Which risks does ALM address?

An asset/liability management model captures three key types of risks facing financial institutions. These risks are measured by ALM solutions and managed by chief financial officers and other financial professionals as well as the institution’s asset/liability management committee (ALCO). The three main risks in ALM are:

• Credit risk
• Liquidity risk
• Interest rate risk

To put it simply, Koch says, bankers can think of each of the above risks in these terms, respectively:

• What will happen if we don’t get paid like we expected?
• What will happen if we don’t have enough money to meet demands for loans or deposit withdrawals?
• What will happen to core earnings or value if rates change and stay there?

A closer look at each type of risk and the interplay among them reveals why ALM is more than a report required by regulators and why it will be critical for managing additional expected interest-rate cuts.

“Asset/liability management is a process – it’s how do I put loans and investments and borrowings together,” Koch says. “It’s about how to make decisions inside the bank to manage risk. And it takes everybody in the organization to bring together the ideas and execute on them to do it well.”

Liquidity risk management and ALM

Liquidity risk management has taken on a completely different perspective since the Fed hiked interest rates 11 times beginning in 2022. Financial institutions had been flush with deposits following COVID but saw those deposits become more expensive as depositors demanded higher yields. Meanwhile, institutions that had made long-term bets on 10-Year Treasuries when rates were low saw the value of their bonds drop and couldn’t access that money to feed lending or manage unexpected stresses.

From regulators’ standpoint, liquidity is defined as the capacity to readily meet cash and collateral obligations at a reasonable cost. They expect management and directors to understand their institution's liquidity risk profiles relative to established limits, and to understand the potential impact of strategic and tactical decisions on liquidity.

ALM helps a financial institution estimate and plan for and meet liquidity demands over various periods without adversely affecting daily operations or financial performance. It projects how funding requirements change during routine times, as well as during times of stress, so banks and credit unions can incorporate liquidity risk mitigation strategies.

Many community financial institutions identify, measure, and monitor liquidity risk through spreadsheets that compute existing balance-sheet liquidity positions, forward-looking source and use projections, and adverse scenario effects. They often solely use a static approach to asset/liability management, examining the balance sheet in its current state over a specific period.

However, a dynamic ALM approach takes the current balance sheet into account but also considers any strategic plans, such as growing a certain category of loans or adjusting pricing on deposits.

A key benefit of dynamic asset/liability management is that it allows banks or credit unions to pivot when conditions warrant — such as a change in the direction of interest rates. Dynamic ALM can help a financial institution decide how to manage funding costs, maintain net interest margins, and manage lending opportunities while still managing risk. Rather than relying solely on what competitors are offering on non-maturity deposit accounts, a dynamic ALM can help the bank or credit union make decisions about what rates are most advantageous for in its specific situation. This style of dynamic asset/liability management allows financial institutions to elude the risk of underperformance while avoiding the hazards of extreme increases in interest rates.