Treasury, Asset–Liability and Liquidity Management

Introduction

A bank transforms short-term, liquid liabilities—especially deposits—into longer-term, less liquid assets such as loans and securities. This transformation supports economic activity but creates interest-rate, funding, liquidity and foreign-exchange (FX) risk. Treasury and asset–liability management (ALM) coordinate the bank’s balance sheet, funding, liquidity reserves, market hedges and internal pricing so that these risks remain within approved limits.

ALM has two related perspectives. The earnings perspective examines how changing rates affect near-term net interest income (NII). The economic-value perspective estimates how rates affect the present value of assets, liabilities and equity. Liquidity management asks whether obligations can be met when due without unacceptable loss, while FX management controls losses caused by exchange-rate movements.

These activities are constrained by regulation, accounting rules, market conditions, customer behaviour and the bank’s risk appetite. Sound ALM therefore combines quantitative models with governance, judgement and stress testing.

Learning Objectives

After studying this chapter, students should be able to:

1. calculate maturity and repricing gaps;
2. estimate NII sensitivity using appropriately timed cash-flow assumptions;
3. apply duration and duration-gap analysis to economic value;
4. explain and apply matched-maturity funds-transfer pricing;
5. calculate liquidity coverage and interpret funding indicators;
6. design liquidity, interest-rate and FX stress tests;
7. measure net open FX positions; and
8. calculate and evaluate futures-based hedges.

1. The Treasury and ALM Function

Treasury typically manages wholesale funding, liquid assets, market transactions, collateral, foreign currency and dealings with the central bank. The asset–liability committee (ALCO) provides senior management oversight. It approves or recommends policies on funding mix, deposit pricing, liquidity buffers, interest-rate positioning and hedging.

A simplified ALM process is shown below.

Figure: ALM is a continuing cycle of balance-sheet measurement, management action and monitoring.

ALM should not be treated as a treasury profit centre operating independently of the bank. A hedge that protects treasury but creates unsuitable customer pricing, accounting volatility or excessive counterparty exposure may not improve the bank’s overall position.

2. Maturity-Gap Analysis

A maturity gap compares the average contractual maturities of assets and liabilities. For assets, the weighted-average maturity is:

where M_A is average asset maturity in years, M_A,i is the maturity of asset category i, and w_A,i is that category’s proportion of total relevant assets. The weights sum to one. Similarly:

The maturity gap is:

A positive gap indicates that assets contractually mature later than liabilities. The bank may therefore need to refinance liabilities before recovering cash from assets. However, contractual maturity can be misleading. Demand deposits have no contractual maturity but may be behaviourally stable, while mortgage customers may repay early. Maturity gap also ignores coupons, repricing dates, embedded options and differences in present-value sensitivity. It is therefore a preliminary indicator rather than a complete risk measure.

3. Repricing-Gap Analysis and Net Interest Income

3.1 Repricing buckets

A rate-sensitive asset (RSA) or liability (RSL) is one whose interest rate resets or whose principal matures within a specified time bucket. For bucket k:

The cumulative gap through bucket K is:

A positive gap usually means that more assets than liabilities reprice during the period. Under a uniform increase in rates, NII would generally rise; a negative gap would generally reduce NII. This interpretation assumes comparable rate movements, pass-through and timing.

3.2 The simple static estimate

If all positions are assumed to reprice immediately, by the same annualized rate change, and that change remains in force throughout a horizon of H years, the special-case estimate is:

Here, ΔNII is the change in interest income minus the change in interest expense in currency units, GAP is the currency amount of RSA minus RSL, and Δr is the annual rate change in decimal form. This formula must not be used as though all instruments resetting anywhere within a one-year bucket earn the new rate for a full year.

3.3 Time-weighted repricing

Suppose instrument j next resets at time t_j within a horizon H, after which the shocked rate remains applicable. For annual rates and simple accrual, define:

where W_j is the number of years during the horizon for which the changed rate applies. A more precise first-order estimate is:

A_j and L_j are asset and liability balances in currency units; Δr_A,j and Δr_L,j are annualized changes in their effective rates. The result is in currency units because balance × annual rate × years gives interest.

