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3 Risks asset/liability management (ALM) addresses

Mary Ellen Biery
November 6, 2024
Read Time: 0 min

The risks ALM addresses will affect performance and strategy

Asset/liability management models and processes address credit risk, liquidity risk, and interest rate risk. 

Balance sheet risks: What they are and how to address them

Banks and credit unions face a seemingly never-ending array of financial risks, as shown by the pandemic, subsequent inflationary pressures, and the fastest increase in interest rates in more than 30 years.

As a result, regulators are keenly focused on how unexpected circumstances can affect financial institutions’ balance sheets. They continue to highlight—in exams and commentary— the risks to financial resilience —the importance of sufficient capital and asset/liability management (ALM) to ensure adequate liquidity.

“We’re not going to get rid of risk,” notes Dave Koch, Director of Advisory Services at Abrigo. “And we don’t want to get rid of risk. In fact, we make money by taking risk.”

Good asset/liability management, he says, “is knowing how much risk do we take.”

Banks and credit unions that use their ALM models to manage risk and plan strategically will generate sustainable earnings that allow them to maintain capital to grow, add shareholder return, or continue bringing value to their communities in other ways. And as interest rates decline, asset/liability committees (ALCOs) that utilize ALM strategically will have an advantage over competitors because they will be able to make data-backed decisions.

Learn more about asset/liability risks in this webinar, "ALCO playbook: Managing liquidity and performance amid rate cuts."

listen

Which risks does ALM address?

An asset/liability management model captures three key types of risks facing financial institutions. These risks are measured by ALM solutions and managed by chief financial officers and other financial professionals as well as the institution’s asset/liability management committee (ALCO). The three main risks in ALM are:

  • Credit risk
  • Liquidity risk
  • Interest rate risk

To put it simply, Koch says, bankers can think of each of the above risks in these terms, respectively:

  • What will happen if we don’t get paid like we expected?
  • What will happen if we don’t have enough money to meet demands for loans or deposit withdrawals?
  • What will happen to core earnings or value if rates change and stay there?

A closer look at each type of risk and the interplay among them reveals why ALM is more than a report required by regulators and why it will be critical for managing additional expected interest-rate cuts.

“Asset/liability management is a process – it’s how do I put loans and investments and borrowings together,” Koch says. “It’s about how to make decisions inside the bank to manage risk. And it takes everybody in the organization to bring together the ideas and execute on them to do it well.”

Credit risk and ALM

Loans are the largest source of credit risk for most banks and credit unions. In addition to loans, other sources of credit risk on and off the balance sheet include:

  • cash management services
  • foreign exchange
  • credit derivatives
  • unfunded loan commitments
  • letters of credit
  • lines of credit

At its core, credit risk plays a vital role in balance sheet management because of the impact that the extension of credit and losses from poor credit have on a financial institution’s capital.

Regulators expect banks and credit unions to be able to forecast credit losses accurately to evaluate both liquidity and interest rate risk. Financial institutions must already calculate the allowance for credit losses (ACL) under the current expected credit loss model, or CECL. Using the same assumptions for prepayment schedules, loan loss forecasts, and loss severity forecasts in both the allowance calculation and the ALM model ensures a consistent approach for accurately projecting cash flow and the impact on capital under various scenarios.

Liquidity risk management and ALM

Liquidity risk management has taken on a completely different perspective since the Fed hiked interest rates 11 times beginning in 2022. Financial institutions had been flush with deposits following COVID but saw those deposits become more expensive as depositors demanded higher yields. Meanwhile, institutions that had made long-term bets on 10-Year Treasuries when rates were low saw the value of their bonds drop and couldn’t access that money to feed lending or manage unexpected stresses.

From regulators’ standpoint, liquidity is defined as the capacity to readily meet cash and collateral obligations at a reasonable cost. They expect management and directors to understand their institution's liquidity risk profiles relative to established limits, and to understand the potential impact of strategic and tactical decisions on liquidity.

ALM helps a financial institution estimate and plan for and meet liquidity demands over various periods without adversely affecting daily operations or financial performance. It projects how funding requirements change during routine times, as well as during times of stress, so banks and credit unions can incorporate liquidity risk mitigation strategies.

