FINANCIAL ENGINEERING

ASSET LIABILITY
MANAGEMENT
SUBMITTED TO : SUBMITTED BY :
PROF. PARAMJEET KAUR ARUSHI GUPTA (4)
UNIVERSITY BUSINESS PRIYANKA CHAUHAN (20)
SCHOOL RADHIKA GOEL (21)
PANJAB UNIVERSITY RIDHI JAIN (22)
INTRODUCTION
 Asset liability management is the process of managing the use
of assets and cash flows to reduce the firm’s risk of loss from
not paying a liability on time. Well-managed assets and
liabilities increase business profits. The asset liability
management process is typically applied to bank loan
portfolios and pension plans. It also involves the economic
value of equity.
 Asset liability management is an effort to minimize exposure to
price risk by holding the appropriate combination of assets and
liabilities so as to meet the firm’s objectives and
simultaneously minimise the firm’s risk. Asset liability
management is most highly developed for managing interest
rate risk. It can also be used in the management of exchange
rate risk, commodity price risk and stock price risk.
EVOLUTION OF ALM
 Asset Liability Management has changed a great deal
over the last several decades. Until 1960s, the
depository institutions derived the bulk of their funding
from customer deposits, long term debt, and equity.
The terms on the deposit accounts were fixed due to
which the short term funding mix was determined by
the depositors. The institutions focused on asset
management and not on liability management.
 It all started to change in 1960s when the demand for
funds from corporate customers of New York money
centre banks began to outstrip those banks traditional
funding source. With the introduction of certificate of
deposits by Citibank, banks had a tool by which they
could manipulate the mix of liabilities that supported
their assets and it soon became apparent that the game
would henceforth one of active management of assets
and liabilities portfolios as opposed to the management
of asset portfolio alone. The first asset liability
management strategies to develop were the strategies
for the management of interest margin. Interest margin
management led to the concept of gap management.
As time went on, asset liability management became
progressively more aggressive and complex. This was a
response to:
 increasingly volatile interest rates

 the introduction of money market mutual funds

 the development of overseas markets as both funding

and lending sources

 the introduction of significant competition in US markets

by both domestic and foreign lending institutions

 major new developments in risk management theory

 the development of new risk management instruments

 new outlets for asset sales

 the gradual erosion of the effectiveness of antiquated

regulations
 the deregulation of financial services
 In 1970s, interest rates became more volatile and rose
significantly and reached post war highs in the early
1980s. In both decades of 1950s and 1960s, there were
a total of 16 changes in the prime rate of interest. In the
1970s, there were 139 changes in the prime rate of
interest. The pace accelerated even more as we moved
into the 1980s.

 Although they retreated from their record levels of the

early 1980s, interest rates nevertheless remained high
by historic standards throughout the 1980s. The sharp
increase in the level and the volatility of interest rates
rang the death knell for the old way of doing business.
 Depository institutions learned the hard way of never
borrowing short for lending long as they found
themselves locked in the proverbial no win situation,
their traditional source of low cost financing dried up as
savers gradually turned to more lucrative, equally liquid,
unregulated alternatives. The process of
disintermediation had begun by which traditional
customers of depository institutions, small savers,
pulled their funds out in order to earn higher returns
elsewhere. The main driving force behind this was the
money market mutual fund, 1973.
 When first introduced, money market funds attracted very
little attention largely because interest rates were still
relatively low and the incremental gains were not
sufficient for most investors to part with their locally
accessible and insured bank and thrift deposits. But after
1970s, the incremental benefits of switching to money
market funds grew greater. The disintermediation process
became a nightmare for the depository institutions as
hundreds of billions of dollars left banks and thrifts for a
new home in the money market funds. The money market
funds then purchased CDs from banks and thrifts and the
latter were forced to pay significantly higher than market
rates.
 Some institutions thought that with time the interest rates
would come down but this didn’t happen and they started
engaging in desperate attempts to return to profitability
by making high risk – high yield investments with
depositor’s money. This strategy then backfired for many
institutions which contributed to the financial disaster
that befell the thrift industry in the late 1980s.
 Institutions which survived, moved to improve their
management skills, sent employees to training programs
in the new methods and instruments for managing assets,
liabilities and risk and also hired financial engineers to
assist in their revitalisation. At the same time, investment
bankers recognised the potential to market a valuable
new product that is asset liability management strategies
and devoted considerable energies to developing them.
 OBJECTIVES OF ASSET
LIABILITY MANAGEMENT
1. Planning to Meet the Liquidity
Needs:

