Asset Liability Management (ALM) can be defined as a mechanism to address the risk faced by a bank due to a mismatch between assets and liabilities either due to liquidity or changes in interest rates. It refers to using assets and cash flows to lower the firm’s risk of loss due to not paying a liability on time. Liquidity is an institution’s ability to meet its liabilities either by borrowing or converting assets.
Apart from liquidity, a bank may also have a mismatch due to changes in interest rates as banks typically tend to borrow short term (Fixed or floating) and lend long term. Well-managed assets and liabilities can help you grow one’s business profits. This process is used to determine the risk on bank loan portfolios and pension plans. It also includes the economic value of equity.
Asset/Liability management is a long-term strategy to manage risk:
· Asset/Liability management reduces the risk that a company may not meet its obligations in the future.
· He success of bank loan portfolios and pension plans depends on asset/liability management processes.
· Bank track the difference between the interest paid on deposits and interest earned on loans to ensure that they can pay interest on deposits and to determine what a rate of interest to charge on loans.
A comprehensive ALM policy framework focuses on bank profitability and long-term viability by targeting the net interest margin (NIM) ratio and Net Economic Value (NEV), subject to balance sheet constraints. Significant among these constraints are maintaining credit quality, meeting liquidity needs and obtaining sufficient capital.