Commercial Bank Management

VAR

Value at Risk= measures the tail risk of an asset or portfolio Calculate using historical market data or via a Monte Carlo simulation More reliable when assessing the risk of liquid securities with extensive pricing history Ex: one month 1% VaR (historical) of $100,000 = based on historical data from the past month, there is a 1% probability that the portfolio loss will exceed $100,000

What Defines a Bank?

1. Economic functions it performs 2. Services it offers to its customers 3. Legal basis for existence (FDIC insured and deposits)

What is Funds Management?

1. Management should exercise as much control as possible over the volume, mix, and return or cost of both assets and liabilities in order to achieve the financial institution's goals 2. Management's control over assets must be coordinated with its control over liabilities to maximize the spread between revenues and costs and control risk exposure 3. Revenues and costs arise from both sides of the balance sheet. Management policies need to be developed that maximize returns and effectively control costs from supplying services

Key Reasons Banks are Regulated

1. Safeguard; protect citizens, and makes customers feel safer 2. Stability 3. Prevent abuse

Pros and Cons of Being in the Investment Banking Business?

Advises clients on different transactions like mergers and acquisitions, asset allocation, restructuring and any service that facilitates capital-raising for its clients Don't need to invest anything at your risk

Check 21 Act

Allow electronic checks; no longer have to physically mail checks

What is the Goal of Risk Management?

Analyze and attempt to quantify the potential for losses in an investment before they occur and then take the appropriate action (or inaction) to mitigate adverse impacts given his investment objectives and risk tolerance

What is Too Big to Fail?

Asserts that certain corporations, are so large and so interconnected that their failure would be disastrous to the greater economic system; therefore, they must be supported by government when they face potential failure

What is Asset and Liability Management?

Asset Management= emphasizing control and selection of assets to achieve institutional goals; liabilities assumed to be dominated by customer decisions and government rules Liabilities Management= managers realized they could control liabilities on their balance sheet by changing interest rates and other terms offered to the public, in order to raise new funds

Key Trends Impacting Banks

Bigger banks are getting bigger: top 3 held 20% of deposits in 2007, now 32% Consolidation Geographic expansion Service proliferation= expanding service offerings Technological change

How Do Banks Window Dress Their Earnings?

Book-Value Accounting: only realized capital gains and losses affect the book values shown on a bank's balance sheet Banks can increase their current income and their capital by selling assets that have risen in value while ignoring the impact of any losses in value experienced by other assets still on the books

In April of 2012, What Changes Would You Have Recommended to JPM?

Broader systemic failure: --Risk limits, for instance, were breached more than 300 times before the bank switched to a more lenient risk-evaluation formula — one that underestimated risk by half because of a spreadsheet error --Failures in prioritization (sought paycheck and bonuses) --Loss of institutional knowledge through turnover and poor coordination among agencies Megabanks such as JPMorgan are not only too big to fail — they may also be too big to manage and too big to regulate.

Asset Items on Bank's Balance Sheet

C + S + L + MA = D + NDB + EC Cash Assets (C) = "Cash and Deposits Due from Bank"; primary reserves provide liquidity to meet deposit withdrawals, customer demands for loans, and other cash needs --Cash in vault --Deposits held at other depository institutions --Reserve account with Fed --Cash items in process of collection Security Holdings (S) = backup source of liquidity and provide a source of income --Liquid portion= secondary reserves -----Short-term government securities -----Privately issued money market securities: commercial paper, interest-bearing time deposits --Income-generating portion -----Taxable securities: US government notes, Government agency securities, Corporate bonds -----Tax-exempt securities: Municipal bonds( have degrees of safety, usually paid back by states but sometimes cities default) Federal Funds Sold and Reverse Repurchase Agreements = type of loan account listed as a separate item on the balance sheet --Repos= overnight loans Loans (L) = supply income, the major asset --Gross loans= sum of all loans --Allowance for Possible Loan Losses (ALL) = reserves; Contra-asset account for potential loan losses --Net Loans --Unearned Discount Income --Nonperforming Loans --Types of Loans: Commercial and industrial (or business), Consumer (or household), Real estate (or property-based), Financial institutions, Foreign (or international), Agricultural production, Security, Leases Specific and General Reserves = determined by management but influenced by taxes and government regulation Miscellaneous Assets (MA) --Bank Premises and Fixed Assets --OREO = other real estate owned (e.g., foreclosed homes) --Goodwill= when one firm acquires another and pays more than the market value of the acquired firm's net assets --Investments in subsidiaries

