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Asset-Liability Management (ALM) can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management.
But in the last decade the meaning of ALM has evolved. It is now used in many different ways under different contexts. ALM, which was actually pioneered by financial institutions and banks, are now widely being used in industries too. The Society of Actuaries Task Force on ALM Principles, Canada, offers the following definition for ALM: "Asset Liability Management is the on-going process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and constraints."

Basis of Asset-Liability Management

Traditionally, banks and insurance companies used accrual system of accounting for all their assets and liabilities. They would take on liabilities - such as deposits, life insurance policies or annuities. They would then invest the proceeds from these liabilities in assets such as loans, bonds or real estate. All these assets and liabilities were held at book value. Doing so disguised possible risks arising from how the assets and liabilities were structured.

Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the same money at 7 % to a highly rated borrower for 5 years. The net transaction appears profitable-the bank is earning a 100 basis point spread - but it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the fixed 7 % it is earning on its loan.

Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in serious trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its financing. Accrual accounting does not recognize this problem. Based upon accrual accounting, the bank would earn Rs 100,000 in the first year although in the preceding years it is going to incur a loss.

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* Contributed by -
Sayonton Roy,
MBA (Finance), IMT Ghaziabad,
Currently working as Consultant - Global Financial Services (Risk and Business Solutions Group) at Ernst & Young, Mumbai.