Useful Resources
Asset & Liability Management
Asset/Liability management is a vital part of Enterprise Risk Management for financial Institutions.
Asset/Liability Management (ALM) is basically a hedging response to the risk in financial intermediation. As a discipline, it has been around since the early 1970s. At the beginning it started out in the from of a simple gap model which analyzes risk in terms of cash inflows and outflows and the gaps or mismatches in these cash flows. Later on, the cash flow gap models gave way to duration gap models which look more at the attribute of cash flows rather than the cash flows themselves. Further advances are taking place in the ALM area.
The relatively rapid progress in the ALM field has been and will be propelled by many driving forces. Among them are:
- The recent phenomenal growth in the capital markets. This growth is fueling the development of new hedging instrument and derivative products with increased hedging effectiveness. At the same time, the same growth is also infusing enough liquidity in these products so as to make them useful and efficient.
- The advancement in the theory and technology of risk analysis, which in turn is advancing the state of the art in the ALM field. The most notable breakthrough is the parametric approach to risk evaluation (i.e. total return, duration, and convexity). By using these and even newer techniques, ALM can be simplified and at the same time expanded to include many capital market instruments.
- The education of financial intermediaries in the necessity as well as in the implementation of ALM. Customer education has advanced ALM more than any other endeavor. It will continue to be the most essential requirement of capital markets in the 1990s. Read more
July 20, 2008 | Filed Under Banking & Finance | Leave a Comment
Capital Account Liberalization, Currency Float, and Twin Crises
After the collapse of the Bretton Woods system in early 1970s, a new breed of financial crisis emerged. Three quarters of the IMF’s member countries suffered some form of banking crisis between 1980 and 1996, and their study did not include the subsequent Asian financial crisis in 1997. In many of these crises, banking panics in the traditional sense were avoided either by central bank intervention or by explicit or implicit government guarantees. But the advent of financial liberalization in many economies in the 1980s, in which free capital in- and out-flows and the entrance and competition from foreign investors and financial institutions follow in the home country, has often led to “twin” banking and currency crises. A common precursor to these crises was financial liberalization and significant credit expansion and subsequent stock market crashes and banking crises. In emerging markets this is often then accompanied by an exchange rate crisis as governments choose between lowering interest rates to ease the banking crises or raising them to defend the home currency. Finally, a significant fall in output occurs and the economies enter recessions.
The entrance of China to the WTO (World Trade Organization) potentially introduces cheap foreign capital and technology, but large scale and sudden capital flows and foreign speculation significantly increase the likelihood of a twin crisis. The first key question is, when and to what extent should a country open its capital account and financial sector to foreign capital and foreign financial institutions? The prevailing view is that success or failure of this policy hinges on the efficiency of domestic financial institutions, while others have promoted reforming the financial sector as a precondition to liberalizing. This latter view assumes that financial liberalization does not alter the efficiency of domestic financial institutions. But this policy change affects both the supply and price of capital, two important determinants of lending contracts. A model of endogenous financial intermediation demonstrates that an efficient financial sector prior to liberalization is neither necessary nor sufficient for a successful financial liberalization. Read more
July 13, 2008 | Filed Under Banking & Finance, Banking Issues, Capital Markets, Currency Issues, Exchange Rate, Financial Sector | Leave a CommentFinancial Crises
Financial crises often accompany the development of a financial system. Conventional wisdom says that financial crises are bad. Often they are very bad, as they disrupt production and lower social welfare as in the Great Depression in the US. Hoggarth et al. (2002) carefully measure the costs of a wide range of recent financial crises and find that these costs are on average roughly 15-20 percent of GDP. It is these large costs that make policymakers so averse to financial crises.
It is important to point out, however, that financial crises may be welfare improving for an economy. One possible example is the late nineteenth century US, which experienced many crises but at the same time had a high long run growth rate. In fact, Ranciere et al. (2003) report an empirical observation that countries which have experienced occasional crises have grown on average faster than countries without crises. They develop an endogenous growth model and show theoretically that an economy may be able to attain higher growth when firms are encouraged by a limited bailout policy to take more credit risk in the form of currency mismatch, even though the country may experience occasional crises (see Allen and Oura (2004) for a review of the growth and crises literature and Allen and Gale (2004a) who show that crises can be optimal).
In this section, we consider financial crises in China. Given China’s current situation with limited currency mismatches any crisis that occurs is likely to be a classic banking, currency or twin crisis. It is perhaps more likely to be of the damaging type that disrupts the economy and social stability than of the more benign type that aids growth. The desirability of preventing crises thus needs to be taken into account when considering reforms of China’s financial system. First, we examine how China can prevent traditional financial crises, including a banking sector crisis and a stock market or real estate crisis/crash. We then discuss how China should be better prepared for new types of financial crises, such as the “twin crises” (simultaneous foreign exchange and banking/stock market crises) that occurred in many Asian economies in the late 1990s.
