Asset-Liability Management: Understanding Core Risks in Banking

Asset-Liability Management (ALM) in banking plays a crucial role in addressing three primary risks that a bank faces: capital risk, liquidity risk, and interest rate risk. Understanding these risks and effective measures to manage them is crucial for banking professionals. This article will explore these risks and elaborate on how they are managed in the banking sector.

Capital Risk

The primary function of capital in banking is to protect the bank from insolvency due to losses. Historically, impaired loans were the primary source of loss. Today, however, sources of losses are more varied and can include security trading losses, goodwill impairment, and regulatory fines for misconduct. Protecting a bank from insolvency ensures the protection of depositors' funds, a primary responsibility for any bank.

Core capital is primarily provided by equity investors and the retained earnings after paying their dividends. This capital, also known as Core Tier 1 Capital, finances future growth. Regulators require that banks maintain a minimum amount of capital in relation to risk assets (primarily loans), assumed to be 8% per 100 lent for simplicity.

In addition to equity, regulators may permit the limited use of non-equity capital, such as subordinated perpetual bonds, referred to as Tier 2 Capital. The capital ratio, the ratio of Tier 1 and Tier 2 Capital to the aggregate of all risk-weighted assets, is a primary measure of capital adequacy employed by regulators.

Liquidity Risk

Liquidity risk arises largely due to maturity transformation, a key function that banks perform. If confidence in a bank is shaken, perhaps due to a string of loan losses, deposits can dry up, leading to a liquidity crisis. This loss of liquidity often triggers bank collapses.

To prepare for potential liquidity issues, banks maintain ample amounts of liquid assets on their balance sheets. Regulatory bodies often prescribe a minimum requirement for these assets. Other sources of liquidity include maturing assets and wholesale market access.

Liquidity is typically measured using the customer loans-to-deposits ratio and the number of days a bank could survive if existing funders do not roll over their positions at maturity.

Interest Rate Risk

Interest rate risk originates from movements in the yield curve. This risk primarily impacts a bank's earnings, as the net interest margin often contributes significantly to bank profits.

The difference between rate-sensitive assets and rate-sensitive liabilities across various repricing periods usually drives a bank's main interest rate risk, referred to as structural risk. Market risk, another significant source of interest rate risk, relates to the fluctuation in the value of fixed-rate securities as interest rates rise and fall.

ALM also extends to other significant risks, such as concentration risk, settlement risk, securitisation risk, and pension risk. Basel II Pillar 2 requires these risks to be identified, analysed, and stress-tested, with capital support estimated to the satisfaction of the regulator.

Lastly, a bank's credit rating affects several key areas, such as the cost of wholesale funds and the types and amounts of business which wholesale and corporate counterparties are prepared to transact with the bank. Therefore, the bank needs to be aware of credit rating agencies' (CRAs’) rating criteria and manage these to achieve the desired rating.

In conclusion, understanding the core risks in ALM and how they are managed is essential for banking professionals. By effectively managing capital, liquidity, and interest rate risks, banks not only protect depositors’ funds and their own financial health but also contribute to overall economic stability.