Bank Asset Liability Management Best Practice

Yesterday, Today and Tomorrow

Polina Bardaeva

• Publisher: De Gruyter
• Year: 2021
• ISBN:
  9783110666601
• Edition: 1
• Topic: Business
• Subtopic: Insurance
• Index: Business

As bankers incorporate more and more complicated and precise calculations and models, a solely mathematical approach will fail to confirm the viability of their business. This book explains how to combine ALM concepts with the emotional intelligence of managers in order to maintain the financial health of a bank, and quickly react to external environment challenges and banks' microclimate changes.

ALM embraces not only balance sheet targets setting, instruments and methodologies to achieve the targets, but also the correct and holistic understanding of processes that should be set up in a bank to prove its prudency and compliance with internal and external constraints, requirements and limitations and the ongoing continuity of its operations. Bank Asset Liability Management Best Practice delves into the philosophy of ALM, discusses the interrelation of processes inside the bank, and argues that every little change in one aspect of the bank processes has an impact on its other parts. The author discusses the changing role of ALM and its historical and current concepts, its strengths and weaknesses, and future threats and opportunities.

Part 1: Historical Asset and Liability Management Concepts

Various changes in financial markets adjust banking activities and impact the structure of the balance sheets. It all leads to modification of the tasks in asset and liability management (ALM). And logically, for solving different tasks at different times in the past various methods and ALM instruments were applied. As tasks, methods, and instruments constitute a concept, we can speak about changing ALM concepts over time. In what follows, is a description of retrospective ALM concepts and their development over time, together with a summary table showing the main characteristics of the concepts and the reason for the changes.

This part answers the following questions:

• How have the ALM tasks and aims developed over time?
• What has triggered every change of the ALM aim?
• When and why have well-known instruments, methods, and approaches appeared?
• What is the interconnection between the ALM concepts?

The definition of ALM, as ALM is considered now, will be offered first in the second part of the book. This is done intentionally, as not all the tasks that are now commonly assigned to the ALM appeared at once. As a response to the changing external conditions, banking activities and balance sheet items (as well as their proportion in the balance sheet) have been changing over time, setting new priorities and tasks for the ALM. The breadth of the new tasks increased as new methods and instruments and their combinations appeared. It also happened as a response to new challenges, regulatory updates, and research for mitigation measures after severe crises. In order to present the development of ALM in a more structural way, I suggest splitting ALM tasks in the following areas:¹

1. Management of ALM risks
2. Setting targets for the balance sheet structure
3. Defining the price benchmarks
4. Allocation of financial resources between business lines

At the same time each ALM area could be split into a short-term part, aiming to solve tactical tasks, which are executed on an everyday basis, and a long-term one. The latter is represented by strategic tasks, long lasting projects, resulting in months’ or even years’ time. They can also be split into two parts as well: the “going concern” – when the bank continues to develop according to its strategy, and the “gone concern” – when a crisis comes and banks need to execute specific measures to recover from it.

Chapter 1 Before the ALM Era

There’s a well-known joke, that in the beginning of the second half of the XX century, banking business operated according to a “3-6-3 principle.” Its main rules were “raise money at 3%, lend money at 6%, and after 3 p.m. bankers should go to play golf.” No one ever thought about any risks (ALM risks), pricing was simple and required no benchmarking, resources were not that scarce to be cautiously allocated within business lines (the business lines, though, also hardly existed at that time), and requirements in the way we know them now were far from their emergence. The world was recovering from the war, production was developing, banks were actively lending to companies and individuals.

From the ALM point of view this period does not deserve much attention, as the ALM almost did not exist at that time. The aim of banks and those managers who were responsible for matching asset and liability sides of the balance sheet was stable margin.² It was achieved by means of thorough planning of loans and funding volumes in the long run, balancing mismatches by interbank borrowing and placements, cash, and equivalents management – as a part of operational activities.

Nevertheless, the volumes on the asset and liability sides were compared according to their contractual time to maturity – so one can already speak of preliminary liquidity management and liquidity risk management. Additional argument toward the fact that banks took tenors into account is already invented misbalance analysis methods for assets and liabilities; for example, duration analysis method was suggested by Macauley³ in 1938 and was further enhanced by Redington⁴ in 1952.

Allocation of interest margin between the lending and deposit raising divisions was made, according to a “single pool approach.” Banks used a single internal rate (the ancestor of the current funds transfer pricing [FTP] rate and curve) and applied it to calculate the margins on assets and liabilities. The difference between asset rate offered to a customer and the single internal rate (multiplied by volume) represented the result of the lending division, the difference between the single internal rate and the liability rate offered to a customer (also multiplied by volume) represented the financial result of the fundraising division. It means that interest expense or interest income was allocated in a way as though assets and liabilities of businesses were equal, with the same maturities.⁵

Having no evidence of other, more sophisticated methods and instruments to be applied, ALM intervention in the banking activities was at its minimum level (that is why the concept can be called minimum intervention), the picture of the ALM tasks is represented in Table 1.1.

Table 1.1:Minimum intervention ALM concept (1950–1973).

1950–1973		ALM risk management	BS structure targeting	Price benchmarking	Resources allocation
Short-term/tactical tasks		Operational liquidity management
		Cash and equivalents management
		Interbank placements
		Exchange operations
Long-term/strategic tasks	Going concern	Liquidity risk management	Volumes planning*

*Today, volumes planning is not considered as an ALM task (it is fully in the area of responsibilities of business lines), but as ALM did not actually exist then – and executed a mixture of controlling and trading functions – it can be counted for the ALM task at that time.

Chapter 2 Financial Turbulence

Change of ALM tasks and priorities happened in the first half of the 1970s, as a result of different worldwide events. U.S. President Richard Nixon trying to curb increasing inflation in the country undertook a series of economic measures. One of them was a breakage of the dollar’s link to gold and turning the American dollar into a freely floating currency. By this measure the Bretton Woods system was eliminated, and starting from 1973 the current regime based on freely floating fiat currencies came in place. Although freeing of the dollar resulted in its further devaluation and higher inflation inside the country. Also, Western European countries that were still holding dollars in their state savings faced revaluation of budgets. In addition to the effects of the Bretton Woods’ system crash and devaluation of the dollar the oil crisis in 1973 impacted Western European countries: as OPEC members proclaimed an oil embargo, prices of oil had risen tremendously, by nearly 400% within a year, according to the Office of the Historian of the U.S. Department of State.¹

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