This expression assumes balances remain constant after reset, no intervening cash flow changes occur, and rates reset once to the specified shocked level. Detailed earnings simulations relax these assumptions.

Worked Example: Timing Within a One-Year Bucket

A bank has a $60 million loan portfolio resetting in three months and $45 million of deposits resetting in six months. Both rates rise by 1 percentage point, and the horizon is one year.

The unweighted calculation ($60m-$45m)×0.01=$150,000 would be valid only under an immediate, full-year repricing assumption. The difference demonstrates why broad annual buckets can conceal timing risk.

3.4 Limitations of gap analysis

Gap analysis may overlook:

• basis risk: asset and liability reference rates move differently;
• option risk: borrowers prepay or depositors withdraw;
• administered-rate risk: management does not pass market changes fully to customers;
• yield-curve risk: short and long rates move by different amounts;
• new-business risk: future volumes and margins differ from assumptions; and
• non-linearity: customer behaviour changes sharply in stressed conditions.

Banks therefore supplement gaps with NII simulation and economic-value measures.

4. Duration and Economic-Value Risk

4.1 Macaulay and modified duration

For a fixed-income instrument with cash flow CF_t at time t, yield per period y, and price P, Macaulay duration is:

The duration is measured in periods corresponding to the yield convention. Modified duration is:

This version assumes annual compounding. For m compounding periods per year, the denominator is 1+y/m. For a small, parallel yield change:

The approximation is first-order: it becomes less accurate for large changes, instruments with embedded options or non-parallel yield-curve movements. Convexity or full revaluation should then be used.

4.2 Duration gap

Let A be the market value of assets, L the market value of liabilities, and E=A-L the economic value of equity. With asset and liability modified durations D_A and D_L, the duration gap is:

Under a small parallel change in relevant yields, assuming the same change applies to both sides:

Worked Example: Economic Value Sensitivity

A bank has assets of $500 million with modified duration 3.2 and liabilities of $460 million with modified duration 1.4.

For a 50-basis-point increase, Δy=0.005:

Thus, the bank’s economic equity is estimated to decline by $4.78 million. This does not imply that accounting equity immediately falls by that amount: accounting classification and hedge-accounting rules affect reported profit and equity.

5. Funds-Transfer Pricing

Funds-transfer pricing (FTP) allocates funding and interest-rate costs between business units and a central treasury. Without FTP, a lending unit might appear profitable merely because it receives funding at the bank’s average deposit cost, even though the loan creates long-term liquidity and rate risk.

A simplified matched-maturity asset FTP rate is:

R_reference is the rate from a reference curve matching the asset’s repricing or cash-flow profile, LP is the liquidity or term-funding premium, and OA represents approved adjustments such as option or basis costs. All components must use the same annual rate convention.

The lending unit’s pre-credit-cost customer margin is:

For stable deposits, treasury may pay the deposit unit an FTP credit reflecting the value of funding supplied:

Worked Example: FTP Attribution

A five-year loan yields 6.80%. Its matched reference rate is 4.10%, the liquidity premium is 0.45%, and approved option and basis adjustments total 0.20%.

The 2.05% is not final profit: expected credit losses, capital charges and operating expenses must still be considered.

Good FTP systems use transaction-level cash flows, behavioural maturities for non-maturity deposits, transparent governance and regular curve updates. Poorly designed FTP can encourage long-term lending funded by unstable short-term liabilities or can unfairly distort business-unit performance.

6. Liquidity and Funding Risk

Funding liquidity risk is the danger that a bank cannot meet obligations when due without unacceptable loss. Market liquidity risk is the danger that an asset cannot be sold quickly at or near its carrying economic value. The two reinforce each other: forced sales by a funding-stressed bank can depress market prices and generate further margin calls.