Making funds available at a competitive price when

they are required is the first task of ALM. The task is
to achieve a proper mix of funds by keeping the level
of non-interest funds to the bare minimum,
maximize the fund allocation to high profit areas
while simultaneously ensuring availability of funds to
meet all eventualities.
 2. Arranging Maturity Pattern of Assets and Liabilities:
Matching of assets and liabilities over different time
bands and keeping a tag on their pricing by limiting
their exposure to interest rate risk are issues to be
looked at in the ALM process.

3. Controlling the rates received and paid to assets

/liabilities to maximize the spread or net interest
income is the final responsibility of ALM.
The aforesaid objectives are accomplished without
exposing the bank to excessive risk of default. Primarily
employing a three pronged strategies described below
ensures the attainment of these tasks,
4. Spread Management: Spread or margin, known
differently as interest spread or interest margin or net
interest spread/margin or net interest income refers to
the difference between interest earned on deployment
and interest paid on the acquisition of financial resources.
 Spread maximization strategy involves:

1. Reducing bank’s exposure to cyclical rates and

stabilizing earnings over the long term,
2. Predicting rate changes and planning for such
eventualities,
3. Coordinating rate structure,
4. Balancing default risk on loans and investments against
probable benefits, and
5. Ensuring a steady but controlled growth as also gradual
increase in profitability
5. Gap Management:
Gap refers to the difference between assets and liabilities
that can be impacted due to the change in the interest
rates. Such assets/liabilities are referred to as rate
sensitive assets (RSA) and rate sensitive liabilities (RSL)
respectively.
For the gap management purpose, the assets and liabilities
are distributed over different time bands/buckets calling
for:
1. Identifying and matching assets and liabilities over
different time bands,
2. Optimizing the earnings over a complete economic cycle
without moving to an extreme position during any one
phase, and
3. Building a mechanism to expand and contract
assets/liabilities in response to rate cycle phases.
6. Interest Sensitivity Analysis:
This analysis is an extrapolation of gap management strategy. It concerns
with the analysis of the impact of interest changes on the bank’s
spread/margin and resultant overall earnings.
The strategy includes:
1. Separating fixed and variable interest rate components of balance sheet,
2. Listing assumptions regarding rate, volume and mix of the projected
portfolio,
3. Making alternative assumptions on rise and fall in interest rates, and
4. Testing the impact of assumed changes in the volume and composition
of the portfolio against both, rising and falling interest rate scenarios.

ALM need to be proactive and be commensurate with the business cycle.

Consideration has to be given to holding long term or short term
assets/liabilities with fixed and variable interest rates. Addressing these
issues should facilitate better interest sensitivity analysis as also spread
and gap management.
 Factors Influencing ALM:
1) ALM information system- Under the Information
system banks are required to ensure development of
information procuring system for measuring, monitoring,
controlling and reporting the risks.
2) ALM Organisation - The ALM Organisation guidelines
insist that each bank at the top management level and
Board of Directors should on the on going basis review
the situation to ensure appropriate policies and
procedures are adopted and implemented to timely arrest
the prospective risks.
3) ALM process -The ALM process is meant to create
parameters for managing the risks like, identification of
risk, measurement of risk, management of risk, planning
to mitigate the risk etc.
THE FOUNDATION CONCEPTS
1. LIQUIDITY