Liability Items on Bank's Balance Sheet

C + S + L + MA = D + NDB + EC Deposits (D) = main source of funding for banks; not all win in low interest rate markets --Noninterest-bearing demand deposits --Savings deposits --NOW accounts = bear interest and permit checks --Money market deposit accounts (MMDAs) = limited check-writing, give notice of withdrawals, competitive interest rate --Time deposits = fixed maturity and stipulated interest rate -----Mainly certificates of deposit (CDs); Use to raise money from most well-to-do customers Nondeposit borrowings (NDB) = supplement deposits and provide additional liquidity that cash assets and securities cannot provide --Federal funds purchased --Repurchase agreements --Issuing commercial paper --Eurocurrency borrowings

Was JPMorgan Organized Correctly?

CIO and IB on opposite sides of same trade

Primary Supervisory Role of the Fed

Central Bank," top of regulator pyramid Supervises big banks and merger applications Impose reserve requirements on deposits Buy and sell own bonds to maintain independence

Primary Supervisory Role of the FDIC

Federal Deposit Insurance Corporation Insures deposits up to $250,000 Approve new branches and mergers

What is Interest Rate Risk? Why is it Important to Banks?

Changing interest rates impact both the balance sheet and income statement Reinvestment Risk= if rates go down, coupons will be reinvested at lower rates Price Risk= as rates rise, the market values of most bonds and fixed-rate loans will fall

What are Financial Futures? How do they help manage risk?

Contract agreement reached today between a buyer and a seller that calls for delivery of a particular security in exchange for cash at some future date --Traded in futures market on organized exchanges --Usually off-balance sheet items: Buyers move to balance sheet after purchase, Sellers remove from balance sheet and record gains/losses on income statement --Deposit an initial margin= exchange protecting themselves; each trader's account is marked-to-market Buyers ("go long")= when futures prices rise/interest rates decline, they gain; if prices fall/rates rise, they lose Sellers ("go short")= when futures prices rise/interest rates decline, they lose; if prices fall/rates rise, they gain

CDS

Credit Default Swaps Financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy.

Risks for Banks

Credit Risk= probability that some of a financial institution's assets, especially its loans, will decline in value and perhaps become worthless Liquidity Risk= danger of not having sufficient cash and borrowing capacity to meet customer withdrawals, loan demand, and other cash needs Market Risk= flux in economies due to uncertainties concerning market rates or prices --Price Risk= sensitivity to market-value movements --Interest Rate Risk= sensitivity in market interest rates Operational Risk= uncertainty regarding a financial firm's earnings due to failures in computer systems, errors, misconduct by employees, floods, lightning strikes, and similar events --Decreased earnings due to unexpected operating expenses Legal and Compliance Risks= law, rules, and regulations Reputation Risk= negative publicity, losing the confidence of customers and creditors Strategic Risk= variations in earnings due to adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes --Human element in making bad long-range management decisions that reflect poor timing, lack of foresight, lack of persistence, and lack of determination to be successful Capital Risk= impact of all the risks above and affect a financial firm's long-run survival

CSPBV

Credit Spread Basis Point Value Measures the price sensitivity of an asset or portfolio for each basis point change in credit spread "Credit Duration"= Good for estimating the impact of credit spreads on small moves on small moves in the credit market like duration, it does not account for convexity Ex: if a portfolio has a CSV of $20,000, it means that for every change in the credit spread of 1 basis point, the portfolio PNL (profit and loss) will move by $20,000

CSW 10%

Credit Spread Widening 10% Scenario analyses of tail events (e.g., what would happen if oil prices dropped, what if another terrorist attack, etc.) It measures a wider movement in spreads and tends to be more relevant when stress-testing portfolios

What is a Financial Intermediary?

