3. Financial Markets and Products.pdf

 ® @GARP FRM I Financial Risk Manager 2024 ® EXAM PART I Financial Markets and Products @Pearson Copyright© 2024, 2023, 2022, 2021, 2020 by the Global Association of Risk Professionals All rights reserved. This copyright covers material...

 ® @GARP FRM I Financial Risk Manager 2024 ® EXAM PART I Financial Markets and Products @Pearson Copyright© 2024, 2023, 2022, 2021, 2020 by the Global Association of Risk Professionals All rights reserved. This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does not cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by Pearson Education, Inc. for this edition only. Further reproduction by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, must be arranged with the individual copyright holders noted. All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. Pearson Education, Inc., 221 River Street, Hoboken, NJ 07030 A Pearson Education Company www.pearsoned.com @Pearson ISBN 10: 0-13-832444-1 ISBN 13: 978-0-13-832444-5 Contents Summary 11 Chapter 1 Banks Questions 12 Short Concept Questions 12 1.1 The Risks in Banking 2 Practice Questions 12 Market Risks 2 Answers 13 Credit Risks 2 Short Concept Questions 13 Operational Risks 3 Solved Problems 13 1.2 Bank Regulation 3 Capital 4 T he Basel Committee 4 Chapter 2 Insurance Companies Standardized Models versus Internal Models 4 and Pension Plans 15 Trading Book versus Banking Book 5 Liquidity Ratios 5 2.1 Mortality Tables 16 1.3 Deposit Insurance 2.2 Life Insurance 16 5 Whole Life Insurance 16 1.4 Investment Banking 6 Term Life Insurance 19 IPOs 7 Endowment Life Insurance 19 Dutch Auctions 7 Group Life Insurance 19 Advisory Services 8 Annuity Contracts 20 Trading 9 Longevity and Mortality Risk 20 1.5 Conflicts of Interest 9 Investments 21 1.6 The Originate to Distribute 2.3 Pension Plans 21 Model 10 iii  2.4 Property and Casualty Global Macro 39 Insurance 22 Managed Futures 39 CAT Bonds 22 3.6 Research on Returns 39 Loss Ratios 23 Mutual Fund Research 39 2.5 Health Insurance 23 Hedge Fund Research 40 2.6 Moral Hazard and Adverse Summary 40 Selection 24 Questions 42 Moral Hazard 24 Short Concept Questions 42 Adverse Selection 24 Practice Questions 42 2.7 Regulation 24 Answers 43 Summary 25 Short Concept Questions 43 Questions 26 Solved Problems 43 Short Concept Questions 26 Practice Questions 27 Chapter 4 Introduction Answers 28 to Derivatives 45 Short Concept Questions 28 Solved Problems 28 4.1 The Markets 47 Exchange-Traded Markets 47 Chapter 3 Fund Management 31 Over-the-Counter Markets 47 Market Size 48 4.2 Forward Contracts 48 3.1 Mutual Funds 32 Open-End Funds 32 4.3 Futures Contracts 50 Closed-End Funds 33 4.4 Options 50 3.2 Exchange-Traded Funds 34 4.5 Market Participants 52 3.3 Undesirable Trading Behavior 34 Hedgers 52 Speculators 52 3.4 Hedge Funds 35 Arbitrageurs 53 Prime Brokers 37 4.6 Derivatives Risks 53 3.5 Types of Hedge Funds 38 Long-Short Equity 38 Summary 53 Dedicated Short 38 Questions 54 Distressed Debt 38 Short Concept Questions 54 Merger Arbitrage 38 Practice Questions 54 Convertible Arbitrage 39 Answers 55 Fixed-Income Arbitrage 39 Short Concept Questions 55 Emerging Markets 39 Solved Problems 55 iv Contents  6.3 Standard and Non-Standard Chapter 5 Exchanges and OTC Transactions 74 Markets 57 6.4 The Move to Central Clearing 75 6.5 Advantages and Disadvantages 5.1 Exchanges 58 of CCPs 77 Central Counterparties 59 6.6 CCP Risks 78 5.2 How CCPs Handle Credit Risk 60 Model Risk 79 Netting 60 Liquidity Risk 79 Variation Margin and Daily Settlement 60 Summary 79 Initial Margin 61 Default Fund Contributions 61 Questions 81 Short Concept Questions 81 5.3 Use of Margin Accounts Practice Questions 81 in Other Situations 61 Options on Stocks 62 Answers 82 Short Concept Questions 82 Short Sales 62 Buying on Margin 62 Solved Problems 82 5.4 Over-the-Counter Markets 63 Bilateral Netting in OTC Markets 64 Collateral 65 Chapter 7 Futures Markets 83 Special Purpose Vehicles 65 Derivative Product Companies 65 7.1 Exchanges 84 Credit Default Swaps 65 7.2 Operation of Exchanges 84 Summary 66 7.3 Specification of Contracts 85 Questions 67 The Underlying Asset 85 Short Concept Questions 67 Contract Size 85 Practice Questions 67 Delivery Location 85 Answers 68 Delivery Time 85 Short Concept Questions 68 Price Quotes 86 Solved Problems 68 Price Limit 86 Position Limits 86 7.4 Delivery Mechanics 87 Chapter 6 Central Clearing 71 Cash Settlement 87 7.5 Patterns of Futures Prices 87 6.1 The Operation of CCPs 73 7.6 Market Participants 88 6.2 Regulation of OTC Derivatives 7.7 Placing Orders 88 Market 73 Market Orders 89 Contents v  Limit Orders 89 8.7 Cash Flow Considerations 105 Stop-Loss Order 89 Summary 105 Stop-Limit Orders 89 Market-if-Touched Orders 89 Questions 106 Discretionary Orders 89 Short Concept Questions 106 Duration of Orders 89 Practice Questions 106 7.8 Regulation of Futures Answers 107 Markets 89 Short Concept Questions 107 Solved Problems 107 7.9 Accounting 90 7.10 Forwards Compared with Futures 90 Chapter 9 Foreign Exchange Summary 91 Markets 109 Questions 92 Short Concept Questions 92 Practice Questions 92 9.1 Quotes 110 Outrights and Swaps 112 Answers 93 Futures Quotes 113 Short Concept Questions 93 Solved Problems 93 9.2 Estimating FX Risk 113 Transaction Risk 113 Translation Risk 113 Economic Risk 114 Chapter 8 Using Futures for Hedging 95 9.3 Multi-Currency Hedging Using Options 114 9.4 Determination of Exchange 8.1 Long and Short Hedges 96 Rates 115 Short Hedge 96 Balance of Payments and Trade Flows 115 Long Hedges 96 Inflation 115 8.2 Pros and Cons of Hedging 98 Monetary Policy 116 Shareholders May Prefer No Hedging 98 9.5 Real versus Nominal Interest There May Be Little or No Exposure 98 Rates 116 Hedging May Lose Money 99 9.6 Covered Interest Parity 116 8.3 Basis Risk 99 Interpretation of Points 118 8.4 Optimal Hedge Ratios 100 9.7 Uncovered Interest Parity 118 Tailing the Hedge 101 Summary 118 8.5 Hedging Equity Positions 102 Questions 120 Managing Beta 103 Short Concept Questions 120 8.6 Creating Long-Term Hedges 104 Practice Questions 120 vi Contents  Answers 121 11.2 Types of Commodities 136 Short Concept Questions 121 Agricultural Commodities 136 Solved Problems 121 Metals 137 Energy 137 Weather 138 Chapter 10 Pricing Financial 11.3 Commodities Held Forwards for Investment 138 and Futures 123 Lease Rates 139 11.4 Convenience Yields 139 10.1 Short Selling 124 11.5 Cost of Carry 140 10.2 The No Income Case 124 A Note on Compounding Frequencies for Interest Rates 141 Generalization 126 10.3 The Known Income Case 126 11.6 Expected Future Spot Prices 141 Early Work 141 Generalization 127 Modern Theory 141 10.4 The Known Yield Case 128 Normal Backwardation and Contango 143 10.5 Valuing Forward Contracts 128 Summary 143 10.6 Forward versus Futures 129 Questions 144 10.7 Exchange Rates Revisited 130 Short Concept Questions 144 Practice Questions 144 10.8 Stock Indices 130 Index Arbitrage 130 Answers 145 Indices Not Representing Tradable Short Concept Questions 145 Portfolios 131 Solved Problems 145 Summary 131 Questions 132 Short Concept Questions 132 Chapter 12 Options Markets 147 Practice Questions 132 Answers 133 12.1 Calls and Puts 148 Short Concept Questions 133 Moneyness 149 Solved Problems 133 Profits from Call Options 149 Profits from