Liquidity is loosely defined as the ease with

which assets can be converted to cash. Liquidity
is particularly important to deposit taking
institutions because depositors may suddenly
withdraw funds, thereby necessitating a need
for liquidity. Cash must be raised quickly to
meet any such liquidity demands. There are two
dimensions to liquidity as the term pertains to
assets:
a. Maturity Liquidity: an asset is said to be liquid if it will
mature in a very short period of time. For example: Fed
funds and overnight repos are very liquid instruments for
the simple reason that they automatically turn into cash in
a single day. Multi-year commercial loans: on the other
hand, these are very illiquid assets. It is sometimes useful
to array assets along a liquidity continuum in order to
better appreciate this aspect of liquidity. Such continuum
is depicted as:

Most liquid Least liquid

Fed fund Call money Short-term loans Notes Mortgages Bonds

Overnight
repos T-bills term loans
b. Marketability: an asset is liquid if it can easily
be sold in the secondary market without a major
price concession.
For example, a treasury security is always readily
marketable and, hence, very liquid. A junk bond,
on the other hand, can be very difficult to sell
(depending on market conditions) without a
significant price concession.

All other things being equal, less liquid assets

provide a greater rate of return than do more
liquid assets. Thus, there is a trade-off between
liquidity and profitability.
2. TERM STRUCTURE

Term Structure at any given point in time there is a

relationship between debt instrument yields and
those instruments‟ maturities. This relationship can
be depicted via the familiar yield curve. Such a
relationship can be drawn for any group of securities
having similar credit rating (default free, AAA, BBB,
junk, etc.). The shape of the yield curve and the
asset/liability manager’s expectations about the
future shape of the curve will play a significant role in
his or her strategy.
3. INTEREST-RATE SENSITIVITY

There are two distinct ways to look at interest-

rate sensitivity :
 Most often, we use the term interest-rate

sensitivity to describe the degree to which an

instrument’s price will change when the
instrument’s yield (a reflection of the current
market rate) changes. In this context, we can
measure interest-rate sensitivity with any of the
tools including, duration, the yield value of a
32nd, or the dollar value of a basis point.
 Second way, to look at interest-rate
sensitivity is to focus on the variable of
floating-rate assets and liabilities. These
instruments are interest-rate sensitive in the
sense that, as market rates rise, the return on
the interest-sensitive assets and the cost of
the interest-sensitive liabilities will also rise.
In this usage, the degree of interest sensitivity
is determined by the degree to which an
instrument’s interest rate adjusts and the speed
of this adjustment. This is the sense in which
we use the term interest-sensitive in our later
discussion of gap management.
4. MATURITY COMPOSITION

The maturities of assets and liabilities can be

matched or unmatched. If the maturity and the
interest-rate sensitivity of an asset and a
liability are matched, then the institution has a
spread lock on that portion of the principals
that are also matched. Maturity composition
and term structure interact to determine
interest-rate sensitivity.
5. DEFAULT RISK

It is the risk that the debtor will be unable to repay the

loan principal and/or interest. Financial institutions,
particularly commercial banks, serve a very useful
function in assessing borrower risks and in pooling
those risks. Depositors at these institutions, in
general, lack the expertise or time to evaluate
borrowers’ creditworthiness. A portion of a bank’s
spread must therefore be viewed as compensation for
risk bearing and credit assessment. An institution’s
spread can always be increased by making higher-risk
loans and/or investing in lower-grade securities.
THE CHANGING FACE OF LIQUIDITY MANAGEMENT
In earlier days, Asset liability management concentrated on asset management and one
of the principal concerns was always liquidity. Since depositors at financial
institutions (depository institutions specifically) could withdraw funds on relatively
short notice, managers had to plan for sufficient liquidity to meet these potential
withdrawals. At some institutions, withdrawals by depositors occur with some
regularity – such as when commercial accounts draw down their deposits to meet
payrolls or when retail accounts are tapped during Christmas shopping seasons. At other
institutions, such as those in farm bell communities, there is a more extended
seasonality which coincides with production and harvest cycles. In the case of
predictable patters described above, assets with appropriate maturity liquidity could be
used to meet the liquidity needs. Nevertheless, there always remained an unpredictable
element in deposit withdrawals and good liquidity management required planning for
the unexpected. Most depository institutions met this type of liquidity need by holding
some cash equivalent assets. These include T-Bills and other short term, readily
marketable, securities.
 Liquidity management changed dramatically after the
introduction of certificates of deposit. These instruments gave
financial institutions a tool by which to manage their liquidity
on the liability side.