Encourage savings and transforming savings into investment spending

FACT Act

Fair and Accurate Credit Transactions Required to help victims of ID theft Makes it easier for victims of identity theft to file fraud alerts The public can apply for a free credit report annually

Services Offered by Banks

Financial intermediary= transform savings into loans Payments Guarantor= pay off customer debts when unable to pay Risk management= financial preparation for risk of loss Investment banking= help corporations and governments raise new funds, pursue acquisitions, and explore new markets Advisor= help save for long-term goals Safekeeping Agency= act on behalf of customers to manage and protect property Wealth management Policy= work with government for trade and currency manipulation Consumer side: Auto loans, Mortgages, Credit cards

What are Net Loans?

Gross Loans and Leases -- Allowance for Loan Losses -- Unearned Income

Option on a Futures Contract

Hedge interest rate risk; offer added leverage, control of large amounts of financial capital with a limited investment and limited risk Hedging against positive or negative gaps between interest-sensitive assets and interest-sensitive liabilities --Put options can be used to offset losses from a negative gap when interest rates rise --Call options can be used to offset a positive gap when interest rates fall

HY

High Yield Riskier, higher return

Key Items in a Bank's Income Statement

Interest Income --Interest and fees on loans --Taxable securities revenue --Tax-exempt securities revenue --Other interest income Interest expenses --Deposit interest costs --Interest on short-term debt (repos, short-term money market borrowings) --Interest on long-term debt (mortgages on the financial firm's property) Noninterest income --Fees earned from fiduciary activities (such as trust services) --Service charges on deposit accounts --Trading account gains and fees --Additional noninterest income (revenues from investment banking, security brokerage, and insurance services Noninterest expenses --Wages, salaries, and employee benefits (personnel expenses) --Premises and equipment expense (rental fees on office space) --Cost of furniture and equipment, legal fees, office supplies, repair costs

How Do Caps, Floors, and Collars Help Banks Manage Interest Rate Risk?

Interest-Rate Caps= Protect holder against rising market interest rates; loan rate cannot be increased above cap --If a lending institution sells a rate cap to one of its borrowing customers, it takes on interest rate risk from that customer but earns a fee as compensation Interest-Rate Floors= Guarantees some minimum rate of return in periods of falling interest rates --Financial intermediaries usually use them when their liabilities have longer maturities than their assets, or when they're funding floating-rate assets with fixed-rate debt Interest-Rate Collars= Combine a rate floor and rate cap in one agreement; net premium paid can be positive or negative

IG

Investment Grade Safer, lower return

Primary Supervisory Role of the OCC

Office of the Comptroller of Currency Issues charters for new national banks Supervise and examine all big banks

What is Financial Leverage?

Leverage is an investment strategy of using borrowed capital to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets. When one refers to a company, property or investment as "highly leveraged," it means that item has more debt than equity.

Long Hedges in Financial Futures

Long Hedge= Buy Futures Contracts Generally applied when a financial firm wishes to hedge itself against falling interest rates (lower yields from loans) --Usually occurs when a cash inflow is expected in the near future Purchase futures contracts today and sell around the time deposits come in--> profit on futures contracts if rates decline because contracts will rise in value

JPM: How Did the American Airlines Bankruptcy Impact the CIO?

Made $400mm by shorting large amounts of CDX series HM Index --Risky-- need to keep short and long side even as possible for protection

What is Gap Management? When is a Financial Firm Asset or Liability Sensitive?

