Balance Sheet Management Research Articles

Financial Intermediary Balance Sheet Management

Conventional discussions of balance sheet management by nonfinancial firms take the set of positive net present value (NPV) projects as given, which in turn determines the size of the assets of the firm. The focus is on the composition of equity and debt in funding such assets. In contrast, the balance sheet management of financial intermediaries reveals that it is equity that behaves like the predetermined variable, and the asset size of the bank or financial intermediary is determined by the degree of leverage that is permitted by market conditions. The relative stickiness of equity reveals possible non-pecuniary benefits to bank owners so that they are reluctant to raise new equity, even during boom periods when equity raising is associated with less stigma, and hence smaller discounts. We explore the empirical evidence for both market-based financial intermediaries such as the Wall Street investment banks, as well as the commercial bank subsidiaries of the large U.S. bank holding companies (BHCs). We further explore the aggregate consequences of such behavior by the banking sector for the propagation of the financial cycle and securitization.

Capital requirements and bank behavior in the UK: Are there lessons for international capital standards?

The financial crisis prompted widespread interest in developing a better understanding of how capital regulation drives bank behavior. This paper uses a unique, comprehensive database of regulatory capital requirements on all UK banks to examine their effects on capital, lending and balance sheet management behavior. We find that capital requirements that include firm-specific, time-varying add-ons set by supervisors affect banks’ desired capital ratios and that resulting adjustments to capital and lending depend on the gap between actual and target ratios. We use these results to measure the effects of a capital regime that includes features similar to those embedded in the UK framework. Our results suggest that countercyclical capital requirements may be less effective in slowing credit activity when banks can readily satisfy them with lower-quality (lower-costing) capital elements versus higher-quality common equity. Given the size of the UK banking sector and the global nature of many of the largest institutions in the UK banking sector, the results have implications for the ongoing debate surrounding the design and calibration of international capital standards.

The margin of safety principle and corporate strategy

PurposeThis paper seeks to analyze the applicability of the time‐tested margin of safety principle from value investing to corporate strategy.Design/methodology/approachThe main source of this paper is the book Margin of Safety, supplementation materials, including a discussion with the book's author, Seth Klarman, were also referenced.FindingsThe paper finds that the margin of safety principle is broadly applicable to corporate strategy in areas such as M&A, hedging, balance sheet management, share buybacks, special dividends, divestments, and cash management. Each of these areas is discussed in the paper and illustrated by way of timely examples as part of the analysis.Research limitations/implicationsFurther research could be conducted into valuation methods in general, including the method practiced by noted value investors. Research could also be conducted into the margin of safety principle and its applications in corporate strategy, corporate finance, strategic risk management, shareholder communications, and operations management.Originality/valueThis is the first paper that the author is aware of that analyzes the applicability of the investment‐based margin of safety principle to corporate strategy and strategy‐related initiatives.

Optimal Allocation of Diversification Benefits

In recent years within Insurance companies measures like RAROC (Risk Adjusted Return on Capital) have become more popular for Balance Sheet Management purposes. RAROC is a performance measure that quantifies the amount of return per unit of risk that can be obtained by a certain entity. Measures like RAROC are often used by a holding company to base investment or risk budgeting decisions on. It is believed that when one increases the investments in or the risk budget of an entity with a high RAROC the risk vs. return profile of the holding company improves. Whether this is actually the case depends on the characteristics of the risks of the subsidiaries of the holding company and the design of the RAROC measure. This paper discusses how the RAROC measure should be designed in order to give the optimal incentives.

Financial Intermediary Balance Sheet Management

Conventional discussions of balance sheet management by nonfinancial firms take the set of positive net present value (NPV) projects as given, which in turn determines the size of the firm’s assets. The focus is on the composition of equity and debt in funding such assets. In contrast, the balance sheet management of financial intermediaries reveals that it is equity that behaves like the predetermined variable, and the asset size of the bank or financial intermediary is determined by the degree of leverage that is permitted by market conditions. The relative stickiness of equity reveals possible nonpecuniary benefits to bank owners so that they are reluctant to raise new equity, even during boom periods when raising equity is associated with less stigma and, hence, smaller discounts. We explore the empirical evidence for both market-based financial intermediaries such as the Wall Street investment banks, as well as the commercial bank subsidiaries of the large U.S. bank holding companies. We further explore the aggregate consequences of such behavior by the banking sector for the propagation of the financial cycle and securitization.

