Risk and Asset Liability Management
Throughout this book we have switched more or less freely in our discussion between traditional investment banks and development institutions. In a development institution (or a small financial institution) the financial activities carried out by the treasury amount to the near totality of all the financial activity of the institution since the remaining ones are fairly basic. In a traditional investment bank the treasury desk is just one of many. As far as risk is concerned we need to introduce the subject with a qualifier as to which type of institution we will be mainly focusing on. Throughout this book we have been focusing on debt (bonds) and loans, and it is the relation between the two that we will be focusing on now: the managing of this relation and the risk involved is defined as asset liability management, as we have mentioned in Section 1.4.
We will begin by discussing leverage and in particular how much of the lending activity is funded by debt; we shall then digress a little with an introduction to hedging and risk neutrality in order to explain what it means when bonds are hedged dynamically or statically. An important section, the core of asset liability management, on the types of funding risks follows; it will be supported by two numerical sections in which we explain these concepts through examples.
A traditional financial institution would face and manage risks (currency, credit, etc.) that in their complexity are beyond our scope. Although throughout the chapter asset liability management is going to be our main focus, in Section 7.3 we will show some examples of simple management tools for credit and other simple market variables.
THE ISSUE OF LEVERAGE
In Section 3.1.2 we touched upon the issue of leverage and the potential havoc it can create in a market. The same way as a lever enables us to lift a great weight with little effort, financial leverage enables us, to put it crudely, to make a lot out of a little. The functioning of a lever, however, abides by the rules of classical mechanics and calculus. The functioning of financial leverage resides instead in the realm of stochastic calculus, meaning that, in order to work we need to accept the possibility of losing a lot out of a little. To be precise, what makes financial leverage dangerous is that, since we cannot physically lose more than everything we have, the loss gets propagated toward someone else.
The simplest example of leverage is the type of mortgage that used to be popular before the financial crisis of 2007 to 2009. Let us imagine that we have $5,000, we borrow $95,000 to purchase a house worth $100,000, and agree with the bank to pay $5,000 a year to service the debt. At the end of one year the price of the house rises to $125,000, we sell it and, once interest payments are taken into account, we make a profit of $15,000, 300% of our initial capital. The extraordinary profit is explained by the fact that we took exposure to 20 times our initial capital. The danger we were mentioning before is the contagious nature of this structure: had the house price dropped below $95,000 (and entered the famous negative equity zone gripping the news headlines), the loss would be on the bank's side.
The type of approach shown above in the domestic sphere is key to the functioning of hedge funds in the financial markets sphere. A central strategy to hedge fund trading is taking a spread position and betting that a difference between two variables is going to take a certain direction. Since the difference is usually small, profit is made only if the overall position is very large. Profit is also made if the position is held until the outcome of the bet becomes known: should the position be exited beforehand, there is a great danger of a liquidity ripple effect. This is basically what happened during the crisis originated by the default of Long Term Capital Management, and the link to liquidity is explored by Jorion  and by Adrian and Shin .
We are looking closely at the core of any bank's activity, the relationship between its borrowing and lending operations. Liquidity risk is strongly linked to this core and to the funds that sustain lending. Funding liquidity risk is defined (see Drehmann and Nikolau ) as the inability to settle obligations with immediacy: this inability can lead to default.
We shall observe in Section 7.4 the dynamics of the flow going from the income generated by the lending to the cost represented by the borrowing. If this careful balancing exercise is interrupted, the institution faces liquidity risk. Leverage exacerbates all this. Since income must be overall greater than the costs necessary to serve our debt, when the debt principal becomes similar in size to, or even greater than, the income principal (lending income for financial institutions or revenues for sovereign or corporate entities) there is a great risk. Particularly considering the fact that often the cost is fixed and the income is variable (the simplest picture is a country paying a fixed coupon on a bond using revenues coming from a variable tax collection), should the expected income not be enough to meet the immediate obligations, unless there are some assets (basically cash) that can be used to do so, there is a possibility of default.
These considerations are at the center of the discussions about capital requirements for financial institutions, the most recent expression of which are the Basel II agreement  and the forthcoming Basel III agreement. Capital requirements are a way of ensuring that financial institutions have those assets mentioned above such that they can immediately and safely meet obligations in case income is less than anticipated. These are not unlike one of the Euro convergence criteria, which was a debt-to-GDP ratio of less than 60%. The capital requirement can be seen as a number of units of principal needed as capital against every 100 units of principal lent. If one institution lends 100, the same institution needs to have X units in cash (or an equivalent liquid asset), which is similar to say that it cannot have a debt with principal greater than 100 – X units.
Since to keep cash is not very profitable, financial institutions in general have historically tried to push for the lowest possible capital requirements. After the 2007 to 2009 financial crisis this position is harder to defend since, should there be large write-offs, the government needs to intervene, and it is only fair that banks, through their own cash, cover a larger portion of these write-offs. Development institutions, not surprisingly, maintain an equity pool that far exceeds any past, or potentially agreed in the future, capital requirements. In Section 1.6.1 we discussed how there are broadly two types of development institutions, those that lend money already held and those that borrow first in order to subsequently lend. The former would essentially meet a 100% capital requirement (although in their situation it probably does not even make sense to talk about capital requirements), the latter, with varying degrees between institutions, would still meet a number that is several multiples the one of the average investment bank.
We shall return to the issue of leverage in Section 7.4.1 to see how it can distort the pillars of risk neutrality. In Section 7.2.1 we shall look at leverage when dealing with funding gap risk, that is, the breaking in the balance between the amount one borrows versus the amount one lends.
-  This, of course, is at the core of the Euro sovereign crisis of 2010 to 2011. Central to it was the question, is a country insolvent, that is, will it never be able to meet its liabilities, or does it have liquidity issues, that is, it cannot generate revenues in time to meet its next liabilities?