Match the maturities and repricing opportunities of interest-bearing assets and interest-bearing liabilities as closely as possible= Revenue from earning assets will change in the same direction and by approximately the same proportion as the interest cost of liabilities Asset-sensitive (positive) gap = interest-sensitive assets -- interest sensitive securities > 0 --As rates increase, banks make more money; net interest margin will increase because the interest revenue generated by assets will increase more than the cost of borrowed funds --If rates fall, the NIM will decline as interest revenues from assets drop by more than interest expenses from liabilities Liability-sensitive (negative) gap= interest-sensitive assets -- interest-sensitive liabilities < 0 --As rates increase, banks lose money because expenses rise faster than revenues (decrease NIM) --If rates fall, it will generate a higher NIM

Duration

Measures average maturity of a promised stream of future cash payments Measures the sensitivity of the market value of financial instruments to changes in interest rates %change in market price= -D * (change in rate/(1+rate))

Net Interest Margin

Measures how large a spread between interest revenues and interest costs management has been able to achieve by close control over earning assets and pursuit of the cheapest sources of funding

Net Non-Interest Margin

Measures the amount of non-interest revenues stemming from service fees the financial firm has been able to collect relative to the amount of non-interest costs incurred (including salaries and wages, repair and maintenance of facilities, and loan loss expenses) Typically negative; non-interest costs generally outstrip fee income

What is the Purpose of an Interest Rate Swap?

Often employed to deal with asset-liability maturity mismatches; alter effective duration --Shorten asset duration by swapping out a fixed interest-rate income stream in favor of a variable interest-rate income stream --If the duration of liabilities is too short, the financial firm can swap out a variable interest-rate expense in favor of a fixed interest-rate expense Only exchange net amount of interest due; notional amount is not exchanged

JPM: Why Was Risk Management of the SCP Not Sufficient to Prevent Such a Large Loss?

No limits on actual market value of SCP, just limits on portfolio composition and asset type for CIO overall --Drew had daily CIO metrics, but not SCP-specific Level 1: VaR and internal thresholds set by JPM CEO and CRO (Zubrow), breaches informed all senior management Level 2: CSBPV and CSW 10% set by CIO Head (Drew) and its CRO (Goldman--Zubrow's family, no prior risk management experience), breaches informed CIO management --CIO not experts in derivatives, price takers Not client-facing, so less regulatory oversight "Fair Value" approach instead of last trade Value Control Group received "needs improvement" audit report

Convexity

Nonlinear relationship between a change in asset price and a change in market interest rates The lower the degree of convexity (or duration), the lower the price volatility of the asset (aka lower market risk)

Explain Off Balance Sheet Items. Are they good or bad?

OBS transactions expose firm to counterparty risk and liquidity risk Unused loan commitments Derivative contracts: futures contracts, options, swaps Standby credit agreement= financial firm receives a fee to guarantee repayment of a loan that a customer has received from another lender

Riegle-Neal Act

Permits interstate full-service banking through acquisitions, mergers, and branching across state lines

Who Do You Hold Accountable for the Wells Fargo Scandal?

Organization structure: needed more upper management and reduced lower/regional management

Gramm-Leach-Bliley Act

Permitted banks to affiliate with insurance and securities firms --Diversifying service offerings reduces overall business risk exposure --Financial supermarket= cheaper for banks Companies can go international Financial-service providers must protect the privacy of their customers and limit sharing private information with other businesses

What Caused the Crisis at Wells Fargo?

Pressure: --Managers publicly shamed --Sales check 4x per day --Increased sales incentives as higher up in company; senior management bonuses dependent on cross-selling --Pay and employment dependent on sales numbers --Fear of retaliation for reporting suspicious behaviors and actions --Recent merger with Wachovia, so need to show success Opportunity: --Good reputation, assumed no bad practices --Relatively small dollar amount involved in scandal --Size of organization-hard to detect --Some parts of population easily misled (students, elderly, immigrants) --No/ineffective monitoring of inactive accounts --Didn't need SSN to open account

How Would You Remedy the Wells Fargo Scandal?

