Asset liability management (ALM) can be stated as the comprehensive and dynamic layout for measuring, examining, analyzing, monitoring and managing the financial risks linked with varying interest rates, foreign exchange rates and other elements that can have an impact on the organization’s liquidity.
Asset liability management is a strategic approach of managing the balance sheet in such a way that the total earnings from interest are maximized within the overall risk-preference (present and future) of the institutions.
Thus, the ALM functions include the tools adopted to mitigate liquidly risk, management of interest rate risk / market risk and trading risk management. In short, ALM is the sum of the financial risk management of any financial institution.
In other words, ALM handles the following three central risks −
● Interest Rate Risk
● Liquidity Risk
● Foreign currency risk
Banks which facilitate forex functions also handles one more central risk — currency risk. With the support of ALM, banks try to meet the assets and liabilities in terms of maturities and interest rates and reduce the interest rate risk and liquidity risk.
Asset liability mismatches − The balance sheet of a bank’s assets and liabilities are the future cash inflows & outflows. Under asset liability management, the cash inflows & outflows are grouped into different time buckets. Further, each bucket of assets is balanced with the matching bucket of liability. The differences obtained in each bucket are known as mismatches.