1. What does ALM manage?
Asset Liability Management (ALM) coordinates a bank’s assets, liabilities and relevant off-balance-sheet positions so that funding, liquidity, interest-rate exposure and profitability remain within its risk appetite. It connects business strategy with the timing, repricing, currency and optionality of cash flows.
Banks transform short-term savings into longer-term credit. ALM manages the resulting mismatches; it does not require every asset to be matched individually with a liability.
2. Why profitable banks can face trouble
A bank funds a ₹100 crore five-year fixed-rate loan at 9% using a one-year deposit at 6%. The initial annual interest spread is ₹3 crore, before other costs. At deposit maturity, replacement funding costs 8%: the annual spread falls to ₹1 crore while the loan coupon remains fixed. If the deposit cannot be replaced at all, the bank faces a liquidity problem even though the loan continues to pay interest.
Maturity mismatch concerns when principal cash flows arrive or leave. Repricing mismatch concerns when interest rates reset. A five-year floating-rate loan resetting every three months has a long contractual maturity but short repricing interval.
3. Four connected pillars
| Pillar | Question | Tools and responses |
|---|---|---|
| Liquidity risk | Can cash obligations be met on time? | Cash-flow ladders, buffers, funding diversification, stress tests and contingency funding |
| Interest-rate risk in the banking book (IRRBB) | How do rates change earnings and economic value? | Repricing gaps, duration, ΔNII / earnings at risk and ΔEVE |
| Foreign exchange risk | What happens when exchange rates or currency funding conditions change? | Currency-wise cash-flow ladders, net positions, hedging and funding plans |
| Governance and ALCO | Who decides, executes and checks? | Board risk appetite, ALCO limits and actions, independent risk monitoring and audit |
4. Earnings and value are different lenses
| Measure | Meaning | Key limitation |
|---|---|---|
| NII | Interest income minus interest expense over a period | Does not capture all future value changes |
| ΔNII / EaR | Change in projected NII under a specified scenario; EaR conventions vary | Depends on horizon, balance-sheet and behavioural assumptions |
| EVE | Present value of relevant asset cash flows less liability cash flows, including off-balance-sheet effects | An economic measure; not identical to reported book equity |
| ΔEVE | Shocked EVE minus base EVE | Sensitive to discounting, deposit and prepayment models |
A fixed-rate loan can retain its accounting carrying amount while its economic value falls as market yields rise. A bank therefore examines both earnings and value.
5. Liquidity ratios in context
LCR = eligible high-quality liquid assets ÷ stressed net cash outflows over 30 days. It addresses short-term stress resilience. NSFR = available stable funding ÷ required stable funding. It addresses structural funding over a one-year horizon. Regulatory weights, eligibility, caps and scope apply; these are not simple raw-balance ratios.
A liquidity buffer is meant to be usable in stress. Neither a strong ratio nor reported profit guarantees that every payment can be met in every currency and at every intraday point.
Check your understanding
Does a floating-rate loan eliminate ALM risk?
No. Reset timing, benchmark basis, deposit pricing, optionality and funding liquidity can still create exposure.
Is ALCO responsible for setting the bank’s ultimate risk appetite?
The Board approves overall risk appetite and policy. ALCO manages the balance sheet within that framework and escalates breaches.
6. The bank’s business model: transformation and intermediation
Maturity, size and risk transformation
Banks bring together many depositors and borrowers. Small deposits can support larger loans; short contractual funding supports longer-term lending; underwriting, diversification and capital help absorb credit losses. These transformations provide economic value but create exposures that must be managed together.
From asset growth to sustainable returns
A bank can grow loans rapidly and report more interest income while weakening its funding resilience. ALM asks whether the bank has appropriate funding tenor, usable liquidity, capital and pricing to support that growth. The objective is a sustainable return for the risk taken, rather than balance-sheet expansion alone.
Reading connection: Choudhry, An Introduction to Banking: Principles, Strategy and Risk Management, Chapter 1; Dermine & Bissada, Stages 1–3.
7. Liquidity, solvency and profitability: three different tests
| Test | What it means | Teaching illustration |
|---|---|---|
| Liquidity | Can the bank pay when cash is due? | Good loans cannot automatically be converted into cash on demand. |
| Solvency | Do asset values support obligations and loss absorption? | Credit losses can erode equity even while cash is available today. |
| Profitability | Do revenues exceed costs over the period? | Positive accrued income can coexist with a near-term funding shortage. |
How the risks can reinforce each other
A funding run can force asset sales at depressed prices. Losses then reduce capital and confidence, potentially triggering more withdrawals. Strong capital and liquidity therefore complement each other.
Reading connection: Choudhry, 2011, Chapters 5–6 and 9. Illustration is newly constructed for this lesson.
8. The mismatch map: what exactly can go wrong?
| Mismatch | Example | What to examine |
|---|---|---|
| Maturity / funding | One-year deposits fund five-year loans | Refinancing access and cash-flow timing |
| Repricing | Deposit rate resets before fixed loan yield | Reset dates and exposure periods |
| Basis | Loan yield follows one index; funding follows another | Unequal benchmark movements |
| Yield curve | Short rates rise while long rates fall | Sensitivity at multiple maturities |
| Embedded option | Borrower prepays after rates fall | Scenario-dependent timing and reinvestment |
| Currency | USD assets funded with INR liabilities | FX exposure, currency funding and swaps |
Even equal headline maturities do not guarantee equal cash-flow behaviour. An amortising loan and a bullet deposit with the same final date have different intermediate flows.
