What is an Asset‑Liability Committee (ALCO)?
An Asset‑Liability Committee (ALCO) is a senior oversight group within a bank or finance company that coordinates how the institution’s assets and liabilities are managed. Its aim is to protect the firm’s liquidity and capital position, control interest‑rate and other balance‑sheet risks, and help achieve acceptable returns consistent with the board’s risk appetite.
Key definitions
– Asset‑liability management (ALM): The set of policies, models, and controls used to shape the mix and timing of assets and liabilities so the institution can meet funding needs and tolerate market moves.
– Interest‑rate risk: The risk that changes in market interest rates will reduce income or economic value.
– Liquidity risk: The risk that an institution cannot meet cash needs without undue cost or loss.
– Contingency funding plan (CFP): A pre‑defined plan identifying emergency funding sources and actions to use in stress events.
Why ALCOs exist (purpose)
– Translate board strategy into balance‑sheet policies (funding mix, liquidity targets, risk limits).
– Monitor and control interest‑rate and liquidity exposures.
– Approve and review funds management and investment policies.
– Provide management information (MIS) and periodic reporting to the board.
– Prepare and maintain contingency funding plans and stress‑testing scenarios.
Why ALCOs matter
A firm’s ability to continue lending, meet deposit outflows, and preserve net interest earnings depends on how well its balance sheet is managed. Poor asset/liability oversight can lead to rapid liquidity shortfalls or large earnings swings when rates change. ALCOs help prevent concentration risk (too much exposure to one sector or funding source) and ensure the firm is prepared for stressed market conditions.
Typical ALCO responsibilities
– Set risk tolerances and policy for liquidity and interest‑rate risk.
– Approve limits on concentrations, funding sources, and investment holdings.
– Receive and validate MIS: gap reports, liquidity metrics, stress tests, and funding forecasts.
– Maintain and test the contingency funding plan.
– Determine centralization vs. delegation of funds management authorities.
– Meet regularly (often at least quarterly; many banks meet monthly or biweekly in practice).
– Report to the board and recommend policy changes.
Common risks ALCOs manage
– Interest‑rate risk: mismatch between asset and liability repricing dates.
– Liquidity risk: insufficient marketable assets or unreliable funding sources.
– Concentration risk: heavy lending to a single industry or reliance on short‑term wholesale funding.
– Operational risk: failures in processes or systems that affect funding or risk measurement.
– Market risk: losses from changes in market prices for securities held.
Short checklist for an ALCO meeting
– Review liquidity position: cash, short‑term investments, unencumbered securities.
– Evaluate funding mix: deposits by type, term funding, interbank lines.
– Examine repricing (gap) and duration reports across time buckets.
– Review net interest income (NII) and economic value sensitivity to rate shocks.
– Stress‑test key scenarios and review contingency funding plan readiness.
– Check concentration limits and recent compliance breaches.
– Approve any recommended policy or limit changes; document decisions and action items.
Worked numeric example — simple repricing gap and rate move
Assume a bank has the following one‑year repricing exposures:
– Assets repricing within 1 year: $120 million
– Liabilities repricing within 1 year: $100 million
Repricing gap (Assets − Liabilities) = $20 million (positive gap).
If market interest rates rise by 1.0% (100 basis points) and all else is equal, the approximate change in net interest income over the next year from this repricing gap is:
Change in NII ≈ Gap × Rate change = $20,000,000 × 0.01 = $200,000 increase.
Notes and assumptions: this is a simplified estimate that assumes no change in volumes, spreads, prepayments, or hedging. Real world impacts require more detailed models and behavioral assumptions for deposits and loan prepayments.
Example of ALCO governance points
– Charter: ALCO should have a written charter approved by the board describing membership, authority, meeting frequency, and reporting lines.
– Membership: Typically senior finance, treasury, risk, and lending officers; an independent risk representative is good practice.
– Frequency: At minimum quarterly; many institutions meet monthly or more often in volatile markets.
– Voting and documentation: Decisions, attendees, and action owners should be recorded and reported to the board.
The bottom line
An ALCO is a governance mechanism that connects the board’s strategic objectives to day‑to‑day balance‑sheet decisions. Its practical tasks include setting policies, monitoring liquidity and interest‑rate exposure,
, and translating board strategy into limits, pricing, and funding plans.
Core ALCO responsibilities
– Set balance-sheet policy: define risk appetite for interest-rate risk, liquidity, concentration, and funding tenor mismatch. (Risk appetite = the board’s tolerance for losses or stress.)