6.1 Liquidity Coverage Ratio

Under the Basel liquidity framework, the Liquidity Coverage Ratio (LCR) is:

HQLA means high-quality liquid assets. Subject to jurisdictional implementation and qualifying conditions, Level 1 assets generally receive no regulatory haircut, while Level 2 assets receive haircuts and are subject to composition caps.

The adjusted stock is conceptually:

The cap adjustments are the deductions required, after applying the prescribed unwind methodology, to enforce the overall Level 2 cap and the Level 2B sub-cap. They should not be replaced by an arbitrary haircut.

Total net cash outflows are:

The inflow cap ensures that net cash outflows are at least 25% of expected outflows. Regulatory outflow and inflow amounts are determined by applying prescribed rates to relevant balances; they are not simply management forecasts. A minimum LCR of 100% means adjusted HQLA is at least equal to stressed net outflows, although regulators may permit temporary buffer use during genuine stress.

Worked Example: LCR

A bank holds $80 million of eligible Level 1 assets and $30 million of eligible Level 2A assets subject to a 15% haircut. The resulting Level 2 amount remains within applicable caps. Expected 30-day outflows are $120 million and eligible inflows are $70 million.

6.2 Structural funding and operational liquidity

The Net Stable Funding Ratio (NSFR) addresses a one-year horizon:

The regulatory target is generally at least 100%. Available and required stable funding are calculated using prescribed categories and factors.

Operational liquidity management also uses contractual maturity ladders, behavioural cash-flow forecasts, intraday liquidity measures, collateral availability and the survival horizon—the time before cumulative stressed outflows exceed available liquidity resources.

A contingency funding plan should identify early-warning indicators, escalation authority, communication procedures, collateral mobilization, central-bank facilities and feasible funding actions. It must avoid assuming that every bank can sell the same asset or obtain unsecured funding during a system-wide crisis.

7. Stress Testing

Stress testing evaluates severe but plausible conditions rather than merely extrapolating historical averages. A structured test includes:

1. a clearly specified scenario and horizon;
2. changes in rates, deposit runoff, market values, collateral and FX rates;
3. behavioural assumptions supported by evidence;
4. counterbalancing actions subject to time and market constraints;
5. effects on NII, economic value, liquidity and capital; and
6. escalation thresholds and management responses.

Scenarios may be idiosyncratic, such as a credit-rating downgrade; market-wide, such as closure of wholesale funding markets; or combined. Reverse stress testing begins with failure—such as breaching a minimum liquidity level—and identifies scenarios capable of producing it.

Management actions should not be double-counted. For example, an asset pledged to obtain central-bank funding cannot simultaneously be assumed sold for cash. Deposit runoff assumptions should distinguish insured retail, uninsured commercial, operational and brokered deposits.

8. Foreign-Exchange Exposure

For currency c, a simplified net open position is:

All terms must be expressed in the same foreign-currency units before conversion into the reporting currency. A positive result is a long position; a negative result is short. Option delta is only a first-order measure and should be supplemented by gamma and volatility analysis when options are material.

Worked Example: FX Position

A bank has €75 million of euro assets, €62 million of euro liabilities, forward purchases of €8 million, forward sales of €16 million and a net positive option delta equivalent of €1 million.

At an exchange rate of $1.10 per euro, the position is $6.6 million long. A 3% euro depreciation produces an approximate first-order loss of:

The estimate assumes a linear exposure and no offsetting basis, funding or option-convexity effects.

9. Hedging Interest-Rate and FX Risk

Banks can alter exposures using balance-sheet actions or derivatives. Common instruments include interest-rate swaps, futures, forward-rate agreements, FX forwards, cross-currency swaps and options.

A pay-fixed, receive-floating interest-rate swap can reduce exposure where liabilities reprice faster than assets. Conversely, receiving fixed may offset fixed-rate liability exposure. The correct direction depends on the bank’s existing sensitivity, not on a general rule that one swap direction is always protective.

