Financial institutions are facing headwinds on account of burgeoning non-performing assets, corporate malfeasance, a slowdown in the economy and a mismatch between the maturity profile of assets and liabilities. Severe liquidity strains caused the failure of Silicon Valley Bank, Signature Bank and First Republic Bank. Yet despite weaker economic conditions, sharply higher interest rates, high inflation, financial market stress and concerns over a potential recession, the banking industry demonstrated resilience. How?

Asset and Liability Management (ALM)

Asset and Liability Management (ALM) is a common phrase thrown around a board room when in discussions about the viability and future of a bank. It is the practice of mitigating financial risks resulting from a mismatch of assets and liabilities, a combination of risk management and financial planning.

Not only is it vital for the sustainability and longevity of financial institutions within the financial landscape, but it solidifies the important roles that banks play in maintaining the stability and growth of economies. Liquidity risk has become an increasingly important parameter for the assessment of a financial institution. But with a new age of depositor behavior and the evolution of regulations, achieving a dynamic, integrated ALM program is challenging for banks of all sizes.

Low interest rates lasted years, resulting in complacency among financial institutions regarding deposit balance behavior. Then, during the past two rising rate cycles, deposit balances grew, coupled with an unusual systemic deposit inflow from 2020-2021 as a result of COVID-19 pandemic-related government fiscal stimulus. But those early 2023 bank failures proved that depository behavior is changing. One of the more important lessons surrounded concentration risk. Prior, deposits were considered one of the safest products in the liability structure of a bank.

But, as the industry quickly learned, some types of depositors are more sensitive than others. Large concentrations of a particular type of client create a higher risk of deposit flight, as was the case with SVB. As a result, banks are needing to diversify their funding basis.

An Agile ALM Framework

The ALM function covers a prudential component and an optimization role within the limits of compliance. Prudential meaning the management of all possible risks and rules and regulations, with optimization covering the management of funding costs, generating results on balance sheet position.

But the industry is riddled with change: business cycles becoming aggressive, global ecosystems and third-party risks becoming more complex, regulations rapidly changing, more stringent compliance enforcement — financial institutions are going to be forced to adopt an agile ALM framework with a broader perspective scoping out broad objectives of the bank’s asset/liability portfolio, as dictated by the Board in order to address new situations where a policy does not yet exist.

With the adverse interest rate environments, it has been found that most ALM systems and processes are not providing accurate and explainable outcomes scaled to meet transaction processing requirements. They lack flexibility to support interest rate risk reporting, scenario modeling requirements and “what if” analysis and are unable to scale to account for a bank’s contract and account volume of deposits and loans. There exists a lack of transparency in the underlying calculation logic, resulting in unexplainable and independently unverified data.

The Three Pillars

It is important for banks to assess the three pillars within an ALM program to include: ALM Information Systems, ALM Organization and ALM Processes. These pillars address the four key components examiners test on: board and senior management oversight policies; procedures and risk limits; management information systems; and internal controls and audit.

ALM Information Systems addresses Management Information Systems and information availability, accuracy, adequacy and expediency. Information is the key to ALM strength.

ALM organization requires a strong commitment from the board and senior management to integrate basic operations and strategic decision making within risk management. The ALCO decision-making unit monitors market risk levels compared to board-set risk limits, articulates the current interest rate view and view on the future direction of interest rate movements to strategize for future business opportunities, and reviews the results of and progress in implementation of the decisions made.

Lastly, the ALM process encompasses a scope of liquidity risk management, management of market risks, trading risk management, funding and capital planning, and profit-planning and growth projection.

Stress Testing

While the above is not all-encompassing, it does assist financial institutions in knowing that their ALM foundation is robust and agile to respond to evolving needs, and that it is modeling the balance sheet, projecting net interest income and economic value of equity, all while performing scenario analysis and stress testing to assess the impact of key performance indicators. This means also hiring a quality ALM professional who understands the need to replicate the portfolio from a sensitivity point of view when modeling a balance sheet or replicating cash flow, including complex structured products and embedded optionality. It requires accuracy and reliability to demonstrate what is happening right now within a portfolio. As stress testing and scenario analysis demands continue, banks need to be able to respond consistently to multiple scenarios via their credit stress models. It should account for evolving requirements, meaning the bank should be able to run a scenario analysis, including stress testing non-interest-bearing checking accounts if there is a move to a higher interest rate.

Be Proactive

Financial institutions need to recognize that change is necessary for how they tackle managing liquidity and interest rate risks. ALM and liquidity are two essential parts of the bank’s overall model risk management structure. In addition, ensure the board has at least one director with a solid understanding of balance-sheet management concepts; be proactive in identifying risks and updating policies and procedures before implementing new products or activities; and reevaluate and communicate guidance and risk tolerances to bank personnel. With the economic landscape, particularly that of community banks changing significantly, it directly correlates to a heightened need for attention to ALM risk management strategies and processes.

Elizabeth is the Vice President of Compliance Operations and Deputy General Counsel at Compliance Alliance. As the Vice President of Compliance Operations, Elizabeth oversees C/A’s Products and Services and plays an important part in all operational areas of C/A.