GOAL PROGRAMMING TECHNIQUES FOR BANK ASSET LIABILITY MANAGEMENT Applied Optimization Volume 90 Series Editors: Panos M. Pardalos University of Florida, U.S.A. Donald W. Hearn University of Florida, U.S.A. GOAL PROGRAMMING TECHNIQUES FOR BANK ASSET LIABILITY MANAGEMENT Kyriaki Kosmidou, Constantin Zopounidis Technical University of Crete Department of Production Engineering and Management Financial Engineering Laboratory University Campus, Chania, Greece KLUWER ACADEMIC PUBLISHERS NEW YORK,BOSTON, DORDRECHT, LONDON, MOSCOW eBookISBN: 1-4020-8105-7 Print ISBN: 1-4020-8104-9 ©2004 Springer Science + Business Media, Inc. Print ©2004 Kluwer Academic Publishers Boston All rights reserved No part of this eBook maybe reproducedor transmitted inanyform or byanymeans,electronic, mechanical, recording, or otherwise, without written consent from the Publisher Created in the United States of America Visit Springer's eBookstore at: http://www.ebooks.kluweronline.com and the Springer Global Website Online at: http://www.springeronline.com To my sisters Marilena and Nadia Kosmidou To Kalia Koukouraki, Dimitrios Zopounidis, Heleni Zopounidis Benefactors love their beneficiaries more than the beneficiaries love their benefactors Aristotle (Ith., Eud., 1241a) Table of contents PREFACE xi CHAPTER 1 : INTRODUCTION 1. Asset liability management 1 1.1 ALM model structure 3 1.1.1 Objective functions 4 1.1.1.1 The Von Neumann-Morgenstern theory 5 1.1.1.2 Classicalutility functions 5 1.1.1.3 The Von Neumann-Morgenstern theory and utility functions 6 1.2 Asset management models 7 1.2.1 Stochastic programming 7 1.2.2 Decision rules 9 1.2.3 Capital growth 11 1.2.4 Stochastic control 12 1.2.5 Advantages and disadvantages of the four approaches 12 1.3 Applications of the asset liability management model 13 2. General characteristics of the banking institutions 14 2.1 The economic role of banking institutions 15 2.2 Management of commercial banks 16 2.3 Basic policies of commercial banks 17 2.3.1 The accumulation of capital 19 2.3.2 Loans 21 2.3.3 Liquidity 21 2.4 Economic statements 22 3. Uncertainty in the banking risk management 26 3.1 Risk of financial institutions 26 viii 3.2 Evaluation and management risk techniques 32 4. The proposed methodological approach and the objective of the book 40 CHAPTER 2:REVIEW OF THE ASSET LIABILITY MANAGEMENT TECHNIQUES 1. Asset liability managementtechniques 43 1.1 Deterministic models 43 1.1.1 Multiobjective linear programming model 46 1.2 Stochastic models 48 1.2.1 Chance constrained programming models 50 1.2.2 Sequential decision theoretic approach 52 1.2.3 Dynamic programming 55 1.2.4 Stochastic linear programming 56 1.2.5 Simulation models 65 1.2.6 Dynamic generalized networks 71 Appendix: Asset liability management programming models 73 CHAPTER 3:BANK ASSET LIABILITY MANAGEMENT METHODOLOGY 1.Objective of the research 77 2. Data 80 3. Multiobjective linear programming 80 3.1 Simple methods of multiobjective linear programming 82 3.1.1 Lexicographic optimisation 82 3.1.2 Global criterion method 83 3.1.3 Interactive procedures 84 3.1.4 Goal programming 85 3.1.4.1 Goal programming as an extension of linear programming 86 3.1.5 The optimisation role 91 3.1.6 Dominance analysis 92 3.1.7 Issues related to goal programming model formulation 92 3.1.7.1 Dominance, inferiority and efficiency in goal programming solutions 93 3.1.7.2 Naïve relative weighting, incommensurability, naïve prioritization and redundancy in goal programming model formulation 94 ix 3.1.7.3 Other goal programming algorithms and methodology 97 4. Interest rate simulation analysis 99 4.1 Monte Carlo simulation 100 CHAPTER 4: APPLICATION 1. Description of the sample data 105 2. Formulation of the problem 107 2.1 Constraints 107 2.2 Goals 110 2.3 Mathematical formulation 116 3. Post-optimality 120 4. Interest rate simulation analysis 120 5. Analysis of results 124 5.1 Sensitivity analysis to the priorities of goals 129 5.2 Forecasting analysis 135 6. Policy and strategy standards of the banks 145 CHAPTER 5: CONCLUSIONS AND FUTURE PERSPECTIVES 1. Summary of main findings 149 2.Issues for further research 152 REFERENCES 155 SUBJECT INDEX 165 Preface Financial engineering involves the design, development and implementation of innovative financial instruments and processes and the formulation of creative solutions to problems in finance (Finnetry, 1988). Among others, financial engineering has been heavily involved in risk management, in as- sessing the types of risk of different securities, in identifying and measuring them, and finally in developing systems for transforming high risk invest- ment means to low risk ones. Besides, risk management provides the most efficient way of managing risk through sophisticated quantitative and opti- mization models, such as Asset Liability Management (ALM) models. In ALM the exposure to various risks is minimized by holding the appro- priate combination of assets and liabilities in order to meet the firm’s objec- tives. More precisely, allocating assets lies at the heart of a strategic risk management system. In addition, liability streams and their uncertainty, in- stitutional constraints and policies, taxes, transaction costs and the like are important features in real financial planning. Application areas include pen- sion plans, insurance companies, banks, university endowments and other leveraged institutions, wealthy and ordinary individuals. These investors possess future liabilities and goals. They must make investment decisions while considering the use of their funds, that is, investing for a purpose. Risks must be measured in the context of the entire organization’s or the individual’s financial situation. Asset investment decisions are combined with liability choices in order to maximize the investor’s wealth over time. During the last decades the growing internationalization, the globalization of financial markets, the intensified competition in the national and interna- tional banking markets and the introduction of complex products have in- creased volatility and risks. Within this economic environment, the banking