PART II INTERNAL TRANSFER PRICING, ACCOUNTING AND AUDITING

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1 Contents Preface Acknowledgments About the author PART I INTRODUCTION 1 1 The History of ALM The history of the banking industry from antiquity to the Middle Ages The modern banking industry and the history of ALM The history of the insurance industry and ALM The history of other businesses and ALM 9 2 What is Asset and Liability Management Today? ALM and the banking industry Other general ALM questions 14 PART II INTERNAL TRANSFER PRICING, ACCOUNTING AND AUDITING 17 3 Balance Sheet Presentation General balance sheet presentation A/L manager s balance sheet presentation Banking Book and Insurance Book Income statement and statement of cash flows 25 COPYRIGHTED MATERIAL 4 Accrued Accounting for Interest Rate Instruments Versus Marked-to-Market Accounting General principles Accrued accounting examples 30 5 IFRS and IAS Accounting IFRS, international organizations and rule presentation IAS Financial disclosures 48 xiii xvii xix

2 viii Handbook of Asset and Liability Management 5.4 IFRS and insurance Other IFRS specificities Impact of IFRS on ALM and criticism of IFRS 56 6 Economic Accounting : Fair Value and Full Fair Value 59 7 Internal Transfer Pricing or Fund Transfer Pricing (FTP) Principles Advanced transfer pricings including credit risk and expected return on economic capital The inclusion of implicit options inclusion in the contract by contract FTP rules and commercial department arbitrage opportunity FTP rules based on the stock and based on the flows Examples of FTP rules Perequations 77 8 ALM as a Profit Centre One profit centre for one financial risk 81 9 Optimal Organization of an ALM Team The usual ALM organization The objectives of ALM ALCO: the ALM committee The different ALM teams 93 PART III BALANCE SHEET ITEMS AND PRODUCTS MODELLING Behavioural Modelling Principles The constitution of databases Event driven modelling Modelling the strategy of the company Expert advice Model backtesting Deposits and Savings Deposits, monetary aggregates, money supply and macroeconomics Demand deposit accounts Saving accounts: regulated and non-regulated savings versus super-savings Demand deposits models in the literature Deposit modelling: the solution through an approach based on customer behaviour modelling Deposit modelling through a customer behaviour modelling based approach: representation in risk indicators and FTP 132

3 Contents ix 12 Loans Different types of loan Different definitions and formulae Prepayments The origins of the prepayment phenomenon The constitution of the database for prepayment modelling Different models: historical database-based approaches and MBS-based approaches Prepayment scoring Prepayment monitoring Other Examples of Products Needing Behavioural Modelling Pipeline risk Margin delay effects such as whistle effects Other volume effects options Examples of Products Partially Correlated with Financial Markets Presence of correlation between the cash flows and financial markets: examples of credit card Costs and commissions correlation with financial markets Examples of embedded options New Production Modelling New contract production Commission and cost modelling Perequation modelling Future strategies modelling Insurance Products Unit of account contracts Mutual funds Hedging Instruments Derivatives Bond strategies Mortgage Backed Securities 198 PART IV RISK MANAGEMENT FOR ASSET AND LIABILITY MANAGERS Financial Risks Liquidity risk Credit risk Interest rate risk Inflation risk 259

4 x Handbook of Asset and Liability Management 19.5 Currency risk Corporate stock market risk Real estate risk/property risk Other financial risks Non-Financial Risks Operational risks Model risks Business risk Risk correlations Accounting risk : the risk representation depends on the accounting scheme! 283 PART V TOOLS FOR ASSET AND LIABILITY MANAGERS Simulation Tools for Interest Rates and Other Financial Indexes Stochastic calculation Equity market simulation Interest rate simulation Generic models for joint simulation of inflation, stock index, interest rates, real estate, liquidity and credit spreads Market simulations including risk premiums Delta Equivalent Computation Principles Delta, penta, correla and courba equivalents or Adam equivalents Delta equivalent associated break-even point Examples of delta equivalent computation Hedging error and gamma equivalent Technical Tools Useful in ALM Risk measures Optimization methods Common statistical tools in ALM Other statistical tools and common ALM functions 355 PART VI ECONOMIC VALUE AND NEW RISK INDICATORS ASSOCIATED WITH THE BASEL II AND SOLVENCY II REGULATORY PERSPECTIVE Basel II Regulation and Solvency II Common regulatory risk constraints Basel II: normalized regulatory constraints Solvency II 378

5 Contents xi 25 Links Between ALM and Financial Analysis Performance indicators in the company Shareholder s equity value, economic value and risk premiums Capital allocation/attribution and capital consumption Company valuation and cost of capital with positive tax rate Merton s model Financial analysis and ALM implications Towards Economic Capital Indicators Economic capital and its implications Economic capital computation main hypotheses ALM stress testing Credit risk economic capital computation Economic capital in ALM IFRS and regulation implications for ALM New indicators for the economic value approach 435 PART VII OPTIMAL RETURN STRATEGIES Risk Perfect Hedging Using the Delta Equivalent Technique Micro hedging strategies with structured products Delta hedging strategies Example of a bank balance sheet with demand deposits Limits Policy Economic capital limit Setting economic capital limits Gap limit Income sensitivity limit Income Smoothing Strategies Important preliminary comment about income smoothing and fraud Examples of income smoothing Example of a cumulative AFS bonds income smoothing strategy ALM and Hawks martingale Economic Value Management: The A/L Manager s Optimization Programme Under Economic Capital Constraints and Accounting Constraints Point of view of traditional A/L managers and criticism of the models Economic value management Economic value optimization using grid methodology 470

6 xii Handbook of Asset and Liability Management 31 Application to Banking Book Activities Deposit accounts: valuation and hedging in an economic capital approach using the grid methodology Application to Stock Market Book Application to Credit Risk Book Prepayment risk optimal hedging strategies Application to a global Banking Book including business and model risk Direct demand deposit income smoothing through a simple example Economic Value Management in Insurance Companies and in Capital Book Management Economic value management in insurance companies Application to economic Capital Book management 492 PART VIII CONCLUSIONS ON THE ALM OF TOMORROW Conclusions on the Future of ALM ALM diversity ALM benchmarking Conclusions on ALM and models 500 PART IX ANNEXES Statistical Advanced Tools Extreme points Copulas The Basis of Interest Rate Modelling Yield curve reconstitution Yield curve stochastic interest rate models 521 Bibliography 533 Index 541