 For example, a sudden withdrawal of deposits could be offset

by the quick issue of negotiable CDs. By managing liquidity on
the liability side of the balance sheet, the institution could
reduce its holdings of low return cash equivalents in favour of
higher –return, longer –maturity, less liquid assets. Not
surprisingly, depository institutions holdings of cash and cash
equivalent assets declined dramatically over the next two
decades.
 For example, at the start of the 1960s, bank holdings of cash
and securities represented about 50 percent of total bank
assets, with loans making up about 45 percent. By 1980, cash
and securities comprised only 30 percent of total bank assets
while loans had risen to almost 60 percent. The ability to
manage liquidity on the liability side of the balance sheet was
later enhanced further by the introduction of the repo/
reverse market.

 The CD approach to managing depository institution liquidity

was soon replicated on the corporate side with the
introduction of commercial paper. In additions, corporations
found the repo/reverse market a very attractive vehicle by
which to invest excess cash and preserve their liquidity.
MARGIN MANAGEMENT (THE ROLE OF THE GAP)

 The essence of modern asset/ liability management, in achieving the

long-run goal of wealth maximization, is efficient and effective
management of interest margins and spreads. Both of these concepts
are linked to the institution’s income statement, also important is the
concept of the gap.

 The gap may be defined as:

(1) The dollar difference between a financial institution’s floating- rate
assets and floating –rate liabilities, or
(2) The dollar difference between an institutions fixed-rate liabilities and
fixed-rate assets. By these definitions, gap is best understood as a
balance sheet concept. In these definitional structures, interest-sensitive
assets and liabilities are defined as those having floating-rates of interest.
 The simplest margin management strategy is a simple spread- lock
strategy. In such a strategy, the institution’s asset/ liability
management group would look to lock-in a spread by matching both
the type and the maturity of its assets and liabilities. Thus, all fixed-
rate assets would be funded by fixed-rate liabilities and floating-
rate assets would be funded by floating- rate liabilities.

 This strategy is relatively safe, barring loan and securities defaults,

but will not necessarily produce spreads sufficient to cover the
institution’s overhead expenses. Examples of these types of
strategies include strategies (1) and (2) in table illustrated. As already
noted above, the spread can be increased by holding higher-risk
assets, but this exposes the institution to greater default risk.
• An increase in the gap will increase the spread when rate rise since
the return on the variables- rate assets will rise but the cost of the
fixed- rate liabilities used to fund these assets will not rise. The
reverse argument applies when rates fall. Strategy (3) is an example
of a gap management strategy employing such forecasts.
• There are a number of problems in applying the basic gap
management strategy outlined above. First, gap management
assumes that the future direction of interest rates can be predicted.
Financial institutions expend a great deal of time and energy attempting to
make such prediction. But a prediction is always just that – prediction- and
it can prove wrong faulty forecasts can lead to an unexpected narrowing of
the spread or an unexpected widening of the spread. Thus, there is a trade
off between the spread to be earned and the risk to be borne. The wider
the gap (in a rising rate market) the greater the potential spread but also
the great the spread variability. This trade-off is depicted in the diagram
below.

SOURCE: Marshall, J. F. (John Francis)., Bansal, V. K.

