fin 653 bank management

1. FIN 653 Bank Management Lecture 1.3: Bank Risk Management

3. II. Why Banks Have to Manage Their Risks 1. The concerns over the increasing volatility of interest rates, exchange rates, commodity prices, and stock prices. 2. The explosion in information technology makes the complex calculation of derivative prices quickly and at low cost that allow financial firms to track the positions taken.

4. II. Why Banks Have to Manage Their Risks 3. The favorable regulatory environment that encourages new product innovation for risk management. 4. The needs of commercial banks to generate fee incomes through offering off-balance-sheet activities.

5. II. Why Banks Have to Manage Their Risks Commodity Prices Have Become More Volatile Commodity prices fluctuated significantly in the 1970s and early 1980s due to the oil embargo of 1974. It is estimated that the 1974 oil price increase contributed to inflation in industrialized countries by 2% to 3%.

6. II. Why Banks Have to Manage Their Risks Currency Exchange Rates Have Become More Volatile Since the dismantle of the Bretton Woods Agreement in 1973, the values of all currencies in general have experienced large and abrupt movements: 1. The movements in exchange rates have been abrupt and large. 2. The volatility of movements in the foreign exchange value of the U.S. dollar has been large. As the obscured volatility surfaced in traded foreign currencies, the financial market began to offer currency traders special tools for insuring against these risks.

7. II. Why Banks Have to Manage Their Risks Interest Rates Have Become More Volatile From the early 1970s, interest rates and bond prices became increasingly volatile due to increases in inflation and the advent of floating exchange rates. This volatility grew substantially from the early 1980s onwards, after the Fed used money supply as a major monetary policy tool. New options on Treasury bills, Treasury notes, and long-term government bonds, as well as futures on synthetic government bonds, were offered by the exchanges; a multitude of OTC interest-sensitive instruments were marketed by banks and other financial intermediaries.

8. II. Why Banks Have to Manage Their Risks Regulators� Push for Implementing Risk Management Systems In the mid-1980s, the Fed and the Bank of England became concerned about the growing exposure of banks to OBS claims, coupled with problem loans to third-world countries. At the same time banks from these two countries were complaining the unfair competition from foreign banks that were more lenient regulated. The results: to strengthen the equity base of banks by requiring more capital against risky assets and to assess capital requirements on OBS claims.

9. II. Why Banks Have to Manage Their Risks Regulators� Push for Implementing Risk Management Systems The BIS was charged with the job of setting common standards and procedures for international banks on capital requirements. The 1988 BIS Accord, and its subsequent amendments, set the rules for risk-based capital requirements. It allows for the more sophisticated financial institutions to make use of their own internal models, while applying a simpler standardized approach to the majority of financial institutions.

10. II. Why Banks Have to Manage Their Risks Expansion of Bank Powers Prior to Gramm-Leach-Bliley: Date Description _________________________________________________________________ April 30, 1987 Federal Reserve authorizes limited underwriting activity for Bankers Trust, JP Morgan, and Citicorp with a 5% revenue limit on ineligible activities. January 18, 1989 Federal Reserve expands Section 20 underwriting permissibility to corporate debt and equity securities, subject to revenue limit. September 13, 1989 Federal Reserve raises limit on revenue from Section 20 ineligible activities from 5% to 10%. July 16, 1993 Court ruling in Independent Insurance Agents of America v. Ludwig allows national banks to sell insurance from small towns. January 18, 1995 Court ruling in Nationsbank v. VALIC allows banks to sell annuities.

11. II. Why Banks Have to Manage Their Risks Expansion of Bank Powers Prior to Gramm-Leach-Bliley: Date Description _________________________________________________________________ March 26, 1996 Court ruling in Barnett Bank v. Nelson overturns states restrictions on banks� insurance sales. October 30, 1996 Federal Reserve announces the elimination of many firewalls between bank and non-bank subsidiaries within BHCs. December 20, 1996 Federal Reserve raises limit on revenue from Section 20 ineligible securities activities from 10% to 25%. August 22, 1997 Federal Reserve eliminates many of the remaining firewalls between bank and non-bank subsidiaries within BHCs April 6, 1998 Citicorp and Travelers Group announce merger initiating a new round of debate on financial reform. _________________________________________________________________

12. III Growth of the Derivative Instruments

13. III Cases of Financial Debacles

14. III.1: The Collapse of Barings The 1995 failure of Barings Bank in Britain was a clear violation of one of the most important rules of the derivatives business: Nicklas Neeson worked as the manager of accounting and settlement operations while expanding his trading activities. The arbitrage activities were to exploit the slight differences in pricing between Nikkei 225 futures on Simex and those on the Osaka securities exchange.

