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Asset and Liability Management for
Banks and Insurance Companies
Series Editor
Jacques Janssen
Asset and Liability

Management for Banks and
Insurance Companies
Marine Corlosquet-Habart
William Gehin
Jacques Janssen
Raimondo Manca
First published 2015 in Great Britain and the United States by ISTE Ltd and John Wiley & Sons, Inc.
Apart from any fair dealing for the purposes of research or private study, or criticism or review, as
permitted under the Copyright, Designs and Patents Act 1988, this publication may only be reproduced,
stored or transmitted, in any form or by any means, with the prior permission in writing of the publishers,
or in the case of reprographic reproduction in accordance with the terms and licenses issued by the
CLA. Enquiries concerning reproduction outside these terms should be sent to the publishers at the
undermentioned address:
ISTE Ltd John Wiley & Sons, Inc.

27-37 St George’s Road 111 River Street
London SW19 4EU Hoboken, NJ 07030
UK USA
www.iste.co.uk www.wiley.com
© ISTE Ltd 2015

The rights of Marine Corlosquet-Habart, William Gehin, Jacques Janssen and Raimondo Manca to be
identified as the authors of this work have been asserted by them in accordance with the Copyright,
Designs and Patents Act 1988.
Library of Congress Control Number: 2015942726
British Library Cataloguing-in-Publication Data

A CIP record for this book is available from the British Library
ISBN 978-1-84821-883-3
Contents
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
CHAPTER 1. DEFINITION OF ALM IN THE BANKING AND

INSURANCE AREAS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2. Brief history of ALM for banks and insurance companies . . . . . . . . 2
1.3. Missions of the ALM department . . . . . . . . . . . . . . . . . . . . . . . 3
1.3.1. Missions of the ALM department for banks . . . . . . . . . . . . . . 3
1.3.2. Missions of the ALM department for insurance companies . . . . . 5
1.4. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
CHAPTER 2. RISKS STUDIED IN ALM . . . . . . . . . . . . . . . . . . . . . . . . . 9

2.1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2. Risks studied in a bank in the framework of Basel II and III . . . . . . . 9
2.2.1. Main risks for banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
2.2.2. From Basel I to Basel III . . . . . . . . . . . . . . . . . . . . . . . . . 11
2.3. Stress tests . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.3.1. What is a stress test? . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
2.3.2. The stress tests of 2014 . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2.4. Risks studied in an insurance company in the
framework of Solvency II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.4.1. Solvency II in a nutshell . . . . . . . . . . . . . . . . . . . . . . . . . . 17
2.4.2. Focus on the risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.5. Commonalities and differences between banks
and insurance companies’ problems . . . . . . . . . . . . . . . . . . . . . . . . 25
2.5.1. Commonalities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.5.2. Differences . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
2.6. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
vi Asset and Liability Management for Banks and Insurance Companies
CHAPTER 3. DURATIONS (REVISITED) AND SCENARIOS FOR ALM . . . . . . . 27

3.1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3.2. Duration and convexity risk indicators . . . . . . . . . . . . . . . . . . . . 28
3.3. Scenario on the cash amounts of the flow . . . . . . . . . . . . . . . . . . 32
3.4. Scenario on the time maturities of the flow . . . . . . . . . . . . . . . . . 34
3.5. Matching asset and liability . . . . . . . . . . . . . . . . . . . . . . . . . . 36
3.6. Matching with flow scenarios . . . . . . . . . . . . . . . . . . . . . . . . . 40
3.7. ALM with the yield curve . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.7.1. Yield curve. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3.7.2. ALM with the equivalent constant rate . . . . . . . . . . . . . . . . . 44
3.8. Matching with two rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
3.9. Equity sensitivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
3.9.1. Presentation of the problem . . . . . . . . . . . . . . . . . . . . . . . . 47
3.9.2. Formalization of the problem . . . . . . . . . . . . . . . . . . . . . . . 48
3.9.3. Time dynamic of asset and liability flows . . . . . . . . . . . . . . . 49
3.9.4. Sensitivity of equities and VaR indicator . . . . . . . . . . . . . . . . 51
3.9.5. Duration of equities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
3.9.6. Special case of the aggregated balance sheet . . . . . . . . . . . . . . 52
3.9.7. A VaR approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
3.10. ALM and management of the bank . . . . . . . . . . . . . . . . . . . . . 58
3.10.1. Basic principles . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3.10.2. ALM and shares . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3.10.3. Stochastic duration . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.11. Duration of a portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
3.12. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
CHAPTER 4. BUILDING AND USE OF AN ALM INTERNAL MODEL

IN INSURANCE COMPANIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
4.2. Asset model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
4.2.1. Equity portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
4.2.2. Bond portfolio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76
4.2.3. Real estate . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82
4.2.4. Central scenario and simulated scenarios . . . . . . . . . . . . . . . . 83
4.3. Liability model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84
4.3.1. Model points . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
4.3.2. Mathematical reserves and annual policyholder benefits. . . . . . . 87
4.3.3. Annual policyholder benefits and crediting rate . . . . . . . . . . . . 87
4.3.4. Profit sharing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90
4.3.5. Policyholder demography and behavior. . . . . . . . . . . . . . . . . 91
4.3.6. Other reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
4.3.7. Future new business . . . . . . . . . . . . . . . . . . . . . . . . . . . . 96
Contents vii
4.3.8. Fees and business costs . . . . . . . . . . . . . . . . . . . . . . . . . . 97

4.4. Structure of an ALM study . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.4.1. Determinist study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.4.2. Stochastic study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
4.5. Case study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
4.5.1. Goal of the study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105
4.5.2. Business plan and other liability inputs . . . . . . . . . . . . . . . . . 105
4.5.3. Central scenario and other asset inputs . . . . . . . . . . . . . . . . . 106
4.5.4. Fee and cost hypotheses . . . . . . . . . . . . . . . . . . . . . . . . . . 107
4.5.5. Step-by-step model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107
4.5.6. The ALM study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
4.6. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114
CHAPTER 5. BUILDING AND USE OF ALM INTERNAL

MODELS IN BANKS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
5.1. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
5.2. Case 1: Reduction of gaps . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
5.2.1. Basic numerical data . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115
5.2.2. Basic ALM indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . 118
5.2.3. Scenario for loss reduction . . . . . . . . . . . . . . . . . . . . . . . . 119
5.3. Case 2: A stochastic internal model . . . . . . . . . . . . . . . . . . . . . 121
5.3.1. Probability of bankruptcy . . . . . . . . . . . . . . . . . . . . . . . . . 121
5.3.2. Presentation of the first model (Model I) . . . . . . . . . . . . . . . . 122
5.3.3. Presentation of the model with correlations
(Model Ibis) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
5.3.4. Presentation of the model with
correlations and non-negative values for
assets and liabilities (Model II). . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.3.5. Consequences for ALM . . . . . . . . . . . . . . . . . . . . . . . . . . 131
5.4. Calibration of the models . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
5.4.1. Historical method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135
5.4.2. Scenario generator . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
5.5. Example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
5.5.1. Model Ibis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 139
5.5.2. ALM II . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
5.6. Key points for building internal models . . . . . . . . . . . . . . . . . . . 146
5.6.1. How to present an internal model? . . . . . . . . . . . . . . . . . . . . 146
5.6.2. Validation of the model . . . . . . . . . . . . . . . . . . . . . . . . . . 147
5.6.3. Partial and global internal models . . . . . . . . . . . . . . . . . . . . 147
5.7. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
viii Asset and Liability Management for Banks and Insurance Companies
CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
BIBLIOGRAPHY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151
INDEX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
Introduction
In recent years, the techniques known as asset and liability management

(ALM) have become a cornerstone of risk management, not only for banks
but also for insurance companies.
ALM can be defined as any continuous management process that defines,

implements, monitors and back tests financial strategies to jointly manage a
firm’s assets and liabilities. More specifically, an ALM strategy is designed
to achieve a financial goal for a given level of risk and under predefined
constraints. Due to the increase of technicalities in the current bank
and insurance regulation and the use of models which have become
increasingly complex and powerful, ALM now plays a central part in any
bank’s or insurance company’s financial strategy.
This book aims at covering the general concepts of ALM from the point
of view of an insurance company or a bank. The core framework and
the philosophy are the same, but regulations, products and models typically
differ on numerous points in pratice because the business and
the risks involved are quite different between an insurance company and a
bank.
In this book, we have tried to draw a parallel between the uses of ALM in
insurance companies and its uses in banks. To our knowledge, this is an
innovative way to present and study ALM techniques. We hope that it will
give the reader a better understanding of the commonalities and divergences
between these two worlds.
x Asset and Liability Management for Banks and Insurance Companies
Chapter 1 defines precisely what ALM is. After a brief history of the
origins and the past developments of ALM, we describe the typical missions
of an ALM department in a bank or in an insurance company.
In Chapter 2, we present the financial risks on which ALM classically

focus. Indeed the actual regulations (Basel II, Basel III and Solvency II)
specify that banks and insurance companies must identify, measure
and manage the financial risks they are exposed to. In this chapter, we
define the typical risks studied in ALM, and analyze the commonalities and
differences between the problem of banks and insurance
companies.
Chapter 3 describes the essential quantitative ALM tools and methods for
banks. We introduce various mathematical concepts such as the actuarial
value, embedded value or market-to-market values and, for the first time, we
introduce extended duration and convexity concepts giving interesting
new risk indicators. Techniques such as balance sheet immunization,
endowment and sensitivity of financial flows are described. We also
explain the use of deterministic and stochastic scenarios for dynamic
financial analysis.
Conversely, Chapter 4 is devoted to insurance companies. From a

pedagogical point of view, it gives the reader the keys to understand and
develop an ALM internal model for life insurance products. In this chapter,
we present basic ways for modeling an insurance company’s assets and
liabilities, and we describe a simple ALM model. This model is then used to
realize, step-by-step, a typical ALM study, in the same way as it is
concretely done in practice in ALM departments.
Lastly, Chapter 5 is the equivalent of Chapter 4 for banks as it explains

how to build and use a specific ALM internal model for banks. We show
how to proceed to gap reduction between asset and liability flows and we
develop global stochastic models for equity time evolution. These models
give the posibility to evaluate bankruptcy risks and so to compute VaR
values. Let us also mention that we illustrate the introduced concepts with
many numerical examples.
Introduction xi
Finally, we can say that this book is written in a relatively self-contained

form at least for our main audience formed by financial and risk managers of
insurance companies and banks, particularly dealing with own risk solvency
assessment (ORSA) techniques, enterprise risk management (ERM),
graduate students in economic or actuarial masters and people involved in
Solvency II for insurance companies and in Basel II and III for banks.
1
Definition of ALM in the

