Risk Management of U.S. Money Center Banks

1. Risk Management of U.S. Money Center Banks Presented by: Wei Chen Bridge Hu Eric Song Jing Zhang Yuan Su Zhi

2. Agenda • Industry Overview • Market Dynamics • Risk Management Environment • JP Morgan Chase • Merrill Lynch • Bank of America • Recommendation

3. Definition of Money Center Bank • Money center bank: a large bank in a major financial center which borrows from and lends to governments, corporations, and other banks, rather than consumers • Market maker: a brokerage or bank that maintains a firm bid and ask price in a given security by standing ready, willing, and able to buy or sell at publicly quoted prices (from their own accounts)

4. Products and Services • Personal banking • Business banking • Investment banking – advisory, debt and equity underwriting, market making, trading and investing of debts and equities • Treasury and Securities Services – cash management, institutional trust services, treasury services, clearing services • Investment management and private banking • Private equity – venture capital

5. Market Dynamics • Global money center banks • market capitalization = 1,221B • ROE = 16.9% • Merrill Lynch (56B)

6. Important Regulations • The Securities Exchange Act - established the Securities and Exchange Commission (SEC) as the primary regulator of US securities markets, including investment banks as well as non-banks that broker and/or deal non-exempt securities • Financial Services Competition Act in 1999 permitted commercial banks to have affiliated securities firms • Bank of International Settlements - Basel Capital Accord • Financial Accounting Standards Board – FASB Statement 133

7. Basel Committee • Basel Committee • The Committee's members come from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States • Countries are represented by their central bank and also by the authority with formal responsibility for the prudential supervision of banking business where this is not the central bank. • The Committee does not possess any formal supranational supervisory authority • It formulates broad supervisory standards and guidelines and recommends statements of best practice in the expectation that individual authorities will take steps to implement them through detailed arrangements - statutory or otherwise - which are best suited to their own national systems

8. FAS 133 • Accounting for Derivative Instruments and Hedging Activities (1998) • Result: substantially enhanced information about derivatives positions is now available in annual reports • FAS 133 has been amended twice already, by FAS 137 and FAS 138

9. The Major Risks Banks Face • Liquidity risk • Interest risk • Market risk • Credit risk • Off-balance sheet risk • Foreign exchange risk • Operating risk

10. Liquidity Risk Definition: risk of not be able to honor bank’s financial commitments promptly It arises from an uncertainty of the timing of cash flows • Liability-side risk results from unexpectedly high rates of deposit redemption • Asset-side risk results from borrowers unexpectedly drawing down loan commitment

11. Liquidity Risk • Useful measurements • The net liquidity position, which measures sources and uses of liquidity • Peer group financial ratios • The financing gap, which show the degree to which loans are not financed by core fund

12. Liquidity Risk Management • The fundamental dilemma of liquidity risk management • low yield of reserve assets • Liquidating investment

13. Liquidity Risk Management Liquidity risk management is carried out at both the retail and wholesale level • Demand deposit • Term deposit • Purchased money • Interbank borrowing • Repos

14. Interest Risk • Definition: is the impact on banks earnings and market value of equity of changes in interest rates • Refinancing risk • Reinvestment risk

15. Interest Risk (measurements) • Gap analysis • Duration analysis • Simulation model

16. Interest Risk Management • Matching average life of assets and liabilities reduces interest rate risk, but it is not perfect hedge • Immunization requires dynamic rebalancing of the portfolio, which may be costly • To immunize the equity, set the leverage adjusted duration gap to zero

17. Market Risk Definition: the risk of bank losses from movement of market prices on its trading inventory

18. Market Risk Measurement • Two ways to measure • Value-at-cost models (VAR) • The BIS standardized measurement method

19. Credit Risk • Definition: the risk of loss due to the failure of a borrower, endorser, guarantor or counterparty to repay a loan or honor another predetermined financial obligation

20. Credit Risk Measurement • Traditional approach • Quantitative approach

21. Credit Risk Management • Available collaterals • Customers creditworthiness

22. Off-balance Sheet Risk • Definition of off-balance sheet activities: activities that do not appear on the current balance sheet because it does not concern holding a currency primary claim(asset) or issuing a current secondary(liability) • Two categories: 1) Credit substitutes 2) Derivatives

