ALM, hedging and early warning system

Nowadays, effectiveness in asset and liability management (ALM) has been increasingly important. Market risk even arises when banks may possibly misapply ALM techniques in order to cope with interest rate risks, currency risks and liquidity risks. Banks could mistakenly measure the gap, forecast the interest rates, project the future income and model the ALM simulation and also ineffectively trade the securities and hedge with derivatives.

Consequently, ALM that is supposed to eliminate interest rate risks, currency risks and liquidity risks could even be failed. Banks may potentially face interest rate and currency losses, a lack of liquidity, insolvency and losses in value of the underlying assets.

However, potential failures in ALM can be early identified by monitoring the fair value of financial assets and derivative instruments, the current exposures of interest rate risk and market risk and the net positions of foreign currency. In New Zealand, this can be seen through the general disclosure statement, which is required by the prudential supervision.

Therefore, one way in which prudential supervision can limit the potential failures in ALM is to early identify a bank’s condition and then involve in managing the failures with capital management.