Put Options 150 Chapter 11 Commodity Forwards Payoffs 150 and Futures 135 12.2 Exchange-Traded Options on Stocks 151 Maturity 151 11.1 Why Commodities Are Strike Prices 151 Different 136 Dividends and Stock Splits 152 Contents vii  Index Options 152 Answers 169 ETP Options 152 Short Concept Questions 169 Non-Standard Products 152 Solved Problems 169 12.3 Trading 152 12.4 Margin Requirements 153 Chapter 14 Trading 12.5 Over-the-Counter Market 153 Strategies 171 12.6 Warrants and Convertibles 153 12.7 Employee Stock Options 154 14.1 Strategies Involving Summary 154 a Single Option 172 Questions 156 Principal Protected Notes 172 Short Concept Questions 156 14.2 Spread Trading Strategies 173 Practice Questions 156 Bull Spread 173 Answers 157 Bear Spread 174 Short Concept Questions 157 Box Spread 175 Solved Problems 157 Butterfly Spread 175 Calendar Spread 177 14.3 Combinations 177 Chapter 13 Properties Straddle 177 of Options 159 Strangle 178 14.4 Manufacturing Payoffs 178 Summary 179 13.1 Call Options 160 American versus European Options: No Questions 180 Dividends 160 Short Concept Questions 180 Employee Stock Options 161 Practice Questions 180 Impact of Dividends 161 Answers 181 Lower Bound When There Are Dividends 162 Short Concept Questions 181 13.2 Put Options 162 Solved Problems 181 American versus European Options: No Dividends 163 13.3 Put-Call Parity 164 Chapter 15 Exotic Options 183 13.4 Use of Forward Prices 166 Summary 167 15.1 Exotics Involving a Single Questions 168 Asset 184 Short Concept Questions 168 Packages 184 Practice Questions 168 Zero-Cost Products 184 viii Contents  Non-Standard American Options 184 Libor 197 Forward Start Options 185 Credit Sensitive Rates 198 Gap Options 185 Derivatives 198 Cliquet Options 185 16.2 Compounding Frequency 198 Chooser Options 185 Usual Conventions 200 Binary Options 186 16.3 Continuous Compounding 200 Asian Options 187 Lookback Options 187 16.4 Zero Rates 201 Barrier Options 188 16.5 Discounting 201 Compound Options 188 16.6 Bond Valuation 201 15.2 Exotics Involving Multiple Bond Yield 202 Assets 189 Par Yield 202 Asset-Exchange Options 189 16.7 Duration 202 Basket Options 189 Modified Duration 203 15.3 Exotics Dependent Limitations of Duration 204 on Volatility 189 Volatility Swap 189 16.8 Convexity 204 Variance Swap 190 16.9 Forward Rates 205 15.4 Hedging Exotics 190 Forward Rate Agreement 206 Summary 191 16.10 Determining Zero Rates 207 Questions 192 16.11 Theories of the Term Structure 207 Short Concept Questions 192 Practice Questions 192 Summary 208 Answers 193 Questions 210 Short Concept Questions 193 Short Concept Questions 210 Solved Problems 193 Practice Questions 210 Answers 211 Short Concept Questions 211 Chapter 16 Properties Solved Problems 211 of Interest Rates 195 Chapter 17 Corporate 16.1 Types of Interest Rates 196 Bonds 213 Government Borrowing Rates 196 Overnight Interbank Borrowing 196 Repo Rates 196 17.1 Bond Issuance 214 Reference Rates 197 17.2 Bond Trading 214 Contents ix  17.3 Bond Indentures 216 18.3 Agency Mortgage-Backed Corporate Bond Trustee 216 Securities (MBSs) 229 216 Trading of Pass-Throughs 229 17.4 Credit Ratings High-Yield Bonds 217 Dollar Roll 230 Other Agency Products 230 17.5 Bond Risk 217 Non-Agency MBSs 231 Event Risk 217 Defaults 218 18.4 Modeling Prepayment Behavior 231 17.6 Classification of Bonds 218 Refinancing 231 Issuer 218 Turnover 232 Maturity 218 Defaults 232 Interest Rate 218 Curtailments 232 Collateral 219 18.5 Valuation of an MBS Pool 232 17.7 Debt Retirement 220 18.6 Option Adjusted Spread 235 Call Provisions 220 Summary 236 17.8 Default Rate and Recovery Rate 221 Questions 237 17.9 Expected Return from Bond Short Concept Questions 237 Investments 221 Practice Questions 237 Summary 222 Answers 238 Short Concept Questions 238 Questions 223 Solved Problems 238 Short Concept Questions 223 Practice Questions 223 Answers 224 Chapter 19 Interest Rate Short Concept Questions 224 Futures 241 Solved Problems 224 19.1 Day Count Conventions 242 Chapter 18 Mortgages and Bonds 242 Money Market Instruments 243 Mortgage-Backed Securities 225 19.2 Price Quotes for Treasury Bonds and Bills 243 Bonds 243 18.1 Calculating Monthly Treasury Bills 243 Payments 226 19.3 Treasury Bond Futures 244 Amortization Tables 227 Quotes 245 18.2 Mortgage Pools 228 Cheapest-to-Deliver Bond Option 245 Calculating the Futures Price 246 x Contents  19.4 SOFR Futures 247 20.2 The Risk-Free Rate 258 SOFR Futures Details 247 20.3 Reasons for Trading Interest Calculating Zero Curves 248 Rate Swaps 258 19.5 Duration-Based Hedging 249 Comparative Advantage Arguments 259 Summary 250 20.4 Valuation of Interest Rate Swaps 261 Questions 251 20.5 Currency Swaps 261 Short Concept Questions 251 Valuation 262 Practice Questions 251 Other Currency Swaps 263 Answers 252 20.6 Other Swaps 263 Short Concept Questions 252 20.7 Credit Risk 264 Solved Problems 252 Summary 264 Questions 265 Short Concept Questions 265 Chapter 20 Swaps 255 Practice Questions 265 Answers 267 Short Concept Questions 267 20.1 Mechanics of Interest Rate Solved Problems 267 Swaps 256 Overnight Indexed Swaps 256 Index 271 Day Counts and Holidays 257 Confirmations 257 Quotes 258 Contents xi  PREFACE I want to thank you on behalf of GARP's Board of Trustees and The FRM program's coverage is dynamic. The advisory our professional certification program staff for your support of committee reacts to and tries to anticipate market changes, the Financial Risk Manager (FRM®) program. global economic trends, technological advances, and regulatory adjustments; and assesses how these will affect the necessary It's gratifying to see that in the 26 years since the first FRM knowledge and skill sets of a risk management professional. examination, the FRM program has become the global standard for educating and credentialing financial risk management pro­ The biggest change to the program's coverage for 2024 fessionals. Its worldwide effects in furthering the understanding revolves around credit risk measurement and management. and acceptance of financial risk management have been highly About t w o -thirds of the subject readings in Credit Risk positive and, in many ways, transformative. Measurement and Management were updated for 2024. COVID is thankfully in the rearview mirror. We now can be much Notably in 2023, GARP expanded the FRM program's coverage more flexible in expanding-and in certain instances re-focusing of operational resilience, an issue of rapidly growing importance and updating-the FRM program to address the many new around the world. Materials deal with structural vulnerabilities challenges encountered by financial institutions globally. and areas of the financial system that may be under stress. The transmission of shocks to the financial system, and the assess­ Our FRM program advisory committee, consisting of senior ment, modeling, and measurement of potential points of failure risk professionals from around the world, that meets regularly are other important covered concepts. to debate and settle the FRM program's subject coverage, has found no shortage of subjects for inclusion in the FRM Also notable in 2023, GARP added two chapters on machine curriculum. learning (ML) in the FRM Part I Quantitative Analysis book. These chapters not only introduce the ML methods risk