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Home > Capital Markets Best Practice > ALM in Financial Intermediation: The Derivatives Business

Capital Markets Best Practice

ALM in Financial Intermediation: The Derivatives Business

by Krzysztof M. Ostaszewski

This Chapter Covers

  • Asset–liability management (ALM) is often viewed as a methodology for hedging risks—or even of eliminating them—to lock in the spread earned by the business.

  • But ALM is not that. Risks in financial intermediation cannot be eliminated; they are an intrinsic part of the business of banks and insurance companies.

  • The worlds of traditional banking and insurance and derivatives markets seem very different but they are merely different expressions of the same business process.

  • In reality, financial intermediation is conceptually equivalent to dealing in derivatives.

  • The bar for ALM must be raised to that of managing a complex portfolio of derivative securities, as that is the underlying nature of the business.

Introduction

The headlines about the credit crisis of 2008 and the subsequent downturn in the global economy often name the exploding trade in derivative securities as the villain in this economic calamity. This attribution of the cause of the crisis is related to the perception that derivatives are somehow new, mysterious, and incomprehensible to the clients of banks, insurance firms, and other financial intermediaries. I consider this perception not only incorrect, I view it as distorting. By association, major dealers in derivatives are also viewed as villains, and are subject to increased scrutiny. In this chapter I propose that this view is misguided, as the growth of derivative instruments represents merely a new form of traditional financial intermediation. Although the investment bankers might be villains in their own right, they earned that distinction the old-fashioned way, not through the use of new financial technologies.

Derivative securities are not villains, they are tools.

In other words, I claim here that the wave of financial innovation we have experienced over the last three decades—with the vast expansion of new derivative instruments, such as futures, options, and swaps—is essentially not a new reality, but rather that this new technology is just a new expression of the same reality that has always existed.

When I want to challenge my students to have a more general perspective on financial issues, I ask them: “How was this done in the year 1000?” I propose that it is quite helpful to pose that challenge when facing a decision on financial matters. For example: How was executive compensation handled in the year 1000? Obviously, we have developed a more sophisticated theoretical base than that existing a millennium ago. With the contribution to understanding of the agency problem by Becker and Stigler (1974) and Shapiro and Stiglitz (1984), and see also Myerson (2011), we have understood that dynamic moral-hazard problems with limited liability, of which the executive compensation problem is the most significant manifestation, are efficiently solved by promising large end-of-career rewards for agents who prove good performance. For example, an efficient solution to moral hazard in banking involves long-term promises of large rewards at career-end for successful bankers. Interestingly enough, the medieval system of transferring the business from master to apprentice was very similar. The reward came in the form of ownership of the business, and it came only after many years of service proving good long-term performance. We now have new ways of expressing this idea, and new technologies, but the idea remains basically the same.

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Further reading

Books:

  • Delbaen, Freddy, and Walter Schachermayer. The Mathematics of Arbitrage. Berlin: Springer, 2006.
  • Fabozzi, Frank J., and Franco Modigliani. Mortgage and Mortgage-Backed Securities Markets. Boston, MA: Harvard Business School Press, 1992.
  • Hull, John C. Options, Futures, and Other Derivatives. 8th ed. Boston, MA: Prentice Hall, 2012.
  • Ostaszewski, Krzysztof M. Asset–Liability Integration. Society of Actuaries (SOA) monograph M-FI02-1. Schaumberg, IL: SOA, 2002. Online at: tinyurl.com/7lfz89k
  • Ostaszewski, Krzysztof M. “Modigliani, Miller, and Mortgages.” In Housing in Retirement. Society of Actuaries (SOA) monograph M-FI09. Schaumberg, IL: SOA, 2009. Online at: tinyurl.com/7ebt5ww [PDF].

Articles:

  • Becker, Gary S., and George J. Stigler. “Law enforcement, malfeasance, and compensation of enforcers.” Journal of Legal Studies 3:1 (January 1974): 1–18. Online at: www.jstor.org/stable/724119
  • Haubrich, Joseph G. “Derivative mechanics: The CMO.” Economic Commentary (Federal Reserve Bank of Cleveland), Issue Q1 (September 1, 1995): 13–19. Online at: tinyurl.com/7pv68ot [PDF].
  • Miller, Merton H., and Franco Modigliani. “Dividend policy, growth, and the valuation of shares.” Journal of Business 34:4 (October 1961): 411–433. Online at: www.jstor.org/stable/2351143
  • Modigliani, Franco, and Merton. H. Miller. “The cost of capital, corporation finance and the theory of investment.” American Economic Review 48:3 (June 1958): 261–297. Online at: www.jstor.org/stable/1809766
  • Myerson, Roger B. “A model of moral-hazard credit cycles.” Working paper. March 2010, revised September 2012. Online at: tinyurl.com/7t43lw2 [PDF].
  • Ostaszewski, Krzysztof. “Is life insurance a human capital derivatives business?” Journal of Insurance Issues 26:1 (2003): 1–14. Online at: www.insuranceissues.org/PDFs/261O.pdf
  • Shapiro, Carl, and Joseph E. Stiglitz. “Equilibrium unemployment as a worker disciplinary device.” American Economic Review 74:3 (June 1984): 433–444. Online at: www.jstor.org/stable/1804018
  • Stiglitz, Joseph E. “A re-examination of the Modigliani–Miller theorem.” American Economic Review 59:5 (December 1969): 784–793. Online at: www.jstor.org/stable/1810676
  • Stiglitz, Joseph E. “On the irrelevance of corporate financial policy.” American Economic Review 64:6 (December 1974): 851–866. Online at: www.jstor.org/stable/1815238

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