Do you think you have already read everything there is out there on financial risk management? Through the 1990's, so many books were published that all explored the same recurring themes. Fortunately, that started to change in 2003. I consider the two significant books of that year to be my own (2003) book on value-at-risk and Allen's (2003) book on market risk management in trading organizations. For 2004, the bombshell is this superb text on financial risk management within commercial banks. It introduces new ways of thinking and invokes history to place familiar concepts in a new light. It is theoretically precise but eminently practical. It is informative, well written and just plain fun to read. There is so much material in this book, that I will only touch on a couple highlights below.

Practicing risk managers know of the profound importance of transfer pricing as a risk management tool. You wouldn't realize this reading other books, but authors van Deventer, Imai and Mesler place this material front and center. What is more, they take us back to the 1970's with an historical account of how Bank of America was the first financial institution to implement a "matched maturity" transfer pricing system. This allowed asset-liability mismatches to be identified and "rolled up" for centralized management. Interestingly, Bank of America incurred a significant loss around 1980 due to a mismatch. The new system made it clear that management was to blame. The system had identified the mismatch, but they had consciously decided to not hedge it.

Within commercial banks, there is a natural tension between book value and market value accounting. Commercial banks are one of the few types of institutions where asset-liability management and market risk management techniques are employed side-by-side. The authors point out how it is this natural tension that makes risk-adjusted return on capital (RAROC) calculations such a natural tool for commercial banks—and such an unnatural tool for so many other institutions! It is a wonderful perspective.

The book has 44 chapters divided into five sections:

Risk Management: Definitions and Objectives

Interest Rate Analytics

Credit Risk Models

Interest Rate and Credit Model Testing

Risk Management Applications, Instrument by Instrument

Chapters of the first section are some of the most interesting. There is plenty of strategy, practical insights and history here. The chapter on yield curve smoothing is excellent.

Chapters of the second section open with a sophisticated discussion of duration and convexity. They discuss duration's assumption of parallel shifts in the term structure and demonstrate how models based on this assumption allow arbitrage opportunities. This leads to a discussion of more sophisticated term structure models, starting with the Vasicek model.

The third section covers credit risk modeling, including structural and reduced form models. An excellent chapter explores credit spread modeling.

The book then turns to techniques for validating credit and interest rate models. This is an emerging field, but there is plenty of material here.

The last section contains 22 chapters. Most explore valuation issues for specific assets or liabilities: corporate bonds, non-maturing deposits, revolving credit facilities. Others explore specific topics, such as the impact of collateral on valuation, or liquidity issues.

The book is not overly technical. For the most part, familiarity with calculus and elementary probability is all you need. A stochastic differential equation shows up here and there, but they are very basic. There are extensive references to relevant literature. End of chapter questions afford plenty of opportunities to practice with concepts.