A modelling process of short-term interest rate risk management for the South African commercial banking sector

This study focuses on banking book interest rate risk (IRR) management, more specifically short-term IRR management (SIRR). This type of risk is partly induced by the inflation targeting policy of the South African Reserve Bank (SARB). As a result, inflation leads to an uncertain interest rate cycle and a period of uncertain interest rate levels as it relates to lending and borrowing activities in the South African commercial banking sector. This study highlights what causes short-term interest rate risk and how the banks may forecast and manage the SIRR with reference to the inflation targeting policy. The banking industry manages a high volume of fund transactions and portfolios of investments. The banks are intricately involved in the financial markets and are therefore exposed to a large number of risk factors. A sound banking system is an important prerequisite for a country’s future economic development. One key empirical finding of this research is that 50 per cent of the South African banks agree that loans that cannot undergo immediate rate adjustments are exposed to the repo-rate adjustment after the Monetary Policy Committee (MPC) meeting. Banks surveyed see the need for the development of a short-term interest rate risk (SIRR) management process to better control such repo-rate risk. The next key empirical finding is that interest rate risk is still managed via traditional repricing gap and sensitivity analysis which is not ideal for risk management due to inherent weaknesses (such as not quantifying capital risk exposure). This agrees with the Pricewaterhousecoopers Balance Sheet Management benchmark survey

Inside Debt and Enterprise-Wide Bank Risk

Inside debt compensation held by top officers of U.S. banks is negatively related to risk and risk-taking. The evidence reveals a robust and strongly negative relation between end-of-2006 inside debt and 2007-2009 bank-specific risk exposures in terms of lost stock market value, volatility, tail risk, and the probability of financial distress. Banks with managers having large inside debt holdings are also characterized by better-quality assets, more conservative balance sheet management, and a stronger tendency towards traditional banking activities. The results suggest that debt-based compensation limits bank risk and risk-taking by encouraging more conservative decision-making.

Monetary Cycles, Financial Cycles and the Business Cycle

One of the most robust stylized facts in macroeconomics is the forecasting power of the term spread for future real activity. The economic rationale for this forecasting power usually appeals to expectations of future interest rates, which affect the slope of the term structure. In this paper, we propose a possible causal mechanism for the forecasting power of the term spread, deriving from the balance sheet management of financial intermediaries. When monetary tightening is associated with a flattening of the term spread, it reduces net interest margin, which in turn makes lending less profitable, leading to a contraction in the supply of credit. We provide empirical support for this hypothesis, thereby linking monetary cycles, financial cycles, and the business cycle.

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Excess Reserves During the Great Contraction: Evidence from the Central Money Market of New York City, 1929 to 1932

Recent turmoil in the financial sector has once again thrust bank liquidity and balance sheet management into the spotlight. History offers some insight into liquidity management in times of financial distress. The banking industry experienced a significant amount of turmoil during the Great Contraction of 1929-1933. In response, banks were forced to adjust their portfolios with the changing economic climate. One aspect banks had control over was their reserves. While there has been extensive analysis of bank reserves after the bank holiday of 1933, little is known about bank-level reserve holdings during the Contraction. This paper exploits a unique data set of state banks that were Federal Reserve members and state banks that were not members of the Federal Reserve Sysytem in New York City during that period. Nonmember banks, without access to a lender of last resort, had a precautionary demand for reserves, increasing their ratio of excess reserves to assets after the first banking panic. Compared to state member banks, nonmember banks held a higher ratio of assets in excess reserves. The interest rates on shortterm, liquid securities had a negative correlation with reserves and support the opportunity cost theory of Frost (1971). The discount rate, representing the price of liquidity, had a positive relationship with reserves, suggesting that Federal Reserve policy could have affected excess reserve holdings during the Great Contraction. These results provide new evidence on the macroeconomic and monetary factors affecting bank behavior in the central money market during the Great Contraction and provide some guidance for policy considerations currently facing monetary authorities.

