Risk Management of U.S. Money Center Banks

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Risk Management of U.S. Money Center Banks

• Presented by
• Wei Chen
• Bridge Hu
• Eric Song
• Jing Zhang
• Yuan Su Zhi

2
Agenda

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

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Definition of Money Center Bank

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

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Products and Services

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

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Market Dynamics
U.S. Money Center Banks Market Capitalization
Citigroup 246B
Bank of America 114B
Wells Fargo 95B
JP Morgan Chase 73B
Wachovia 61B
US Bankcorp 52B
Bank One 47B

• Global money center banks
• market capitalization 1,221B
• ROE 16.9
• Merrill Lynch (56B)

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Important Regulations

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

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Basel Committee

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

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FAS 133

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

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The Major Risks Banks Face

1. Liquidity risk
2. Interest risk
3. Market risk
4. Credit risk
5. Off-balance sheet risk
6. Foreign exchange risk
7. Operating risk

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Liquidity Risk

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

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Liquidity Risk

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

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Liquidity Risk Management

• The fundamental dilemma of liquidity risk
  management
• low yield of reserve assets
• Liquidating investment

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Liquidity Risk Management

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

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Interest Risk

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

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Interest Risk (measurements)

• Gap analysis
• Duration analysis
• Simulation model

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Interest Risk Management

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

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Market Risk

• Definition the risk of bank losses from
  movement of market prices on its trading
  inventory

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Market Risk Measurement

• Two ways to measure
• Value-at-cost models (VAR)
• The BIS standardized measurement method

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Credit Risk

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

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Credit Risk Measurement

• Traditional approach
• Quantitative approach

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Credit Risk Management

• Available collaterals
• Customers creditworthiness

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Off-balance Sheet Risk

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

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Foreign Exchange Risk

• The potential adverse impact on a banks earning
  and value of its equity from foreign exchange
  rate movement 

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Operating Risk

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

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About JP Morgan Chase

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

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Industry Standing
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Five Business Segments

• Investment Bank
• Investment Management Private banking
• Treasury Securities Services
• JPMorgan Partners
• Chase Financial Services

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Two Brands

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

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Revenue Structure

• Business segment 44 of total revenue from fixed
  income capital markets
• Client segment 50 of total revenue from
  financial institutions
• Geographic region 59 of total revenue from
  North America

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Revenue Structure
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Risk Management Structure

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

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Risk Management Structure
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Capital Management

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

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Liquidity Management

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

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Credit Ratings for Funding Plan
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Off-balance Sheet Arrangements

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

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Off Balance-sheet Obligations and Commitments
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Credit Risk Management

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

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Credit Risk Policy

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

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Global Credit Management

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

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Credit Portfolio
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Commercial Portfolio
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Consumer Portfolio
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Credit Management in Derivatives

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

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Mark-to-market Fair Value of Derivative Contracts
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Risk Profile of Derivative Receivables
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Use of Credit Derivatives
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Allowance for Credit Losses

• Intended to cover probable credit losses
• The Risk Management Committee reviews the
  allowance for credit losses relative to the risk
  profile of the firms credit portfolio and
  current economic conditions, and adjusts it
  accordingly

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Summary of Allowance and Provision for Credit
Losses
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Market Risk Management

• Corporate function identify, measure, monitor
  and control market risk
• Seek to facilitate efficient risk/return
  decisions and to reduce volatility in operating
  performance
• Individual coverage teams are assigned to
  particular businesses where they have expertise
  in the specific types of risk

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Market Risk Measurement

• Statistical risk measures
• Value-at-Risk (VAR)
• Risk identification for large exposures (RIFLE)
• Nonstatistical risk measures
• Economic value stress tests
• Net interest income stress tests
• Other measures of position size and sensitivity
  to market moves

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Value-at-Risk

• Measure the dollar amount of potential loss from
  adverse market moves in an ordinary market
  environment
• Used to compare risks across businesses, to
  monitor limits and to allocate economic capital
• Back-testing of VAR against actual financial
  results to evaluate the soundness of the model
• Stress-testing capture exposure to unlikely but
  plausible events in abnormal markets (VAR loss
  due to unlikely events in normal markets)
• VAR and stress-testing are important determinants
  in capital allocation for market risk

