Download Banking and FIs 10

Guy Hargreaves
ACF-104
Wechat: Guyhargreaves
Recap of yesterday
 Appreciate the key drivers to the business of
commercial banking
 Review how commercial banks generate financial
returns
 Describe the key metrics used in commercial bank
financial management
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Goals of today
 Understand the tools used to manage the various
balance sheet risks
 Understand the credit analysis and approval process
within commercial banks
 Review of Central Bank roles and goals in commercial
bank regulation
 Review the pros and cons of existing and new
regulations around balance sheet risk management
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Recall asymmetric information
 Financial system participants often have varying levels
of information –> Information Asymmetry
1.
2.
3.
Some players have differing information
Some players have Inside Information
All players have imperfect information
 Asymmetric information can lead to Adverse Selection
and Moral Hazard
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Adverse selection
 Adverse selection can become a big problem in
commercial banking due to information asymmetry
 Better informed banks can tend to “exploit” less well
informed customers

Extreme examples in 2007-9 GFC when investors were sold
portfolios of mortgage loans where borrowers were adversely
selected to be poor quality
 Compliance and Risk Management functions are being
heavily increased in banks today to prevent outcomes
like this
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Moral hazard
 Moral hazard arises in a contract when one of the
parties has an economic incentive to behave against
the interests of the other
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Classical example is a homeowner buying fire insurance just
before their home burns down
Insurance industry is large target of this behaviour
Banks have a poor record of managing moral hazard given
large incentives to behave poorly
 Often arises in the Principal-Agent relationship where
the agent has information asymmetry and can act in
its own interests rather than the interests of its
customer
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Commercial banks and risk
 Commercial banks are in the risk business
 Risk is everywhere in banking
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Credit risk
Market risk
Liquidity risk
Operational risk
Country risk
Reputational risk
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Banks and risk
 The profitability of commercial banks is driven by how
well they manage risk “flows”:
Customers transfer their risk to banks
 Banks take on risk for principal trading
=> Managing all these risk flows as an ongoing viable business
has risk

 Some risk is unmanageable - banks need to avoid
 All risk needs to be properly priced and managed
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Credit (default) risk
 Loans in the banking book and bonds in the trading book
both have credit default risk
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The issuer will fail to repay a coupon or principal, or will go into
bankruptcy
Banks have Special Asset Management units which do nothing but
manage defaulted or near defaulted customers
Once in default, banks will often take control of the company as
“senior creditors”, sell all remaining company assets and use the
proceeds to repay “creditors” in order of seniority
If a bank receives less than it is owed following liquidation it has
suffered a recovery rate of < 100%
 Banks may make “provisions” in their balance sheets for
loans which they expect have a high chance of defaulting
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Major market risk types
 Interest rate risk:
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Exposure through a financial instrument to movements in
interest rates
Fixed rate bonds, interest rate swaps, bond futures – anything
with a long dated fixed cashflow
“Delta” – the change in the $ value of that instrument for a
0.01% change in interest rates
VAR – “Value at Risk” how much the bank would lose if a
significant move in interest rates occurred
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Major market risk types
 FX risk:
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Exposure through a financial instrument to movements in
foreign exchange rates
Spot FX, foreign exchange swaps, FX futures
“Delta” – the change in the $ value of that instrument for a
certain change in FX rates
Included in firmwide VAR
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Major market risk types
 Credit trading risk:
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Exposure through a financial instrument to movements in
credit margins
Corporate bonds, credit swaps, credit indices
“Delta” – the change in the $ value of that instrument for a
0.01% change in credit margins
Included in firmwide VAR
Not to be confused with credit default risk
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Major market risk types
 Commodity risk:
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Exposure through a financial instrument to movements in
commodity prices
Gold swaps, commodity futures
“Delta” – the change in the $ value of that instrument for a
certain change in commodity prices
Included in firmwide VAR
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Trading versus banking books
 Banks use two broad accounting regimes:
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Banking book – holds corporate and retail loans on an
“accruals” basis; uses the “loan provision” model for potential
losses from defaults; no market risk
Trading book – holds securities and marketable instruments
on a “mark-to-market” basis; gains and losses in market value
brought to P&L daily; all market risk
 Whether a financial instrument is held in a banking
book or a trading book is critical to the way it is risk
managed
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Liquidity (gap) risk
 The ongoing ability of a commercial bank to refinance
its short term liabilities like deposits
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Banks tend to “lend long” and “borrow short” – borrowers
want the certainty of funding for long periods whereas savers
don’t want to lock up their funds for long periods
Liquidity or gap risk is the risk savers will not redeposit their
savings when they mature, leaving the bank repaying deposits
whilst remaining invested in longer term loans
 Reinvestment or refinancing risk is the risk that when
a bank comes to refinance a deposit interest rates will
be higher – interest rate risk
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Operational risk