The continuing saga – Basel II developments: liquidity regulation into the 21st century

Leverick, Head of Balance Sheet Management for the Royal Bank of Scotland and a stalwart of the Asset and Liability Management Association, takes a look at the latest situation in the efforts to provide regulation that is intended to bring order to liquidity.

International Perspectives in Horticultural Extension—A New Zealand Viewpoint

The government-funded horticulture extension service, which provided a free service to New Zealand growers for nearly 50 years, was privatized in the late 1980s as part of major reforms to the primary production sector. That service had provided one-on-one on-farm visits, budget advice, provision of technical information, and facilitation of field days, workshops and discussion groups throughout the country. This government-funded service also provided policy advice, acted as an interface between industry and the research and development (R&D) sector, and responded to biosecurity incursions. A decade following privatization, the number of people involved in equivalent consultancy activities has almost halved with very little recruitment of new people into the profession. The emphasis is now much more towards providing advice on the overall management of an individual enterprise to ensure its financial viability, with less emphasis on technical transfer. Large horticultural businesses are increasingly employing specialists in-house who can provide technical solutions and advice on balance sheet management. Private consultancy companies now tend to work more at a local or regional level rather than at a national level and links with R&D providers have markedly weakened as research organisations are increasingly protecting intellectual property for their own commercial advantages and as information provision is now largely on a user-pays basis. In addition, biosecurity incursions over the past decade appear to have increased as a result of a weakened surveillance effort. Nonetheless, horticultural exports from New Zealand continue to grow at around 10% per annum and many sectors remain very competitive on world markets.

Originating Collateralized Debt Obligations for Balance Sheet Management

The collateralized debt obligation (CDO) is a structured finance product modeled along similar lines to earlier securitized products such as asset-backed securities and mortgage-backed securities, in which a distinct legal entity known as a special purpose vehicle (also referred to as a special-purpose entity) issues bonds or notes against an investment in the cash flows of an underlying pool of assets. These assets can be bonds, commercial bank loans, or a mixture of both bonds and loans. Banks developed CDOs as a tool for use in regulatory capital management and credit risk management. Further development of CDOs saw them integrated with credit derivatives and used for additional purposes such as credit trading and arbitrage. In this article, the authors consider the economic drivers behind the origination of CDOs and analyze their structure. They then illustrate their application to economic capital management using two actual transactions.

Unrecognized Deferred Taxes: Evidence from the U.K.

We examine whether U.K. managers use the flexibility provided under the partial method for deferred taxes to measure unrecognized deferred taxes opportunistically. We first test whether firm-specific operational and opportunistic factors are associated with the level of unrecognized deferred taxes. The tests provide evidence certain U.K. managers opportunistically measure deferred taxes to manage leverage, consistent with arguments by commentators that deferred taxes heavily influence leverage indicators that play a prominent role in the U.K. contracting framework. Because the proper identification and measurement of both operational and opportunistic determinants of unrecognized deferred taxes influence our tests, we additionally investigate whether unrecognized taxes relate to future deferred tax reversals and future operating profitability of the firm. These tests show the components of deferred taxes predict both future deferred tax reversals and indicators of future profitability of the firm as predicted. Taken together, our results indicate that, on average, the existence of balance sheet management does not nullify the predictive power of (unrecognized) deferred taxes for future deferred tax reversals and for profitability measures. One implication of the results is that the recent U.K. standard change eliminating the partial provision method for deferred taxes potentially has reduced the usefulness of deferred tax disclosures.

Digging deep into derivatives: balance sheet management – making strategic decision‐making better

In this case study the author describes how the Ohio State Savings Bank tied its strategic decision‐making to its balance sheet management processes and interest rate risk process.