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Value-at-Risk Aggregate Portfolio
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Daily Market Risk-related Losses VS. VAR
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Market Risk Monitoring and Control

• Limits examine factors such as market
  volatility, product liquidity, business track
  record, and management
• Qualitative risk management review business
  strategy, market conditions, product details and
  effectiveness of risk controls
• Model review review risk models to assess
  appropriateness and consistency across businesses
• Policies and procedures specify a clear set of
  objectives, responsibilities, and procedures

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Operational Risk Management

• Maintain a system of comprehensive policies and a
  control framework designed to provide a sound and
  well-controlled operational environment
• Reputational risk during 2002, the firm put in
  place an additional structure to take account of
  the potential for adverse reputational impact of
  transactions with clients, especially complex
  derivatives and structured finance transactions

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Operational Risk Management Practices

• Governance structure
• Operational risk policies and procedures
• Operational Risk Committee
• Business Control Committees
• Self-assessment process
• Focused on business-specific key risks and
  controls
• Automated using Horizon software application
• Develop and monitor action plans
• Operational risk event monitoring
• Internal error and loss data reported and
  analyzed to determine causal effects
• Enables comparative analysis with external data
• Alignment with internal audit activities
• New capital allocation methodology (2003
  Implementation)

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Merrill Lynch
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Company Overview

• Merrill Lynch
• One of the world's leading financial management
  and advisory companies, with offices in 36
  countries and private client assets of
  approximately 1.1 trillion. As an investment
  bank, it is a leading global underwriter of debt
  and equity securities and strategic advisor to
  corporations, governments, institutions and
  individuals worldwide. Through Merrill Lynch
  Investment Managers, the company is one of the
  world's largest managers of financial assets.

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Risk Management Philosophy

• Risk-taking is an integral part of Merrill
  Lynchs core business activities.
• In the course of conducting its business
  operations, Merrill Lynch is exposed to a variety
  of risks including market, credit, liquidity,
  operational, and other risks that are material
  and require comprehensive controls and ongoing
  management.
• The Corporate Risk Management (CRM) group,
  along with other control units, works to ensure
  that these risks are properly identified,
  monitored, and managed throughout Merrill Lynch.

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Corporate Risk Management Process

• A formal risk governance organization that
  defines the oversight process and its components
• A regular review of the entire risk management
  process by the Audit Committee of the Board of
  Directors
• Clearly defined risk management policies and
  procedures supported by a rigorous analytical
  framework

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Corporate Risk Management Process - cont

• Communication and coordination between the
  business, executive, and risk functions while
  maintaining strict segregation of
  responsibilities, controls, and oversight
• Clearly articulated risk tolerance levels as
  defined by a group composed of executive
  management (the Management Group) which are
  regularly reviewed to ensure that Merrill Lynchs
  risk-taking is consistent with its business
  strategy, capital structure, and current and
  anticipated market conditions.

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Risk Governance Structure

• Merrill Lynchs risk governance structure is
  comprised of the Audit Committee, the Management
  Group, the Risk Oversight Committee (ROC), the
  business units, CRM, and various corporate
  governance committees.

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Risk Governance Structure

• The Audit Committee
• The Management Group
• The ROC
• Various other governance committees

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Corporate Risk Management

• CRM is an independent control function
  responsible for Merrill Lynchs market and credit
  risk management processes both within and across
  the firms business units
• The co-heads of Risk management joined by other
  units such as Finance and Legal Corporate Audit

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Risks

• Market risk
• Credit risk
• Operational risk
• Liquidity risk

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Market Risk (VaR)

• Trading

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Market Risk (VaR)

• Non-trading

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Credit Risk Management

• CRMs Credit Risk Group assesses the
  creditworthiness
• Credit risk mitigation techniques include the
  right to require initial collateral or margin,
  the right to terminate transactions or obtain
  collateral should unfavorable events occur, the
  right to call for collateral when certain
  exposure thresholds are exceeded, and the
  purchase of credit default protection.

