Balance Sheet Management of Banks and Insurers

Banking and insurance companies have perpetual time horizons. Strategically, their goal is to maximize net present value to capital holders; tactically, this may be achieved by liability-driven investing (LDI) over intermediate and shorter horizons.

LDI investing involves first focusing on the liabilities of an organization, making sure they can be met in full. Later, surplus optimization can come into play if permitted in the IPS. Surplus optimization works by first creating a portfolio of low-risk assets meant to satisfy the liabilities, and when a surplus is left, this amount of the portfolio can be used to seek a higher return. If the surplus disappears, the focus shifts back to managing the liabilities.

Balance Sheet Management Considerations

The financial claims against banks and insurers may not always be known with certainty, but they are, at any point in time, measurable. Such measurement may require the use of probabilistic methods to account for such outcomes as:

• The liquidation of bank deposits.
• Insurance policy claims and surrenders. /li>
• Losses on derivatives, guarantees, or forward purchase commitments./li>
• Returns on variable annuities, among other outcomes. /li>

In the case of banks and insurers, the well-defined, contractual nature of the financial claims, along with their measurability, imply that–unlike with other institutions–the underlying investment strategy is mainly liability-driven investing (LDI as earlier defined). We can obtain insight into both investment strategy and regulation of financial institutions by applying a fairly simple economic model. The model's first two equations define the relationship between an institution's assets A, liabilities (claims) L, and residual equity of the institution's shareholders.

$$ A = L + E $$

Similarly,

$$
\Delta A = \Delta L + \Delta E $$

Volatility of Shareholder Capital

The management of shareholder capital volatility is a top concern for the owners of banks and insurers. In the same way that a single stock decays over time, unnecessary volatility does the same. The volatility of shareholder capital can be managed by:

• Decreasing the price volatility of portfolio investments, loans, and derivatives.
• Reducing volatility in claims, deposits, guarantees, and other liabilities.
• Limiting leverage.
• Ensure that asset and liability value changes are positively correlated.

Some of the ways management and regulators attempt to achieve low volatility of shareholder capital value include:

• Sufficient liquidity.
• Diversification of portfolio and other assets.
• High investment quality.
• Transparency.
• Stable funding.
• Duration management.
• Diversification of insurance underwriting risks.
• Monetary limits on guarantees, funding commitments, and insurance claims.

Question

The liabilities of a bank can best be described as all but which of the following?

1. Contractual.
2. Long-term.
3. Measurable.

Solution

The correct answer is B.

The terms of the claim can be long but vary depending on the type. Some claims, such as depository accounts, are short-term in nature.

A and C are incorrect. The claims against banks are contractual and well-defined. They are also measurable, even if some probabilistic accounting methods need to be used. All of these factors point towards the use of LDI.

Portfolio Construction: Learning Module 5: Portfolio Management for Institutional Investors; Los 5(i) Describe considerations affecting the balance sheet management of banks and insurers