Banking and Insurance Areas
1.1. Introduction
In recent years, the technique known as asset and liability management

(ALM) has enjoyed remarkable popularity. Initially pioneered by
English-speaking financial institutions during the 1970s as an actuarial and
cash flow matching technique, ALM has grown into an essential framework
for banks and insurance companies.
The objective of ALM is to ensure the proper coordination between assets

and liabilities to achieve the financial targets for a specified level of risk and
under predefined constraints. The ALM department, whether in an insurance
company or in a bank, is therefore responsible for producing studies
providing recommendations on marketing strategy and asset allocation.
In recent years, the ALM department has become increasingly important

in a bank or an insurance company for three main reasons. First, modeling
tools are increasingly sophisticated, facilitating making relevant cash flow
projections. Second, accounting standards, which are central in ALM
business, are constantly evolving. Last, but not least, financial
communication is increasingly regulated.
This chapter is devoted to the definition of ALM in the banking and

insurance areas. We will specifically focus on the history of ALM and the
missions of an ALM department.
Asset and Liability Management for Banks and Insurance Companies, First Edition.
Marine Corlosquet-Habart, William Gehin, Jacques Janssen and Raimondo Manca.
© ISTE Ltd 2015. Published by ISTE Ltd and John Wiley & Sons, Inc.
2 Asset and Liability Management for Banks and Insurance Companies
1.2. Brief history of ALM for banks and insurance companies
Prior to the 1970s, interest rates in developed countries varied little and
thus losses caused by asset and liability mismatches were low. The proceeds
of their liabilities (for example deposits, life insurance policies or annuities)
were invested in assets such as loans, bonds or real estate. All assets and
liabilities were held at book value, hiding possible financial risks if assets
and liabilities were to diverge suddenly.
In the 1970s, a period of volatile interest rates started and continued until
the early 1980s. This volatility had dangerous implications for financial
institutions. US regulation, which had capped the interest rates that banks
could pay depositors, was abandoned to arise a migration overseas of the
market for USD deposits. As most firms used accrual accounting, the
emerging risk was slow to be recognized. Firms gradually accrued financial
losses over the subsequent 5 or 10 years.
The most famous example is that of Equitable, a US mutual life insurance

company. During the early 1980s, the USD yield curve was inverted.
Equitable sold a number of long-term Guaranteed Interest Contracts (GICs)
guaranteeing rates of around 16% for periods up to 10 years. During this
period, GICs were routinely exchanged with a principal of USD 100MM or
more. Equitable invested in short-term interest rates to pay the lower long-
term high interest rates they guaranteed to their clients. But short-term
interest rates soon collapsed. When Equitable had to reinvest, they could not
get a sufficiently high interest rate to pay their GICs, and the firm was
crippled. Ultimately, Equitable had to demutualize and was then acquired by
the Axa Group.
Learning the lessons from Equitable, managers of financial firms focused

on developing a sounder ALM. They sought ways to manage balance sheets
in order to maintain a mix of loans and deposits consistent with the bank’s
goals for long-term growth and risk management. Thus, they started
developing new financial techniques such as gap analysis, duration analysis
or scenario analysis.
ALM practices have evolved since the early 1980s. Today, financial
firms, particularly investment banks that enter trading operations daily, are
increasingly using market-value accounting for certain business lines. For
trading books, techniques of market risk management (for example
Definition of ALM in the Banking and Insurance Areas 3
Value-at-Risk) are more appropriate than techniques of ALM. In financial

firms, ALM is used for the management of assets and liabilities that must be
accounted on an accrual basis. This includes bank lending, deposit taking
and essentially all traditional insurance activities.
ALM techniques have also evolved. The growth of derivatives markets

has facilitated a variety of hedging strategies. A significant development has
been securitization, which facilitates firms to directly address asset and
liability risk by substantially removing assets or liabilities from their balance
sheets. This not only reduces asset and liability risk but also frees up the
balance sheet for new business.
The scope of ALM activities has widened. Today, ALM departments are
addressing a wider variety of risks, including foreign exchange risks. Also,
ALM has extended to non-financial firms. Corporations have adopted some
of the ALM techniques to manage interest-rate exposures, liquidity risks and
foreign exchange risks. They also use related techniques to address
commodities risks.
Nowadays, the process of ALM is at the crossroads between risk

management and strategic planning. It not only offers solutions to mitigate
or hedge the risks arising from the interaction of assets and liabilities, but
also conducts the bank or the insurance company from a long-term
perspective.
1.3. Missions of the ALM department
The objective of this chapter is to define the different missions of an

ALM department in a bank or an insurance company. These two entities
share the same goals, which are to analyze economic risks (mainly market
risk), to produce studies providing recommendations on marketing strategy
and asset allocation, and to monitor the implementation of those strategies.
However, the underlying business is not the same between banks and
insurance companies, and therefore the missions of their ALM department
can differ.
1.3.1. Missions of the ALM department for banks
The first mission of ALM was essentially to manage interest risks and
liquidity risks to prevent mismatches between the cash flows of the assets
and the cash flows of the liabilities. This is why ALM uses concepts such as
liquidity gap to quantify liquidity risks, and more mathematical indicators
such as duration or convexity introduced a long time ago by McCauley. This
led to the ALM policy of immunization which aimed to structure financial
cash flows in a way that minimizes their sensitivity to small changes of the
underlying interest rates. Thus, the ALM committee had to work hand in
hand with the other departments of the bank and soon played a central role
within the structure of the bank.
In 1988, the first Basel rules extended the field of application of ALM
even more. They gave the ALM department supervision of other financial
risks such as the equity risks, in addition to the traditional liquidity and
interest rates risks. Therefore, progressively, ALM gained a central position
in the management of the bank, often inside the risk management
department. However, the ALM department must keep, as far as possible, a
total independence within the firm.
In summary, ALM aims to coordinate the financial decisions of a firm so

that the structure of its assets and liabilities optimizes both the financial
benefits and the underlying risks, while respecting the prudential rules
imposed by the regulators.
As we will see in Chapters 3 and 5, different deterministic or stochastic

models exist which are particularly useful for risk managers.
1.3.1.1. Deterministic models

In a deterministic model, the evolution of the different financial variables
(such as interest rates, equity volatility, etc.) during a given period of time is
deterministic. This defines a single scenario, called the central scenario.
This central scenario is used to project the cash flows generated by the firm’s
assets and the cash flows generated by the firm’s liabilities and to study the
discrepancies between these two series of cash flows. Of course, this initial
study has to be complete with the consideration of other possible scenarios
for the considered cash flows.
Nevertheless, deterministic models are useful to quickly detect the weak

and strong points of hedging strategies and to have a basic understanding on
how to reduce the eventual mismatches.
1.3.1.2. Stochastic models

To face the uncertainty of economic, financial and social evolution in the
future, the use of stochastic models is necessary. However, stochastic models
simple enough to be easily implemented and parameterized tend to rely on
strong assumptions which are unfortunately sometimes unrealistic.
Nowadays, the models used in ALM are directly borrowed from

quantitative finance. In Chapter 5, we will see how we can build such a
model for the evolution of equities.
These models are also quite useful for the VaR computation. The VaR is
an indicator of solvability recommended by the Basel authorities as well as
by Solvency II for insurance companies.
Stochastic models are also used for the simulation of possible scenarios,
and for each of them, basic risk and profit indicators can be computed.
1.3.1.3. Mission of the bank ALM department

The ALM department has to coordinate the management of assets and
liabilities in such a way that benefits are optimized under an acceptable level
of risk. This level of risk is now imposed by the regulatory authorities. This
implies that the ALM department must have an overall, long-term view of
the financial activity of the bank. Using different economic scenarios, the
ALM department gives the necessary information to the Board of Directors
of the bank so that they can soundly plan future financial investments.
The coordination of assets and liabilities was already considered long

before the birth of ALM. However, nowadays the presence of a specific
ALM department is crucial in a sector as competitive as banking. Indeed, the
techniques used in ALM (for example to build generators of scenarios) are
now increasingly specific and elaborate.
1.3.2. Missions of the ALM department for insurance companies
An insurance company must have good knowledge of its asset and

liability risks to ensure its financial strength and honor its contractual
commitments to its clients. To do so, the main tasks of the ALM department
are the following:
– to ensure proper coordination of assets and liabilities to achieve a

financial goal with an accepted level of risk under predefined constraints;
– to produce studies providing recommendations on marketing strategy
and asset allocation;
– to calculate the capital requirement for market risks in the framework of
the Solvency II regulations.
The following section details these three missions.
1.3.2.1. To ensure proper coordination of assets and liabilities

The Asset-Liability Manager’s main function is to analyze the balance
sheet of the company, and its likely evolution over a period of time. This
analysis is based on a number of variables for which he anticipates the future
evolution (interest rates, business development, macroeconomic indicators
and other market variables). The main objective is to estimate and control
the balance between resources (assets) and expenses (liabilities) to the risks
taken by the insurance company, under the constraint of a level of
profitability and a regulatory framework.
In order to model liabilities, policyholder behavior should be analyzed to

determine all liability flows (for example deaths and lapses). The contract
specifications must also be taken into account (for example in life insurance,
profit sharing and the guaranteed minimum interest rate must be modeled).
Concerning the assets, the financial risks and their impact on the net
worth of the company must be analyzed. An insurance company must, for
example, manage interest risks (because assets mainly include bonds),
liquidity risks (when the company is not able to sell an asset or a liability at
the price it is valued), or currency risks (due to the variation of the value of
an item after a change of the currency price).
If the asset manager invests without taking into account the expected
behavior of insured people, then there will be a mismatch with liabilities.
Without the analysis of future cash flow liabilities, it is impossible to
determine the horizons of investments to be made. The insurance company
can then no longer have enough reserves to pay out, or have a low
profitability if the horizon is short. As the market is very competitive, poor
financial performance will decrease the level of profit sharing, and thus
weaken profitability. It is therefore essential to coordinate the assets and
liabilities to achieve better efficiency for the company. Furthermore, life

insurers are particularly exposed to asset and liability mismatching given the
long-term nature of their engagements. The ALM department must rely on
the skills of actuaries and asset managers to ensure proper management,
hence a better profitability.
1.3.2.2. To provide recommendations on marketing strategy and asset

allocation
ALM is responsible for establishing recommendations on the two main
levers for controlling the activity: marketing strategy and asset allocation.
On the one hand, marketing strategy can guide the composition of the
portfolio of insurance contracts. On the other hand, strategic asset allocation
limits financial risks arising from the reversal of the production cycle, in
order to ensure the payment of benefits to policyholders and the future
profits of the company.
The business of insurance is indeed particular: its production cycle is

reversed. Life insurance premiums can be locked up to 30 years, so
insurance companies must find investments with stable yields for the
lifetime of these policies. Reinvestment risks are apparent, because future
premiums must be invested even if their rate of return is lower than the rate
necessary to cover present-day pricing. Likewise, insurance companies are
exposed to disinvestment risk, when assets must be sold even at low prices
to cover claims or other expenses. The impact of rising interest rates can be
compounded by lost profits from suspended policies as consumers search for
more lucrative financial instruments.
Thus, ALM studies are used to select the optimal strategic allocation of
investments based on risk aversion of the insurance company.
1.3.2.3. To calculate the Solvency II capital requirement for market risks