 Operational risk is defined as “the risk of loss resulting
from inadequate or failed internal processes, people
and systems or from external events”
 Regulators and banks are working towards a consistent
and standardised way of measuring and holding
capital against this risk
 Causes of operational risk include internal and
external fraud, employment practices and work safety,
illegal business practices (eg money laundering) and
physical or system failures
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Country risk
 Global commercial banks invest significant capital into
many countries around the world to support their local
operations
 Some of these countries are risky emerging markets
(eg Argentina) where there is a risk that the local
government introduces foreign exchange controls or
other measures that might be harmful to the bank
 Sovereign risk is not country risk – it is the risk a
sovereign will default on its debt
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Reputational risk
 Banks have suffered scandals and bad media headlines
throughout history
 As a result many banks have seen their reputations
with customers, governments and other important
stakeholders suffer badly
 When a bank earns a poor reputation its WACC
increases as savers become reluctant to deposit, and
borrowers are less willing to do business with banks
that have behaved badly
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Credit risk management tools
 Credit default risk management is a critical element of
commercial banking management
 “Credit Committees” (CC) establish maximum
exposure limits to individual, group and related
borrowers
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Limits are set for loans, derivatives, settlement, FX and many
other financial products
CC monitors total exposure to the borrower or group
Bankers are forbidden to lend or trade in more volume with
the borrower or group than the limit set by CC
This prevents the bank from becoming overexposed to any
one borrower or group
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Bank risk management tools
 Critical to bank credit default risk management is to
lend to a broad diversified set of borrowers
 Diversification means investing in a broad range of
borrowers so that risk can be reduced in the portfolio
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“Don’t put all your eggs in one basket”!
Investing in $1 in each of 50 borrowers is far less risky than
investing $50 in just one borrower
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Classical credit analysis
 Every commercial bank has a slightly different way of
performing credit analysis
 Many banks use the classical model of five “C”s
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Character – is the borrower of good character eg have they
defaulted before or ever committed fraud?
Capital– is the borrower too leveraged?
Capacity - does the borrower have a strong capacity to repay
the loan? What is the earnings volatility of the borrower?
Conditions – what is the loan going to be used for? Does this
make sense?
Collateral – is the loan secured by specific assets or is it
unsecured?
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Bank credit scoring
 Once a credit analysis is performed many banks score
or “rate” the loan or borrower
Standard & Poor’s
Moody’s
Commercial Bank
Default Risk profile
AAA
Aaa
R0
Investment Grade: extremely strong
AA+ | AA | AA-
Aa1 | Aa2 | Aa3
R1 R2 R3
Investment Grade: very strong
A+ | A | A-
A1 | A2 | A3
R4 R5 R6
Investment Grade: strong
BBB+ | BBB | BBB-
Baa1 | Baa2 | Baa3
R7 R8 R9
Investment Grade: adequate
BB+ | BB | BB-
Ba1 | Ba2 | Ba3
R10 R11 R12
High Yield : less vulnerable
B+ | B | B-
B1 | B2 | B3
R13 R14 R15
High Yield : more vulnerable
CCC
Caa1 | Caa2 | Caa3
R16 R17 R18
High Yield : vulnerable
CC
Ca
R19
High Yield : highly vulnerable
C
C
R20
High Yield : highly vulnerable +
SD
Selective default
D
D
Default
NR
NR
Not rated
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Expected loss
 From the credit default risk analysis banks estimate
Probability of Default (PD), Loss Given Default (LGD)
ad Expected Loss
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PD estimates are usually quite accurate but LGD is much
harder to calculate
Expected Loss (EL) = PD * LGD * EAD
EAD is Exposure at Default and can often be larger than the
facilities granted if interest is unpaid
 Expected Loss then feeds into the RAROC model to
determine whether the loan makes financial sense for
the bank
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Credit provisioning
 When a commercial bank expects to take a loss on a
loan it makes an individual credit provision
 Large banks routinely take collective provisions against
their overall portfolios
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Market risk -VAR
 Value at Risk (VAR) – banks look at 2-3 years of price
history and use probability models to determine to a
high degree of confidence how far a market can move
over say 1 or 5 days
 Traders are then given $ amounts they can potentially
gain or lose based on VAR – this sets the total amount
of a financial instrument a trader can have exposure to
in his/her trading book
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VAR example
Joe is an interest rate swaps trader and is given a $1m daily VAR limit he can
trade for the bank
 Joe trades 3-year bonds which have a delta of $250 ie if Joe owns $1m bonds
and interest rates rise by 1 basis point (or o.o1%) Joe will lose ~$250 on a
market valuation
 Joe’s Risk Management team tells him based on their VAR models the 3-year
bond is assumed to move a maximum of 20 basis points or 0.2% in a day
 Joe is offered $30m of 3-year bonds by an investor – can he buy them?
 if Joe bought the bonds he would have a delta of $250 * 30 = $7,500 ; at worst
the bond yield will increase by 20 basis points in a day and if so Joe would
lose $7,500 * 20 = $150,000 => Joe can buy the bonds as he has a daily VAR
limit of $1m
 Joe could buy a maximum of $200m bonds under that VAR limit

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VAR weaknesses
 Weaknesses in the VAR method have been shown up
since the 2007-9 GFC
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Markets have a capacity to move in much more extreme ways
than VAR models predict
VAR models may underestimate “tail risks” – so-called “black
swans” championed by Nassim Taleb
Regulators and bankers became too comfortable with VAR –
belief that it is worst case loss potential makes risk managers
overly comfortable
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Why do we need bank regulation?