Prevent Employees: --Employee satisfaction surveys --Monitor retention rate --Improved ethics training --Use hotline and other feedback avenues Prevent Managers: --Incentive package changes --Change practice around sales reporting --Improve quality of sales report card with tighter tolerances --Review hiring practices --Change organization structure

Monetary Policy

Primary job of the Fed Try to ensure that the economy grows at an adequate rate, unemployment is kept low, and inflation is held down Drive interest rates higher when it wants to reduce lending and borrowing in the economy and slow down the pace of economic activity; lower interest rates when it wishes to stimulate business and consumer borrowing

Primary vs. Secondary Reserves

Primary reserves= Cash and Due from Depository Institutions --Meet the financial firm's need for liquidity --Earn little or no interest income, so banks strive to keep the size of this account as low as possible Secondary reserves= Investment Securities: The Liquid Portion --Occupy the middle ground between cash assets and loans, earning some income but also held as a backup source of liquidity

Patriot Act

Required financial institutions to report suspicious activity on the part of their customers Those believed to be terrorists forced to leave the bank

Sarbanes-Oxley Act

Requires publicly owned companies to strengthen their auditing practices Prohibits the publishing of false or misleading information about the financial condition or operations of a publicly held firm

ROA

Return on Assets ROA= Net Income/ Total Assets Primarily an indicator of managerial efficiency; how capable management has been in converting assets into net earnings

ROE

Return on Equity Capital ROE= Net Income/ Total Equity Capital Measure of the rate of return flowing to shareholders ROA is a component of ROE; the return to a financial firm's shareholders is highly sensitive to how its assets are financed ROE= ROA * (TA/TE) --As earnings efficiency (ROA) declines, the firm must take on more risk in the form of higher leverage (heavy use of debt and minimal use of owners' capital) to achieve its desired ROE ROE= Net Profit Margin * Asset Utilization * Equity Multiplier NPM= Net Income/ Total Operating Revenues AU= Total Operating Revenues/ Total assets EM= Total Assets/ Total Equity Capital ROE= Tax Management Efficiency * Expense Control Efficiency * Asset Management Efficiency * Funds Management Efficiency

Call Option

Right to buy securities/futures at a specific price at or before a specific time for a premium Protect against falling yields/ increasing market value on assets (loans, investments) Profit if security/futures prices rise above strike price (plus premium)

Put Option

Right to sell securities/futures at a specific price at or before a specific time for a premium Protect against rising deposit costs and falling market values of assets (rising rates) Profit if security/futures prices fall below strike price (minus the premium)

RWA

Risk-Weighted Assets Higher amounts of RWA require a higher ratio of equity-based capital; determine the minimum amount of capital that must be held by banks and other institutions to reduce the risk of insolvency The goal is to prevent banks from losing large amounts of capital when a particular asset class declines sharply in value

Competitors of Traditional Banks

Savings associations= specialize in selling savings deposits and granting home mortgage loans and other forms of household credit to individuals and families Credit unions= collect deposits from and make loans to their members as nonprofit associations of individuals sharing a common bond Fringe banks= payday lenders, pawn shops, and check-cashing outlets, offering small loans bearing high risk and high interest rates to cover immediate financial needs of cash-short individuals and families Money market funds= collect liquid funds from individuals and institutions and invest these monies in quality securities of short duration Mutual funds= sell shares to the public representing an interest in a professionally managed pool of stocks, bonds, and other securities Hedge funds= sell shares in a pool of assets mainly to upscale investors that typically include many different kinds of assets Security brokers and dealers= buy and sell securities on behalf of their customers for their own accounts Investment banks= provide professional advice to corporations and governments, help clients raise funds in the financial marketplace, seek possible business acquisitions, and trade securities Finance companies= offer loans to commercial enterprises and to individuals and families using funds borrowed in the open market or from other financial institutions Financial holding companies= often include credit card companies, insurance and finance companies, and security broker/dealer firms operating under one corporate umbrella Life and property/casualty insurance companies= protect against risks to persons or property and manage the pension plans of businesses and retirement funds of individuals