manag­ One of the advisory committee's more-material challenges is ers need to understand, but also address key issues associated to understand and assess where the global financial services with artificial intelligence (Al) and ML, including transparency, industry is headed, and then identify issues and subjects most interpretability, and explainability; data considerations; and risks important for risk management professionals. that arise from the use of Al/ML, including the potential for bias, The FRM advisory committee also recommends how the FRM discrimination, and unethical behavior. program covers subject matter. Its objective is to ensure that Throughout the FRM curriculum, GARP aims, wherever possible, candidates who complete the FRM program successfully can be to present lessons learned from noteworthy current events to confident that their skills have been assessed objectively, and contextualize program content and give FRM candidates critical that they possess the requisite knowledge to succeed as a risk insight. management professional anywhere in the world. xii Preface As you will see from reviewing the program's coverage and Yours truly, readings, it keeps up with a world that is becoming more interconnected and complex by the day. GARP is committed to offering a program that is dynamic, sophisticated, and responsive to the needs of financial institu­ tions and risk professionals around the world. We wish you the very best as you study for the FRM exams. And Richard Apostolik much success in your career as a risk-management professional. President & CEO Preface xiii  ® FRM COMMITTEE Chairperson Nick Strange, FCA Senior Technical Advisor, Operational Risk & Resilience, Prudential Regulation Authority, Bank of England Members Richard Apostolik Keith Isaac, FRM President and CEO, GARP VP, Capital Markets Risk Management, T D Bank Group Richard Brandt William May MD, Operational Risk Management, Citigroup SVP, Global Head of Certifications and Educational Programs, GARP Julian Chen, FRM SVP, FRM Program Manager, GARP Attilio Meucci, PhD, CFA Founder, ARPM Chris Donohue, PhD MD, GARP Benchmarking Initiative, GARP Victor Ng, PhD Chairman, Audit and Risk Committee Donald Edgar, FRM Former MD, Head of Risk Architecture, Goldman Sachs MD, Risk & Quantitative Analysis, BlackRock Matthew Pritsker, PhD Herve Geny Senior Financial Economist and Policy Advisor/Supervision, Former Group Head of Internal Audit, London Stock Exchange Regulation, and Credit, Federal Reserve Bank of Boston Group Samantha C. Roberts, PhD, FRM, SCR Aparna Gupta Instructor and Consultant, Risk Modeling and Analytics Professor of Quantitative Finance Associate Dean, Academic Affairs Til Schuermann, PhD A.W. Lawrence Professional Excellence Fellow Partner, Oliver Wyman Co-Director and Site Director, NSF IUCRC CRAFT Evan Sekeris, PhD Lally School of Management Head of Non-Financial Risk, MUFG Rensselaer Polytechnic Institute Sverrir l>orvaldsson, PhD, FRM John Hull Senior Quant, SEB Senior Advisor Maple Financial Professor of Derivatives and Risk Management, Joseph L. Rotman School of Management, University of Toronto xiv FRM® Committee ATTRIBUTIONS Author John C. Hull, PhD, University Professor, Maple Financial Group Chair in Derivatives and Risk Management, University of Toronto Reviewers Erick W. Rengifo, PhD, Associate Professor of Economics, Charles Currat, PhD, FRM, SVP, Head of Investment Risk Fordham University Methodology, Wells Fargo Bank David W. Wiley, MBA, CFA, President, WHW Investments, LLC Claus-Peter Mueller, PhD, FRM, BCS, Head of Group Organization, Transformation, and IT, Heta Asset Resolution Sam Wong, PhD, CEO and Chief Quant, 5Lattice Securities Limited Daniel Homolya, PhD, FRM, ERP, Treasury Risk and Control Manager, Diageo Tao Pang, PhD, FRM, CFA, Director of the Financial Mathematics Program, North Carolina State University Jeffrey Goodwin, FRM, Founder and President, Crescendo Investments, LLC Masao Matsuda, PhD, FRM, CAIA, President and CEO, Crossgates Investment and Risk Management Patrick Steiner, FRM, Large Institution Supervision Coordinating Committee, Federal Reserve Bank of New York Colin White, PhD, FRM, Economist, Canadian Securities Transition Office Attributions xv Banks Learning Objectives After completing this reading, you should be able to: Identify the major risks faced by banks and explain how Describe the potential conflicts of interest among these risks can arise. commercial banking, securities services, and investment banking divisions of a bank, and recommend solutions to Distinguish between economic capital and regulatory these conflict of interest problems. capital. Describe the distinctions between the banking book Summarize the Basel committee regulations for regulatory and the trading book of a bank. capital and their motivations. Explain the originate-to-distribute banking model and Explain how deposit insurance gives rise to a moral hazard discuss its benefits and drawbacks. problem. Describe investment banking financing arrangements, including private placement, public offering, best efforts, firm commitment, and Dutch auction approaches. 1 Banks are the cornerstone of the world's financial system. The Consider the exchange rate between the U.S. dollar (USD) and activities of banks in many countries can be subdivided into the British pound (GBP). If the demand to buy GBP using USD commercial banking and investment banking. is greater than the demand to sell GBP for USD, the value of the exchange rate (USD per GBP) will increase. Similarly, if the Commercial banking involves the traditional activities of demand to sell GBP is greater than the demand to buy GBP, receiving deposits and making loans. These activities can be the exchange rate will decrease. categorized as either retail or wholesale. Retail banking involves transacting with private individuals and small businesses. The values of market variables can be affected by many Wholesale banking involves transacting with large corporations. different events. For example, the value of the British pound Loans and deposits are much larger in wholesale banking than decreased in June 2016 after the United Kingdom voted to in retail banking. As a result, the administrative costs per dollar leave the European Union (an event that market participants of deposits (or loans) are lower. The spread between the rates viewed as bad news for the British economy). Another example paid on deposits and the rates charged on loans is lower for can be seen with the reinstatement of sanctions by the U.S. wholesale banking as well. government on oil-producer Iran in May 2018. This event led to an increase in the price of oil because market participants Meanwhile, investment banking involves a variety of activities thought that it could reduce the supply of oil in global markets. such as: A bank's exposure to movements in the values of market vari­ Raising debt or equity capital for companies; ables arises primarily from its trading operations. As previously Providing advice to companies on mergers, acquisitions, and explained, proprietary trading by banks is not currently allowed financing decisions; and in the U.S. However, banks provide corporate clients and insti­ Acting as a broker-dealer for trading debt, equity, and other tutional