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Home > Balance Sheets Best Practice > Bank Asset–Liability Management and Liquidity Risk Management

Balance Sheets Best Practice

Bank Asset–Liability Management and Liquidity Risk Management

by Moorad Choudhry

This Chapter Covers

  • Bank risk management is encompassed by the discipline of asset–liability management (ALM) and liquidity risk management;

  • The principal tenet of ALM philosophy is the centralization of risk management, including interest-rate risk and liquidity risk, within a central ALM function;

  • The Basel III banking regulations seek to enshrine good ALM and liquidity practice through implementation of the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR) metrics;

  • Liquidity risk principles necessary to ensure adherence to the requirements of Basel III regulatory rules include the need for stable long-term funding, diverse funding sources, and an adequate reserve of genuine liquid assets;

  • To ensure long-term through-the-cycle viability it is necessary to enshrine a fit-for-purpose risk culture within the firm, captured by an effective ALM committee framework.

Introduction

Risk management in banking is summarized in essence by asset–liability management (ALM). This reflects the nature of the products that banks offer to their customers, and the risk exposures that these products generate. In banks the three main strands of risk exposure are credit risk, interest rate (and foreign exchange) risk, and liquidity risk. ALM practice is concerned with managing these risks. Interest rate risk exists in two strands. The first strand is the more obvious one, the risk of changes in asset–liability value due to changes in interest rates. The second strand is that associated with optionality, which arises with products such as early-redeemable loans. The other main type of risk within the bailiwick of ALM is liquidity risk, which refers both to the liquidity of funding markets and to the ease with which assets can be translated into cash.

ALM is conducted primarily at an overview, balance-sheet level. The risk that is managed is an aggregate, group-level risk. This makes sense because one could not efficiently manage a viable banking business by leaving interest rate and liquidity risk management at individual operating levels. We illustrate this in Figure 1, which highlights the cornerstones of ALM. Essentially, the risk exposure is managed at the group or entity level by the treasury desk.

We speak of risk exposure as being for the group as a whole. This exposure must therefore aggregate the net risk of all the bank’s operating businesses. Even for the simplest banking operation, we can see that this will produce a net mismatch between assets and liabilities, because different business lines will have differing objectives for their individual books. This mismatch will manifest itself in two ways:

  • the mismatch between the different terms of assets and liabilities across the term structure;

  • the mismatch between the different interest rates at which each asset or liability contract has been executed.

This mismatch is known as the ALM gap. The first type is referred to as the liquidity gap, while the second is known as the interest rate gap. We value assets and liabilities at their net present value (NPV); hence, we can measure the overall sensitivity of the balance sheet NPV to changes in interest rates. As such, ALM is an art that encompasses aggregate balance sheet risk management at the group level.

Liquidity Risk Management

The art of banking is essentially the art of liquidity management. What exactly do we mean by this? According to Wikipedia: “In banking, liquidity is the ability to meet obligations when they become due.” The important part is to understand exactly what is meant by “when they become due.” Essentially, it means in perpetuity, or at least as long as we wish the bank to remain a going concern. In other words, maintenance of liquidity at all times is the paramount order of banking.

This is also the paradox of banking. Banking creates maturity mismatches between assets and liabilities, because assets are invariably long-dated and liabilities are short-dated, and this creates liquidity risk. In fact, to undertake banking is to assume a continuous ability to roll over funding, otherwise banks would never originate long-dated illiquid assets such as residential mortgages or project finance loans. As it is not safe to assume anything in finance, prudent liquidity risk management in banks dictates that all leveraged financial institutions need to set in place an infrastructure and governance ability to ensure that liquidity is always available, to cover for times when market conditions deteriorate.

The Scope of Liquidity Risk

The crash of 2007–2008 was as much a crisis of liquidity as it was of capital. Many banks ran a funding regime that was heavily overweight in short-term liabilities and volatile liabilities, such as wholesale funds (see the case study). That this is accepted as a prime causal factor of the crash is apparent from the way banks are adjusting to the new requirements of Basel III. Basel I and Basel II did not address liquidity, only capital. The new regime, which will be fully implemented by 2019, makes material demands on banks with respect to the way they manage liquidity.

However, liquidity risk management is not simply a matter of liquidity metrics and ratios. There are important governance and policy issues that also need to be built into the infrastructure and workings of a bank’s treasury and risk departments. Liquidity risk management needs to be addressed at the highest level of a bank’s management, the board of directors. The board will delegate this responsibility to a management operating committee such as an ALM committee (ALCO), but it is the board that owns liquidity policy. If it does not own it, then it is not following business best practice. Given this, it is important that the board understands every aspect of liquidity risk management.

Business best practice dictates that liquidity risk management encompass the following specific areas:

  • a formal statement by the board on liquidity risk appetite and tolerance;

  • liquidity strategy, policy, and processes;

  • regulatory requirements and reporting obligations;

  • bank funding strategy and policies;

  • institution-specific and market-wide stress scenarios, and stress-testing;

  • the liquid asset buffer;

  • a liquidity contingency funding plan.

In other words, liquidity management is devised at and dictated from the highest level, and it influences every aspect of the bank’s business strategy and operating model.

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Further reading

Books

  • Castagna, Antonio, and Fede, Francesco. Measuring and Managing Liquidity Risk. Hoboken, NJ: Wiley, 2013.
  • Choudhry, Moorad. Bank Asset and Liability Management: Strategy Trading Analysis. Singapore: Wiley, 2007; chapters 5–9.
  • Choudhry, Moorad. The Principles of Banking. Singapore: Wiley, 2012; chapters 7–15, 18.

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