This lesson explores the supervisory framework and internal processes banks use to manage the risks arising from mismatches between their assets and liabilities.

7.1 The Fundamentals of Asset Liability Management

At its core, ALM captures all financial risks arising from mismatches between a bank’s assets and liabilities in terms of timing, value, or currency . This encompasses liquidity and funding risks, interest rate risk, credit spread risk, and structural currency risk . The objective of liquidity management is to ensure that banks are able to meet all their financial obligations as they fall due .

7.2 Key ALM Risks

  • Liquidity Risk: The risk that the bank cannot meet its obligations when they fall due, potentially leading to a liquidity crisis . Banks face challenges from clients who now have instant access to their funds through digital channels, making their reactions faster and less predictable .

  • Interest Rate Risk in the Banking Book (IRRBB): The risk to earnings and capital from adverse movements in interest rates. For significant banks, net interest income (NII) makes up two-thirds of their operating income on average, underscoring the importance of sound ALM practices . Banks are dealing with increased interest rate convexity and credit spread volatility.

  • Funding Risk: The risk of not being able to access funding sources or having to access them at an elevated cost.

7.3 Supervisory Framework and Best Practices

Regulators (like the ECB in Europe) expect banks to have strong ALM governance and risk management practices . Key supervisory expectations include:

  • Strong Governance: Reliable and timely information for decision-making, and an active Asset-Liability Committee (ALCO) .

  • Strategic ALM Choices: Adapting funding plans as excess liquidity declines, ensuring liquidity and collateral can be transferred within the group, and carefully evaluating interest rate and credit spread exposures .

  • Sound Risk Identification and Measurement: Beyond regulatory metrics (like the LCR and NSFR), banks must develop additional stress scenarios tailored to the current market environment . Behavioral models for non-maturing deposits and loan prepayments must be robust and well-calibrated .

  • Operational Readiness: Banks must have the technical and procedural capacity to access central bank facilities (like the ECB’s MROs) effectively and seamlessly whenever needed .

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