(1992). Financial engineering: a complete guide to financial
innovation. Boston: Allyn and Bacon.
 The problem with gap management is that it took considerable time to
alter the character of an institution’s assets and/or liabilities. One did
not just dump fixed-rate term loans made to corporate clients, for
example, and invest the proceeds in short-term prime loans(the
interest on which fluctuates with the prime rate). Established
relationships would be damaged and relationships are a key to
successful banking. The final problem with gap management concerns
the very ability to alter the gap. Through the 1970s for example, one
could only alter the gap if opportunities for appropriate types of
lending and borrowing were available. Such opportunities were
determined by the current state of the world and by the competitive
pressures of the marketplace.
 All of the old problems with gap management enumerated above
disappeared during the 1980s as a consequence of financial
engineering.
 Consider, for example, the impact of the risk management instruments.
These include forward rate agreements, futures, swaps, and single-
period and multi-period options. These instruments dramatically
altered the landscape for asset/ liability managers.
 They can create positive gaps in rising interest-rate-markets or
create negative gaps in falling interest-rate markets and then hedge
the resultant exposures.
 They can also transform the character of their assets and / or
liabilities by entering into appropriately structured swaps. For
example, a bank treasurer carrying floating rate assets funded by
fixed rate liabilities (a large positive gap) can quickly alter the
character of the liabilities by entering into fixed-for-floating rate
swap with his institution as fixed-rate receiver.
 While the swap transaction is off- balance sheet, the character of the
liabilities may now be regarded as floating. Thus, the gap is reduced.
No longer are there the delays associated with altering the mis of the
institution’s individual assets or liabilities. Nor does one need to be
overly concerned about the market opportunities to acquire the type
of assets one want- all one really needs are liquid derivative product
markets.
 The development of the risk management mentioned above
has greatly enhanced the flexibility and the opportunities for
asset/liability manager but it has also dramatically increased
the competitive pressures and narrowed the interest margins
and spreads available.
 The new products have also increased the level of
sophistication required of asset/ liability managers. Indeed, as
recently witnessed on a wide scale in the thrift industry, failure
to employ the available risk management tools in strategies
appropriate to one’s institution can lead to serious charges of
mis- management and, in extremes cases, to charges of
criminal fraud.
THE INVESTMENT BANKER IN ASSET/LIABILITY MANAGEMENT
In an effort to carve out new product niches, a number of investment banks
developed strategies to assist financial institutions in the management of
their portfolios. Most of these strategies were developed in the late 1980s.
Some worked well and others can only be described as failures.

Undoubtedly, new strategies will appear as the 1990s progressive and some
of the old strategies will fall by the wayside. In would be instructive to look
at a few of the strategies that are marked under the general umbrella of
asset/liability management techniques. In particular we will discuss the
following two techniques:
1. TOTAL RETURN OPTIMIZATION
Total Return Optimization employs tools from the management sciences,
such as linear programming, in an effort to determine the optimal mix of
assets given a set of constraints and a variety of yield curve projections.
This particular application of financial engineering is another excellent
example of the contributions made by the academic community to many of
the financial innovations of the last decade because most management
science techniques were developed by the academicians. It also
demonstrates the role of the quant jock in developing customer services.