The Pricing Puzzle: The Default Term Structure of Collateralised Loan Obligations

Ambivalence in the regulatory definition of capital adequacy for credit risk has recently steered the financial services industry to collateral loan obligations (CLOs) as an important balance sheet management tool. CLOs represent a specialised form of Asset-Backed Securitisation (ABS), with investors acquiring a structured claim on the interest proceeds generated from a portfolio of bank loans in the form of tranches with different seniority. By way of modelling Merton-type risk-neutral asset returns of contingent claims on a multi-asset portfolio of corporate loans in a CLO transaction, we analyse the optimal design of loan securitisation from the perspective of credit risk in potential collateral default. We propose a pricing model that draws on a careful simulation of expected loan loss based on parametric bootstrapping through extreme value theory (EVT). The analysis illustrates the dichotomous effect of loss cascading, as the most junior tranche of CLO transactions exhibits a distinctly different default tolerance compared to the remaining tranches. By solving the puzzling question of properly pricing the risk premium for expected credit loss, we explain the rationale of first loss retention as credit risk cover on the basis of our simulation results for pricing purposes under the impact of asymmetric information.

Central Bank and Commercial Banks' Liquidity Management – What is the Relationship?

The paper explores the relation between individual banks' liquidity management in the euro area and the ECB's management of the aggregate current accounts held by banks with the Eurosystem. It is argued that, in the case of the euro area with its large, remunerated reserve requirements that have to be fulfilled only on average over a one‐month period, the banks' demand for working balances to serve as a buffer against market imperfections is always below reserve requirements. It is therefore normally sufficient for the ECB when steering short‐term interest rates to control aggregate liquidity in a way that the aggregate banking system is in a position to fulfil adequately its reserve requirements. In particular, the ECB normally does not need to take care of any factors that affect temporarily the demand for working balances, such as the level and uncertainties of interbank payment flows. However, two exceptions are noteworthy and are discussed in the paper: the banks' balance sheet management activities implying a regular end of month peak of the EONIA rate; and the liquidity situation in the case of substantive market tensions as in the days following the terrorist attacks of 11 September 2001. The need of the ECB's liquidity management to address the associated deviations from a model of perfect markets is discussed.

Balance Sheet Management: The Case of Short‐Term Obligations Reclassified as Long‐Term Debt

We investigate potential management of balance sheet ratios by a sample of firms that reclassify short‐term obligations to long‐term debt and subsequently declassify that debt (return it to the current liability section). Although aggregate measures of liabilities and equity remain unchanged when firms reclassify (declassify), the practice does increase (decrease) reported measures of liquidity, such as the current ratio, and long‐term leverage. Our results suggest that firms reclassify and declassify to smooth reported liquidity and leverage, relative to the prior year and to industry benchmarks. Our evidence is also consistent with firms working around restrictive debt covenants.

A linear programming model for bank balance sheet management

Bank balance-sheet management which involves the determination of the size and composition of a bank's assets and liabilities over a multiperiod planning horizon is one of the most prominent issues in bank strategic planning. Not only management policy choices, but legal restrictions and minimum safety requirements, dictated by the economic and political environment operated in, mean a balance has to be struck between the conflicting objectives of profitability, liquidity and risk. Bank balance-sheet management is further complicated by the fact that decisions made at any point in time affect profits, liquidity and risk, not only at the time they are made, but in the periods that follow. This paper discusses a multiperiod linear programming model constructed for a commercial bank in Turkey, that takes into consideration this systematic relationship in the legal, financial and institutional setup of Turkey over the period 1987–1990. Sensitivity analysis results demonstrate the relevance of the model for informed policy choice, and the use of the model as a planning tool.

Que valent les options cachées ?

What are hidden options worth ? Advance redemption, loan right, power of redemption, possibility of extension, all this are examples of hidden options : a designation which may seem misleading. These options are not at all hidden ones, but they are part of a variety of banking and insurance products which we are analysing on the French market. Instead, they share some typical characteristics of options, even if the comparison with derivative products negotiated on the financial markets enables to distinguish some differences. The article shows that the evaluation of these options remains a difficult task to perform mainly because it requires the modelling of customer's behaviour. It is nevertheless necessary to take into account their value when billing services, as well as regards financial and balance-sheet management. In fact, their small « issue » value (some 0,3 % in the case of early redemption) hides strong potential variations. As all derivatives products, these options have a high gearing.