– Approve limits and triggers: e.g., maximum duration gap, minimum liquidity buffer, repricing-gap bands, and counterparty/funding concentration caps.
– Monitor metrics and reporting: receive regular dashboards, exception reports, and stress-test results; escalate breaches to the board.
– Oversee funding and hedging strategy: choose tenor mix of wholesale funding, deposit pricing strategy, and whether/when to use interest-rate derivatives.
– Coordinate business units: ensure lending, treasury, and retail deposit strategy align with balance-sheet objectives.
– Governance and documentation: maintain an ALCO charter, meeting minutes, action logs, and periodic review of models.
Key metrics, definitions, and formulas
– Repricing (rate-sensitive) gap: measures mismatch of assets and liabilities that reprice within a time bucket.
– Formula: Repricing gap (t) = Rate-sensitive assets (t) − Rate-sensitive liabilities (t)
– Approximate NII sensitivity: ΔNII ≈ Repricing gap × Δr
– Example: If 1‑year bucket RSA = $600m, RSL = $700m, gap = −$100m. If rates rise 1% (0.01), annual NII change ≈ −$100m × 0.01 = −$1.0m.
– Duration gap (macroeconomic interest-rate exposure): captures market-value sensitivity of equity to parallel yield shifts.
– Definitions: DA = duration of assets; DL = duration of liabilities; A = market value of assets; L = market value of liabilities; E = equity (A − L).
– Formula: Duration gap = DA − (L/A) × DL
– Approximate change in equity value for a small parallel yield change Δy (in decimals):
– ΔE ≈ −Duration gap × Δy × A
– Worked numeric example:
– A = $1,000m, L = $900m, E = $100m. DA = 4.0 years, DL = 2.0 years.
– Duration gap = 4.0 − (900/1000)×2.0 = 4.0 − 1.8 = 2.2 years.
– If yields rise 100 bps (Δy = 0.01): ΔE ≈ −2.2 × 0.01 × $1,000m = −$22m.
– New equity ≈ $100m − $22m = $78m (a 22% decline). Assumptions: parallel shift, small Δy, linear approximation.
– Liquidity Coverage Ratio (LCR): high-quality liquid assets / net cash outflow over 30 days; Basel III requires LCR ≥ 100% (for covered banks). See Basel documentation for details.
– Net Stable Funding Ratio (NSFR): available stable funding / required stable funding over one year; another Basel liquidity standard targeting structural funding.
ALCO meeting checklist (monthly/quarterly)
1. Pre-reads distributed 3 business days prior: balance-sheet summary, cashflow forecasts, repricing table, duration and DV01 (dollar value of a basis point) measures, stress-test outputs, and exceptions.
2. Agenda:
– Executive summary and action follow-ups from prior meeting.
– Liquidity dashboard: LCR, NSFR, short-term cash runway, wholesale maturities.
– Interest-rate exposure: repricing gaps, duration gap, hedging status, DV01.
– Funding plan: upcoming maturities, deposit trends, pricing initiatives, contingency funding sources.
– Stress-test review: scenarios, assumptions, and capital/liquidity impacts.
– Model and limit exceptions, compliance issues, and regulatory updates.
3. Decisions and owners: record approved actions, responsible parties, and deadlines.
4. Escalation: decide which items require immediate board notification.
Practical stress-test example (simple)
– Base case: A = $1,000m; L = $900m; E = $100m; DA = 4; DL = 2.
– Scenario: parallel +200 bps (Δy = 0.02).
– Equity impact (linear approx): ΔE ≈ −2.2 × 0.02 × $1,000m = −$44m → E ≈ $56m.
– Liquidity check: assume 30‑day net cash outflow = $80m; HQLA = $120m →
→ 30‑day liquidity buffer passes: HQLA − outflow = $120m − $80m = $40m remaining (sufficient under this simple check).
Interpretation (what the numbers mean)
– Capital: Equity falls from $100m to $56m after a +200 bps parallel shock. That is a 44% drop in equity. With total assets of $1,000m, a simple leverage proxy is Equity/Assets = 56/1,000 = 5.6%. This highlights material interest‑rate sensitivity even though the bank remains technically solvent in this scenario.
– Liquidity: The 30‑day cash outflow is covered by HQLA with a $40m cushion. That cushion could evaporate under deposit runs, market disruption, or additional funding needs.
