Chapter 3 - Asset and Liability Management, and Value at Risk

Abstract

Asset and liability management (ALM) was developed in the mid-1970s with the aim of fostering bank performance in the face of high and volatile interest rates. Its objective being to coordinate the functions affecting interest-bearing assets and interest-burdened liabilities, ALM is also a model archetype for the analysis of margin, value, and liquidity risks. This chapter introduces Bank Alpha, a stylized international commercial bank used as an illustrative example throughout the book. A brief description of its balance sheet and profit and loss paves the way to the ALM analysis. Firstly, the study focuses on the net interest income computed as the difference between interest revenue and expenses over a given time horizon (e.g., 1 year). Given the link between net interest income and interest rates, the investigation of an affine term structure model shows how to assess margin fluctuations due to macroeconomic changes. As part of the stress testing and risk integration process, the next step of the journey proposes a quick overview of value at risk methods. Three main approaches are considered: variance-covariance, Monte Carlo, and historical simulations. A methodological description is presented, followed by its regulatory implementation. Finally, the ALM mechanism is used to analyze the mismatch between cash outflows and inflows. Bank Alpha serves to illustrate some of the main liquidity issues experienced during the 2007–09 crisis.