The latest developments indicate that there are now financial institutions that run a much more sophisticated ALM operation than that associated with a traditional banking book.

Let us review the traditional and developed elements of an ALM function.

Traditional ALM

We have noted that the simplest approach to ALM is to match assets with liabilities. For a number of reasons, which include the need to meet client demand and to maximize return on capital, this is not practical and banks must adopt more active ALM strategies. One of the most important of these is the role of the "gap" and "gap management." This term describes the practice of varying the asset and liability gap in response to expectations about the future course of interest rates and the shape of the yield curve. The gap here is the difference between floating-rate assets and liabilities, but gap management must also be pursued when one of these ele- ments is fixed rate. Simply put, this means increasing the gap when interest rates are expected to rise, and decreasing it when rates are expected to decline.

Such an approach is not without hazards. Gap management assumes that the ALM manager is correct in his/her prediction of the future direction of interest rates and the yield curve. Expectations that turn out to be incorrect can lead to unexpected widening or narrowing of the gap spread and losses. The ALM manager must choose the level of trade-off between risk and expected return.

Gap management also assumes that the profile of the banking book can be altered with relative ease. This was not always the case, and even today may still present problems, although the availability of a liquid mar- ket in off-balance sheet interest-rate derivatives has eased this problem somewhat. However, historically it has always been difficult to change the structure of the book, as many loans cannot be liquidated instantly and fixed-rate assets and liabilities cannot be changed to floating-rate ones. Client relationships must also be observed and maintained, a key banking issue. For this reason, it is much more common for ALM managers to use off-balance sheet products when dynamically managing the book. For example, FRAs can be used to hedge gap exposure, while interest-rate swaps are used to alter an interest-basis from fixed to floating, or vice- versa. The widespread use of derivatives has enhanced the opportunities available to ALM managers, as well as the flexibility with which the bank- ing book can be managed, but it has also contributed to the increase in competition and the reduction in margins and bid-offer spreads.

Basic Concepts in ALM

Generally a banks ALM function has in the past been concerned with