Asset & Liability Management (ALM) is the process for managing financial performance by identifying, measuring and managing the returns on risk for off and on balance sheet exposures.
Here are the top 10 challenges and their key drivers in Asset & Liability Management today.
1. Ensuring a robust ALCO process: the ALCO process must include an analysis of balance sheet exposures and an economic value frame.
This must include off balance sheet risks such as derivatives and backstops, as well as strategic issues such as the mix of assets, sources of funding, reliance on professional funding and economic return on capital.
2. The planning process is extremely important and should include:
- 1. Income analysis: that is, the mix of fees, and net interest income and spread forecasts
- 2. Product Mix: so, volumes and types of products. For example, the mix of fixed and floating mortgages and ensuring product marketing is in sync with balance sheet goals
- 3. Funds Transfer Pricing: a clear and transparent system so that all business lines can buy into the process
- 4. Expense Planning: so remuneration and what incentives are in place to generate certain types of business
- 5. Segment profitability: so, analysis of the income-producing activities of the individual business lines; and finally,
- 6. Capital Planning: what is needed to support the business lines from a regulatory and economic perspective
3. Liquidity: the days of Central Banks supplying unlimited amounts like the Fed’s quantitative easing or the ECB’s LTRO, known as the “Long Term Purchase Operation” won’t last forever.
Liquidity buffers for unexpected seasonal variations must be integrated into the process.
Stressed scenarios – that are increasingly demanded by regulators.
Contingency planning for liquidity shortfalls, and finally, the LCR, or the Liquidity Coverage Ratio, which is a new ratio introduced by Basel III, should be integrated into the analysis even though the final rules have not been completely settled yet.
4. Gap analysis should integrate this new liquidity rule, again, even though the final weightings have not been completely finalized by the BIS.
5. Market Risks must include a range of market factors that impact not just net interest income (INI) but also Foreign Exchange and other risks such as credit, equity and commodities where appropriate.
6. Behavioural modeling must be enhanced of the various assets and liabilities. This can range from the standard mortgage prepayment speeds to the econometric modeling of indeterminate maturity deposits.
7. An important aspect of the ALCO is to integrate all business segments into this process. Make sure all business lines from mortgage lending to commercial lending to investment banking are part of the process and there are debates and exchange of ideas in the ALCO.
However, once the strategy is set, ALCO must ensure adherence to direction of the institution to avoid short-term approaches to business that can lead to business lines putting on business that in the long term could be detrimental to the institution’s health.
The best example of this is of course the weakening of credit standards in the United States Mortgage business in 2007 and 2008 that led to severe problems later on.
8. There is a new regulatory environment, which is an ever-changing landscape at this point of time.
What are some of these factors?
The increasing focus on Tier 1 common equity as new gold standard for capital. Another is the LCR, the Liquidity Coverage Ratio, which is new, and also the Net Stable Funding Ratio which will be implemented throughout the next ten years, as part of the new BIS III capital plan.
There is also the new leverage ratio of 3%, which is a new rule for most banks that would require substantial analysis.
And finally, the evolution of securitization. This is an area undergoing quite a bit of change and which has attracted more regulatory scrutiny but will remain a key tool for balance sheet management.
9. Active credit risk management
Recently, due to certain problems that took place at one large institution that came to be known as the “London Whale incident”, active credit risk management has come under increasing scrutiny.
However, it is still an important ALM tool for firm-wide credit risk management and concentrations with the use of CBA hedging for derivative exposures as one example.
10. New collateral requirements and their impact with regards to both on and off balance sheet activities and the potential unintended consequences of shortfalls in the high-quality collateral will be something that the markets will have to deal with most urgently in the coming months.
In sum, these are a few of the key items that are the focus of ALM and the ALCO process today.
Part 1 covers the first five challenges and drivers.
Part 2 covers the last five challenges and drivers:
Learn more about how to face and manage these Asset & Liability Management challenges