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Credit Risk Management

• Merrill Lynch enters into International Swaps and
  Derivatives Association, Inc. master agreements
  or their equivalent (master netting agreements)
  with substantially all of its derivative
  counterparties as soon as possible. The
  agreements are negotiated with each counterparty
  and are complex in nature.

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Credit Risk Management

• In addition, to reduce default risk, Merrill
  Lynch requires collateral, principally cash and
  U.S. Government and agency securities, on certain
  derivative transactions.
• To further mitigate its default risk on
  derivatives whenever possible by entering into
  transactions with provisions that enable Merrill
  Lynch to terminate or reset the terms of its
  derivative contracts.

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Credit Risk Management

• Credit exposure from derivative transactions

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Operational Risk

• Maintaining a comprehensive system of internal
  controls
• Using technology to automate processes and reduce
  manual errors, monitoring risk events,
• Employing experienced personnel

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Operational Risk - cont

• Monitoring business activities by compliance
  professionals
• Maintaining fully operational, off-site backup
  facilities, conducting internal audits, requiring
  education
• Training of employees, and emphasizing the
  importance of management oversight.

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Liquidity Risks

• Liquidity risks include both being unable to
  raise funding with appropriate maturity and
  interest rate characteristics or being unable to
  liquidate an asset in a timely manner at a
  reasonable price.

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Liquidity Risks Management

• Maintain appropriate mix of short- and long-term
  capital
• Maintain sufficient alternative funding sources
• Concentrate unsecured financing at ML Co.
• Diversify unsecured funding sources
• Adhere to prudent governance processes

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Non-Investment Grade Holdings andHighly
Leveraged Transactions(high-risk assets)

• Non-investment grade holdings have been
  defined as debt and preferred equity securities
  rated as BB or lower or equivalent ratings by
  recognized credit rating agencies, sovereign debt
  in emerging markets, amounts due under derivative
  contracts from non-investment grade
  counterparties, and other instruments that, in
  the opinion of management, are non-investment
  grade.

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Trading Exposures
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Non-Trading Exposures
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Valuation of Financial Instruments

• Fair values for exchange traded securities and
  certain exchange-traded derivatives, principally
  futures and certain options, are based on quoted
  market prices.

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Valuation of Financial Instruments - cont

• Fair values for OTC derivative financial
  instruments, which represent amounts estimated to
  be received from or paid to a third party in
  settlement of these instruments, are valued using
  pricing models based on the NPV of estimated
  future cash flows, and directly observed prices
  from exchange-traded derivatives, other OTC
  trades, or external pricing services.

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Categorized Assets

1. Highly liquid cash and derivative instruments for
   which quoted market prices are readily available
2. Liquid instruments
3. Less liquid instruments that are priced using
   managements best estimate of fair value, and
   instruments which are valued using a model, where
   either the inputs to the model and/or the models
   themselves require significant judgment by
   management

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Special Purpose Entities (SPEs)

• SPEs are trusts, partnerships, or corporations
  established for a particular limited purpose.
  Merrill Lynch engages in transactions with SPEs
  for a variety of reasons. Many of these SPEs are
  used to facilitate the securitization of client
  assets whereby mortgages, loans or other assets
  owned by clients are transformed into securities
  (securitized).

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Company Overview

• No. 2 in U.S. in terms of revenues
• No. 2 in U.S. in terms of assets
• No. 3 debt arranger (underwriter) of global
  loans, international bonds, and medium-term
  notes.
• More than 100,000 Bank of America associates
  provide financial products, services

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Contd

• Their consumer and commercial banking operations
  serve more than one in four households in the
  United States
• Bank of America is U.S.s No. 1 small business
  lender
• Bank of America Investment Services Inc., offers
  more than 820,000 account holders for wealth
  management

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Risk Management Overview

• Corporate Governance Structure
• -Liquidity
• -Credit
• -Market
• -Operational

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Governance Structure

• Begins with Board of Directors. The Board of
  Directors evaluates risk through the Chief
  Executive Officer (CEO) and three Board
  committees
• -Finance Committee reviews market, credit,
  liquidity and operational risk
• -Asset Quality Committee reviews credit risk
• -Audit Committee reviews scope and coverage of
  external and corporate audit activities

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Three Lines of Defense

• Lines of business
• Risk management joined by other units such as
  Finance and Legal
• Corporate Audit

