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:
- Meet financial goals
- Manage risks
- 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.
Will ALM help financial institutions avoid risk?
What are the different approaches to ALM?