– Risk concentration: A large duration gap (DA − DL) or a large positive DV01 on assets relative to liabilities creates the equity sensitivity seen here.
Extend the stress (worked numeric example)
– If the shock doubles to +400 bps (Δy = 0.04) using the same linear approx (ΔE ≈ −2.2 × Δy × A):
– ΔE ≈ −2.2 × 0.04 × $1,000m = −$88m.
– E ≈ $100m − $88m = $12m → leverage proxy = 12/1,000 = 1.2%.
– Liquidity: if deposit outflows increase to $160m under the harsher scenario while HQLA remains $120m, the 30‑day shortfall = $40m → indicates contingency funding needed.
Simple DV01 check (back‑of‑envelope)
– DV01 ≈ Duration × Market value × 0.0001.
– For assets: DA = 4, A = $1,000m → DV01_assets ≈ 4 × 1,000m × 0.0001 = $400k per 1 bp.
– For liabilities: DL = 2, L = $900m → DV01_liab ≈ 2 × 900m × 0.0001 = $180k per 1 bp.
– Net DV01 ≈ $220k per 1 bp → a 200 bp move ≈ $44m impact (consistent with the earlier linear approximation).
Practical ALCO actions checklist (prioritize and assign)
1. Immediate (within 24–72 hours)
– Confirm model inputs and assumptions for the stress scenario (owner: Risk modeller).
– Verify HQLA liquidity availability and legal/operational encumbrances (owner: Treasury).
– Notify senior management and trigger contingency funding playbook if predefined breach conditions met (owner: CFO/Treasurer).
2. Short term (1–4 weeks)
– Consider targeted hedges to reduce net DV01 (interest rate swaps,
interest rate caps/floors, futures) focused on the specific tenor buckets where the imbalance is largest (owner: Treasury/Risk Trading Desk). – Reprice or re-bucket new retail product offerings to discourage duration mismatches (owner: Deposits/Product). – Tighten limits on unsecured wholesale funding and extend maturities where feasible (owner: Funding). – Run and validate rapid “what‑if” hedging P&L and balance-sheet sensitivity runs (owner: Risk Modelling). 3. Medium term (1–6 months) – Execute a program of systematic hedge rollouts to smooth cost and operational load (owner: Treasury). – Adjust deposit pricing and promotional structure to shift mix toward more stable, lower-duration balances (owner: Retail Deposits). – Use structural balance‑sheet tools: issue longer-term debt, securitise short-term assets, or buy longer-duration securities to add asset duration (owner: Capital Markets). – Review product approvals and ALCO limits to prevent recurrence (owner: ALCO Chair). – Update scenario library and calibrations based on realized stress behavior (owner: Risk Modelling). 4. Strategic (6–24 months) – Re-design funding strategy to increase stable funding ratios (e.g., increase retail core deposits, diversify wholesale counterparties) (owner: CFO/Treasurer). – Consider changes to asset mix (more floating-rate assets, shorter-duration securities) and capital planning to reduce sensitivity to rate shifts (owner: CIO/CFO). – Strengthen IT/operational capabilities for intraday liquidity and faster hedge execution (owner: CIO/Treasury). – Revise compensation/incentive structures that encourage taking undesired duration or liquidity risk (owner: HR/Board Remuneration). Governance, reporting and controls checklist – Immediate reporting: produce an ALCO dashboard showing net DV01 by tenor bucket, liquidity buffer, LCR (Liquidity Coverage Ratio), and contingent funding runway (owner: Risk Reporting). – Escalation triggers: predefine metrics that require escalation (e.g., net DV01 > X, LCR Y days) and who must be notified. – Approval gates: any hedge instrument above defined size must pass legal, collateral, accounting (hedge accounting), and limit-check workflows before execution. – Audit trail: retain model inputs, approval memos, trade confirmations, and post‑trade P&L attribution for at least regulatory retention period. Key metrics to monitor (minimum daily during stress) – Net DV01 by tenor bucket (DV01: dollar value of a one basis point move in rates). – Curve convexity exposures (measures how DV01 changes for larger moves). – Liquidity Coverage Ratio (LCR) and High‑Quality Liquid Asset (HQLA) composition. – Contingent Funding Runway (days until cash exhaustion under prescribed scenarios). – Concentration of funding sources and deposit decay rates. Simple worked hedge-sizing example (continuing prior numbers) Assumptions (from prior example): – Net DV01 = $220,000 per 1 bp. – Hedging target: reduce net DV01 to $50,000 per 1 bp (risk appetite). Required DV01 to hedge = 220k − 50k = 170k per 1 bp. Suppose an available 5‑year interest rate swap with DV01 ≈ $4,000 per $1m notional per 1 bp (note: DV01 per notional depends on tenor and market convention — compute or get from risk system). Steps: 1) Compute DV01 per $1m notional for the chosen instrument using market PV01 or vendor analytics (example here uses $4,000 per $1m per 1 bp). 