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Risk Management of U.S. Money Center Banks


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Title: Risk Management of U.S. Money Center Banks

Risk Management of U.S. Money Center Banks
  • Presented by
  • Wei Chen
  • Bridge Hu
  • Eric Song
  • Jing Zhang
  • Yuan Su Zhi

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

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

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

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)

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
  • Financial Accounting Standards Board FASB
    Statement 133

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
  • 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

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

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

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

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

Liquidity Risk Management
  • The fundamental dilemma of liquidity risk
  • low yield of reserve assets
  • Liquidating investment

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

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

Interest Risk (measurements)
  • Gap analysis
  • Duration analysis
  • Simulation model

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

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

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

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

Credit Risk Measurement
  • Traditional approach
  • Quantitative approach

Credit Risk Management
  • Available collaterals
  • Customers creditworthiness

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

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

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
  • No. 1 private bank in the U.S.
  • No. 5 in global MA
  • No. 1 in U.S. dollar clearing and commercial
  • No. 4 originator of residential mortgage loans in
    the U.S.
  • Fourth largest domestic credit card issuer

Industry Standing
Five Business Segments
  • Investment Bank
  • Investment Management Private banking
  • Treasury Securities Services
  • JPMorgan Partners
  • Chase Financial Services

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

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

Revenue Structure
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

Risk Management Structure
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

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)

Credit Ratings for Funding Plan
Off-balance Sheet Arrangements
  • Report off-balance sheet obligations and
  • Special-purpose entities (or special-purpose
  • SPE involves a company selling assets to the SPE,
    which funds the purchase by selling securities to
  • Critical to markets such as mortgage-backed
    securities, asset-backed securities, and
    commercial paper

Off Balance-sheet Obligations and Commitments
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
  • Two functions Credit Risk Policy and Global
    Credit Management

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

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

Credit Portfolio
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

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

Summary of Allowance and Provision for Credit
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
  • Individual coverage teams are assigned to
    particular businesses where they have expertise
    in the specific types of risk

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

  • Measure the dollar amount of potential loss from
    adverse market moves in an ordinary market
  • 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

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

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

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
  • 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

Merrill Lynch
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.

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
  • 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.

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
  • Clearly defined risk management policies and
    procedures supported by a rigorous analytical

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.

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.

Risk Governance Structure
  • The Audit Committee
  • The Management Group
  • The ROC
  • Various other governance committees

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

Market Risk (VaR)
  • Trading

Market Risk (VaR)
  • Non-trading

Credit Risk Management
  • CRMs Credit Risk Group assesses the
  • 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.

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.

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.

Credit Risk Management
  • Credit exposure from derivative transactions

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

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

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
  • Maintain sufficient alternative funding sources
  • Concentrate unsecured financing at ML Co.
  • Diversify unsecured funding sources
  • Adhere to prudent governance processes

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

Trading Exposures
Non-Trading Exposures
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.

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.

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

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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

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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
  • More than 100,000 Bank of America associates
    provide financial products, services

  • 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
  • Bank of America Investment Services Inc., offers
    more than 820,000 account holders for wealth

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Risk Management Overview
  • Corporate Governance Structure
  • -Liquidity
  • -Credit
  • -Market
  • -Operational

Governance Structure
  • Begins with Board of Directors. The Board of
    Directors evaluates risk through the Chief
    Executive Officer (CEO) and three Board
  • -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

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

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

Liquidity Risk Management
  • 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

  • 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

  • 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
  • ALCO regularly reviews the funding plan for the
    banking subsidiaries and focuses on maintaining
    prudent levels of wholesale borrowing

Credit Rating
Balance Sheet
Deposits and Other funding Sources
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
  • In January 2003, the FASB issued a new rule that
    addresses off-balance sheet financing entities

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.

Credit Risk Management
  • 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

Outstanding Loans and Leases
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

Nonperforming Assets
Nonperforming Assets Activity
Allowance for Credit Losses
  • Conduct periodic and systematic detailed reviews
  • The allowance for credit losses represents
    managements estimate of probable losses in the

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

Trading Activities Market Risk
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

  • 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

Operational Risk Management
  • 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

  • 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
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