The ALM department can also be in charge of different studies or
regulatory calculations such as the solvency capital requirement (SCR)
market for insurance. An asset and liability manager is involved in the
innovation, development and improvement of the prospective cash flow
model (or internal model). This includes investment strategy, credit risk
modeling and policyholder behavior modeling. He can also work on
integration in the ALM studies of elements of Solvency II’s Pillar 1 and 2:
SCR and coverage ratio, risk profile and risk appetite.
1.4. Conclusion
This chapter has highlighted the fact that ALM has become a key
indicator for risk management, not only for banks but also for insurance
companies. It is a continuous process involving the formulation,
implementation, monitoring and review of strategies related to assets and
liabilities in order to achieve financial goals, taking into account a certain
risk tolerance and constraints. Thus, ALM is crucial for any business, bank
or insurance company that needs to invest capital to meet its contractual
commitments and eager to ensure a well-balanced financial management.
The next chapter will describe the risks studied in ALM. After this
definition of ALM in a bank and in an insurance company, we will now
carry out a deep analysis of the different risks that the ALM department
monitors.
2
Risks Studied in ALM
2.1. Introduction
In recent years, the financial and economic crises have increased the
importance of risk management in banks and insurance companies. Indeed,
banks, insurance and even reinsurance companies must now be able to
understand the inherent risks of their business in order to allocate enough
capital to cover it. This need has been initiated by Basel II and then Basel III
for banks, and now has been extended to the insurance industry with
Solvency II.
The purpose of this chapter is to list the key risks in asset and liability
management (ALM), by differentiating banking and insurance problems. We
describe how they are understood by today’s standards: Basel II and III for
banks and Solvency II for insurance companies. Last, but not least, we
analyze the similarities and differences between the problems of banks and
those of insurance companies.
2.2. Risks studied in a bank in the framework of Basel II and III
2.2.1. Main risks for banks
The main risks to which banks are exposed are the following: liquidity
risk, credit risk, market risk (interest rate risk, foreign exchange risk and risk
from change in market price of securities, financial derivatives and
commodities), exposure risks, investment risks, risks related to the country
of origin of the entity to which a bank is exposed, operational risk, legal risk,
reputational risk and strategic risk. In this chapter, we will define all of these
Asset and Liability Management for Banks and Insurance Companies

Marine Corlosquet-Habart, William Gehin, Jacques Janssen and Raimondo Manca.
© ISTE Ltd 2015. Published by ISTE Ltd and John Wiley & Sons, Inc.
risks. Let us mention that some of these risks are similar for insurance
companies (see section 2.3.2).
Liquidity risk is the risk caused by the inability of the banks to face their
obligations, particularly for cash demands.
Credit risk is the risk caused by the eventual default of borrowers on their
obligations to the bank and is also the risk of loss of present bond values due
to the degradation of the issuer. This last one is also called risk of
degradation.
Market risk can be subdivided as follows:

– interest rate risk, which is the risk caused by changes in interest rates;
– foreign exchange risk, which is the risk of financial losses caused by
changes in exchange rates, especially for financial derivatives and
commodities traded in the international market;
– asset risk, which is the risk of financial losses due to the depreciation of
assets on stock exchanges.
Exposure risk is the risk of a bank’s exposure to a single entity or a group

of related entities.
Investment risk is the risk of bad investment outside the financial sector
and in fixed assets.
Country risk is the risk from foreign activities due to political, economic
or social condition in the considered country.
Operational risk is the risk caused by omissions in the work of

employees, inadequate internal procedures and processes, inadequate
management of information and other systems, failures in the computer
system and unforeseeable external events.
Legal risk is the risk of loss caused by penalties or sanctions originating

from court disputes due to a breach of contractual and legal obligations, and
penalties and sanctions pronounced by a regulatory body.
Reputational risk is the risk of loss caused by a negative impact on the

market positioning of the bank.
Risks Studied in ALM 11
Strategic risk is the risk caused by a lack of a long-term development

component in the bank’s managing team.
2.2.2. From Basel I to Basel III
2.2.2.1. Basel I and Basel II

Inside the Bank for International Settlements (BIS), the Basel Committee,
grouping the most important 27 central banks of the world, the prudential
authorities established rules and norms to stabilize the banking system with a
view to avoid bankruptcies and worldwide crises. Since 1988, three
regulations have been elaborated: Basel I in 1988, Basel II in 2007 and Basel
III after the subprime crisis. These rules are transformed into national rules
in all the countries represented in the worldwide bank and all the banks have
the obligation to apply them.
Let us summarize briefly the most important impacts of these successive

Basel rules.
Basel I mainly concerns the market finance with the introduction of the
Cooke ratio concerning the equities of the banks in conformity of the
recommendations called capital adequacy directives (CA). Roughly, this
ratio must ensure a minimal level of capital guaranteeing the solidity of the
banks. Banks are required to maintain a liquidity buffer of 8% of their
capital. This ratio is defined as follows:
equities(Core Tier one + goodwill)

(≥ 8%).
credit risk + market risk
To calculate this ratio, the equities are traditionally divided into three
large bodies (the core or Tier 1, Tier 2 and Tier 3). The ratio of equity to
risk-weighted assets must be equal to or greater than 8% with a minimum of
4% on Tier 1.
The credit risk calculation worked on a risk-weighted basis of the credits

