Handbook of Asset and Liability Management: From models to optimal return strategies

28

Limits Policy

La vertu même a besoin de limites. (Montesquieu)

Once the risk free strategy has been described with the delta equivalent techniques, the A/L manager is able to measure the risk position. Associated with this risk position, the ALCO may propose a risk limit policy.

This policy usually has the effect that:

• the gross economic capital will not go beyond a certain amount;
• the interest rate (or liquidity) gap has to be in a specified tunnel;
• the interest rate income sensitivities have to be in a specified tunnel.

28.1 ECONOMIC CAPITAL LIMIT

The economic capital allocation process at the group level is incorporated in the company budgetary process.

This economic capital amount may become a constraint for A/L managers: ALCO may set a limit on the economic value exposure to market conditions.

On the other hand, since the capital allocation process contains a strategic risk allocation, this would impose at least a benchmark for A/L managers and sometimes a minimum amount of economic capital by risk type.

Figure 28.1 Economic capital limit

In the example above, A/L managers have gone beyond the inflation risk economic capital limit: ALCO should decide upon prompt intervention in order to reduce this risk or to review the limit.

28.2 SETTING ECONOMIC CAPITAL LIMITS

Some companies compute their economic capital limits using a model. The idea is to set a confidence interval ...