FIN 653 Bank Management

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FIN 653 Bank Management

• Lecture 1.3
• Bank Risk Management

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I. What is Bank Risk Management

• The practice of
• Defining Risk defining the risk level a firm
  desires,
  
• Measuring Risk identifying the risk level of a
  firm currently has, and
  
• Hedging Risk using derivatives or other
  financial instruments to adjust the actual level
  of risk to the desired level of risk.
  

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.
  
• __________________________________________________
  _______________
  

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III Growth of the Derivative Instruments
13
III Cases of Financial Debacles
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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.

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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.

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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).
  

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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 FIs 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.

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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.

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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.

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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.

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IV. RISKS OF FINANCIAL INTERMEDIATION

• Off-Balance-Sheet Risk
• Off-balance-sheet activities affect the future
  shape of an FIs 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.

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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 FIs exposure to credit, interest rate,
  or foreign exchange risks, mismanagement or
  inappropriate use of these instruments can result
  in major losses to FIs.

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IV. RISKS OF FINANCIAL INTERMEDIATION

• Liquidity Risk
• Liquidity risk arises whenever an FIs 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.

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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 FIs liquidity problem into a
  solvency problem and could cause it to fail.

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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.

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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.

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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.

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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.

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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

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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

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

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

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