Interest rate risk is the risk of an adverse effect on the earnings and liquidity position of a financial institution resulting from changing interest rates. A sound ALM position has a balance sheet structure such that management is able to raise deposit rates in a rising rate environment in a manner that is consistent with rising asset returns so that the net interest income (NII) remains reasonably stable. This can be difficult to accomplish if a long-term asset structure is primarily financed by short-term liabilities, a low capital position or the lack of other risk-reducing offsets.

Liquidity management is the other side of the ALM coin. If the asset returns are not increasing commensurate with market interest rates and the institution cannot afford to raise deposit rates because asset returns are not increasing fast enough, it will be only a matter of time before deposit outflows commence and induce liquidity problems. Ultimately, the funds underlying the deposit outflows will have to be replaced at a higher cost thus adversely affecting the NII and NI. This liquidity situation is usually compounded by strong loan demand. When this happens, lending must be curtailed by raising loan rates, raising credit standards, or both.