Bank Asset-Liability Management (ALM) has gained increasing relevance in recent years, especially with the implementation of the Basel II norms for the regulation of Indian banks by the Reserve Bank of India, and particularly in the wake of the global financial crisis. At the heart of ALM is the fundamental trade-off between liquidity, profitability and interest rate risk. The present study proposes a linear programming model for ALM, which seeks to maximize the rate of return/profit, subject to constraints dictated by liquidity and statutory requirements. The model was applied to a sample of banks operating in India, resulting in a recommended optimal asset-liability mix of the banks in the sample. Using these results, the study assesses the nature of ALM of different bank groups, in terms of its implications on liquidity, profitability and interest rate sensitivity.

Bank Asset-Liability Management (ALM) may be defined as the simultaneous planning of all asset and liability positions on the bank's balance sheet, by taking into consideration the different bank management objectives and legal, managerial and market constraints, for the purpose of enhancing the value of the bank, providing liquidity, and mitigating interest rate risk (Gup and Brooks, 1993). An efficient ALM system aims to manage the volume, mix, maturity, rate sensitivity, quality and liquidity of the assets and liabilities as a whole, so as to earn a predetermined, acceptable risk-reward ratio.

The framework of ALM broadly covers the area of interest rate risk, liquidity risk, exchange risk and credit risk. ALM can be defined as an operation for assessing the above-mentioned risks, actively altering the asset-liability portfolio, and for strategically taking actions and managing risks with the objective of maximizing profits. ALM is not limited to only on balance sheet assets and liabilities such as deposits and lending, but also includes off-balance sheet activities such as swaps, futures and options. The objective of ALM is to make banks fully prepared to face the emerging challenges.

The present study proposes a linear programming model for ALM, with profitability as the objective, and constraints based on liquidity and statutory requirements. The model was applied to a sample of banks operating in India, resulting in a recommended optimal asset-liability mix of the banks in the sample. Using these results, the study assessed the nature of ALM of different bank groups, in terms of its implications on profitability, liquidity, and interest rate sensitivity.

There is a considerable literature addressing ALM in banks. One of the key motivators of ALM worldwide was the Basel Committee. The Basel Committee on Banking Supervision (2001) formulated broad supervisory standards and guidelines and recommended statements of best practice in banking supervision. The purpose of the committee was to encourage global convergence toward common approaches and standards. In particular, the Basel II (2004) norms were proposed as an international standard for the amount of capital that banks need to set aside to guard against the type of financial and operational risks they face. Basel II proposed setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater the risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability. This would ultimately help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse.

Financial Risk Management Journal, Asset-Liability Management, ALM, bank management objectives, linear programming, risk and capital management, Statutory Liquidity Ratio, SLR, Reserve Bank of India, RBI, Demand and Time Liabilities, DTL, tructural Liquidity Statement, Interest Rate Sensitivity Statement, Rate-Sensitive Assets, RSA.