done by the bank. Each asset is placed into one of five categories and the
total assets in each category are multiplied by a specific percentage. For
example, loans to the national government in the bank’s own country are
considered so safe that the category total is multiplied by 0%, meaning those
assets are effectively ignored. Riskier loans fall into the 10, 20, 50 and 100%
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because the trade of the Vistula would then be freed from obstacles,
and be opened to her by favourable commercial treaties. Such was
868
Hertzberg’s final plan for the preservation of the status quo. In
order to secure the acquiescence of the Turks, he had long kept the
Porte on tenter-hooks by delaying the ratification of Dietz’s treaty, and
by ordering the recall of that masterful envoy. On the other hand, the
Turks were left with a glimmer of hope of eventual assistance from
Berlin.
Accordingly, Prussian policy seemed about to win a brilliant
triumph at the proposed Conference of Reichenbach, where the Triple
Alliance and Austria (Russia having refused Britain’s mediation) were
to thrash out these questions; and nothing is more curious than to
watch the collapse of Hertzberg’s ingenious web. In order at the outset
to settle matters separately with the Austrian envoy, Spielmann, the
King of Prussia held Ewart aloof because the British Ambassador
consistently warned Hertzberg against the complicated exchanges
projected by him. Thereupon Ewart drew up a Memorial insisting that
England must be a principal party, and that, as both Austria and
Prussia had promised to admit the status quo as the basis of
negotiation, the latter could not make war on the former if she
consented to it. In that case, or even if he (Ewart) were excluded from
the Conference, Great Britain must cancel her engagements to Prussia.
He further declared his conviction that Austria would retract her
869
extreme claims and listen to reason.
This sharp protest had some effect on Hertzberg; but the chief
difficulty was now with Frederick William. At the head of his splendid
army, he seemed to court war. He sent a courier to the Porte to ratify
Dietz’s treaty; and he cut off all communications with Austria as
though hostilities had begun. At the first three sessions of the
Conference (27th-29th June) the Austrian and Prussian envoys
indulged in eager but vague wrangling; but the arrival of news from
Constantinople that the Turks would never concede the Prussian
demands sufficed to depress the bellicose ardour of the monarch. As
there was a serious risk of the Porte coming to terms with Russia and
Austria, he now harked back towards the status quo. This move, which
the Duke of Brunswick and Möllendorf heartily supported, gathered
strength when it appeared that Poland would accept none of
Hertzberg’s benefits. The arrival of the British note of 2nd July to the
same general effect ended the last efforts of Frederick William for
870
Danzig and Thorn. He now gave Hertzberg written orders to
abandon at once the whole scheme of exchanges “since it could only
serve to commit him with Great Britain as well as with the Porte and
Poland.” Whence it appears that Hertzberg’s scientific and
philanthropic plans fell through simply because all the States
concerned utterly repudiated them.
The renunciation, however, was made not unskilfully. The Prussian
and British Ministers were careful to keep secret Hertzberg’s change of
front and thus prepared a surprise for Spielmann. That envoy having
put forward some equally untenable schemes of aggrandisement,
Ewart rose and read out a Memorial, drawn up in concert with his
Prussian and Dutch colleagues, demanding an exact restitution of the
old boundaries. In vain did the Hapsburg Minister seek to wriggle out
of the dilemma by betraying Prussia into glaring inconsistency. Prussia
stood firm; and finally he reduced his demands to Orsova and district.
Even this cold comfort was denied him. The Triple Alliance was
inexorable. Thereupon he demanded the dissolution of Prussia’s
compacts with Turkey and Sweden, only to meet with the reply that
871
the Austro-Russian alliance must first be annulled. Thus Hertzberg,
even in the hour of personal defeat, brought down the Hapsburg
schemes in utter collapse; and the result of the discussions at
Reichenbach was the recurrence to the status quo—the very same
arrangement which Pitt and Leeds had throughout declared to be the
best of all solutions.
Hertzberg’s annoyance at the destruction of his pet plans must
have diminished when he heard from Vienna that Austria had secretly
empowered Potemkin to make her peace with the Turks on that same
basis. If this be true, each of the rivals was playing a game of bluff at
Reichenbach; and the sight of the two Ancient Pistols eating the leek
in turn must have filled Ewart with a joy such as falls to few
diplomatists. Even as regards the Belgians, the British suggestion held
good. They were to regain their ancient constitution together with an
amnesty for past offences, and a guarantee by the three Allied
872
Powers. Frederick William, in complimenting Hertzberg on the end
of the negotiations at Reichenbach, added that they must now assure
themselves, through Ewart, of England’s support in imposing the
873
status quo on Russia. A new chapter in the relations of the Powers
and in the career of Pitt lay enfolded in this suggestion.
* * * * *
Shortly after this happy ending to the disputes in Central Europe
came the news of a settlement of the war in the Baltic. Once again
Gustavus III startled the world. After his sudden and furious attack on
Catharine, and her no less fierce counter stroke, it seemed that the
struggle must be mortal. But many circumstances occurred to allay
their hatred. The aims of the Czarina had always trended southwards;
and the war in Finland was ultimately regarded chiefly as an annoying
diversion from the crusade against the Turks. Moreover the valour of
the Swedes, who closed the doubtful campaign of 1790 with a decided
success at sea, added to the difficulties of campaigning in Finland, left
little hope of conquest in that quarter so long as the Triple Alliance
kept the Danes quiet and subsidized Gustavus. Catharine was in fact
fighting against the forces of nature and the resources of England,
Prussia, and Holland. Gustavus, too, even in the year 1789 felt the
sobering influences of poverty. In 1790 they threatened him with
bankruptcy, and at that same time the outlook was far from bright in
Finland. Fortunately, the Russians were not in a position to press
Gustavus hard. But nothing could stave off the advent of bankruptcy
unless the Allies promptly advanced a considerable sum. This they
were not prepared to do, for his unceasing importunities had wearied
them out. The Dutch declined to help in a matter which concerned
them but little, and after long negotiations at Stockholm Great Britain
and Prussia agreed on 31st July to advance £200,000, or only two-
thirds of the minimum named by the King. By the month of August
1790 the treasury at Stockholm was absolutely empty, so our envoy,
Liston, reported.
While Gustavus was chafing at the restraints of poverty, Catharine
held out to him alluring hopes. So soon as she heard of the turn which
affairs were taking at Reichenbach she resolved to end her quarrel
with him in order the better to browbeat Prussia and England. Leopold
had early informed her of his resolve to conclude the Turkish war, in
accordance with the demands of the Allies; and he also warned her of
their intention to deprive Russia of her chief conquest. With a
quickness of insight and a magnanimous resolve instinct with the
highest statesmanship, she resolved to end the war in the Baltic by
offers which would appeal irresistibly to a knight-errant struggling with
debts and worries. She therefore despatched a courier to him in
Finland, holding out virtually the same terms which the Allies had
guaranteed to him.
Gustavus did not long hesitate. It is true that he had the promise
of seventeen British battleships, which were in the Downs ready to sail
to his succour; Prussia also had already sent one half of the subsidy
which he demanded; and he had pledged his troth to the Allies not to
make a separate peace with Russia. That step, however, he now
decided to take; and the impression afterwards prevailed at London
874
and Berlin, that Russian money had some influence on his decision.
However that may be, he sent Baron Armfelt to treat for peace. Where
both sides were bent on a speedy settlement, difficulties vanished; and
thus on 14th August 1790, the Peace of Werela was signed. It restored
the few gains of territory which the belligerents had made, and gave
permission to the Swedes to buy grain in Russian ports. The treaty
was remarkable chiefly for its omissions. No mention was made of
previous Russo-Swedish treaties, which gave the Empire some right to
interfere in Swedish affairs. As Liston pointed out, the absence of any
such claim was a personal victory for Gustavus; for it increased his
authority and depressed that of the Russophile nobles. The King at
once asserted his prerogative by condemning to death, despite the
entreaties of Liston, the ringleader of the mutiny in Finland and by
875
incarcerating two others for life. Events were to show that the
faction was cowed but not wholly crushed. The bullet of Ankerström
repaid the debt of vengeance stored up in September 1790.
Equally strange was the abandonment of the Turks by their
headstrong ally. Gustavus had gone to war ostensibly in order to
prevent their overthrow, and now he left them at the mercy of
Catharine. It is true that the signature of the Reichenbach Convention
three weeks earlier ended their conflict with Austria; but the
indignation of the Sultan, the wrath of the King of Prussia, and the
876
quiet contempt of Pitt manifested the general feeling of the time.
Gustavus had salved his conscience by requiring Catharine to accord
lenient treatment to the Moslems. The Czarina was quite ready to
make any promises to this effect, if they formed no part of the treaty
with Sweden. She assured Gustavus of her desire to renew the Treaty
of Kainardji rather than continue the war; and Gustavus decided, so he
informed Liston, “to trust to the elevated and honourable character of
the Empress” on this point. Liston had his doubts. He ventured to
express his surprise at the generosity of the imperial promises, which
implied the restoration of the Crimea to Turkey, and he remarked that
the combined pressure of Great Britain and Prussia had not availed to
extort so great a boon. Gustavus, however, persisted in his estimate of
the character of Catharine, doubtless because she humoured his latest
plan, a crusade to Paris on behalf of the French monarchy, while she
further promised him the sum of 2,000,000 roubles for his immediate
877
needs. She, too, sang loudly the praises of the man whom she had
sworn to ruin. The cause of this new-born enthusiasm will appear in
due course.
From the Swedish point of view much might be said for the action
of Gustavus. He had rid himself and his land from the irksome tutelage
of Russia: he came out of the war with no loss of territory, the first
Russo-Swedish war of the century of which this can be said; his
martial energy had inspirited his people; and he had overthrown a
corrupt and unpatriotic aristocracy. But, from the standpoint which he
took up at the outset of the war, his conduct had proved him a shifty
ally, who merited the suspicion of his former comrades. Nevertheless
he had played no small part in checking the subversive schemes of
Catharine and Joseph. Thanks to him the Moslems maintained a
struggle which gave time for the army of Prussia and the diplomacy of
Pitt to exert themselves with effect. Had he stood by his promises, the
Triple Alliance would probably have brought Russia to terms favourable
to the interests both of Turkey and of Poland.
Even as matters stood at the end of that year of turmoil, 1790, Pitt
might reflect with something of pride that his efforts had decisively
made for peace and stability. He it was who had been mainly
instrumental in saving Sweden from ruin, the Hapsburg States from
partition, and Prussia from Hertzberg’s policy of exchange and
adventure. Moreover, at that same time British policy won another
success at a point which has always been deemed essential to the
maintenance of equilibrium in Europe.
* * * * *
The recovery of his authority in the Belgic provinces lay near the
heart of Leopold II. His letters and those of Kaunitz show that he
consented to patch matters up at Reichenbach largely in order that he
might be free to subdue Brabant and Flanders. True, he admitted the
mediation of the Triple Alliance in those affairs; but his missive to
Catharine shows that he acquiesced in that convention only in order to
prevent the disruption of his dominions, and that he hoped to evade
some at least of its provisions by means of an “eternal alliance” with
Russia. As will appear in a later chapter, fidelity to Russia involved a
policy of procrastination and trickery towards Turkey, Prussia, England,
and the Belgians. The conduct of Austria in the Eastern Question
helped to checkmate Pitt and secure a diplomatic triumph for
Catharine in the year 1791.
Here we may notice that Leopold and Kaunitz, so soon as the
threat of war from the Prussian side passed away, and their own
troops in Luxemburg were reinforced, took a stern tone with the men
of Brabant and Flanders. At the Conference held at The Hague for the
settlement of those affairs, the Austrian envoy, Count Mercy, refused
to extend the time of the armistice in those provinces, and warned the
three mediating Powers that their services would no longer be
recognized by the Viennese Court. Austrian troops also began to
march towards Brussels. Thereupon Lord Auckland hotly protested
against this high-handed proceeding; and the British Cabinet
threatened to send a large fleet to co-operate with the Prussians and
878
Dutch in preventing the re-conquest of Belgic lands by Leopold.
This threat, formidable in view of the large armament kept up by
England, even after the end of the Spanish dispute, emanated largely
from Pitt himself. For Ewart, who was then in London on furlough,
wrote to Auckland on 28th November 1790 concerning the opinions of
Ministers:
Some difference of opinion existed; but I trust Mr. Pitt will

write to your lordship himself in a satisfactory manner; and you
know better than I do of what consequence the opinions of others
are. I confess I am very uneasy about the explosion this affair
must have produced at Berlin; but I trust the explanations sent
from hence will have given satisfaction both there and with you on
the great principle of making the Emperor adhere—bon gré, mal
gré—to his engagements for re-establishing the [Belgic]
Constitution: and it appears impossible he should venture in his
879
present situation to risk the consequences of a refusal.
Pitt’s firmness won the day. Leopold shrank from a contest with
the Allies, and consented to a convention which was signed on 10th
December at The Hague. The ancient customs and privileges of the
Pays Bas were to be restored (including those of the University of
Louvain and the Catholic seminaries), and an amnesty granted to all
concerned in the recent revolt. Leopold promised never to apply the
conscription to his Belgian subjects, and he recognized the guarantee
of Great Britain, Prussia, and Holland for the present arrangements.
The satisfaction of Pitt at this turn of affairs appeared in the order
to place the British navy on a peace footing—a measure which we can
now see to have been premature, in that it encouraged Catharine to
reject the demands of the Allies, and Leopold to display the duplicity
which often marred his actions. The failure of Pitt to coerce the
Czarina will engage our attention later; but we may note here that, on
various pretexts, Leopold refused to ratify the Hague Convention, and
left Belgian affairs in a state which earned the hatred of that people
880
and the suspicion of British statesmen.
For the present, as the shiftiness of Leopold and the defiance of
Catharine could not be surmised, there seemed to be scarcely a cloud
on the political horizon. By the end of the year 1790, the policy of Pitt,
cautious at the beginning of a crisis, firm during its growth, and drastic
at the climax, had raised Great Britain to a state of prosperity and
power which contrasted sharply with the unending turmoil in France,
the helplessness of Spain, the confusion in the Hapsburg States, and
the sharp financial strain in Russia. In truth, the end of the year 1790
marks the zenith of Pitt’s career. In seven years, crowded with complex
questions, he had won his way to an eminence whence he could look
down on rivals, both internal and external, groping their way
doubtfully and deviously.
Of these triumphs, those gained over foreign Powers were by far
the most important, except in the eyes of those who look at British
history from the point of view of party strife. To them the events of
this fascinating period will be merely a confused background to the
duel between Pitt and Fox. Those, however, who love to probe the
very heart of events, and to pry into the hidden springs of great
movements, which uplift one nation and depress another, will not soon
tire even of the dry details of diplomacy, when they are seen to be the
gauge of human wisdom and folly, of national greatness and decline.
In the seven years now under survey, England emerged from
defeat, isolation, and discredit which bordered on bankruptcy, until she
soared aloft to a position of prestige in the diplomatic and mercantile
spheres which earned the envy of her formerly triumphant rivals.
Strong in herself, and strengthened by the alliance of Prussia and
Holland, she had to all appearance assured the future of the Continent
in a way that made for peace and quietness. Pitt had helped to
compose the strifes resulting from the reckless innovations of Joseph
II, strifes which, had Hertzberg succeeded, must have led to a general
war. The importance of this work of pacification has escaped notice
amidst the dramatic incidents of the Revolution and Napoleonic Era.
For in the panorama of history, as in its daily diorama, it is the
destructive and sensational which rivets attention, too often to the
exclusion of the healing and upbuilding efforts on which the future of
the race depends. A more searching inquiry, a more faithful
description, will reveal the truth, that a statesman attains a higher
success when he averts war than when he wages a triumphant war.
CHAPTER XXIV
THE FRENCH REVOLUTION
A disposition to preserve, and an ability to improve, taken