Reading connection: ALM NOTES, Chapter 7; Choudhry, 2011, Chapters 5–6.
9. Contractual terms versus customer behaviour
Non-maturity deposits and core balances
Current and savings balances may be withdrawable on demand, yet a diversified portion may persist in normal conditions. Behavioural modelling estimates that persistence by customer segment. It must also allow for concentrations, withdrawals and migration from low-rate accounts into higher-rate deposits.
Deposit beta and repricing lag
If a market rate rises by 1 percentage point and the deposit rate eventually rises by 0.40 percentage points, the observed beta is 40%. A lag describes how long repricing takes. Both can differ across products, customers, rising-rate and falling-rate environments.
Prepayments and early deposit withdrawals
Borrowers may refinance fixed-rate loans when rates fall; depositors may break deposits when more attractive rates become available. Penalties, switching costs and customer circumstances influence these options. ALM tests alternative behaviour instead of assuming contracts always run to maturity.
Reading connection: ALM NOTES, Chapter 7. The uploaded Handbook of Asset and Liability Management contains a contents extract only; its deposit and prepayment chapters were not available for consultation.
10. ALM, treasury and enterprise risk management
Who does what?
Treasury manages funding execution, liquid assets and market transactions. ALM analyses structural exposures, pricing and balance-sheet plans. Independent risk challenges assumptions and monitors risk appetite. Responsibilities can be arranged differently across banks, but conflicts and escalation routes must be explicit.
ALM is broader than a gap report
A report describes exposure. Management requires choosing actions, assessing earnings and liquidity trade-offs, executing them and checking results. Credit, operational and model risks interact with ALM, even where specialist teams own those risks.
Reading connection: Kallur, Bank’s asset and liability management: A chief risk officer’s perspective, in the uploaded Compilation, PDF pp. 3–11.
11. A foundation for later ALM studies
The next topics can build on this introduction: detailed cash-flow ladders; liquidity buffers and collateral; LCR and NSFR calculations; repricing gaps and NII simulation; duration and EVE; deposit and prepayment models; funds transfer pricing; currency ALM; stress testing and contingency funding. This first series provides the vocabulary and decision logic for those studies.
Materials used to expand this series
Selected relevant sections were reviewed and synthesised into original explanations and new examples. The source books and notes are not reproduced.
| Material | Reviewed section / use |
|---|---|
| Moorad Choudhry: An Introduction to Banking, Liquidity Risk and Asset–Liability Management (2011) | Chapter structure; ALCO policy and reporting, Chapter 7, printed pp. 224–229 |
| Moorad Choudhry: An Introduction to Banking, Principles, Strategy and Risk Management, 2nd edition | Chapter 1 business model, strategy, capital and financial statements |
| Jean Dermine and Youssef F. Bissada: Asset & Liability Management (2002) | Value creation, ROE and Stage 5 transfer-pricing discussion |
| ALM NOTES: Chapter 7, Asset Liability Management Risk | Financial statements, ALCO, liquidity gaps, amortisation and balance-sheet scenarios |
| Asset Liability Management: Compiled Practical Resources | Kallur’s CRO perspective, governance, FTP, policy and contingency funding |
| CAIIB PAPER 2 | Selected banking statements and coordinated balance-sheet management; historical definitions reviewed critically |
| Gurnani: Asset Liability Management In The Banks | Two-page conceptual overview; historical buckets not treated as current requirements |
| Handbook of Asset and Liability Management upload | Seven-page contents extract only; used as a reading map |
| RBI_2008-09_ | Historical FX circular; scope and date distinguished from current ALM requirements |
Sources and further reading
Regulatory sources support the concepts; requirements differ by jurisdiction and bank category. Check amendments and commencement provisions before applying a rule.
- RBI: Commercial Banks – Asset Liability Management Directions, 2025 — liquidity governance, intraday liquidity, LCR, NSFR and interest-rate risk.
- Basel Framework — LCR, NSFR and IRRBB; SRP98 application guidance explains earnings and economic-value perspectives.
- Federal Reserve: SR 10-6, Interagency Advisory on Interest Rate Risk Management.
- EBA: Guidelines on IRRBB and CSRBB (EBA/GL/2022/14).
Recommended academic reading
The following bibliography was supplied for this series. The full books were not available for direct consultation; no chapter or page claims are made.
- Joël Bessis (2015), Risk Management in Banking, 4th edition, Wiley — recommended for integrated banking risk, liquidity and interest-rate risk.
- Dimitris N. Chorafas (2002), Asset/Liability Management for Banking Institutions, Elsevier — recommended for ALM measurement and balance-sheet modelling.
- Andrea Resti and Andrea Sironi (2007), Risk Management and Shareholders’ Value in Banking, Wiley — recommended for risk measurement, value and capital allocation.
Continue learning
- 1. Introduction to Asset Liability Management in Banks
- 2. Understanding Banks’ Balance Sheet and Income Statement
- 3. ALM Process
Educational illustrations use fictional data. Prof. V. Ravichandran · The Mountain Path Academy.