Learn more about ALM and financial institution best practices with additional articles and event news.

About the Author

Zach Langley

Consultant
As an Advisory Consultant on Abrigo’s Advisory Services Team, Zach Langley assists financial institutions in a number of ways, including transitioning to CECL, managing ALM outsource projects, and performing core deposit studies. He has also led Abrigo’s Paycheck Protection Program (PPP) Forgiveness outsourcing and capital planning/stress testing business lines. Zach

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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