together, would be my standard of a statesman. Everything else is
vulgar in the conception, perilous in the execution.—Burke,
Reflections on the French Revolution.
Ideas rule the world and its events. A Revolution is the
passage of an idea from theory to practice.—Mazzini, The French
Revolution of 1789.
T HAT the career of Pitt is divided into two very diverse portions by
the French Revolution is almost a commonplace. Macaulay in
artful antitheses has pointed the contrast between the earlier and the
later Pitt; poets, who lacked his art but abounded in gall, descanted on
the perversion of the friend of liberty into the reactionary tyrant; and
Jacobins hissed out his name as that of “the enemy of the human
race.”
If we carefully study the attitude of Pitt towards the French
Revolution, we shall find it to be far from inflexible. It changed with
changing events. It was not that of a doctrinaire but of a practical
statesman, who judges things by their outcome. He has often been
blamed for looking at this great movement too much from the
standpoint of a financier; and the charge is perhaps tenable as regards
the years of the Jacobin ascendancy, when the flame kindled by
Rousseau shrivelled up the old order of things. But the ideas prevalent
in 1793 differed utterly from those of 1789, which aimed at reforms of
a markedly practical character.
There was urgent need of them. As is well known, the unprivileged
classes of France were entangled in a network of abuses, social, fiscal,
and agrarian, from which the nobles had refused to set them free.
Despite the goodwill of Louis XVI, the well-meant efforts of his chief
minister, Necker, and the benevolent attempts of many of the clergy
and some nobles, the meshes of Feudalism and the absolute monarchy
lay heavily on the land up to the time of the Assembly of the States-
General at Versailles in May 1789. It is of course a gross error to
assume that the French peasants were more oppressed than those of
other continental lands. Their lot was more favoured than that of the
peasantry of Spain, South Italy, Prussia, and most parts of Germany, to
say nothing of the brutish condition of the serfs of Poland and
881
Russia. Those of France were more prosperous than Arthur Young
believed them to be. They kept on buying up plot after plot in ways
that illustrate the ceaseless land-hunger of the Celt and his elusive
stubbornness.
But he would be a shallow reasoner who argued that, because the
poverty of the French peasants was less grinding than it appeared,
therefore the old agrarian and fiscal customs were tolerable. The most
brilliant display of what Carlyle called “tongue-fencing” cannot justify a
system which compels millions of men to live behind a perpetual
screen of misery. To notice the case of that worthy peasant whose
hospitality was sought by Rousseau during his first weary tramp to
Paris. The man gave him only the coarsest food until he felt sure of his
being a friend of the people and no spy. Then wine, ham, and an
omelette were forthcoming, and Jacques Bonhomme opened his heart.
“He gave me to understand,” said Rousseau, “that he hid his wine on
account of the duties, and his bread on account of the tax; and that he
would be a lost man if he did not lead people to suppose that he was
dying of hunger. All that he told me about this subject—of which
previously I had not had the slightest idea—made an impression upon
me which will never be effaced. There was the germ of that
inextinguishable hatred which developed later in my heart against the
882
vexations endured by the poor, and against their oppressors.”
Multiply the case of that hospitable peasant a million times over, and
the outbreak of the Revolution becomes a foregone conclusion. The
only surprising thing is that the débâcle did not come far earlier.
But the old order rarely breaks up until the vernal impulses of
hope begin potently to work. These forces were set in motion, firstly,
by the speculations of philosophers, the criticisms of economists and
the social millennium glowingly sketched by Rousseau. Ideas which
might have been confined to the study, were spread to the street by
the French soldiers who had fought side by side with the soldiers of
Washington, and became on their return the most telling pleaders for
reform. Thus, by a fatal ricochet, the bolt launched by the Bourbons at
England’s Colonial Empire, glanced off and wrecked their own fabric.
The results, however, came slowly. It is often assumed that the
destructive teachings of the Encyclopaedists, the blighting raillery of
Voltaire, and the alluring Utopia of Rousseau would by themselves
have been the ruin of that outworn social order. But it is certain that
no one in France or England, up to the eve of the Revolution,
anticipated a general overturn. Ultimately, no doubt, ideas rule the
world; but their advent to power is gradual, unless the champions of
the old order allow decay to spread. Furthermore, constructors of
ingenious theories about the French Revolution generally forget that
nearly all the ideas given to the world by Voltaire, Montesquieu, and
Rousseau, were derived from the works of Hobbes, Locke, and
Bolingbroke. The sage of Ferney drew his arrows from the quiver of
English philosophy, and merely added the barbs of his own satire;
Montesquieu pleaded on behalf of a balance of political powers like
that of England; and all that was most effective in the “Social
Contract” of the Genevese thinker came from Hobbes and Locke. The
verve of Frenchmen gave to these ideas an application far wider than
that which they had gained in their island home. Here the teachings of
Locke formed a prim parterre around the palace of the King, the heir
to the glorious Revolution of 1688. When transferred to that political
forcing-bed, France, they shot up in baleful harvests.
It is the seed-bed which counts as well as the seed. The
harmlessness of philosophic speculation in England and its destructive
activity in France may be explained ultimately by the condition of the
two lands. In the Island State able Ministers succeeded in popularizing
an alien dynasty and promoting the well-being of the people.
Retrenchment and Reform were not merely topics of conversation in
salons; they were carried out in many parts of the administration. This
was specially the case after the peace of 1783, which left France
victorious and England prostrate. There the fruits of victory were not
garnered; and the political fabric, strained by the war, was not
underpinned. Thinking men talked of repair, but, thanks to the
weakness of the King and the favouritism of the Queen, nothing was
done. Here the ablest constructive statesman since the time of
Cromwell set about the needed repairs; and his work, be it
remembered, coincided with the joyous experiments of the Court of
Versailles to maintain credit by a display of luxury. The steady recovery
of England and the swift decline of France may be ascribed in large
measure to Pitt and Calonne.
It was against definite and curable ills in the body politic that the
French reformers at first directed their efforts. In May–June 1789 the
ideals of Rousseau remained wholly in the background. The Nobles
and Clergy (as appears in their cahiers, or instructions) were, with few
exceptions, ready to give up the immunities from taxation to which
they had too long clung. Those of the Tiers Etat, or Commons, laid
stress on fair taxation, on the abolition of the cramping customs of
Feudalism, whether social, agrarian, or judicial, on the mitigation of
service in the militia, while some even demanded better lighting of the
streets. The Nobles and Clergy asked for a limitation of the powers of
the Crown; and the Commons desired a constitution; but it was to
resemble that of England, save that larger powers were left to the
King, the Ministers being responsible to him alone. Few of the cahiers
of the Commons asked for a fusion of the three Orders in one
883
Assembly; and not one breathed the thought of a Republic. Their
bugbear was the game laws, not the monarchy; the taille à
miséricorde and the corvées, not the Nobles; the burdensome tithes,
not the Church.
As at Paris and Versailles, so among the peasants. At first, even in
troublous Franche Comté, their thoughts did not soar beyond taxes
and feudal burdens. Arthur Young calmed a demonstration against
himself by telling excited patriots near Besançon of the differences
between taxes in England and France:
Gentlemen [he said] we have a great number of taxes in

England which you know nothing of in France; but the tiers état,
the poor, do not pay them, they are laid on the rich; every window
in a man’s house pays; but if he has no more than six windows, he
pays nothing; a Seigneur, with a great estate, pays the vingtièmes
and taille, but the little proprietor of a garden pays nothing; the
rich, for their horses, their carriages, their servants, and even for
liberty to kill their own partridges; but the poor farmer nothing of
all this; and what is more, we have in England a tax paid by the
884
rich for the relief of the poor.
Who would not sympathize with these people! They were

