Asset liability management (ALM) is the practice of managing a financial institution's assets and liabilities together, so that mismatches between them in maturity, interest rate and currency do not threaten its earnings, capital or ability to pay. It is carried out by banks, insurers and pension funds, each of which holds assets funded by obligations to other people.
For a bank the mismatch is built into the business. Banks take short-term deposits and make longer-term loans, a process known as maturity transformation, and they earn a margin for doing so. ALM is the discipline that decides how much of that mismatch to run and how to protect against it. It is closely related to balance sheet management, which adds capital and funding strategy; insurers apply the same ideas through insurance asset liability management.
The risks ALM covers
Three risks are central. The first is interest rate risk outside the trading book, known to supervisors as interest rate risk in the banking book (IRRBB) and within banks as structural interest rate risk. It arises when assets and liabilities reprice at different times or by different amounts. The second is liquidity risk, the danger that the institution cannot meet payments as they fall due without unacceptable cost. The third is structural currency risk, where assets and liabilities, or capital and investments in foreign subsidiaries, are in different currencies.
Measuring the mismatch
ALM teams use a small set of standard measures:
- Gap analysis. Assets and liabilities are sorted into time bands by when their rate resets, giving the repricing gap, or by when cash is due, giving the liquidity gap analysis.
- Earnings sensitivity. The change in net interest income (NII) over the next one to three years is modelled under different rate paths.
- Value sensitivity. The change in the present value of all banking book cash flows, the economic value of equity (EVE), is calculated under rate shocks. The related duration gap compares the average rate sensitivity of assets and liabilities.
- Liquidity ratios and stress tests. Regulatory measures such as the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR) sit alongside the institution's own stress scenarios.
The earnings and value views can point in opposite directions. Locking in fixed-rate assets steadies income but makes the economic value more sensitive to rate rises, so institutions set limits on both.
Behavioural assumptions
Contract terms alone do not describe a bank's balance sheet. Current accounts can be withdrawn on demand, yet in practice a large share stays for years and reprices slowly. Fixed-rate mortgages may be repaid early when rates fall. Credit lines may be drawn when customers are under stress. ALM models therefore rely on behavioural assumptions: how long non-maturity deposits will stay, how much of a rate change is passed on to depositors, and how fast loans prepay.
These assumptions carry considerable model risk. The failure of Silicon Valley Bank in March 2023 followed a rapid loss of deposits that had been assumed to be stable, combined with large holdings of long-dated fixed-rate securities whose value had fallen as rates rose.
Tools for managing the position
The balance sheet can be reshaped directly, by changing the pricing and terms of loans and deposits, lengthening wholesale funding or holding more liquid assets. It can also be hedged. The most common instrument is the interest rate swap, used to convert fixed-rate exposure to floating or the reverse. Many banks invest a portion of stable deposits and equity in a rolling portfolio of fixed-rate assets or swaps, often called a structural hedge, to smooth income through the rate cycle.
Inside the bank, funds transfer pricing (FTP) moves interest rate and liquidity risk from business lines to the treasury. Each loan is charged, and each deposit credited, at an internal rate matching its term, so that branches and product teams earn a stable margin and the mismatch is gathered in one place where it can be managed.
Governance and regulation
Responsibility normally rests with an asset and liability committee, usually called ALCO, chaired by the chief executive or chief financial officer and including treasury, risk and business heads. It sets limits within the board's risk appetite, approves behavioural assumptions and hedging strategy, and reviews positions each month. Day-to-day execution sits with the treasury function, with independent challenge from risk management.
Supervisors expect banks to measure IRRBB under standard shock scenarios set by the Basel Committee and to explain large falls in economic value relative to Tier 1 capital. Liquidity is covered by the Basel III ratios and by internal liquidity adequacy assessments. Unlike credit or market risk, IRRBB is generally addressed through supervisory review, with extra capital required case by case, and not through a fixed minimum requirement.