9.1 Futures hedge ratio

A robust sensitivity-based futures hedge uses value change per basis point (DV01):

N^* is the signed number of contracts. DV01_exposure is the exposure’s currency-value change for a one-basis-point yield decline under the institution’s sign convention, and DV01_futures is the corresponding amount per contract. A negative result indicates a short futures position when positive-duration assets must be protected against rising yields. In practice, futures DV01 should reflect the deliverable security, conversion factor and expected cheapest-to-deliver instrument.

A simplified duration form, applicable when the exposure and futures underlying respond to the same parallel yield shift, is:

where D_P and D_F are modified durations, V_P is portfolio value, and V_F is the value represented by one futures contract. Basis and delivery-option risks can make this simplified form inaccurate.

Worked Example: Futures Hedge

A fixed-income portfolio has a DV01 of $34,000. An interest-rate futures contract has an estimated DV01 of $68 per contract. The portfolio loses value when yields rise; a short futures position gains under that scenario.

The bank should therefore sell 500 contracts. If the calculated result were 500.4, the bank would have to choose an integer number and accept a small residual exposure. Hedge effectiveness should subsequently be monitored because duration, cheapest-to-deliver status and basis relationships change.

9.2 Hedge limitations

Hedges introduce counterparty, basis, collateral, rollover and accounting risks. A derivative that offsets economic exposure may create profit volatility if hedge-accounting requirements are not met. Options provide asymmetric protection but require a premium. FX forwards lock an exchange rate but can create liquidity needs through collateral or settlement requirements.

10. Illustrative Integrated Case: Meridian Bank

Background

Meridian Bank is a fictional medium-sized commercial bank. Rapid fixed-rate lending has been funded partly with rate-sensitive corporate deposits. Management reports a regulatory LCR above 100%, but recent market volatility and deposit concentration concern ALCO.

Problem

The bank must assess one-year NII sensitivity, economic-value risk, stressed liquidity and a long FX position. It must then select proportionate management actions.

Analysis

Within a one-year horizon, $220 million of assets reset after three months and $100 million after nine months. Liabilities of $250 million reset after 1.2 months, or 0.10 year, and $60 million after six months. Assume all rates rise by 1.5 percentage points and remain at the shocked level after reset.

An immediate full-year gap calculation would have indicated a gain of ($320m-$310m)×0.015=$0.150m. That result is inappropriate here because liabilities reset much earlier than assets.

Meridian has assets of $1.0 billion, liabilities of $920 million, asset duration of 2.6 and liability duration of 1.1:

Its approximate economic-equity DV01 is:

If a suitable futures contract has a DV01 of $79.40, a first-order hedge requires:

The indicated hedge is a short position because the bank’s positive duration gap exposes it to losses when rates rise.

Meridian has $150 million of adjusted HQLA, expected outflows of $230 million and eligible inflows of $100 million:

Under a combined stress, HQLA falls by 8% to $138 million, outflows rise to $260 million, and inflows fall to $70 million:

The bank also has a $12 million reporting-currency-equivalent long FX position.

Approach and Solution

ALCO decides to:

• execute part of the indicated futures hedge in stages, subject to basis and accounting analysis;
• increase term funding and reprice selected loans using revised FTP charges;
• retain additional Level 1 liquid assets and diversify concentrated deposits;
• pre-position unencumbered collateral while testing operational access to facilities;
• sell $9 million equivalent of the exposed foreign currency forward, leaving a controlled $3 million residual position; and
• impose enhanced daily monitoring and escalation triggers.

Outcome

The proposed actions reduce economic-value and FX exposure and improve the stressed liquidity profile. They do not eliminate risk: futures require margin, term funding may be expensive, and a larger liquidity buffer reduces earnings. ALCO therefore evaluates the package against risk appetite rather than attempting to minimize every exposure independently.

Learning Points

The case demonstrates that an apparently positive annual repricing gap and an LCR above 100% can conceal meaningful timing and stress vulnerabilities. Integrated decisions must consider earnings, value, liquidity, capital, collateral and hedge effectiveness simultaneously.