Primary Supervisory Role of the SEC

Securities and Exchange Commission Approve public security offerings

Short Hedges in Financial Futures

Short Hedge= Sell Futures Contracts Use when market rates expected to rise (decline in asset value, increase in borrowing cost) Sell futures contracts, choosing contracts expiring around the time new borrowings will occur, when a fixed-rate loan is made, or when bonds are added to a financial firm's portfolio; before maturity, buy more contracts to cancel out through clearinghouse --Offset cash loss from rising rates by gain in futures market

How Does the Yield Curve and Hedging Play Impact Interest Rate Risk?

Short-term interest rates tend to rise or fall faster than long-term rates --Upward-sloping yield curves= rising interest rates and expansion in the economy -----In periods of economic prosperity, usually begins with a fairly wide gap between long- and short-term interest rates, but that interest-rate gap tends to narrow and sometimes becomes negative -----Revenues from longer-term assets will outstrip expenses from shorter-term liabilities; usually positive net interest margin --Negatively sloped= suggests interest rates will begin falling and the economy may soon head into a recession -----In periods of recession, short-term interest rates tend to fall relative to long-term interest rates and the yield "spread" or gap" between short and long maturities often tended to widen --Horizontal yield curve= suggests that interest rates may be stable for a time with little change occurring in the slope of the curve

What Factors Influence a Bank's Stock Price?

Stock values are sensitive to changes in market interest rates, currency exchange rates, and the strength/weakness of the economy Value of the financial firm's stock tends to rise if: 1. The value of the stream of future stockholder dividends is expected to increase --Due perhaps to recent growth in some of the markets served or because of profitable acquisitions the organization has made --Dividend rate = annual dividend / stock price per share 2. The financial organization's perceived level of risk falls --Due perhaps to an increase in equity capital, a decrease in its loan losses, or the perception of investors that the institution is less risky overall (by further diversifying its service offerings or expanding the number of markets it serves) and therefore has a lower equity risk premium 3. Market interest rates decrease, reducing shareholders' acceptable rates of return via the risk-free rate of interest component of all market interest rates 4. Expected dividend increases are combined with declining risk, as perceived by investors --Economy on the rise= risk level decreases as returns increase

SCP

Synthetic Credit Portfolio= value from insurance premiums of defaulted firms' credit default swaps Supposed to generate returns when credit spreads widen; hedge against long bias of CIO portfolio (JPM) The seller takes a long position, assuming the underlying assets will perform. The investor takes a short position, assuming the underlying assets will default.

Open Market Operations

The buying and selling of securities by the Federal Reserve banks Sells securities to decrease the growth of deposits and loans within the financial system→ interest rates rise Purchases securities tend to increase the growth of deposits and loans→ interest rates fall

Duration Gap Analysis

The larger the duration gap (Duration Assets - Duration Liabilities), the greater the impact on the firm when interest rates fluctuate The dollar volume of assets usually exceeds the dollar volume of liabilities, a financial institution seeking to minimize the effects of changing interest rates needs to adjust for leverage: DG= DA - DL * (TL/TA)

Would you break up the banks?

Too-big-to-fail firms will tend to take more risk than desirable, in the expectation that they will receive assistance if their bets go bad Creates an uneven playing field between big and small firms The firms themselves become major risks to overall financial stability, particularly in the absence of adequate resolution tools--failures of smaller firms have not had substantial effects on the stability of the financial system as a whole

The Discount Window

When the Fed loans reserves to borrowing institutions, the supply of legal reserves expands temporarily, which may cause loans and deposits to expand (provide additional liquidity, like in mortgage crisis)