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1.4 INVESTING AND ALM

The main source of income for a development bank is the revenues from its lending business. There is however usually, as in any normal financial institution, considerable investment activity taking place. In Section 7.1 we shall discuss where a development bank's funds come from and what percentage they constitute of the loan portfolio. Here we simply state that a bank is in possession of funds of its own that are independent of those raised through debt. We have seen in Section 1.1 that these funds can be made of equity and other assets or in the specific case of development institutions they can be donations or requested capital. We have also seen that these funds are also replenished by the net income (i.e, a profit, should there be one) given by the sum of the inflows from the loans and the outflows of the debt.

In a traditional financial institution these assets can be used to reward employees or shareholders (or partners) or can be used for other specific activities such as share buybacks. In a development institution, which of course is not for profit, they are mainly used as a buffer. These assets are held and nurtured not only to mitigate some of the institution's risks but also to provide a safety net in case a borrower should default on a bank's loan. In Section 7.1 we shall discuss the concept of capital requirement, but it is already quite easy to grasp that a situation where a large portion of a loan is funded through cash is less risky than one where the loan is almost completely funded through debt. A further requirement on the type of investment carried out with these funds, so that they can be used as a buffer, is that they need to provide emergency liquidity: they need to be invested in assets so liquid that, should there be the need to repair the damage caused by a defaulting borrower, they can be liquidated at a moment's notice. We shall see this in more detail in Section 6.4.2.

Some of these assets are also used by the fourth main activity of a development institution, which is asset-liability management (ALM), the activity that tries, using our previous term, to match in the best possible way loans and debt.

What are some of the activities carried out by the investment and ALM arm of a development institution? As we have stressed already quite a few times, a development institution is rather risk averse, therefore these activities are considerably less adventurous than those carried out by a similar prop desk in a traditional investment bank.

Currency risk management: One could look at things philosophically and claim that currency risk is one of the most insidious because it makes us aware, particularly in our globalized world, that there is no such thing as an absolute frame of reference and everything is relative to something else, in this case, the rate of exchange between currencies. These types of considerations aside, a development bank, like any institution, is subject to currency risk and at the same time stands to gain from it.[1]

A way to protect and/or gain from currency exposure is to either trade instruments–such as the one mentioned in the previous section where cash flows are linked to floating interest rates in different currencies–or simpler, purely currency-related instruments–such as one where cash amounts in different currencies fixed in the present are exchanged at future dates.

Interest rate risk management: We shall later see, and understand, how a development bank's business is essentially a fixed-income business where interest rates play the dominant role. We have already seen how a development institution prefers to see everything in terms of one specific standard interest rate. To this end it would trade instruments converting any floating- or fixed-rate cash flow not conforming to its chosen standard into that standard rate. Later we shall learn that this standard rate, like similar other rates used in the market, is called a benchmark. This benchmark is also used to measure similar trades made by the investment arm of the institution to gain from exposure in the interest rate markets.

Inflation risk management: Inflation is the great enemy of the creditor and the prudent. Any holder of substantial assets stands to lose from the eroding effect of inflation. Given that development institutions are, particularly when compared to traditional investment banks, considerably better funded than the average institution in terms of liquid assets, they would in principle stand to lose a great deal from the effect of inflation. To this end some of the investment energy of the bank goes toward purchasing protection against inflation. The simplest and least adventurous kind of protection is given by government bonds where the principal does not remain fixed but grows with inflation.

Investment and liquidity creation: The final high-level objective is the one of not letting the institution's equity depreciate (for reasons other than inflation) by investing it with a certain target in mind. The type of investments need to be of the most liquid kind so that they can be sold/unwound in order to provide an emergency buffer for the institution. These investments can be of the spot kind, such as buying and selling shares or foreign currency; they can involve placing deposits abroad and swapping the income into USD (or the native currency of the institution); they can involve purchasing different type of debt (sovereign, agency, corporate) and swapping it into the native currency; or they can involve investing in more exotic instruments, such as asset-backed securities (ABS), and swapping the income into the native currency of the institution. We shall revisit these in Section 6.4.2, however, it is already easy to see how different mixes with different proportions of each of the above result in different risk profiles.

After having given a very high-level description of what the fundamental activities of an investment bank and particularly a development bank are, let us try to paint a schematic structure of the internal organization of these institutions.

  • [1] To be precise, a risk by definition is something one can stand to gain something from, however, in a risk-averse view, one tends to see risk as something dangerous- and therefore, here we choose to stress the profit opportunities next to it.
 
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