investors with a wide range of products whose values securities. depend on the prices of market variables. Consider again the In some countries, the commercial banking and investment USD per GBP exchange rate. Among the transactions a corpo­ banking sectors are strictly separated. The U.S., for example, rate client may request are as follows. once limited the extent to which a single corporation could Spot transactions: where GBP is bought or sold for almost engage in both commercial and investment banking. Until the immediate delivery. repeal of the Glass-Steagall Act in 1999, investment banks Forward contracts: where an exchange rate for the purchase were not allowed to take deposits and make loans while or sale of a certain amount of GBP on a future date is agreed. commercial banks were not allowed to arrange equity issuances Options: where one side has the right (but not the obligation) for other companies. to buy or sell GBP at a pre-arranged price (i.e., the exercise Following the financial crisis of 2007-2008, policymakers in price) at a certain future time. some countries prohibited banks from putting depositors' funds For many of these contracts, banks act as market makers by quot­ at risk by engaging in proprietary trading (often referred to as ing both a bid (i.e., the price at which they are prepared to buy) prop trading). This is the speculative trading that an investment and an ask (i.e., the price at which they are prepared to sell). Banks bank does in the hope of increasing its profitability. typically ensure that their exposures to market variables are kept within certain limits, but they do not (usually) eliminate those 1.1 THE RISKS IN BANKING exposures entirely. As a result, banks are always exposed to some market risk. In this section, we explain three major risks that banks face. In the next section, we will outline the way in which banks are regulated to ensure that they can survive these risks. Credit Risks Credit risk arises from the possibility that borrowers will fail to Market Risks repay their debts. For banks, loans to corporations and individu­ als are a major source of credit risk. If a borrower defaults, a loss Market risks are the risks arising from a bank's exposure to is usually incurred. In a bankruptcy, the size of the loss depends movements in market variables (e.g., exchange rates, interest on whether assets have been pledged as collateral and how the rates, commodity prices, and equity prices). These market vari­ bank's claims rank compared with those of other creditors.1 ables are often referred to as risk factors. The value of a market variable is determined by trading in the financial markets. 1 This is discussed in more detail in Chapter 17. 2 Financial Risk Manager Exam Part I: Financial Markets and Products A bank builds expected losses into the interest rate it charges Operational Risks on loans. For example, suppose the bank's cost of funds (the average interest rate paid on deposits and on the bank's debt) Operational risk is defined by bank regulators as: 5 is 1.5%. The average interest rate charged on loans might be The risk of loss resulting from inadequate or failed internal 4%. The difference between the two interest rates (2.5% in processes, people, and systems or from external events. our example) is referred to as the net interest margin. If a bank This definition includes all risks that are not market or credit expects to lose 0.8% of what it lends, it will be left with 1.7% to risks (with the exception of strategic and reputational risks). cover administrative/operational costs and contribute to profits. Operational risk is harder to quantify than either market risk or In this example, 0.8% is the bank's expected (or average) loan credit risk. Examples from seven categories of operational risk losses. However, loan losses show significant variation from year identified by regulators include the following. to year. During stressed economic conditions, a bank might expe­ Internal fraud: Rogue traders intentionally misreporting posi­ rience loan losses as high as 4%, while during good economic tions or employees stealing from the bank by creating loans times these losses might be as low as 0.2%.2 Current regulations to fictitious companies. require banks to maintain enough capital to cover losses that are estimated to occur only once every thousand years.3 External fraud: Cyberattacks, bank robberies, forgery, and check kiting. Other bank contracts also give rise to credit risk. For example, Employment practices and work place safety: Worker banks trade a variety of derivatives (e.g., forward contracts and compensation claims, employee discrimination claims, and options). As already indicated, these give rise to market risk litigation arising from personal injury claims at bank branches. because the value of a derivatives contract depends on the under­ lying market variables. Derivatives also give rise to credit risk. This Clients, products, and business practices: Money laundering comes from the possibility that the counterparty to a derivatives and other actions that are either unlawful or prohibited by transaction will default when the transaction has a positive value regulators. to the bank (and therefore a negative value to the counterparty). Damage to physical assets: Terrorism, vandalism, earth­ Banks typically account for expected losses on transactions as quakes, fires, and floods. soon as they are initiated. An accounting rule known as IFRS 9, Business disruption and system failures: Hardware and software which covers most bank-issued loans, requires banks to show failures, telecommunication problems, and utility outages. the outstanding principal net of estimated expected losses over Execution, delivery, and process management: Data entry the following 12 months on their balance sheet. 4 In the case of errors, collateral management issues, and inadequate legal derivatives, banks calculate a credit value adjustment (CVA) documentation. reflecting the amount they expect to lose over the life of the Operational risk is regarded by many to be a greater challenge derivatives due to counterparty default. This is subtracted from for banks than either market risk or credit risk. Since 2008, banks the balance sheet value of the outstanding derivatives. In both in North America and Europe have been fined hundreds of bil­ cases, expected losses, even though they have not (yet) been lions of dollars for operational risk violations such as money incurred, are charged to income. laundering, market manipulation, terrorist financing, and inap­ propriate activities in the mortgage market. 2 Statistics published by the credit rating agency S&P show that the Significant sources of operational risk in banking include cyber risk, default rate per year on all rated corporate debt varied between 0.14% legal risk, and compliance risk (i.e., failure to comply with rules and and 4.19% between 1981 and 2018. The worst default rate (4.19%) regulations, either accidentally or intentionally). These risks are dis­ was in 2009, following the financial crisis. Other years with defaults rates greater than 3% were 1991 (3.25%), 2001 (3.79%), and 2002 (3.63%). In cussed further in Chapter 7 of Valuation and Risk Models. 2018, the default rate was 1.03%. Source: S&P Global. (2019, April 19). 