15. III.1: The Collapse of Barings Leeson heavily purchased Nikkei futures during the autumn and winter of 1994, betting that Nikkei would rise in value. On January 17, 1995, a powerful earthquake hit Kobe and Osaka. On Monday, January 23, Nikkei 225 dropped by 1,000 points to 17,950. At this point, Leeson began heavy purchasing of the Nikkei March and June 1995 futures contract for account number 88888. By February 23, 1995, the error account contained 55,399 Nikkei contracts expiring in March and 5,000 contracts expiring in June.

16. III.1: The Collapse of Barings Leeson was following a time-honored tradition among losing gamblers: Double up the bet in an effort to salvage an otherwise hopeless position. By February 24, 1995, losses amounted to �850 million ($1.3 billion).

17. III.1: The Collapse of Barings On Monday, February 27, the Bank of England announced the failure of the bank. The bank was finally acquired by International Nederlanden Group. With hindsight, the derivatives losses in Baring Futures could have been prevented through an adequate system of managerial control.

18. III. 2: Orange County's Losses in Derivatives For over15 years before the event, funds managed by the Orange County fund manager, Robert Citron, had delivered a 10.1% average annual return for the county while California's own treasury department averaged 5% to 6% on its portfolio. On December 6, 1994, Orange County filed for bankruptcy with a loss of $1.5 billion out of the County's $7.7 billion investment pool since the beginning of the year due to rises in interest rates.

19. III. 2: Orange County's Losses in Derivatives The failure was due to leveraging and wrong prediction on interest rates: Leveraging: using a "reverse-repurchase agreement," the county bought securities on credit, increasing the fund's holdings. This involved buying instruments such as five-year Treasury bonds and simultaneously pledging them to an investment bank as a collateral for a loan. A total of $12.9 billion of the agreements was accumulated, increasing the fund's holdings to about $20 billion.

20. III. 2: Orange County's Losses in Derivatives Its interest-rate sensitivity was further enhanced by purchasing some $8 billion of a type of bond known as an �inverse floater� from investment bankers headed by Merrill Lynch. An inverse floater is a hybrid security composed of a floating-rate note and an interest-rate swap. The notional amount of the swap is twice as large as that of the floating note. The payoff of the inverse floater at any settlement date was equal to twice the fixed payment minus the floating-rate payment. The holder of an inverse floater will benefit when interest rates decrease and will lose when interest rates increase.

21. III. 2: Orange County's Losses in Derivatives Legal lawsuit against Merrill Lynch: Citron blamed that the investment bankers had sold him complex instruments including derivatives without his full understanding of the underlying risk. Merrill Lynch, as the main investment banker, had a multifaceted relationship with Orange County, including providing loans and underwriting and distributing its securities.

22. III. 2: Orange County's Losses in Derivatives In May 1995, Citron pleaded guilty to six felony charges of misappropriating funds and misleading investors, but most of those crimes were committed in a desperate effort to prop up his collapsing fund.

23. III. 3: Bankers Trust's Court Battles with Equity Group Holdings, Gibson Greetings, and Procter & Gamble By the end of 1994, most of the high- profit leveraged derivatives that Bankers Trust was known for had dried up and what was left were plain vanilla derivatives that produced low profit margins. Yet, at the end of 1994, Bankers Trust's derivative account totaled $1.98 trillion in notional amounts, an amount equal to that of J.P. Morgan, which has twice as much in capital. The replacement cost of Bankers Trust's derivatives amounted to $10.9 billion.

24. III. 3: Bankers Trust's Court Battles with Equity Group Holdings, Gibson Greetings, and Procter & Gamble In March 1994, Equity Group Holdings, an investment firm, sued Bankers Trust after it had lost $11.2 million (in derivatives products purchased from the bank. In September, Gihson Greetings sued the bank for derivatives-related losses of $20 million and damages. In October, Procter & Gamble sued the bank for the $195 million that it had lost in derivatives transactions. These lawsuits depicted Bankers Trust as the symbol of what was wrong with derivatives, and propelled regulators and legislators into trying to restrict the activities of derivatives dealers.