In Total Return Optimization strategies, the total return to be maximised

consists of the interest (coupons), the reinvestment income, and the
change in market value of the assets. The constraints, sometimes called
portfolio attributes, can include such things as liquidity requirements,
durations, industry sector specifications, default risk levels, tax treatment
of income, and obligations to hold minimum quantities of specific entities’
debt (often necessitated by relationships with existing customers).
It might help for us to consider a simple example. Suppose
that a client has five debt securities available to include in a
portfolio. These are
• Treasury Bills
• Treasury Bonds
• State Bonds
• Local Municipal Bonds, and
• Corporate Bonds
Assume that the interest income earned on the T-bills and
T-bonds is exempt from state and local taxes; the interest
earned on the state bonds is exempt from federal and state
taxes; the interest earned on the local municipal bonds is
exempt from all taxes; and the interest earned on the
corporate bonds is not exempt from any taxes. The federal
tax rate is 26%, the state tax rate is 12%, and the local tax
rate is 3%. For the purpose of this example, we will treat
applicable tax rates as though they are additive. For
example, if the interest income is subject to both federal
and state taxes, then the applicable tax rate is 26% plus
12% for a total of 38%.
Suppose now the client’s objective is to maximize the total after tax rate of
return on its portfolio of debt securities. Under the first scenario, yields are
not expected to change and, therefore, neither are prices. Our goal is to
determine the optimal weights for the five securities to be included in the
portfolio. If there were no constraints on our selections, we would simply
calculate the after-tax rate of return on each security and then commit all
the client’s funds to that one security.
But, as it happens, there are a number of constraints. Suppose, for example,
that no more than 32% of the portfolio can be invested in any one security
but that at least 12% must be invested in T-bills. Second, no more than fifty
per cent of the portfolio can be invested in state and local securities
combined. Third, the portfolio’s duration cannot exceed 7.2 Fourth, the
weighted-average term to maturity (a crude measure of liquidity) cannot
exceed 12. Finally, the portfolio weights must sum to unity and short
positions are not permitted.
The individual securities’ durations, maturities, and before-and after-tax
yields appear in below table. The after-tax rate of return on a security is
found by multiplying the before-tax rate by (1-t) where t denotes the
applicable tax rate.
 TABLE

RELEVANT SECURITY CHARACTERISTICS

  Before-Tax Applicable After-Tax    

Security Return Tax Rate Return Duration Maturity

T-bills 6.55% 26% 4.847% 0.5 0.5

T-bonds 9.30% 26% 6.882% 8.8 18.5

State 8.30% 3% 8.051% 9.9 19.4

Municipal 7.65% 0%
This particular problem lends itself to7.650% 5.6
a linear programming 7.3
solution. A
linearCorporate
programming12.44%is any41%
problem having
7.340% three7.6parts. First,
24.4 there must

be a linear objective function (linear with respect to the control variables).

Second, there must be a set of linear constraints which can take the form
of greater than or equal to, less than or equal to, or strict equality (=). The
control variables cannot take on negative values. The control variables, in
this particular case, are the weights to be assigned to the different
securities.
2. RISK CONTROLLED ARBITRAGE
Risk controlled arbitrage is an effort to
maximize the interest spread by
purchasing high-yield assets and
funding these assets at the lowest
possible cost. The assets purchased
can be corporate loans, whole
mortgages, mortgage pass-through’s,
mortgage backed securities such as
CMO and REMICs, and so on. The
funding source will usually be the repo
market or fed funds as these are
usually the cheapest sources for
borrowers in a position to use these
markets. The strategy will employ a
swap to convert the floating character
of the repo liabilities into a fixed-rate
liability which closely matches the
character and the principal of the
assets.
The structure would work as follows:
The institution engages in a reverse
repo to secure funding (30 or 90 day
term repos are most common). The
funds obtained are used to purchase
the higher yielding asset. The
institution then enters a fixed-for-
floating interest rate swap with itself as
fixed-rate payer. The floating rate of
the swap is tied to the repo rate or
some other short-term rate (say one-
month or three-month LIBOR). The
combination of the reverse repos and
the interest-rate swap create a
synthetic fixed-rate obligation. The full
structure, using three-month LIBOR on
the floating-rate side of the swap, is
depicted:
The structure depicted above is not risk free. First, there is default risk on the
higher-yielding assets held, particularly if these take the form of corporate
loans or securities, and, second, there is the basis risk associated with the
mismatch of the two floating rates. Nevertheless, the strategy is relatively low
risk in the sense that the interest-rate risk has been eliminated by the use of
swap.
For obvious reasons, the strategy can be viewed as an arbitrage between the
capital markets (corporate loans, securities and mortgages) and the money
markets (the repo sourced financing).
When amortizing assets are used for the high-yield assets employed in the
strategy, which is often the case, it is necessary for the swap dealer and the
institution employing the strategy to agree on the amortization schedule and
the pre-payment assumptions. This is particularly critical if the assets are
mortgages or mortgage-backed securities. In these cases, the swap principal
must also employ the same amortization schedule and prepayment
assumptions. The pre-payable nature of the assets, however, poses an
additional risk to the user of the strategy. No matter how much effort is put into
the preparation of the pre-payment estimates, they can never hope to exactly
capture the actual prepayment flows, and, therefore, there is some residual
prepayment risk.
 ASSET LIABILITY MANAGEMENT IN DIFFERENT SECTORS

