Asset Liability Management

Overview


The Merton Model of the Firm hypothsizes that a firm is a mix of assets and liabilities, with the value of the firm is the difference in value of the two. That is, the firm is insolvent when the value of the assets is less than the value of the liabilities.
{% Value = Assets - Liabilities %}
For financial firms, such as banks and insurance companies, the management of the assets and liabiliites of the firm is critical, especially because financial firms need to be highly leveraged in order to compete in the market.

Asset Liability Management


Asset liability management is the process of structuring a financial firms balance sheet (that is choosing the mix of its assets and liabilities) in such a way as to achieve the banks objectives. This typically involves specifying the the types and size of the risks that the bank is willing to take.

  • Risk ALM - seeks to manage the enterprise risk of the firm through its portfolio.
  • Strategic ALM - focuses on the firm strategy and ways to tailor the asset/liability mix to meet those objectives.
  • Metrics
  • Balance Sheet Optimization refers to the process of choosing the assets and liabilities to hold on a bank's balance sheet in order to optimize some criteria set by the banks management, such as the Return on Equity, subject to a set of constraints, such as risk constraints or leverage constraints.

Modeling Assets and Liabilities


The primary difference in asset liability management among financial firms is the nature of the firms liabilities.

  • Assets
  • Liabilities
    • Banks - the primary liabilities for most banks are deposits and bonds, but may include derivative contracts.
    • Insurance Companies - insurance policies
  • Portfolio

Governance


  • Risk Appetite Statement - Many banks adopt a risk appetite statement that is used to articulate how the banks board views risk and its appetite and limits of the various types of risk that the bank faces. The statement typically will involve specifying a set of measures that the board uses to evaluate the banks risk position and the acceptable limits (tolerances) of those metrics.
  • Bank Asset Liability Committee (ALCO) - The Bank Asset Liability Committee is a bank committee that is responsible for setting the ALM policies of the bank. Typically the committee meets monthly and reviews the current risk position of the bank in order to validate that the bank is within the risk limits set by the committee.