11. Governance, Ethics and Contemporary Practice

The board approves risk appetite and major policies; ALCO oversees implementation; treasury executes within limits; independent risk management challenges assumptions; finance verifies performance and accounting treatment; and internal audit reviews controls. Model validation should cover data quality, assumptions, back-testing, limitations and change control.

Ethical concerns arise when internal pricing is manipulated to shift profit between units or when favourable liquidity assumptions conceal vulnerabilities. Reports should communicate uncertainty rather than presenting model outputs as exact forecasts. Incentives should not reward revenue without charging for liquidity, optionality and risk.

Modern ALM platforms integrate transaction data, market curves, customer behaviour and collateral positions. Machine learning may improve deposit-decay, prepayment and cash-flow forecasts, but unstable relationships, biased data and limited explainability can be dangerous during structural breaks. Human oversight and stress overlays remain necessary.

Contemporary challenges include rapid digital deposit withdrawals, social-media-amplified confidence shocks, greater collateral demands, benchmark transitions, cyber disruption and climate-related market or funding stress. These developments increase the importance of intraday data, scenario analysis and executable contingency plans.

Chapter Summary

Treasury and ALM coordinate funding, liquidity, interest-rate and FX exposures across the bank. Maturity gaps provide an initial view of refinancing structure, while repricing gaps estimate earnings sensitivity. Repricing calculations must recognize when instruments reset; a full-year gap estimate requires the strong assumption of immediate and sustained repricing. Duration gap estimates changes in economic equity under small, approximately parallel yield shifts.

Matched-maturity FTP allocates funding, liquidity and optionality costs to the activities that create them. Liquidity management combines HQLA, regulatory ratios, cash-flow ladders, survival horizons and contingency plans. Stress tests reveal vulnerabilities that normal-condition ratios may conceal. FX positions include spot, forward and option exposures in consistent units. Futures and other derivatives can reduce risk, but hedges remain exposed to basis, collateral, counterparty and accounting effects. Effective ALM ultimately depends on integrated analysis, transparent governance and credible management actions.

Key Terms

Asset–liability committee (ALCO): Senior management committee overseeing balance-sheet and liquidity risk.

Asset–liability management (ALM): Coordinated management of balance-sheet risks and returns.

Basis risk: Risk that related interest rates or prices move by different amounts.

Contingency funding plan: Prearranged framework for responding to liquidity stress.

Duration gap: Difference between asset duration and liability duration adjusted for the liability-to-asset ratio.

DV01: Approximate currency-value change resulting from a one-basis-point yield movement.

Economic value of equity: Present value of assets minus the present value of liabilities.

Funds-transfer pricing: Internal mechanism allocating funding and interest-rate costs or credits.

High-quality liquid assets: Eligible assets expected to remain liquid under stress.

Liquidity Coverage Ratio: Adjusted HQLA divided by 30-day stressed net cash outflows.

Market liquidity risk: Risk that an asset cannot be sold promptly without a material discount.

Maturity gap: Difference between weighted-average asset and liability maturities.

Net open position: Net exposure to changes in a particular foreign-currency exchange rate.

Net Stable Funding Ratio: Available stable funding divided by required stable funding.

Repricing gap: Rate-sensitive assets minus rate-sensitive liabilities within a time bucket.

Survival horizon: Period for which available liquidity can cover cumulative stressed outflows.

Stress testing: Evaluation of financial resilience under severe but plausible conditions.

Yield-curve risk: Risk arising from non-parallel changes in rates across maturities.

Review Questions

Short Answer Questions

1. Distinguish contractual maturity from repricing maturity.
2. Why can a one-year repricing bucket misstate NII sensitivity?
3. What is the economic purpose of funds-transfer pricing?
4. How does the LCR inflow cap affect net cash outflows?
5. What does a positive foreign-exchange net open position mean?