25. III. 3: Bankers Trust's Court Battles with Equity Group Holdings, Gibson Greetings, and Procter & Gamble For Bankers Trust, the problems began when the bank marketed highly complex derivatives products with large profit margins to clients who wanted to take their chances with an element of financial risk such as interest rates. In the case of Gibson Greetings, the bank had sold leveraged interest-rate swaps that would have increased in value if interest rates had remained lower than the market expectation and would have produced huge losses if interest rates had increased above market expectations The increase in interest rates in 1994, partially due to Fed actions, created significant losses for Gibson Greetings as well as other Bankers Trust clients.

26. III. 3: Bankers Trust's Court Battles with Equity Group Holdings, Gibson Greetings, and Procter & Gamble Gibson Greetings argued that the officers at the bank had willfully misled them in their risk exposure. Initially, Bankers Trust fought the accusation, but when an internal tape was discovered that pointed to officers' wrongdoing, it set tied the case with Gibson Greetings In December, Bankers Trust was fined $10 million by the SEC and the CETC and forced to sign an "agreement" with the Federal Reserve Bank of New York to follow strict rules of transparency in selling leveraged derivatives and to be certain that the clients understand the products. Consequently, Moody's, a credit-rating agency, reduced the long-term rating of Bankers Trust from Aa2 to Aa3, citing its heavy dependence upon derivatives-generated earnings.

27. IV. RISKS OF FINANCIAL INTERMEDIATION Interest rate risk. Credit risk. Off-balance-sheet risk. Technology/operational risk. Foreign exchange rate risk. Country/sovereign risk. Liquidity risk.

28. IV. RISKS OF FINANCIAL INTERMEDIATION Interest Rate Risk: In mismatching the maturities of assets and liabilities, FI potentially expose themselves to interest rate risk. 1. Refinancing Risk: As a result, whenever an FI holds longer-term assets relative to liabilities, it potentially exposes itself to refinancing risk. This is the risk that the cost of rolling over or reborrowing funds could be more than the returns earned on asset investments.

29. IV. RISKS OF FINANCIAL INTERMEDIATION Interest Rate Risk: 3. Market Value Risk Mismatching maturities by holding longer-term assets than liabilities means that when interest rates rise, the market value of the FI�s assets fall by a greater amount than its liabilities. If holding assets and liabilities with mismatched maturities exposes them to reinvestment or refinancing and market value risks, FIs can be approximately hedged or protected against interest rate changes by matching the maturity of their assets and liabilities.

30. IV. RISKS OF FINANCIAL INTERMEDIATION Interest Rate Risk: Note that matching maturities works against an active asset-transformation function for FIs. . While reducing exposure to interest rate risk, matching maturities may also reduce the profitability of being FIs because any returns from acting as specialized risk-bearing asset Transformers are eliminated. Finally, matching maturities only hedges Interest rate risk in a very approximate rather than complete fashion.

31. IV. RISKS OF FINANCIAL INTERMEDIATION Interest Rate Risk: Should a borrower default, both the principal loaned and the interest payments expected to be received are at risk. As a result, many financial claims issued by corporations and held by FIs promise a limited or fixed upside return. The return distribution for credit risk suggests that FIs need to both monitor and collect information about any firms whose assets are in their portfolios. Thus, managerial efficiency and credit risk management strategy affect the shape of the loan return distribution.

32. IV. RISKS OF FINANCIAL INTERMEDIATION Credit Risk: Should a borrower default, both the principal loaned and the interest payments expected to be received are at risk. As a result, many financial claims issued by corporations and held by FIs promise a limited or fixed upside return. The return distribution for credit risk suggests that FIs need to both monitor and collect information about any firms whose assets are in their portfolios. Thus, managerial efficiency and credit risk management strategy affect the shape of the loan return distribution.

33. IV. RISKS OF FINANCIAL INTERMEDIATION Off-Balance-Sheet Risk: Off-balance-sheet activities affect the future shape of` an FI�s balance sheet in that they involve the creation of contingent assets and liabilities. The ability to earn fee income while not loading up or expanding the balance sheet has become an important motivation in FIs pursuing off-balance-sheet business. Unfortunately, this activity is not risk free. Indeed, significant losses in off-balance-sheet activities can cause an FI to fail.

34. IV. RISKS OF FINANCIAL INTERMEDIATION Off-Balance-Sheet Risk: Letters of credit Loan commitments by banks; Mortgage servicing contracts by thrifts; Positions in forwards. futures. swaps, options, and other derivative securities by almost all FIs. While some of these activities are structured to reduce an FI�s exposure to credit, interest rate, or foreign exchange risks, mismanagement or inappropriate use of these instruments can result in major losses to FIs.

