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Asset Liability Management in Risk Framework

- by Sayonton Roy *

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The capital of most financial institutions is small relative to the firm's assets or liabilities, and so small percentage changes in assets or liabilities can translate into large percentage changes in capital. Accrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Firms responded by forming asset-liability management (ALM) departments to assess these asset-liability risk.

Techniques for assessing Asset-Liability Risk

Techniques for assessing asset-liability risk came to include Gap Analysis and Duration Analysis. These facilitated techniques of managing gaps and matching duration of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. But cases of callable debts, home loans and mortgages which included options of prepayment and floating rates, posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic. Accordingly, banks and insurance companies started using Scenario Analysis.

Under this technique assumptions were made on various conditions, for example: -

  • Several interest rate scenarios were specified for the next 5 or 10 years. These specified conditions like declining rates, rising rates, a gradual decrease in rates followed by a sudden rise, etc. Ten or twenty scenarios could be specified in all.

  • Assumptions were made about the performance of assets and liabilities under each scenario. They included prepayment rates on mortgages or surrender rates on insurance products.

  • Assumptions were also made about the firm's performance-the rates at which new business would be acquired for various products, demand for the product etc.

  • Market conditions and economic factors like inflation rates and industrial cycles were also included.

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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.