The Role of ALM and Treasury in Banking: Risk-Return, Capital Structure, and Balance Sheet Profile

Asset and Liability Management (ALM) plays a crucial role in banking. As the name implies, it is fundamentally about managing the bank's balance sheet. Two functional areas are directly involved in this process: ALM, which has a policy and monitoring role, and Treasury, which takes on execution and reporting responsibilities.

Understanding ALM

ALM is primarily concerned with capital structure, funding/liquidity, and interest rate risk management, shaping the financial profile of the bank's balance sheet. This financial profile is directly influenced by the bank's product-market or business model and its risk appetite or risk-return preferences.

The business model and risk-return preferences are guided by the bank's strategy and shareholders' expectations. This interaction between business model, equity shareholder returns, financial profile, capital structure, and risk-return preferences, forms the foundation of a bank's operation.

Shareholder returns consist of dividends, which reflect past performance, and share value changes, which are a product of future market expectations.

Risk Appetite in Banking

Risk in banking is primarily about volatility around expected outcomes and the potential for absolute loss. Banks, typically low-margin businesses with a pre-tax return on total assets of around 1%, could see their profits wiped out by a loss of 1 for every 100 lent. As a result, even very small potential losses must be carefully assessed, managed, and monitored.

Critical to risk management is the identification of all risks to which a particular business model exposes the bank. It's essential to decide if it's a risk the bank wishes to assume and how much of that risk it's prepared to take on. The responsibility for setting a bank's risk appetite lies with the board, which is supported by internal risk management processes and control systems.

Due to the economic and social significance of banks, regulators establish limits on specific types of risks that a bank may wish to assume when providing a product or service.

Importance of Governance

Governance signifies the management of large business entities, encompassing various dimensions such as economic, social, political, regulatory, and legal. Responsibilities of directors and senior managers are more closely prescribed by codes of practice, regulation, and legislation in modern banking, a trend reflected in governance.

Banks have always been subject to these constraints due to banking regulation, the legal surround of banking products and services, and financial accounting standards. Yet, governance frameworks in banks have been found seriously ineffective in recent years, necessitating a re-emphasis, reinforcement, and public reporting.

The governance framework typically involves the board delegating responsibilities to businesses, who assume responsibility for managing and monitoring risks. The ALCO acts as the first line of defence, providing assurance to the board, followed by the Risk Management Oversight function, and finally internal/external audit. Strong leadership is key to endorsing and demonstrating commitment to the governance structure.

Treasury: Execution in Practice

While ALM is focused on policy, the treasury function is about execution. The short-term nature of much of the wholesale liabilities and all of the liquid assets makes treasury a vital function.

The bank's survival depends on its ability to roll over both sides of the balance sheet continuously. Additionally, capital and senior wholesale funding need to be refinanced and increased regularly to avoid liquidity crises. Both short-term and long-term refinance should be efficient to protect interest earnings, and interest rate mismatch hedging is vital for earnings protection.

Moreover, treasury can also contribute significantly through product improvement and innovation, further enhancing the bank's financial performance.

In conclusion, ALM and Treasury play critical roles in maintaining the financial stability of a bank, managing its risk appetite, and ensuring smooth daily operations. A thorough understanding of these functions is key for any banking professional.