Trade Governance
All asset managers should have a trade policy document that clearly and comprehensively... Read More
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.
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:
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,
$$
\Delta A = \Delta L + \Delta E $$
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:
Some of the ways management and regulators attempt to achieve low volatility of shareholder capital value include:
Question
The liabilities of a bank can best be described as all but which of the following?
- Contractual.
- Long-term.
- 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