A. INSURANCE SECTOR

INTRODUCTION
Insurance companies face various financial risks associated with assets
backing liability cash flows. How these risks are managed varies by company
and jurisdiction and is largely influenced by the regulatory environment.

Asset liability management (“ALM”) is a fundamental element of life insurer

strategy and operations. It is also important to the operations of other types of
insurers. The importance of ALM to insurers’ results from insurance being
primarily a liability driven business with assets purchased to match, in a risk
efficient manner, the estimated insurance obligation cash flows, which may be
uncertain for various reasons such as policyholder options.
Life insurance companies with long liability durations can be exposed to
significant interest rate risk exposure. Inadequate ALM, ignoring the economic
risk exposure and/or using only simple risk metrics such as duration has
resulted in, and will continue to result in, insolvencies.

For life insurance companies with long liability durations, it is important to

understand the multiple dimensions of the interest rate risk exposure. P&C
insurance companies with short liability durations have less exposure to interest
rate risk and the focus is more on managing liquidity. P&C insurance companies
with long-tailed liabilities can be exposed in a similar way to life companies.

One of the greatest challenges facing life insurance companies selling long
duration contracts, and non-life companies with long-tailed liabilities, has been
the prolonged extreme low interest rate environment. Traditional guaranteed
products with long durations have been difficult to immunize with available
fixed income assets.
Many insurance company portfolios are suboptimal. There is an opportunity for
insurance companies to improve the risk efficiency of their portfolios; in some
cases, simultaneously increasing portfolio yield, increasing net income and
adding positive convexity3 to the portfolio while decreasing risk. Asset
management approaches that manage assets separately against a benchmark
rather than directly against the liabilities, or ignore the impact on capital
requirements if they are risk-sensitive, do not support effective ALM.

Effective governance is a key part of ALM, one of the most vital functions
related to many insurers’ long term financial health. Effective governance
provides a clear objective for the ALM function and ensures there is a framework
in place for making decisions, the organizational structure supports effective
ALM, there is accountability in respect of taking market views and that senior
management and/or the board are aware of and fully understand the risk
exposures and uncertainties, associated with the assets and liabilities.
B. BANKING SECTOR

INTRODUCTION

Asset Liability Management is the process of managing Assets (uses of funds)

and Liabilities (sources of funds) of banks in a strategic manner so that any
adverse situation due to any shortfall in the positions of liquid assets of the
bank and interest rates etc. are managed inside desired limits. The function
establishes a balance between Liquidity and Profitability.

The ALM is defined as “managing both assets and liabilities simultaneously for
the purpose of minimizing the adverse impact of interest rate movement,
providing liquidity and enhancing the market value of equity.” (Gardner,
M.J.1991)
Bank asset-liability management (ALM) may be defined as “the simultaneous
planning of all asset and liability positions on the bank's balance sheet under
consideration of the different bank management objectives and legal,
managerial and market constraints, for the purpose of enhancing the value of
the bank, providing liquidity, and mitigating interest rate risk” (Gup and Brooks,
1993).