staggering under burdens piled up by a monarchy absolute in name,
but powerless in all that made for reform and retrenchment. Where
Louis XVI by his weakness, and the Queen by her caprice, had failed
to right the wrong, the nation was bent in succeeding; and it is highly
probable that, if the King had shown more tact in dealing with the
Commons, and they a little more patience, the popular movement
might have progressed peacefully for a decade, with wholly beneficent
results. We, who know how one event led on to another, find it difficult
to escape from the attractive but fallacious conclusion that the
sequence was inevitable. The mind loves to forge connecting links, and
then to conclude that the chain could not have been made otherwise—
a quite gratuitous assumption. At several points it was the exceptional
which happened. A perusal of the letters of intelligent onlookers shows
that they foresaw, and most naturally, a wholly different outcome of
events. They looked to see a few drastic reforms, a time of unrest, and
then the remodelling of the monarchy à l’Anglaise.
As for Pitt, he waited to see whither all this would tend. His
attitude towards France in the early part of 1789 was distinctly
friendly. He assured the French ambassador, M. de Luzerne, that
France and England had the same principles, namely, not to
aggrandize themselves and to oppose aggrandizement in others, and
he added that he hoped for the assistance of France to assist Sweden
and Turkey against the powerful Empires that were seeking their
overthrow.
This declaration bespoke his fixed resolve to save Europe from the
ambitious schemes of the other monarchs; and, now that France
accepted Anglo-Prussian ascendancy in Holland and abandoned her
forward policy in the Orient, she might serve to redress the balance of
power. Such views were consonant with Pitt’s lofty aim of winning over
“the natural enemy.” In truth, they were the outcome of common
sense, even of self-interest. The suspicion and dislike were all on the
side of the Court of Versailles. Montmorin and Luzerne were haunted
by the fear that Pitt meant to pour oil on the smouldering discontent in
France, and shrivel up the Bourbon power. There is not a shred of
evidence that he ever entertained these notions. That they were
harboured at Versailles merely showed that a Power which has rent
another in twain cannot believe in the goodwill of the injured nation;
and this suspicion was one of the many causes begetting irritation and
alarm in Paris. On the other hand it must be remembered, as one of
Pitt’s greatest services, that his protests against the American War and
his subsequent efforts for an entente cordiale with France, had so far
effaced resentment on this side of the Channel, that the strivings of
Frenchmen after political freedom and social equality aroused the
deepest interest. The majority of our people sympathized with Fox,
when, on hearing of the fall of the Bastille, he exclaimed: “How much
885
is this the greatest and best event that has happened in the world.”
Official prudence or natural reserve kept Pitt silent on these affairs,
and on the horrors of the ensuing Jacquerie, which speedily cooled the
first transports of Britons. We know, however, that he must have
viewed the financial collapse of France with secret satisfaction; for in
August–September 1788 he wrote to Grenville in terms which implied
that the recovery of the credit of France, then expected under the
fostering care of Necker, would be a very serious blow, implying as it
886
did the resumption of her aggressive schemes in the East. Now,
however, the disorders in France aroused his pity; and on 14th July,
before he can have heard of the fall of the Bastille, he wrote to his
mother that France was fast becoming “an object of compassion even
887
to a rival.” There is no sign that he feared the spread of democratic
opinions into England. The monarchy had never been so popular as
since the mental malady of the King. On the whole, then, Pitt surveyed
the first events of the Revolution from the standpoint of a diplomatist
and financier. France seemed to him doomed to a time of chastening
and weakness which might upset the uneasy equilibrium of Europe.
Already he had come into touch with the French people at a very
sensitive point, and in a way which illustrated their eager expectancy
and his cool and calculating character. On 25th June Necker sent to
him an urgent appeal begging that he would sanction the export of
flour from Great Britain to France in order to make good the scarcity
which there prevailed. If the request must come before Parliament, he
trusted that the boon would speedily be granted by a generous nation,
and by a statesman “whose rare virtues, sublime talents, and superb
888
renown have long rivetted my admiration and that of all Europe.”
* * * * *
In sharp contrast to this personal and effusive request was the
cold and correct demeanour of Pitt. He sent the following formal reply,
not to Necker, but to the French ambassador, the Marquis de Luzerne:
889
Downing Street, 3rd July, 1789.
Mr. Pitt presents his compliments to the Marquis de Luzerne.
He has felt the strongest desire to be able to recommend sending
the supply of flour desir’d by Monsr Necker and had hopes from
the information at first given him by Mr. Wilson that it would be
practicable; but, having afterwards received some contrary
information, he thought it necessary that the subject should be
examined by the Committee of Council for the Affairs of Trade,
whose enquiry was not clos’d till this morning. Mr. Pitt has now the
mortification to find that, according to the accounts of the persons
most conversant with the corn trade, the present supply in this
country compar’d with the demand, and the precarious prospect
of the harvest render it impossible to propose to Parliament to
authorize any exportation.
Three days later Pulteney brought the matter before the House of
Commons and deprecated the export of 20,000 sacks of flour to
France which had been talked of. Pitt thereupon stated that skilled
advice was being taken as to the advisability of allowing such an
export, in view of the shortness at home, and the gloomy prospects
for the harvest. Wilberforce, Dempster, and Major Scott urged the
more generous course towards our suffering neighbours; but others
pointed out that, as the price of home wheat was rising (it rose seven
shillings the bushel on that very day), any such proposal would
enhance that perilous tendency at home without materially benefiting
the French. Even at the present figures export was forbidden under
the existing Corn Law; but Pitt mentioned that a curious attempt was
on foot at Shoreham to depress the price from forty-eight shillings to
forty-four in order to procure the export of 8,000 sacks of flour to
Havre. As the transaction was clearly fictitious, he had directed the
Customs officers to stop the export. On 13th July Grenville, in the
absence of Pitt, asked leave to introduce a Bill for the better
ascertaining and regulating the export of corn; and the House at once
890
agreed.
Such, then, was the beginning of Pitt’s relations to French
democracy. They are certainly to be regretted. His reply to Necker’s
request is icily correct and patriotically insular; and his whole attitude
was a warning to the French not to expect from him any deviation
from the rules of Political Economy. Of course it is unfair to tax him
with blindness in not recognizing the momentous character of the
crisis. No one could foresee the banishment of Necker, the surrender
of the Bastille, on the very day after Grenville’s motion, still less the
stories of the pacte de famine, and their hideous finale, the march of
the dames des halles to Versailles, ostensibly to get food.
Nevertheless, the highest statesmanship transcends mere reason. The
greatest of leaders knows instinctively when economic laws and the
needs of his own nation may be set aside for the welfare of humanity.
The gift of 20,000 sacks of flour outright would have been the best
bargain of Pitt’s career. It would have spoken straight to the heart of
France, and brought about a genuine entente cordiale. His conduct
was absolutely justified by law. The Commercial Treaty of 1786 with
France had not included the trade in corn or flour, which had long
been subject to strict regulations, and therefore remained so.
Moreover, the Dublin Government did not allow the export of wheat to
Great Britain until home wheat sold at more than thirty shillings the
barrel; and in that year of scarcity, 1789, when the harvest was
extremely late, and the yield uncertain even at the beginning of
December, the fiat went forth from Dublin Castle that no wheat must
for the present cross the Irish Sea to relieve the scarcity in
891
England. If that was the case between the sister kingdoms, Pitt
certainly acted correctly in forbidding the export of flour to France.
Meanwhile, Anglo-French relations were decidedly cool. The Duke
of Dorset, our ambassador at Paris, reported that it was not desirable
for English visitors to appear in the streets amid the excitements that
followed on the fall of the Bastille; and an agent, named Hippisley,
employed by him, reported that “the prejudices against the English
were very general—the pretext taken being our refusal to aid the
French with grain, and our reception of M. Calonne, which, they
892
contended, was in deference to the Polignacs.” The Duke of Dorset
also referred to the prevalence of wild rumours as to our efforts to
destroy the French ships and dockyard at Brest, and to foment
893
disorders in France.
Certainly we were not fortunate in our ambassador. In the year
1786 the Duke of Dorset had often shown petty touchiness in his
relations with William Eden, besides jealously curbing the superior
abilities of his own subordinate, Daniel Hailes. Now that they were
gone, his despatches were thin and lacking in balance. After the fall of
the Bastille, he wrote to the Duke of Leeds that “the greatest
Revolution that we know of has been effected with, comparatively
speaking, ... the loss of very few lives. From this moment we may
consider France as a free country, the King as a very limited monarch,
and the nobility as reduced to a level with the rest of the nation.” He
described the tactful visit of Louis XVI to Paris on 17th July as the
most humiliating step he could possibly take. “He was actually led in
triumph like a tame bear by the deputies and the city militia.” He
added, with an unusual flash of insight, that the people had not been
led by any man or party, “but merely by the general diffusion of reason
and philosophy.”
Nevertheless, though the King’s youngest brother, the Comte
d’Artois, and his reactionary followers were scattered to the four
winds, Dorset had the imprudence to write to congratulate him on his
escape. The letter was intercepted, and the populace at once raised a
hue and cry against the British embassy, it being well known that the
Duke was on the most familiar terms with the highest aristocracy.
Dorset thereupon wrote to the Duke of Leeds urging the need of
stating officially the good will of England for France; and that Minister
at once expressed “the earnest desire of His Majesty and his Ministers
to cultivate and promote that friendship and harmony, which so
happily subsists between the two countries.” Dorset communicated this
to the National Assembly on 3rd August; but that was his last official
act. He forthwith returned to England, presumably because of the
indiscretion related above.
During the next months the duties of the embassy devolved upon
Lord Robert Stephen Fitzgerald (brother of the more famous Lord
Edward), who was charged to do all in his power to cultivate friendly
relations with the French Government, and, for the present at least, to
894
discourage the visits of English tourists. The new envoy certainly
showed more tact than Dorset; but his despatches give the impression
that he longed for the political reaction which he more than once
predicted as imminent. We may notice here that the Pitt Cabinet
showed no sign of uneasiness as to the safety of its archives at the
Paris embassy until 5th March, when orders were issued to send back
to London all the ciphers and deciphers. The attitude of Pitt towards
French affairs was one of cautious observation.
In the meantime affairs at Paris went rapidly from bad to worse.
The scarcity of ready money, the dearness of bread, and the wild
stories of the so-called pacte de famine, for starving the populace into
obedience, whetted class-hatreds, and rendered possible the
extraordinary scenes of 5th and 6th October. As is well known, the
tactlessness of the Queen and courtiers on the one side, and on the
other the intrigues of the Duke of Orleans and his agents, led up to
the weird march of the market-women and rabble of Paris upon
Versailles, which brought the Royal Family captive into the capital.
The absence of the Duke of Orleans being highly desirable, he was
sent to London, ostensibly on a diplomatic mission, but really in order
895
to get rid of him until affairs should have settled down. The pretext
was found in the troubles in the Austrian Netherlands. As we saw in
the previous chapters, nothing could be more unlike the growingly
democratic movement in France than the revolt of the Flemings and
Brabanters against the anti-national reforms of Joseph II of Austria.
Men so diverse as Burke and Dumouriez discerned that truth. The
great Irishman in a letter to Rivarol termed the Belgian rising a
896
resistance to innovation; while to the French free-thinker it was
une révolution théocratique. Nevertheless, as many Frenchmen
cherished the hope of giving a prince to the Pays Bas, it was thought
well to put forth a feeler London-wards; and Philippe Egalité in fancy
saw himself enthroned at Brussels.
Such a solution would have been highly displeasing both at
Westminster and at Windsor; and there is no proof that the Duke even
mentioned it at Whitehall. In point of fact his mission was never taken
seriously. George III, with characteristic acuteness in all matters
relating to intrigue, had divined the secret motive of his journey and
expressed it in the following hitherto unpublished letter to the Duke of
Leeds:
897
Windsor, Oct. 19, 1789. 9.55 a.m.
The language held by the Marquis de Luzerne to the Duke of
Leeds on the proposed journey of the Duke of Orleans does not
entirely coincide with the intelligence from Lord Robert Fitzgerald
of the Duke’s message to the States General [sic] announcing his
absence as the consequence of a negotiation with which he is to
be employed at this Court. I confess I attribute it to his finding his
views not likely to succeed or some personal uneasiness for his
own safety....
The King argued correctly; and doubtless his suspicions ensured