2018 Annual Global Corporate Default And Rating Transition Study. https://www.spratings.com/documents/20184/ 774196/2018AnnualGlobalCorporateDefaultAndRatingTransitionStudy.pdf 1.2 BANK REGULATION 3 This is explained in more detail in Chapter 6 of Valuation and Risk Banks are subject to regulations designed to protect depositors Models. as well as maintain confidence and stability in the financial sys­ 4 The Financial Accounting Standards Board (FASB), the accounting tem. In this section, we outline the development of the global standard-setting body in the United States, has a rule similar to IFRS 9. In the case of the FASB rules, it is losses over the whole life of the loan banking regulatory environment. which are subtracted from the net principal. In the case of IFRS 9, losses over the whole life of the loan are considered only when there is a sig­ 5 See Bank for International Settlements, "Working Paper on the Regula­ nificant increase in credit risk. tory Treatment of Operational Risk," September 2001. Chapter 1 Banks 3 Capital By the 1990s, however, bank trading activities had significantly increased. In response, the Basel Committee agreed that banks It is important for banks to keep sufficient capital for the risks should keep capital for both market risk and credit risk. This they are taking. The most important capital is equity capital. modification to Basel I, known as the Market Risk Amendment, Because losses have the effect of reducing equity capital, banks was implemented in 1998. must try to maintain enough equity capital to cover potential In 1999, the Basel Committee proposed what has become losses and remain solvent (i.e., have a positive amount of equity known as Basel II. This agreement revised the procedure for cal­ capital). Debt capital is the other main category of capital, and culating credit risk capital and introduced a capital requirement it is usually subordinate to assets held for depositors (therefore for operational risk. It took about eight years for the final Basel providing an extra degree of protection for depositors). II rules to be worked out and implemented. The total capital Equity capital is sometimes referred to as going concern capital requirement was then the sum of amounts for (a) credit risk, because it absorbs losses while the bank is a going concern (b) market risk, and (c) operational risk. (i.e., it remains in business). Debt capital is referred to as gone The 2007-2008 crisis led to several bank failures and bailouts. concern capital because it is only affected by losses once a bank Global bank regulators subsequently determined that the rules has failed. In theory, depositors are at risk only when losses are for calculating market risk capital were inadequate. Thus, the sufficiently large to wipe out both equity and debt capital. rules were revised in what is referred to as Basel 11.5 We can distinguish between regulatory capital and economic The Basel Committee also decided that equity capital require­ capital. Regulatory capital is the minimum capital that regulators ments needed to be increased. This latest set of regulations, require banks to keep. Economic capital is a bank's own estimate called Basel Ill, includes a large increase in the amount of equity of the capital it requires. In both cases, capital can be thought of capital that banks are required to keep and is expected to be as funds that are available to absorb unexpected losses. A com­ fully implemented by 2027.8 mon objective in calculating economic capital is to maintain a high credit rating (as will be described in later chapters). Economic Meanwhile, the rules for market risk have been revised yet again capital is allocated to a bank's business units so that they can be with the Fundamental Review of the Trading Book, which is due compared using a return on allocated economic capital metric. to be implemented in 2022. The amount of capital that is necessary depends on the size of possible losses. If a bank's equity capital is USD 4 billion and Standardized Models versus Internal there is a 1% chance that the bank will incur a loss higher than Models USD 4 billion over a year, the equity capital will be consid- ered insufficient by both regulators and the bank itself. This is Models are necessary to determine bank capital. Some models because even a 1% chance that the bank will become insolvent are standardized tools developed by the Basel Committee, while is unacceptable. As mentioned earlier, the regulatory capital others are internal models developed by the banks themselves. for credit risk is designed to be sufficient to cover a loss that is Generally, banks need approval from regulators before they can expected to be exceeded only once every thousand years.6 use a specific internal model. The models for credit risk that were introduced in Basel I were The Basel Committee standardized models developed by the Basel Committee. This means that two banks, when presented with the same portfolio, The Basel Committee for Banking Supervision was established should calculate the same capital requirements. The Market Risk in 1974 to provide a forum where the bank regulators from Amendment included a standardized model approach and an different countries could exchange ideas.7 Prior to 1988, bank internal model approach. Banks could determine market risk regulation and enforcement varied from country to country. capital using an internal model provided that the model satis­ In 1988, there was an international agreement (which became fied the requirements laid down by the Basel Committee and known as Basel I) that required regulators in all signatory was approved by national regulators. Basel II allowed internal countries to calculate capital requirements in the same manner. Initially, these capital requirements were designed to cover 8 Bank for International Settlements. (2019, March 20). Base/ Ill monitor­ losses arising from defaults on loans and derivatives contracts. ing results published by the Basel Committee [Press release!. Retrieved from https://www.bis.org/press/p190320.htm 6 See Chapter 6 of Valuation and Risk Models for further discussion. Many bankers refer to the second half of the Basel Ill rules, which were agreed in 2016 and 2017, as Basel IV. These rules include limits on the 7 The Basel Committee for Banking Supervision is based at the Bank for extent to which internal models can be used and will be described in the International Settlements in Basel, Switzerland. next section. 