23. Foreign Exchange Risk • The potential adverse impact on a bank’s earning and value of its equity from foreign exchange rate movement 

24. Operating Risk • It is business risk which includes organizational behavior, technological systems and legal aspects of managing a bank

26. About JP Morgan Chase • Leading global financial services firm with operations in more than 50 countries • The merger of The Chase Manhattan Corporation and J.P. Morgan & Co. Incorporated was completed in December 2000 • Assets of $793 billion; component of DJIA • No. 1 in global syndicated loans and asset backed securities • No. 1 private bank in the U.S. • No. 5 in global M&A • No. 1 in U.S. dollar clearing and commercial payments • No. 4 originator of residential mortgage loans in the U.S. • Fourth largest domestic credit card issuer

27. Industry Standing

28. Five Business Segments • Investment Bank • Investment Management & Private banking • Treasury & Securities Services • JPMorgan Partners • Chase Financial Services

29. Two Brands JPMorgan • Investment bank, research, private equity, treasury and securities services, asset management, private banking Chase • Auto loans, checking, credit cards, education loans, home equity, investments, mortgage, online services, savings, insurance

30. Revenue Structure • Business segment: 44% of total revenue from fixed income capital markets • Client segment: 50% of total revenue from financial institutions • Geographic region: 59% of total revenue from North America

31. Revenue Structure

32. Risk Management Structure • Risk Policy Committee of Board of Directors – oversees risk management • Capital Committee – deal with firm-wide capital planning, internal capital allocation, and liquidity management • Risk Management Committee – deal with credit risk, market risk, operational risk, private equity risk, and fiduciary risk

33. Risk Management Structure

34. Capital Management • Economic risk capital: assess capital adequacy utilizing internal risk methodologies • The methodology quantifies credit, market, and operating risk (and private equity risk for its private equity business) for each business, and assigns capital accordingly

35. Liquidity Management • Utilize liquidity monitoring tools through normal and stress periods • Analytics rely on management’s judgment about ability to liquidate assets or use them as collateral for borrowings • Three primary measures of liquidity: holding company short-term surplus, cash capital surplus, and basic surplus • Derivatives: enter into derivative contracts to swap fixed-rate debt to floating-rate obligations and vice versa • Funding plan: use a variety of both short-term and long-term instruments (including deposits, federal funds purchased, repurchase agreements, commercial paper, bank notes, medium- and long-term debt, capital securities and stockholders’ equity)

36. Credit Ratings for Funding Plan

37. Off-balance Sheet Arrangements • Report off-balance sheet obligations and commitments • Special-purpose entities (or special-purpose vehicles) • SPE involves a company selling assets to the SPE, which funds the purchase by selling securities to investors • Critical to markets such as mortgage-backed securities, asset-backed securities, and commercial paper

38. Off Balance-sheet Obligations and Commitments

39. Credit Risk Management • Ensure that credit risks are accurately assessed, properly approved, continually monitored and actively managed • Assess on- or off-balance sheet exposures including loans, derivative receivables and lending-related commitments • To measure these risks, estimates are made of both expected and unexpected losses for each segment of the portfolio using statistical techniques • Two functions: Credit Risk Policy and Global Credit Management

40. Credit Risk Policy • Formulate credit policies, limits, allowance adequacy and guidelines • Independent from the groups that approve and support credit activities • Manage problem credits

41. Global Credit Management • Three functions: Credit Risk Management, Corporate Banking, and the Credit Portfolio Group • The first two participate in client coverage, are responsible for approving and monitoring all credit exposures • The last one manages the firm’s credit exposures resulting from both traditional lending and derivative trading activities

42. Credit Portfolio

43. Commercial Portfolio

45. Consumer Portfolio

47. Credit Management in Derivatives • Use the same credit risk management procedures to assess and approve potential credit exposures when entering into derivative transactions as those used for traditional lending • Use mark-to-market value of the contract, or the cost to replace the contracts at current market rates should the counterparty default, to measure credit risk exposure • Dynamic management: adjust and rebalance hedges as market conditions change, such as counterparty’s credit quality

48. Mark-to-market Fair Value of Derivative Contracts

49. Risk Profile of Derivative Receivables

50. Use of Credit Derivatives