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Home > Financial Risk Management Best Practice > Correcting the Financial Crisis Failures of Asset-Liability Management (ALM) Risk Management

Financial Risk Management Best Practice

Correcting the Financial Crisis Failures of Asset-Liability Management (ALM) Risk Management

by Jerome L. Kreuser

This Chapter Covers

  • ALM risk management has been widely accused of failing to anticipate and manage the financial crisis of 2007 and beyond. It did fail—but it didn’t have to.

  • A risk management framework was available that could have helped to mitigate the impact of the crisis on asset–liability portfolios.

  • We discuss the ALM risk management failure factors spawned by the financial crisis and then outline a framework that corrects or mitigates most of them.

  • We discuss tools that are under development to integrate into the framework to anticipate the next crisis.

  • We provide two examples applied in 2008 and 2009 that mitigated the impact of the crisis.

Introduction

Asset–liability management (ALM) is a term whose meaning has evolved. Its use began in banks and insurance companies and has now extended to most financial institutions and corporations. The term risk management has also evolved. When we use the term “ALM risk management,” we do so in the spirit of Zenios and Ziemba (2007).1 We use the term ALM for managing institutional strategic objectives over a period measured in months and years. A suitable definition, consistent with Zenios and Ziemba (2007), is that:

“ALM is the allocation of financial and real instruments designed and managed to best obtain desired outcomes of measures of institutional strategic objectives.”

The measures apply to future outcomes and therefore are defined on a probability distribution. One example of a measure is value-at-risk (VaR). Examples of strategic objectives include pension funds’ funding ratios and smoothing of contributions; reinsurance firms’ distributions of losses and returns; central banks’ asset safety, liquidity, returns, and ratio of reserves to short-term debt; and commercial banks’ returns, capital ratios, losses, and regulatory risks.2

We consider more than profits and losses or credit and interest rate risk. We consider risks that are aligned to an institution’s strategic objectives and are analyzed together—not, as is often the case, in silos. We take a top-down view, looking at the strategic risks of institutions and not just the volatility of returns.

The causes of the crisis spawned factors that impacted asset–liability portfolios and resulted in risk management failures. The crisis was not caused by one factor alone, and it was not relegated to one geographical location. The crisis was a systemic, worldwide failure. The complex financial system had reached a point of instability and several triggers caused the system to fail, resulting in extreme draw-downs. Most existing risk management systems were incapable of handling the resulting factors individually and especially simultaneously.

In the sections that follow we provide a framework that corrects most of the identified risk management failure factors and summarizes the lessons that have been learned from the financial crisis. We show how the framework was applied in 2008 and 2009 and what the results were. Finally, we summarize and conclude.

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Further reading

Books:

  • Taleb, Nassim Nicholas. The Black Swan: The Impact of the Highly Improbable. 2nd ed. New York: Random House, 2010.
  • Zenios, Stavros A., and William T. Ziemba (eds). Handbook of Asset and Liability Management. Vols 1 and 2. Amsterdam: Elsevier, 2007.
  • Ziemba, William T., and John M. Mulvey (eds). Worldwide Asset and Liability Modeling. Cambridge, UK: Cambridge University Press, 1998.

Articles and Reports:

  • Basel Committee on Banking Supervision. “Principles for sound stress testing practices and supervision.” Bank For International Settlements, Basel, May 2009. Online at: www.bis.org/publ/bcbs155.pdf
  • Bhattacharya, Himadri, Jerome Kreuser, and Sivaprakasam Sivakumar. “A sovereign asset–liability framework with multiple risk factors for external reserves management—Reserve Bank of India.” Paper presented at the conference on “Portfolio and risk management for central banks and sovereign wealth funds” held jointly by the Bank for International Settlements, the European Central Bank, and the World Bank, November 2009.
  • Claessens, Stijn, and Jerome Kreuser. “Strategic investment and risk management for sovereign wealth funds.” In Arjan B. Berkelaar, Joachim Coche, and Ken Nyholm (eds), Central Bank Reserves and Sovereign Wealth Management, Hampshire, UK: Palgrave MacMillan, 2010. Paper first presented at the conference on “Strategic asset allocation for central banks and sovereign wealth managers” held jointly by the Bank for International Settlements, the European Central Bank, and the World Bank, November 2008.
  • Crane, Dwight B. “A stochastic programming model for commercial bank bond portfolio management.” Journal of Financial and Quantitative Analysis 6:3 (1971): 955–976.
  • Lane, Morton, and Jerome Kreuser. “Designing investment strategies for fixed-income portfolios.” In A. V. Fiacco and K. O. Kortanek (eds), Extremal Methods and Systems Analysis, New York: Springer Verlag, 1980.
  • Levin, Carl, and Coburn, Tom. “Wall Street and the financial crisis: Anatomy of a financial collapse.” US Senate Permanent Subcommittee on Investigations, Washington DC, April 2011. Online at: tinyurl.com/6dhewck
  • Merrouche, Ouarda, and Erlend Nier. “What caused the global financial crisis?—Evidence on the drivers of financial imbalances 1999–2007.” IMF Working paper WP/10/265, December 2010. Online at: tinyurl.com/7x9zjzb
  • Sornette, Didier. “Dragon Kings, Black Swans and the Prediction of Crises.” International Journal of Terraspace Science and Engineering 2:1(July 30, 2009): 1-17. Online at: arXiv.org/abs/0907.4290
  • Stulz, René M. “Risk management failures: What are they and when do they happen?” Journal of Applied Corporate Finance 20:4 (2008): 58–67. Online at tinyurl.com/yhdgahn
  • Ziemba, William T. “The stochastic programming approach to asset, liability, and wealth management.” Research Foundation of the Association for Investment Management and Research (AIMR), Charlottesville, VA, 2003.

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