The purpose of ALM is to match assets and liabilities to avoid adverse changes to the bank’s profit, firm value, and liquidity. But how do we measure the bank’s profit and firm value?
This leads to two of the most important metrics in ALM: NII and EVE.
NII standards for “net interest income” and is calculated as follows:
NII = interest income from assets – interest expense from liabilities
For commercial banks that engage heavily in lending, NII is the primary component of net income.
EVE stands for “economic value of equity” and is calculated as follows:
EVE = economic value of bank’s assets – economic value of bank’s liabilities
The job of the bank’s treasury department is to manage loan originations (assets) and funding sources (liabilities) so that EVE and NII don’t fall below acceptable thresholds. This is the heart of ALM.
While NII and EVE can both be used to quantify the effects of interest rate risk, they can’t be used to measure liquidity risk. Thus, banks do liquidity stress tests to see how hypothetical scenarios would affect liquidity (and then create contingency plans to deal with such events).
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