4 Financial Risk Manager Exam Part I: Financial Markets and Products models to be used to determine both credit risk capital and could lead to lower funding costs (in many interest rate envi­ operational risk capital. ronments) is to issue a three-month commercial paper. At the end of the three months, a new three-month commercial paper Since the crisis, the Basel Committee has decided to reduce is issued and used to repay the first issuance. At the end of a bank reliance on internal models. The committee felt that it further three months, there is a third issuance of a three-month had given banks too much freedom to choose internal models commercial paper, which would be used to repay the second that would produce the lowest capital requirements. It now issuance, and so on. requires that banks use a standardized model for determining operational risk capital. For credit risk and market risk, banks A risk with this strategy comes when the commercial paper can­ must calculate capital using a standardized model and can not be rolled over in the way we have described. If the market (if they receive approval from their national regulators) also cal­ (rightly or wrongly) loses confidence in the bank, it is likely that culate capital using an internal model. However, these internal the maturing commercial paper cannot be replaced (or must models cannot reduce total capital requirements below a mini­ be replaced at much higher interest rates). Unless the bank has mum level that is set equal to a certain percentage of the capital other guaranteed lines of credit, it could default on its debt and given by the standardized approach. By 2027, this percentage go bankrupt. Note that if the five-year loans had been financed will be 72.5%. This means that: with five-year debt, this problem would have been avoided because the loan repayments could have been used to repay Required Capital = max(IMC,0.725 x SMC) the debt. where IMC is the capital given by the internal models and SMC The failure of Northern Rock in the United Kingdom can be is the capital given by the standardized (Basel Committee) traced to this type of liquidity problem. The British bank had models. a mortgage portfolio that it was partly funding with commer­ cial paper. While this mortgage portfolio was not unduly risky, Trading Book versus Banking Book problems in the U.S. mortgage market made investors nervous, When calculating regulatory capital, it is important to distinguish and the commercial paper could not be rolled over. Lehman's between the trading book and the banking book. The trading demise in 2008 was also largely a result of liquidity problems of book (as its name implies) consists of assets and liabilities that this type. are held to trade. The banking book consists of assets and As a result of the liquidity problems encountered during the liabilities that are expected to be held until maturity. Items in crisis, the Basel Committee has (as part of Basel Ill) developed the trading book are subject to market risk capital calculations, two liquidity ratios to which banks are required to adhere. whereas items in the banking book are subject to credit risk The Liquidity Coverage Ratio is a requirement designed to capital calculations. These calculations are quite different. In ensure that banks have sufficient sources of funding to survive the past, there had sometimes been ambiguity as to whether a 30-day period of acute stress (e.g., where it is downgraded, a transaction (e.g., a credit derivative) should be in the bank- loses deposits, or has drawdowns on its lines of credit). The ing book or the trading book. Banks tended to take advantage Net Stable Funding Ratio is a requirement that limits the size of this ambiguity by putting each transaction in the book that of mismatches between the maturity of assets and the maturity would lead to the lowest capital requirement (usually this was of liabilities. the trading book). The Fundamental Review of the Trading Book mentioned ear­ 1.3 DEPOSIT INSURANCE lier attempts to clarify the Basel Committee's rules concerning whether an instrument should be in the banking book or the To maintain confidence in the banking system, many countries trading book. If a bank has a desk for trading a specific instru­ have introduced deposit insurance. This typically provides a ment, that instrument will normally be considered to be part of certain amount of protection to a depositor against losses aris­ the trading book. Otherwise, it will be part of the banking book. ing from a bank failure. In the U.S., the amount is currently USD 250,000. In some jurisdictions, all banks pay the same insurance Liquidity Ratios premium per year per dollar of deposit insured. In other jurisdic­ tions (such as the U.S.), the insurance premium is based on an Many of the problems experienced during the financial crisis assessment of each bank's risk. were a result of a lack of liquidity, rather than a shortage of capital. Consider a bank that wants to fund five-year loans. One If deposit insurance were provided to a bank without any other possibility is to issue five-year bonds so that the maturities of its measures being taken, the insurance might encourage banks assets and liabilities are matched. A tempting alternative that to take on more risks than they would otherwise. For example, Chapter 1 Banks 5 banks could offer slightly above average interest rates to deposi­ can be on a best efforts or a firm commitment basis. As its name tors and then use the funds to make risky loans at relatively high implies, best efforts means that the bank will do its best to sell interest rates to borrowers. Without deposit insurance, this would the securities for the agreed upon price. However, there are not be possible because depositors would withdraw their money no guarantees. The bank is paid a fee that usually depends when the risks being taken became apparent. With deposit (to some extent) on how successful it has been in selling the insurance, the strategy might be feasible because depositors securities for the agreed upon price. know that they are protected in the event of bank failure and will In the case of a firm commitment, the bank does guarantee that appreciate the above average interest rates they are receiving. the securities will be sold for an agreed upon price. The bank This argument is an example of what is known as a moral hazard, buys the securities at the agreed upon price and then attempts which can be defined as the risk that the behavior of an insured to sell them for a higher price. Its profit is the difference between party will change because of the mere existence of the insur­ the two prices. If it misjudges the market and is unable to sell the ance, and thus the insurance contract will become riskier. It is a securities for more than the agreed upon price, it will incur a loss. serious consideration in deposit insurance, because governments A firm commitment is sometimes referred to as a bought deal. certainly do not want to set up a program that encourages a A firm commitment arrangement is riskier for an investment bank to take larger risks. bank (but less risky for the issuing company) than a best efforts Risk-based deposit insurance premiums reduce the moral hazard arrangement. Suppose that a company wants to issue 10 million to some extent. The moral hazard is also lessened by regulations new shares. It is currently publicly traded, and its share price that ensure that a bank's required capital increases with the risks (which has risen recently) is USD 58. In negotiations with its it takes (see Section 1.2). investment bank, there are two offers on the table: 1. A best efforts arrangement where shares will be sold at the best possible price and the bank will be paid USD 1.50 per 1.4 INVESTMENT BANKING share sold (to keep the example simple, we assume that the bank's fee does not depend on the price at which the A major activity of a bank's investment banking arm is rais- shares are sold); and ing capital for companies in the form of debt, equity, or more complicated