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Senior Management Committees

• The Risk and Capital Committee (RCC)
• The Asset and Liability Committee (ALCO)
• The Credit Risk Committee (CRC)

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Liquidity Risk Management
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• Two primary levels
• -parent company
• -banking subsidiaries
• Finance Committee is responsible for establishing
  the liquidity policy as well as approving
  operating and contingency procedures and
  monitoring liquidity on an ongoing basis

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• Parent company
• -Source dividends received from its banking
  subsidiaries and proceeds from the issuance of
  senior and subordinated debt, commercial paper
  and equity
• -Uses repayment of maturing debt and commercial
  paper, share repurchases,dividends paid to
  shareholders and subsidiary funding.
• Primary measure Time to required funding

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• Banking subsidiaries
• -Source customer deposits, wholesale funding
  and asset securitizations and sales
• -Uses repayment of maturing obligations and
  growth in the core and discretionary asset
  portfolios, including loan demand. Discretionary
  portfolio consists of securities, certain
  residential mortgages held for asset and
  liability management purposes, and our swap
  portfolio
• ALCO regularly reviews the funding plan for the
  banking subsidiaries and focuses on maintaining
  prudent levels of wholesale borrowing

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Credit Rating
103
Balance Sheet
104
Deposits and Other funding Sources
105
Off-Balance Sheet Financing Entities

• Facilitate customers access to the commercial
  paper markets
• Receive fees for providing combinations of
  liquidity, standby letters of credit (SBLCs) or
  similar loss protection commitments, and
  derivatives to the commercial paper financing
  entities
• In January 2003, the FASB issued a new rule that
  addresses off-balance sheet financing entities

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Capital Management

• Shares issued under employee plans and unrealized
  gains on securities
• These increases were offset by share repurchases
  and dividends paid
• On October 23, 2002, the Board approved a 0.04
  per share, or seven percent, increase in the
  quarterly common dividend.

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Credit Risk Management
108

• Commercial Portfolio Credit Risk Management
• -Assessment of the credit risk profile of an
  individual borrower
• -Risk rating
• Consumer Portfolio Credit Risk Management
• -Statistical techniques are used
• -Statistical models are built using detailed
  behavioral and demographic information

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Outstanding Loans and Leases
110
Nonperforming Assets and Net Charge-offs

• Routinely review the loan and lease portfolio
• These losses resulted from a multitude of
  factorsbusiness failures as a result of
  financial reporting fraud, the prolonged weak
  economic environment and industry specific
  issues.

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Nonperforming Assets
112
Nonperforming Assets Activity
113
Allowance for Credit Losses

• Conduct periodic and systematic detailed reviews
• The allowance for credit losses represents
  managements estimate of probable losses in the
  portfolio

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Problem Loan Management

• Assist borrowing companies in refinancing with
  other lenders or through the capital markets
• Facilitate the sale of entire borrowing companies
  or certain assets/subsidiaries
• -selling individual assets in the secondary
  market

115
Market Risk Management
116
Trading Risk Management

• Trading account assets and liabilities
• Derivative positions
• Mortgage banking assets

117
Trading Activities Market Risk
118
Interest Rate Risk Management

• Goal to manage interest rate sensitivity so that
  movements in interest rates do not adversely
  affect net interest income
• What involved securities,residential mortgage
  portfolio, Securities

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Techniques

• Complex sensitivity simulations are used to
  estimate the impact
• The Balance Sheet Management division maintains a
  net interest Income forecast utilizing different
  rate scenarios
• The overall interest rate risk position and
  strategies are reviewed on an ongoing basis with
  ALCO and other committees as appropriate

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Operational Risk Management
121
Techniques

• Corporate wide or business segment specific
  policies and procedures, controls and monitoring
  tools.e.g. personnel management practices, data
  reconciliation processes, fraud management units,
  transaction processing monitoring and analysis,
  systems interruptions and new product
  introduction processes
• Company-wide quarterly self-assessment process
• Identify key risk indicators

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Structure
 
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Recommendations

• Disclose more detailed information on specific
  derivative instruments used in risk management
• Generally well established risk management models
  for each institution given respective risk
  management philosophies