 Financial systems suffer periods of instability
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Business cycle, fundamental changes, technology can all cause
instability
 The banking sector is vulnerable to this instability due
to its in-built high leverage
 An unstable banking system can cause “bank runs”
when depositors lose confidence
 Central bank regulation of banks and the banking
system is vital to minimise the chances of banking
system instability and to protect bank customers
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Types of bank regulation
 Bank regulations come in the form of either Systemic
Regulation of Prudential Regulation
 Systemic regulation is usually:
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Government deposit insurance
Lender of last resort
 Prudential regulation is usually:
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Capital rules
Liquidity rules
Code of conduct
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History of bank regulation
 Each local financial system has its own history of bank
regulation
 Globally a number of major regulatory milestones have
had widespread impact:
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1933 Glass-Steagall – separation of Investment and Corporate
Banking in the US (largely repealed in 1999)
1988 first Basel Capital Accord “BIS I”. Concept of Tier 1
(Equity) and Tier 2 (sub debt, hybrids, other) and Risk
Weighted Assets (RWAs). Tier 1 + Tier 2 capital = 8% * RWA
1996 second Basel Capital Accord “BIS II”. Three “Pillars” – 1:
capital, 2: supervisory review, 3: disclosure
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BIS II
 Currently the “global” banking system is supposed to be
operating under BIS II
 Pillar 1:
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Risk Weightings aligned to actual expected credit risk
Credit risk calculation could be “Standardised” or “Internal Ratings
Based”
Market and Operational risk also included
 Pillar 2:
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Boosting regulatory powers to review and supervise banks
 Pillar 3:
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More disclosure of risk, capital adequacy and risk management
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BIS III
 Required Capital – increase required capital – Tier 1 up
from 4% to 6%
 Introduce Leverage Ratio – ratio of Tier 1 capital
divided by “total exposure” to be a minimum of 3%
 Introduce Liquidity Cover Ratio – High quality liquid
assets divided by net cash outflow over the next 30
days >100%
 Introduce Net Stable Funding Ratio – Long Term
Stable Funding divided by Long Term Assets (> 1-year)
> 100%
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BIS III
 Introduce counter-cyclical capital buffers – increase capital
in good times so banks have more protection for bad times
 Strengthen risk frameworks across a lot of areas of the
banks eg:
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Credit Valuation Adjustment (CVA) for swap counterparty risk
management
OTC derivative clearing through centralised exchanges
 BIS III is costly for banks and will be less efficient (ie a
burden for the global economy) - but should strengthen
the banking system
 Timetable for introduction 2011-19
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Financial Crises
 There are many types of financial crises, including:
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Banking crises
Currency crises
Speculative asset price bubbles
Economic crises
 2007-9 GFC was mostly a banking crisis but it came
from a speculative asset bubble
 Economic crises are usually deep recessions or
depressions where GDP falls sharply
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Banking Crises
 Loss of confidence in a bank or number of banks
leading to bank run where depositors withdraw funds
rapidly
 Often associated with periods of poor lending
decisions leading to high loan portfolio loss provisions
 High leverage in the banking system means
confidence is fragile
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Small loan losses can quickly turn into a banking crisis
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Currency Crises
 A large increase in country risk can cause foreign investors
to lose confidence in the country
 Country risk might come from a local economic crisis or
perhaps political change
 Foreign investors will sell a currency quickly if they lose
confidence
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25%+ fall on relevant FX rate
Often the Central Bank will try to support the currency by increasing
local interest rates
 1997 Asian Currency Crisis is classic example of currency
crisis – began in Thailand and flowed across the region
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Currency Crises - IDR
Indonesian Rupiah – USD FX rate:
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Speculative Asset Price Bubbles
 A speculative asset price bubble is a large increase in
the price of an asset, often over longer periods, which
leaves the asset valuation out of line with underlying
fundamental valuations
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Dutch tulip bubble of 1637
1929 Wall St crash
1980s Japan property bubble
Late 1990’s “dot-com” bubble
US housing price bubble 2003-6
 Bubbles usually end with a large price crash!
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Conclusion: improve bank regulation
 The 2007-9 wasn’t just a US crisis – Europe has had
enormous problems as well
 Result was fast track Basel / BIS III
 US passed “Dodd Frank” law
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Reduce bank trading
Increase derivative transparency through clearing
Allow for orderly bank closures
Rid system of “too big to fail”
Reform mortgage market
Toughen consumer finance protection laws
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