securities (e.g., convertible debt). This process is 2. A firm commitment arrangement where the bank guaran- referred to as underwriting. Typically, a company will approach tees that the shares can be sold for USD 50. the investment bank to discuss its plans to issue securities. Once Table 1.1 summarizes these alternatives from the perspective the plans have been agreed upon, the securities are originated of the investment bank and considers two outcomes. In the along with documentation itemizing the rights of investors who first one, the shares can be sold for USD 55; in the second purchase the securities. A prospectus detailing the company's one, they can be sold for USD 48. The best efforts alternative past performance and future prospects is also produced. This is certain to give the bank a gross profit of USD 15 million. includes a discussion of risks, any outstanding lawsuits, and On the other hand, the firm commitment alternative is much other relevant information. There is usually a road show in which riskier. If the shares can be sold for USD 55, the bank will make senior management from the issuing company and executives USD 50 million. If the shares can only be sold for USD 48, from the investment bank attempt to persuade investors to buy however, the bank will lose USD 20 million. the securities. Finally, a price for the securities is agreed upon The decision taken by the bank will depend on the subjective between the bank and the issuing company, and the bank then probabilities it assigns to different outcomes in conjunction proceeds to market the securities. with its risk appetite. For the company, the risks are less with a There are two types of offerings. firm commitment because it knows it will realize USD 500 million 1. Private placements: where the securities are sold (or placed) (regardless of the final market price). Under the best efforts with a small number of large institutional investors arrangement, the maximum amount realized (after consider­ (e.g., pension plans and life insurance companies). ing the bank's fee) would be USD 535 million for the first sce­ nario in Table 1.1 and a maximum of USD 465 million for the 2. Public offerings: where securities are offered for sale to the second scenario.9 general public. In the case of a private placement, the investment bank receives 9 Table 1.1 may understate the risks of a best efforts arrangement to the an agreed upon fee. In the case of a public offering, the agree­ company. If there is a dramatic market downturn, the issue may be with­ ment between the investment bank and the issuing company drawn so that the company raises no capital. 6 Financial Risk Manager Exam Part I: Financial Markets and Products Uffntlll Profit to Bank from Best Efforts and Firm Commitment Alternatives to Sell 10 Million Shares (USD Million) Best Efforts, Fee Equals USD 1.50 Firm Commitment, Bank Buys Shares per Share Sold for USD 50 Price Realized = USD 55 +15 +50 Price Realized = USD 48 +15 -20 IPOs the bids presented in Table 1.2. To evaluate the bids, it is nec­ essary to sort bidders from the highest to the lowest. This has An IPO (initial public offering) is a first-time offering of a com­ been done in Table 1.3. We then search for the maximum price pany's shares to the public. Prior to an IPO, shares are typically at which 500,000 shares or more can be sold. From Table 1.3, held by the company's founders, venture capitalists, and others we see that 30,000 shares have been bid for at USD 70 or who have provided early stage funding. The shares being sold more, 130,000 have been bid for at USD 65 or more, 170,000 can be a mixture of existing and new shares, which can provide have been bid for at USD 63 or more, and so on. Furthermore, additional capital for the company. Sometimes the founders 480,000 shares have been bid for at USD 56 or more and retain control by arranging for the shares they keep in the com­ 680,000 have been bid for at USD 55 or more. The maximum pany to have better voting rights than other shares. price at which 500,000 shares can be sold is therefore USD 55. Because the company's shares do not yet trade on an exchange, All successful bidders pay this price. The seven highest bidders it is difficult for an investment bank to accurately assess what the in Table 1.3 get the full amount of the shares for which they bid. share price will be after the IPO. Bidder D gets 20,000 shares (the difference between the 500,000 being sold and the 480,000 for which a higher price For example, suppose the company wishes to raise USD 100 than USD 55 has been bid). million. The investment bank must try and estimate An advantage of Dutch auctions is that (if all potential investors Value of Company After USD 100 Million Cash Injection in a company bid) the price charged is the one that balances Number of Shares Post IPO supply and demand in the market. In theory, the post-IPO price Typically, the investment bank sets the offering price below its should be similar to the pre-IPO price. best estimate to make it more likely that it can sell the issue at One high profile IPO that used the Dutch auction approach was the offering price. that of Google in 2004. This auction was a little different from There is often a substantial increase in the share price after an IPO. This means that the company could have probably issued shares at a higher price, thereby raising more money. It also ifffntlifj Bids for Ten Participants in a Dutch Auction indicates that IPOs tend to be good investments. Unfortunately, when 500,000 Shares are Being Sold it is often difficult for small investors to buy IPOs. Bidder Number of Shares Requested Price Bid (USD) A 100,000 65 Dutch Auctions B 50,000 60 The advantage of using investment banks to handle an IPO is C 30,000 70 that they have the necessary expertise as well as relationships D 200,000 55 with potential investors. However, some issuers feel that they E 70,000 58 would prefer for the market to decide the right price for their company. One way they can do this is through a Dutch auction. F 150,000 61 This is a procedure where all investors (not just clients of an G 40,000 63 investment bank) are invited to submit bids indicating how many H 40,000 56 shares they would like to purchase and at what price. I 80,000 54 As a simple example of how a Dutch auction works, suppose that a company wants to sell 500,000 shares and has received J 100,000 50 Chapter 1 Banks 7 ifflMlfj Bids in Table 1.2 Sorted from Highest to Lowest Bidder Number of Shares Requested Cumulative Number of Shares Requested Price Bid (USD) C 30,000 30,000 70 A 100,000 130,000 65 G 40,000 170,000 63 F 150,000 320,000 61 B 50,000 370,000 60 E 70,000 440,000 58 H 40,000 480,000 56 D 200,000 680,000 55 I 80,000 760,000 54 J 100,000 860,000 50 the "plain vanilla" Dutch auction we have described. Instead, bankers will also advise companies that are the subject of a Google reserved the right to change (at the last minute) the takeover attempt by another company. number of shares that would be offered and the percentage of In advising Company A on a potential takeover of Company B, the requested amount allocated to each bidder. When it saw it is necessary for an investment bank to value Company B and the bids, it decided that the number of shares being offered