for the Duke a chilly reception at the Foreign Office. On 22nd or 23rd
October Leeds saw him at his residence in London, but could get from
him no more than polite professions of regard for England. Leeds
thereupon urged Fitzgerald to find out whether the Duke’s “mission”
was a plausible pretext for securing his absence from Paris; to which
our envoy replied that everyone at Paris spoke of him with indifference
or contempt, and that Lafayette had discovered proofs of his
complicity in the outrages of 5th to 6th October, and therefore had him
sent away. On 6th November Fitzgerald added that Louis XVI had
given the Duke no instructions whatever. Leeds had already come to
much the same conclusion. On 30th October he saw Orleans, who
merely suggested a close understanding between England and France,
especially if the Emperor should march an army into his Belgic
provinces. Leeds coolly replied that the desire of Joseph II to crush the
revolt was most natural, and that France would do well to restore
order at home rather than look with apprehension on events beyond
her borders. As he accompanied these remarks with expressions of
sincere commiseration for Louis XVI, Orleans must have seen that the
secret of his involuntary mission was divined. This seems to be the
only notice of it in the British archives. His sinister reputation and his
association with loose company in London soon deprived him of all
consequence.
Pitt’s attitude towards the Belgian Question has been already
described. He seems to have given more time and thought to it than
to the French Revolution—a fact which is not strange if we remember
that the future of the Belgic lands was of untold importance for Great
Britain. To secure their independence from France she had many times
poured out her blood and treasure; and Pitt was destined to spend his
last energies in the greatest of those efforts. Moreover, as we have
seen, the European polity was far more seriously menaced by the
schemes of Catharine, Joseph, and Hertzberg than by French
reformers; and no one expected that in a short time the shifting
kaleidoscope of European States would be altogether shivered by
blows dealt from Paris. We, who know the outcome of events, are apt
to accuse Pitt of shortsightedness for not concentrating his attention
on France; but the criticism rests on the cheapest of all kinds of
wisdom—wisdom after the event. In Pitt’s mind the advent of militant
democracy aroused neither ecstasy nor loathing. His royalism had
nothing in common with the crusading zeal of Gustavus III, and
therefore did not impel him to rescue the Bourbons from the troubles
which resulted so largely from their participation in the American War.
Here, as everywhere, Pitt allowed cold reason to rule; and reason
suggested that the Bourbons might atone for that stupendous blunder
as best they could. Besides, the experience of nations, as of families,
forbade the interference of an outsider in domestic quarrels. Apart
from its bearing on Belgian affairs, the French Revolution is scarcely
named in Pitt’s correspondence of this time.
Still more curious is it that the letters of George III to his Minister
contain not a single reference to the Revolution. This silence
respecting events of untold import for all crowned heads is explicable
if we remember that to most men they seemed but the natural
outcome of mismanagement and deficient harvests, which
statesmanship and mother Nature would ere long set right. The
proneness of George to look at everything from his own limited point
of view was also at this time emphasized by ill health and family
troubles, which blotted out weightier topics. Thus, on 1st May 1789,
he declared his annoyance at the sudden return of Prince William from
the West Indies—a proof that his paternal commands would never be
obeyed. The Prince, he says, must now have the same allowance as
the Duke of York. “I have,” he adds, “but too much reason to expect
no great comfort but an additional member to the opposite faction in
my own family.” He concludes with the desire that some arrangement
may be made for the Queen and the princesses in case of his death;
for his whole nervous system has sustained a great shock in the late
illness. On 9th June the King again expresses to Pitt his regret that
Prince William declines to return to sea. His letters during the rest of
that exciting year are devoid of interest if we except the effort to
reconcile Pitt and Thurlow referred to in Chapter XX.
The King’s domestic dronings are varied on 14th January 1790 by
an excited declaration that a frigate must be provided at once in order
to convey Prince Edward, afterwards Duke of Kent, to Gibraltar, as it
898
was of urgent importance that he should at once leave London. On
3rd March he records his heartfelt joy at the failure of Fox’s attempt to
procure the repeal of the Corporation and Test Acts; and on the 28th
of that month occurs the first reference to the French Revolution which
I have found in the King’s letters. He then expresses to Pitt regret that
the papers forwarded by the Comte d’Artois (younger brother of Louis
XVI) and his political agent, Calonne, contain so little real information
about the affairs of France. He continues thus: “Mr. Pitt’s answer
should be very civil, and may be very explicit as to no money or other
means having been used to keep up the confusion in France; and M.
de Calonne ought to convey those assurances wherever he thinks they
899
may be of use.” Readers who have an eye for the ironies of history
may notice that the first of the myriad stories thrown off by the
perfervid Gallic imagination, as to the ubiquitous potency of British
money in creating famines, arming assassins, and trumping up
Coalitions against France, originated with the royalist exiles, who saw
in the French Revolution the first manifestation of the wonder-working
power of “Pitt’s gold.”
That statesman’s opinion concerning the Revolution was first made
known during the debates on the Army Estimates (5th and 9th
February 1790). Having inserted in the King’s Speech a reference to
the friendly assurances which he received from all the Powers, and a
guarded statement that the internal troubles in certain states engaged
the King’s “most serious attention,” he was twitted by champions of
economy with a slight increase in the army. True, the total provided for
was only 17,448 officers and men; and part of the increase was due to
the drafting of 200 men to keep order in the infant colony of New
South Wales. But even these figures, which
barely could defy
The arithmetic of babes,
aroused the compunctions of Marsham, Fox, and Pulteney. They

complained that, though most of our Colonial Empire had been lost,
yet our army had been increased by thirteen regiments since the
disastrous peace of 1783. Marsham deemed this increase “alarming,”
and wholly needless in view of the paralysis of France. Fox did not
repeat the stale platitude that a standing army was a danger to liberty;
for, as he pointed out, the French soldiers had shown themselves to be
good citizens; but he opposed the present vote on the ground of
economy, and because it was urgently necessary to strengthen the
public credit, which could be done only by reductions of expenditure.
He repeated these arguments in the second debate, that of 9th
February.
On both occasions Pitt defended the proposed vote for the army,
on the ground that “a small saving now might prove the worst
economy, by involving us in disputes which might be attended with
greater additional burthens to the kingdom.” In the latter debate he
skilfully used the admission of Fox, that any one who three years
before had foretold the present convulsions in France would have been
deemed a lunatic, in order to enforce the need of preparedness, it
being no excuse for responsible Ministers to exclaim in the midst of
disasters—“Who would have thought of it?” Then, as was his wont, he
opened up wider vistas in this noble but, alas, less prophetic strain:
The present convulsions of France must, sooner or later,

terminate in general harmony and regular order; and though the
fortunate arrangements of such a situation may make her more
formidable, it may also render her less obnoxious as a
neighbour.... Whenever the situation of France shall become
restored, it will prove freedom rightly understood; freedom
resulting from good order and good government; and thus
circumstanced France will stand forward as one of the most
brilliant Powers in Europe; she will enjoy just that kind of liberty
which I venerate, and the valuable existence of which it is my
duty, as an Englishman, peculiarly to cherish; nor can I, under this
predicament, regard with envious eyes, an approximation in
neighbouring States to those sentiments which are the
characteristic features of every British subject. Easier, I will admit
with the right hon. gentleman, is it to destroy than rebuild; and
therefore I trust that this universally acknowledged position will
convince gentlemen that they ought, on the present question, not
to relax their exertions for the strength of the country, but
endeavour to regain our former pinnacle of glory, and to improve,
for our security, happiness and aggrandisement, those precious
900
moments of peace and leisure which are before us.
This statesmanlike utterance was not prompted by considerations

of the mutability of human affairs. The bent of Pitt’s mind was too
practical to be influenced by copy-book maxims. Already, on 21st
January, the first rumours had reached the Foreign Office, which
portended serious friction with Spain. To this question we must devote
the following chapter.
It will be well, however, to conclude this chapter by a few remarks
on the standpoints from which Pitt and Burke viewed the French
Revolution. They were in truth so different as scarcely to admit of
comparison. The judgements of Pitt were those of a statesman of an
objective order of mind, who weighed events carefully, judged men
critically, and was content to change his policy as occasion required. In
his view institutions were made for men, not men for institutions. But
his zeal for Reform was tempered by respect for the verdicts of the
past and by the knowledge that the progress of mankind must be slow
if it is to be sure. He had lost much of his earlier zeal for Parliamentary
Reform, but only because the people had seemed to care little for it,
and were sincerely attached to their time-worn institutions. His
attitude towards this great question during the stormy years of the
Jacobin ascendancy will concern us later; and we need only notice
here that, even at that time of political ferment, he never declared that
under no circumstances would he bring in a Reform Bill, but always
left open a door of hope in that direction when quieter days should
return. For the present he repressed all movements which he
considered seditious, dangerous, or likely to cause divisions; and for
that alone he may be condemned by friends of progress.
From the other side he is censured for his lack of sympathy with
the woes of a distressed King and Queen. Certainly we miss in his
utterances any gush of genuine feeling on a subject which touched the
inmost springs of emotion in our people. True, he had small ground for
liking Louis XVI and his consort. The King of France had dealt the
British Empire a deadly blow in America; and Marie Antoinette was an
inveterate intriguer against England. Even up to the flight to Varennes
at midsummer 1791, she impelled her brother, Leopold II of Austria, in
his anti-English courses, which, as we shall see, cost us so dear. What
was worse, she even accused England of having instigated all the
disorders of which she was the victim. Nevertheless, it would have
been generous to attribute this spitefulness to her narrow training and
bitter sorrows. Pitt would have been a more engaging figure if he had
occasionally shown a spark of that indignation which burnt so fiercely
in Burke. If he had any deep feelings on the subject, he chose to
conceal them, perhaps from a conviction that the expression of them
would do more harm than good.
Well would it have been for the cause of peace if the champion of
French royalism in these islands had obeyed the dictates of reason
which held Pitt tongue-tied. Unfortunately sentiment and emotion at
this time reigned supreme in the great mind of Burke. Every student of
history must admire the generous impulses which were incarnate in
the great Irishman. They lent colour to the products of his
imagination, and they lit up his actions with a glow which makes his
blunders more brilliant than the dull successes of mediocre men.
Where sentiment was a safe guide, there Burke led on with an energy
that was not less conspicuous than his insight. Where critical acumen,
mental balance, and self-restraint were needed, the excess of his
qualities often led him far astray. The true function of such a man is to
interpret the half-felt impulses of the many. If he seek to guide them
to definite solutions, his ardent temperament is apt to overshoot the
mark. Observers noted how Burke’s vehement conduct of the Warren
Hastings affair injured his cause; and many more were soon to discern
the same failing when, with Celtic ardour, he rushed into the complex
mazes of the French Revolution.
Opinions will always differ as to the merits of his remarkable book
on that subject. Its transcendent literary excellences at once ensured it
an influence enjoyed by no other political work of that age; but we are
here concerned with his “Reflections” not as literature, but as criticism
on the French movement. Even in this respect he rightly gauged some
of the weaknesses of Gallic democracy. He was the first of Britons to
discern the peril to the cause of freedom when the brutal fury of the
populace broke forth in the hour of its first triumph, the surrender of
the Bastille, and still more in the Jacqueries that followed. He also
gave eloquent and imperishable expression to the feeling of respect for
all that is venerable, in which the French reformers were sadly
deficient; and, while he bade them save all that could be saved of their
richly-storied past, he truly foretold their future if they gave rein to
their iconoclastic zeal. In my judgement the passage in which Burke
foretells the advent of Bonaparte is grander even than that immortal
rhapsody on the fate of Marie Antoinette and the passing away of the
age of chivalry. The one is the warning of a prophet; the latter is the
wail of a genius.
Equally profound are his warnings to the French enthusiasts of the
danger of applying theories to the infinite complexities of an old
society. To quote some sentences:
The science of constructing a commonwealth, or renovating it,

