Banks and credit unions face a seemingly never-ending array of financial risks, as the pandemic showed. From health-related surprises to natural disasters to terrorist attacks, the unexpected circumstances that can affect the balance sheets of financial institutions highlight the importance of capital planning and asset/liability management (ALM). Indeed, having sufficient capital to handle the unexpected economic impacts allowed financial institutions to play a key role in the U.S. recovery to date.
“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 continue to use their ALM models to manage risk and plan strategically during the projected recovery 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.
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 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.
“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.”