Many community financial institutions identify, measure, and monitor liquidity risk through spreadsheets that compute existing balance-sheet liquidity positions, forward-looking source and use projections, and adverse scenario effects. They often solely use a static approach to asset/liability management, examining the balance sheet in its current state over a specific period.

However, a dynamic ALM approach takes the current balance sheet into account but also considers any strategic plans, such as growing a certain category of loans or adjusting pricing on deposits.

A key benefit of dynamic asset/liability management is that it allows banks or credit unions to pivot when conditions warrant — such as a change in the direction of interest rates. Dynamic ALM can help a financial institution decide how to manage funding costs, maintain net interest margins, and manage lending opportunities while still managing risk. Rather than relying solely on what competitors are offering on non-maturity deposit accounts, a dynamic ALM can help the bank or credit union make decisions about what rates are most advantageous for in its specific situation. This style of dynamic asset/liability management allows financial institutions to elude the risk of underperformance while avoiding the hazards of extreme increases in interest rates.

Interest rate risk and ALM

Interest rate risk, the risk most strongly associated with an ALM model, is generally associated with risk resulting from changes in interest rates.

Four common interest rate risks among community financial institutions are:

  • Repricing risk: Also known as mismatch risk, repricing risk is the risk tied to having loans and investments mature or reprice at different times than deposits and other borrowings.
  • Basis risk: Basis risk is the risk that underlying rates used to price assets and liabilities change in a non-correlated manner, putting margins at risk of narrowing.
  • Prepayment/extensions risks (also called option risk): Prepayment risk in a higher rate environment is the risk that asset repayments slow, reducing the ability to reinvest funds at potentially higher yields. Extension risk, on the contrary, in a rising rate environment can occur when an institution has exposure to callable or convertible advances that are rate sensitive. In either case, cash flows can be affected by borrower decisions rather than by decisions made by the bank or credit union.
  • Yield curve risk: The risk that asset values or cash flows will be disproportionately affected by nonparallel changes in short- and long-term rates used to price assets.
  • Regulators expect a financial institution's interest rate risk measurement tools and techniques to be sufficient to quantify its risk exposure. Due to varying levels of risk and risk profile complexity, these tools and techniques can differ widely from institution to institution. As a result, some banks and credit unions run ALM models themselves, others outsource the process entirely, and some use a hybrid approach of using outside ALM experts to help run a model in-house.

Financial institutions that understand their balance sheet risks will be able to manage them better as interest rates decline, Koch said.

“As rates drop, loans made at higher rates will be more likely to be refinanced, leading to an increase in prepayments. However, this depends on the composition of the loan portfolio, with older, lower-rate loans being less likely to prepay,” he said. “It’s essential for institutions to analyze their portfolios carefully to anticipate prepayment speeds accurately.”

Managing prepayment speeds will help institutions maintain portfolio stability and better align their lending strategies during rate cuts.

"If 20% of your portfolio is sitting in rates that went up 150 to 200 basis points, those loans will likely refinance quickly. But if 80% of your loans were booked at pre-rise rates, those loans won’t refinance as fast,” Koch said. “It’s important to break down prepayment speeds by the age and rate of the loans." to better anticipate which loans are at risk of refinancing and adjust their strategies accordingly.

Risk management for changing times

Many financial institutions assess the three major types of risk in siloes because of the way their data systems and models are constructed. But this approach ignores the benefits of an integrated model. By utilizing the same assumptions and data across the financial institution, executives harness consistent data that helps them maintain profitability and sufficient capital even when interest rates change or economic circumstance change without warning.

Banks and credit unions that actively manage their balance sheets using dynamic ALM will be able to achieve their desired growth and profitability while mitigating risks – even in the face of the unexpected.

Key Takeaways

This updated post was originally published June 7, 2021.
About the Author

Mary Ellen Biery

Senior Strategist & Content Manager
Mary Ellen Biery is Senior Strategist & Content Manager at Abrigo, where she works with advisors and other experts to develop whitepapers, original research, and other resources that help financial institutions drive growth and manage risk. A former equities reporter for Dow Jones Newswires whose work has been published in

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About Abrigo

Abrigo enables U.S. financial institutions to support their communities through technology that fights financial crime, grows loans and deposits, and optimizes risk. Abrigo's platform centralizes the institution's data, creates a digital user experience, ensures compliance, and delivers efficiency for scale and profitable growth.

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