or reforming it, is, like every other experimental science, not to be
taught a priori. Nor is it a short experience that can instruct us in
that practical science, because the real effects of moral causes are
not always immediate.... The science of government being
therefore so practical in itself, and intended for such practical
purposes, a matter which requires experience, and even more
experience than any person can gain in his whole life, however
sagacious and observing he may be, it is with infinite caution that
any man ought to venture upon pulling down an edifice, which has
answered in any tolerable degree for ages the common purposes
of society, or on building it up again, without having models and
patterns of approved utility before his eyes.... The nature of man
is intricate; the objects of society are of the greatest possible
complexity; and therefore no simple disposition or direction of
power can be suitable either to man’s nature, or to the quality of
his affairs. When I hear the simplicity of contrivance aimed at and
boasted of in any new political constitutions, I am at no loss to
decide that the artificers are grossly ignorant of their trade, or
totally negligent of their duty.... The rights of men in governments
are their advantages, and these are often in balances between
differences of good, in compromises sometimes between good
and evil, and sometimes between evil and evil.... I cannot
conceive how any man can have brought himself to that pitch of
presumption to consider his country as nothing but carte blanche,
upon which he may scribble whatever he pleases.
We are here reminded of the saying of Dumont, the friend of

Mirabeau, that the fear of being thought officious and interfering is as
universal among the English as is the desire of the French of taking a
901
prominent part and interfering in everything. This home thrust by
the able Swiss thinker goes far to explain the difference between the
Revolution of 1688 in England and that of a century later in France.
Vanity, love of the sensational, and, a mania for wholesale
reconstruction on geometrical designs largely account for the failures
of the French revolutionists; and Burke’s warnings on these heads
were treated with the petulant disdain characteristic of clever children.
Burke also did good service by pointing out the fundamental
differences between the general overturn in France and the “glorious
Revolution” of 1688 in England. Slipshod comparisons of the two
events were then much in vogue, witness the sermon of Dr. Price in
the Old Jewry, on which Burke conferred the fame of a never ending
pillory. The Whigs, who formed a rapidly thinning tail behind their
impetuous leader, were never tired of discovering historical parallels;
and it is possible that Pitt’s sympathy with Whiggism, stunted but not
wholly blighted by Parliamentary friction, led him to the hopeful
prophecy already quoted. Certainly very many Frenchmen saw
themselves in fancy entering on peaceful paths of progress under a
more genial William III. At the time when Burke was completing his
“Reflections,” Wordsworth and his friend during a Long Vacation tour in
France were met with warmest cheer by fédérés who had shared in
the ecstatic Festival of the Federation (14th July 1790):
And with their swords flourished as if to fight

The saucy air.
At once the Englishmen were greeted as brothers.
We bore a name
Honoured in France, the name of Englishmen,
And hospitably did they give us hail
As their fore-runners in a glorious course.
All this was very pleasing; but it could only end in bitter estrangement
when France was found to be concerned, not with “preventing a
902
Revolution” (as Burke finely showed that England did in 1688 ), but
in carrying through with unimaginable zeal a political overturn, along
with social, religious, and agrarian changes of the most drastic kind.
This was evident enough even by the summer of 1790. Feudalism had
been swept away root and branch; copy-holders had become
freeholders; the old taxes were no more—and none had definitely
taken their place; titles of nobility were abolished; and the Assembly
declared war on the discipline and on one of the dogmas of the Roman
Catholic Church. Well might Burke stand aghast and declare that this
cataclysm had little or nothing in common with the insular,
conservative, and constitutional efforts of Englishmen a century
before.
Strange to say, the defects of his book arose largely from his
underrating the differences between the two movements. In his
eagerness to preserve Englishmen from the risk of hazily sympathizing
with French democracy, he inveighed against the new doctrines with a
zeal that was not always born of knowledge. Forgetting his earlier
adage respecting America—“I will never draw up an indictment against
a whole people”—he sought to convict Frenchmen of fickleness and
insanity. He calls the Revolution “this strange chaos of levity and
ferocity, and of all sorts of crimes jumbled together with all sorts of
follies”; and he even ventured to prophesy that in France learning
would be “trodden down under the hoofs of a swinish multitude.”
Coming nearer to facts, he took the French to task for not repairing
their old constitution. He likened it to a venerable castle in which some
of the walls and all the foundations were still in existence, and added
the surprising statement—“you had the elements of a constitution very
nearly as good as could be wished.”
Here Burke went wholly astray. A constitution, which gave to the
King a power limited only by the occasional protests of the Paris and
other “Parlements”; under which the States-General (at best little more
than an advisory body) had not been summoned for 175 years; which
assigned to the “Tiers Etat” only one third of the legislative power and
no control over the executive, though the Commons of France paid
nearly all the taxation; and which promised to perpetuate the old
division into three classes,—such a constitution was merely an
interesting blend of the principles of Feudalism and Absolute
Monarchy, but could never satisfy a nation which had listened to
Voltaire and given its heart to Rousseau. Sir Philip Francis, with his
usual incisiveness, pointed out to Burke that the French could not act
as we did in 1688, for they had no constitution to recur to, much less
one that was “very nearly as good as could be wished.”
In truth, Burke did not know France. Hence his work is of
permanent value only where he praises English methods and launches
into wise and noble generalizations. For his own people it will ever be
the political Book of Proverbs. His indictments against the French
people in the main flew over their heads. On most insufficient
knowledge he ventured on sweeping assertions which displayed the
subtlety and wide sweep of his thought, but convinced only those who
did not know the difficulties besetting the men of 1789. Nevertheless,

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Asset and Liability Management for Banks and

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Asset and Liability

ISTE Ltd John Wiley & Sons, Inc.

© ISTE Ltd 2015

Library of Congress Control Number: 2015942726

British Library Cataloguing-in-Publication Data

CHAPTER 1. DEFINITION OF ALM IN THE BANKING AND

CHAPTER 2. RISKS STUDIED IN ALM . . . . . . . . . . . . . . . . . . . . . . . . . 9

CHAPTER 3. DURATIONS (REVISITED) AND SCENARIOS FOR ALM . . . . . . . 27

CHAPTER 4. BUILDING AND USE OF AN ALM INTERNAL MODEL

4.3.8. Fees and business costs . . . . . . . . . . . . . . . . . . . . . . . . . . 97

CHAPTER 5. BUILDING AND USE OF ALM INTERNAL

In recent years, the techniques known as asset and liability management

ALM can be defined as any continuous management process that defines,

In Chapter 2, we present the financial risks on which ALM classically

Conversely, Chapter 4 is devoted to insurance companies. From a

Lastly, Chapter 5 is the equivalent of Chapter 4 for banks as it explains

Finally, we can say that this book is written in a relatively self-contained

Definition of ALM in the

In recent years, the technique known as asset and liability management

The objective of ALM is to ensure the proper coordination between assets

In recent years, the ALM department has become increasingly important

This chapter is devoted to the definition of ALM in the banking and

1.2. Brief history of ALM for banks and insurance companies

The most famous example is that of Equitable, a US mutual life insurance

Learning the lessons from Equitable, managers of financial firms focused

Value-at-Risk) are more appropriate than techniques of ALM. In financial

ALM techniques have also evolved. The growth of derivatives markets

Nowadays, the process of ALM is at the crossroads between risk

1.3. Missions of the ALM department

The objective of this chapter is to define the different missions of an

1.3.1. Missions of the ALM department for banks

In summary, ALM aims to coordinate the financial decisions of a firm so

As we will see in Chapters 3 and 5, different deterministic or stochastic

1.3.1.1. Deterministic models

Nevertheless, deterministic models are useful to quickly detect the weak

1.3.1.2. Stochastic models

Nowadays, the models used in ALM are directly borrowed from

1.3.1.3. Mission of the bank ALM department

The coordination of assets and liabilities was already considered long

1.3.2. Missions of the ALM department for insurance companies

An insurance company must have good knowledge of its asset and

– to ensure proper coordination of assets and liabilities to achieve a

The following section details these three missions.

1.3.2.1. To ensure proper coordination of assets and liabilities

In order to model liabilities, policyholder behavior should be analyzed to

liabilities to achieve better efficiency for the company. Furthermore, life

1.3.2.2. To provide recommendations on marketing strategy and asset

The business of insurance is indeed particular: its production cycle is

1.3.2.3. To calculate the Solvency II capital requirement for market risks