Asset Liability Management is the dynamic process of adjusting bank liabilities

i.e. volume of deposits in order to meet demands for loans, ensuring liquidity
position and fulfilling safety requirements. It is totally different from the general
acceptance of deposit (i.e. liabilities) from the public for carrying out
intermediation and maturity transformation into assets on regular basis. ALM is
an approach through which the banks can expect asset growth by adjusting
liabilities accordingly to fulfill their needs. Therefore, Asset and Liability
Management has become a very important bank management approach. The
ultimate goal of ALM is ensuring bank profitability and long term viability of
Asset-Liability Management aims to achieve following objectives:
• To ensure and optimize the net worth of the bank.
• To maximize the Net Interest Income (NII) the bank.
• To formulate vital business strategies and proper allocation of funds.
• To quantify various risks involved in financial intermediation.
• To optimize the profit by maintaining an appropriate balance between
acceptable risk, profitability and growth rate..
• To judiciously leverage the assets and liabilities mix of the balance sheet.
• Providing a suitable liquidity management framework and selecting a model
that promises an optimum net interest income consistently as well as ensures
liquidity.
• To plan the capital requirements of banks operations through capital
allocation decisions.
• To determine the pricing of banking products and introduction of new
products.
• To minimize the volatility of market value of capital from market risk.
CONCLUSION
Asset/liability management is the art
and science of choosing the best mix
of assets for the firm’s asset for the
firm’s asset portfolio and the best mix
of liabilities for the firm’s liability
portfolio. While asset/liability
management is important to all firms,
it is particularly critical for financial
institutions.
For a long time it was taken for
granted that the liability portfolio of
such firms was beyond the control of
the firm and so management
concentrated its efforts on choosing
the asset portfolio mix. This changed
dramatically during the 1970s and the
1980s as new instruments and
strategies emerged giving the firm a
much freer hand over the makeup of
its liabilities.
There are five key concepts in understanding asset/liability
management strategies. These are liquidity, term structure,
interest rate sensitivity, maturity composition, and default
risk. Many strategies are based gap management and
interest margin. The gap is defined as the dollar difference
between floating rate assets and floating rate liability and is
best viewed as balance sheet concept. Interest margin is the
difference between the rate on earning assets and the rate
paid on liabilities. Interest margin is best viewed as income
statement concept.

In recent years financial engineers working for investment

banks have developed sophisticated assets/liability
management strategy. Some of the strategies incorporate
advanced tools from the quantities side of the management
sciences. These investment banks then market these
strategies as “advisement services” to financial institutions.
Two of the strategies that became popular are total return
optimization and risk controlled arbitrage.
REFERENCES
BOOKS:
Marshall, J. F. (John Francis)., Bansal, V. K. (1992). Financial engineering: a
complete guide to financial innovation. Boston: Allyn and Bacon.
WEBSITES AND RESEARCH PAPERS
1.
https://www.actuaries.org/LIBRARY/Papers/RiskBookChapters/Ch13_Asset_Liab
ility_Management_24Oct2016.pdf
2.http://citeseerx.ist.psu.edu/viewdoc/download?doi
=10.1.1.123.7323&rep=rep1&type=pdf
3.https://link.springer.com/content/pdf/bfm%3A978-0-230-30723-0%2F1.pdf
4.http://www.yourarticlelibrary.com/business/risk-management/assets-
liabilities-management-alm/89514
5. sciencedirect.com/topics/economics-econometrics-and-finance/asset-
liability-management
6. Chawla,OP. ALM in banks. The Financial Express, 7th Feb, 1998,
http://www.expressindia.com/fe/daily/19980207/03855464.html
7. Asset Liability Management: An Overview An Oracle White Paper
ORACLE(FINANCIAL SERVICES) Published in 2008
8. Sciencedirect.com/topics/economics-econometrics-and-finance/asset-
liability-management