2) Required notional = required DV01 / DV01_per_$1m = 170,000 / 4,000 = 42.5 million. 3) Round and check: trade a notional of $42.5m (or nearest execution lot), then re-run net DV01 and stress P&L to confirm target achieved. 4) Check secondary impacts: mark‑to‑market initial cost, collateral posting, basis and curve risk, and accounting (hedge designation if needed). Practical trade‑execution and control checklist – Pre‑trade: confirm limit availability, legal authority, counterparty credit, margin requirements, and capital/IFRS/GAAP accounting implications. – Trade: route via approved trading desk, capture trade ticket with timestamp and trader ID. – Post‑trade: affirmation, confirmation, settlement instructions, collateral calls, accounting entries, hedge effectiveness testing schedule. – Post‑implementation review: within 1 week and 1 month, compare realized sensitivities and P&L vs. model projections; document lessons. Communication and governance script for briefings (2–5 minute executive summary) – Situation: concise statement of what moved (e.g., “Net DV01 rose to $220k per bp after rapid front‑end steepening; projected P&L impact of a 200 bp shock is ~$44m”). – Actions taken: immediate hedges, liquidity checks, management notifications. – Risk posture: remaining exposures, contingency runway in days, and any limit breaches. – Ask: approvals needed, budget for hedging, or board notification request. Common pitfalls
Common pitfalls
– Weak scenario design. Scenarios that are too narrow (e.g., only parallel rate shifts) miss concentrated risks such as curve twists, basis moves, or credit spread decompression. Mitigation: include at least three families of scenarios—parallel, steepener/flatteners, and non‑parallel (twists and basis)—and add reverse‑stress cases that combine rates and liquidity shocks.
– Data quality and timing gaps. Missing or stale market data causes mis‑measured sensitivities. Mitigation: maintain automated feeds for yields, spreads, volatilities and position life‑of‑book; implement simple reconciliation rules (e.g., daily P&L vs. model P&L tolerance of X bps or Y dollars) and exception alerts
– Overreliance on hedges. Hedging instruments (swaps, FRAs, futures, options) reduce exposures but introduce counterparty, basis, and operational risk. Mitigation: require hedge documentation (objective, hedge ratio, effectiveness test), counterparty limits, and unwind scenarios. Stress the residual (unhedged) exposure and simulate hedge breakdowns (e.g., counterparty default or basis widening).
– Model risk and validation gaps. Incorrect valuation or sensitivity models understate risk. Mitigation: independent model validation, backtests (model P&L vs. realized P&L), parameter sensitivity tables, and conservative model assumptions for stress runs.
– Siloed decision‑making. Treasury, risk, finance, and business lines working in isolation produce misaligned hedges or ineffective approvals. Mitigation: clear ALCO escalation paths, standing agenda items for exceptions, and shared dashboards with reconciled numbers.
– Inadequate contingency plans. Plans that lack triggers, responsibilities, and funding lines are unusable in fast markets. Mitigation: publish a documented contingency funding plan with clear triggers (e.g., days of runoff, rises in funding spreads), assigned owners, and pre‑approved fallback funding sources.
– Talent and capacity shortfalls. ALM (asset‑liability management) needs quantitative skills and market experience. Mitigation: hire/train for rate‑risk modeling, create redundancy for key roles, and codify procedures to avoid key‑person dependence.
Practical ALCO and ALM checklist (operational steps)
1. Define governance and remit. Document ALCO charter, member list, vote rules, meeting cadence, and escalation thresholds (e.g., any EVE shock > X% must go to the board).
2. Inventory positions and exposures. Produce a life‑of‑book position file: nominal, cash flows, contractual maturity, repricing dates, and market values. Automate daily or intraday feeds where possible.
3. Compute core metrics each cycle:
– Duration (modified) of assets and liabilities. Definition: percentage change in value for a small parallel yield change. See sources.
– Duration gap: DG = DA – (L/A) * DL. Use A = total assets, L = total liabilities.
– EVE shock: ΔE