For a non-financial firm, the MM theory provides at least a starting point for the resource allocation process: the firm should find the net present value of the prospective real asset first as if it is being financed exclusively by stockholders; and if it is positive, then the appropriate asset financing should take advantage of existing financial market imperfections. For a financial firm or bank, such a dichotomy of investment and financing decisions creates one major problem.The bank’s assets are as much financial as its liabilities. The basic premise for the existence of banks is rooted in financial market inefficiencies, and this premise is at odds with the MM theory. Indeed, such inefficiencies signify a joint consideration of investment and financing decisions, and the computation of the cost of capital (as suggested by, for instance, MM) as a cutoff rate becomes less meaningful for a bank than for the non-financial firm.1 Furthermore, any investment project cannot be considered in isolation or by itself. Instead, its impact on the owners must be analyzed in the context of other investments of the firm.
Bank management practice that focuses on joint consideration of (a) investment-financing decisions, and (b) an investment proposal with existing investments (rather than the proposal in itself ) is consistent with the above conceptual implications. Hence, concentrates on bank management practice that emphasizes asset-liability management, rather than consideration of a single project. In turn, the asset-liability management practice has highlighted the risk (rather than return) dimension.2 Its objective has been to optimize three components of risk: liquidity risk, credit risk, and interest rate risk. Liquidity risk is typically monitored by liability and liquidity managers. Similarly, most banks delegate the management of credit risk to the bank’s loan and investment centers; credit risk, specifically pertaining to the international dimension. Hence we concentrate here on the interest rate risk dimension as it relates to asset-liability management.3 One risk typically ignored in the domestic, single-currency dimension is the foreign exchange risk. Currency risk is intimately interrelated to the interest rate risk.Therefore, for expository ease, we will first focus on a single-currency scenario, and later modify the analysis to include the multi-currency consideration.
Bank management practice that focuses on joint consideration of (a) investment-financing decisions, and (b) an investment proposal with existing investments (rather than the proposal in itself ) is consistent with the above conceptual implications. Hence, concentrates on bank management practice that emphasizes asset-liability management, rather than consideration of a single project. In turn, the asset-liability management practice has highlighted the risk (rather than return) dimension.2 Its objective has been to optimize three components of risk: liquidity risk, credit risk, and interest rate risk. Liquidity risk is typically monitored by liability and liquidity managers. Similarly, most banks delegate the management of credit risk to the bank’s loan and investment centers; credit risk, specifically pertaining to the international dimension. Hence we concentrate here on the interest rate risk dimension as it relates to asset-liability management.3 One risk typically ignored in the domestic, single-currency dimension is the foreign exchange risk. Currency risk is intimately interrelated to the interest rate risk.Therefore, for expository ease, we will first focus on a single-currency scenario, and later modify the analysis to include the multi-currency consideration.