35. IV. RISKS OF FINANCIAL INTERMEDIATION Liquidity Risk: Liquidity risk arises whenever an FI�s liability holders, demand immediate cash for their financial claims. When liability holders demand cash immediacy, the FI must either borrow additional funds or sell off assets to meet the demand the withdrawal of funds. Although, minimize their cash assets because such holdings earn no interest, low holdings generally not a problem.

36. IV. RISKS OF FINANCIAL INTERMEDIATION Liquidity Risk: However, there are times when an FI can face a liquidity crisis. When all or many FIs are facing similar abnormally large cash demands, the cost of additional funds rises as their supply becomes restricted or unavailable. Such serious liquidity problems may eventually result in a run in which all liability claimholders seek to withdraw their funds simultaneously from the FI. This turns the FI�s liquidity problem into a solvency problem and could cause it to fail.

37. IV. RISKS OF FINANCIAL INTERMEDIATION Technology and Operation Risk: In the 1980s and 1990s banks. insurance companies, and investment companies have all sought to improve operational efficiency with major investments in internal and external communications, computers. and an expanded technological infrastructure. The automated teller machine (ATM) networks The automated clearing houses (ACH) and Wire transfer payment networks such as the clearinghouse interbank payments system (CHIPS) developed.

38. IV. RISKS OF FINANCIAL INTERMEDIATION Technology and Operational Risk: Technology risk occurs when technological investments do not produce the anticipated cost savings in economies of scale or scope. Diseconomies of scope arise when an FI fails to generate perceived synergies or cost savings through major new technology investments. Operational risk is partly related to technology risk and can arise whenever existing technology malfunctions or back-office support systems break down. Even though such computer glitches are rare, their occurrence can cause major dislocations in the FIs involved and potentially disrupt the financial system in general.

39. IV. RISKS OF FINANCIAL INTERMEDIATION Foreign Exchange Risk: To the extent that the returns on domestic and foreign investments are imperfectly correlated, there are potential gains for an FI that expands its asset holdings and liability funding beyond the domestic frontier. One potential benefit from an FI becoming increasingly global in its outlook is the ability to expand abroad directly or to expand a financial asset portfolio to include foreign securities as well as domestic securities. Even so, undiversified foreign expansion exposes an FI to foreign exchange risk in addition to interest rate risk and default risk.

40. IV. RISKS OF FINANCIAL INTERMEDIATION Country or Sovereign Risk: Country or sovereign risk is a more serious credit risk than that faced by an FI which purchases domestic assets such as the bonds and loans of domestic corporations. A foreign borrower may be unable to repay the principal or interest on its issued claims even if it would like to. Most commonly, the government of the country may prohibit payment or limit payments due to foreign currency shortages and political reasons. In the event, the FI claimholder has little if any recourse to the local bankruptcy courts or an international civil claims court.

41. V. The Evolution of Risk Management Products Early1973- Foreign Currency Futures Mid 1973- Equity Futures Mid 1975- T-Bill Futures and Futures on Mortgage Backed Bonds Late 1977- T-Bond Futures Late 1979- Over-the Counter Currency Options Early 1980- Currency Swaps Late 1980- Bank CD Futures Early 1981- Interest rate Swaps Early 1981- Options on T-Bond Futures Mid 1981- Eurodollar Futures Late 1981- Equity Index Futures and T-Note Futures

42. V. The Evolution of Risk Management Products Early 1983- Options on T-Note , Currency, and Equity Index Futures Mid 1983- Interest Rate Caps and Floor Early 1985- Swaptions Late 1985- Eurodollar Options and Futures on U.S. Dollar and Municipal Bond Indices Early 1987- Commodity Swaps and Compound Options Late 1987- Average Options and Bond Futures and Options Mid 1988- RMUs Mid 1989- Three-Month Euro-DM Futures Captions, Futures on Interest rate Swaps and ECU Interest rate Futures Mid 1990- Equity Index Swaps Late 1991- Portfolio Swaps Late 1992 Differential Swaps

43. V. The Evolution of Risk Management Products: The Global OTC Derivative Markets

44. V. The Evolution of Risk Management Products: The Global OTC Derivative Markets

45. V. The Evolution of Risk Management Products: Credit Exposure of Derivative Activity