Long Answer Questions

1. Compare repricing-gap analysis with duration-gap analysis, including their objectives, assumptions and limitations.
2. Explain how a matched-maturity FTP system can influence loan and deposit pricing decisions.
3. Discuss the design of an effective liquidity contingency funding plan.
4. Evaluate the benefits and limitations of derivatives in bank ALM.
5. Explain the governance responsibilities of the board, ALCO, treasury, risk management, finance and internal audit.

Analytical / Application Questions

1. A bank has $90 million of assets resetting after two months and $110 million of liabilities resetting after eight months. Estimate the one-year NII effect of an 80-basis-point increase that persists after each reset.
2. A bank has assets of $750 million, liabilities of $690 million, asset duration of 3.0 and liability duration of 1.6. Calculate the duration gap and estimate the change in economic equity following a 40-basis-point rate increase.
3. Construct an integrated stress scenario involving deposit withdrawals, HQLA price declines, FX depreciation and futures margin calls. Explain how double-counting of liquidity resources should be prevented.

Multiple Choice Questions with Answers

Question 1

A bank has $60 million of assets resetting after three months and $45 million of liabilities resetting after six months. If both rates rise by 1 percentage point and remain at the new level, what is the estimated one-year change in NII?

A. Increase of $150,000

B. Increase of $225,000

C. Increase of $450,000

D. Decrease of $225,000

Correct Answer: B. Increase of $225,000

Question 2

Which assumption is required for the simple estimate ΔNII=GAP×Δr over a one-year horizon?

A. All included balances reprice immediately and the rate change persists for the year

B. Assets reprice only at year-end

C. The yield curve must be inverted

D. All liabilities must be non-interest-bearing

Correct Answer: A. All included balances reprice immediately and the rate change persists for the year

Question 3

A bank has asset duration 3.2, liability duration 1.4, assets of $500 million and liabilities of $460 million. What is its duration gap?

A. 1.288

B. 1.800

C. 1.912

D. 2.520

Correct Answer: C. 1.912

Question 4

A loan yields 6.80%. Its reference FTP rate is 4.10%, liquidity premium is 0.45%, and option adjustment is 0.20%. What is the lending unit's pre-credit-cost asset margin?

A. 1.60%

B. 2.05%

C. 2.25%

D. 2.70%

Correct Answer: B. 2.05%

Question 5

Expected 30-day cash outflows are $120 million and eligible inflows are $100 million. After applying the LCR inflow cap, what are net cash outflows?

A. $20 million

B. $30 million

C. $90 million

D. $120 million

Correct Answer: B. $30 million

Question 6

A bank has adjusted HQLA of $105.5 million and 30-day net cash outflows of $50 million. What is its LCR?

A. 47.4%

B. 105.5%

C. 155.5%

D. 211.0%

Correct Answer: D. 211.0%

Question 7

A bond portfolio has a DV01 of $34,000 and each futures contract has a DV01 of $68. How many contracts are required for a first-order hedge?

A. 200

B. 340

C. 500

D. 2,312

Correct Answer: C. 500

Question 8

A bank has €75 million of euro assets, €62 million of euro liabilities, forward purchases of €8 million, forward sales of €16 million and positive option delta of €1 million. What is its euro net open position?

A. €6 million long

B. €6 million short

C. €14 million long

D. €22 million long

Correct Answer: A. €6 million long

Question 9

Which measure primarily evaluates the sensitivity of the economic value of equity to interest-rate changes?

A. Repricing gap

B. Duration gap

C. Liquidity Coverage Ratio

D. Net Stable Funding Ratio

Correct Answer: B. Duration gap

Question 10

Which action is most likely to invalidate a liquidity stress test through double-counting?

A. Applying different runoff rates to retail and corporate deposits

B. Reducing inflows during market stress

C. Assuming the same security is both sold and pledged for funding

D. Including futures margin calls as cash outflows

Correct Answer: C. Assuming the same security is both sold and pledged for funding