to assess any potential synergies (i.e., cost savings, economies would be 19,605,052 at a price of USO 85. The total value of of scale, market share, or other benefits from merging the two the offering was therefore USO 1.67 billion, and investors who companies). It must also consider the type of offer that should had bid USO 85 or more got 74.2% of the shares for which they be made. This could be a: had bid. This was a surprising decision. Google could have raised USO 2.25 billion instead of USO 1.67 billion with a more Cash offer: where the existing shares of Company B are pur­ usual Dutch auction (where investors bidding USO 85 or more chased for cash, got 100% of the shares for which they had bid). Perhaps found­ Share-for-share exchange: where newly issued shares of ers Sergei Brin and Larry Page anticipated (correctly as it turned Company A are exchanged for those of Company B so that out) that they would be able to issue more shares at a much Company B's shareholders become shareholders of Com­ higher price later on. pany A, or On the first day of the new issuance, Google's shares closed at Combination of a cash offer and a share-for-share exchange. USO 100.34 (i.e., 18% above the issue price). This was followed In a cash offer, the acquisition's risk and uncertainties are borne by a further 7% increase on the second day. In this example, the by the acquiring company. In a share-for-share exchange, they use of a Dutch auction did not eliminate the IPO underpricing are shared between the two companies. problem we mentioned earlier. Google did use two investment The initial offer is not usually the final offer, and the investment banks (Morgan Stanley and Credit Suisse First Boston) to assist bank must use its experience to develop a reasonable plan in the issuance. However, the fee paid was less than it would for the price negotiations. The investment bank must assess have been for a regular IPO. the best way to approach the management of the target company. The takeover may be hostile (i.e., opposed by existing Advisory Services management) or friendly (i.e., supported by management). In some instances, it may be necessary for investment bankers to In addition to handling securities issuances, investment banks consider antitrust concerns and whether regulatory approval for also offer advice to corporations on decisions involving mergers the merger will be necessary. and acquisitions, divestments, and restructurings. Specifically, they assist companies in finding acquisition partners and in The companies targeted by takeover attempts are also advised finding buyers for divisions that are to be divested. Investment by investment bankers. Sometimes a company (often with the 8 Financial Risk Manager Exam Part I: Financial Markets and Products advice of an investment bank) will take steps to avoid being taken metal prices, and so on. Some of the products involve options, over. These are known as poison pills. Examples of poison pills are forward contracts, and more complex derivatives that will be explained in later chapters. Typically, a bank will enter into a Granting key employees attractive stock options that can contract with a corporate end user and then hedge all or part of be exercised in the event of a takeover-this could dissuade its risk by trading with another financial institution. a potential acquirer from proceeding because the key employees will almost certainly leave; Banks also offer brokerage services to retail clients. They will Adding a provision to the company's charter making it take orders from a client and arrange for them to be executed impossible for a new owner to fire the existing directors for on an exchange. A full-service broker offers investment research a period of time; and advice. Others offer low-cost services where little or no advice is given to clients. Sometimes a broker manages discre­ Issuing preferred shares that automatically get converted to tionary accounts where clients have entrusted them to make regular shares in the event of a takeover; investment decisions on their behalf. Allowing existing shareholders to purchase shares at a discount in the event of a takeover; Changing the voting structure so that management has 1.5 CONFLICTS OF INTEREST sufficient votes to block a takeover; and Adding a provision that allows remaining shareholders to sell Banking gives rise to several potential conflicts of interest. The shares to the new owner at a 50% premium in the event of a following are examples. successful takeover. Suppose that an investment banker is handling a new equity Poison pills are illegal in many countries, but they are permitted in issue for a client and is finding it difficult to persuade inves­ the U.S. However, they must be approved by the majority of share­ tors to buy the shares. The investment banker might ask the holders. If shareholders feel that the poison pills will benefit man­ bank's brokers to advise clients to buy the securities and to agement at the expense of shareholders, they are likely to vote buy them for clients' discretionary accounts. against them. One argument in favor of poison pills is that they can Suppose an investment banker is advising a client about a benefit shareholders by improving the negotiating position of man­ possible acquisition. It knows that the target company is a agement in the event of a takeover attempt (potentially resulting in client of the commercial banking arm of the bank. Investment a price more favorable to existing shareholders). bankers might ask the commercial bankers for their impres­ sions of the target and thereby gain confidential information that can be passed on to the acquiring company. Trading Suppose an investment bank is hoping for lucrative business Another activity of investment banking is trading. As discussed from a company. It might contact researchers that work for earlier, regulations implemented since the 2007-2008 financial the brokerage end of the bank and ask them to come up with crisis have limited the extent to which banks can do speculative a "buy" recommendation for the company's stock to please trading. In the U.S., the Volcker rule (part of the Dodd-Frank the company's management. Act) does not allow U.S. banks to engage in proprietary trad­ Suppose that a bank's commercial banking arm has a large ing.10 In some other countries, such as the UK, proprietary trad­ loan outstanding to a client where there is a high probability ing must be ring fenced to ensure that depositors are not of a loss. It might suggest to the client that it replace the loan adversely affected by any losses.11 with a bond issue handled by the bank's investment banking Banks offer market-making services where they quote bids and arm. If the investment banking arm agrees to this, the debt offers on a wide range of different products to meet the needs is likely to be taken over by investors who are less informed of corporate treasurers and institutional investors. These prod­ than the commercial bankers. ucts typically depend on exchange rates, interest rates, precious Conflicts of interest are handled in part by what are termed Chinese walls. These are rules within a bank preventing the 10 The Dodd-Frank Act is a US law passed in 2010 designed to provide transfer of information from one part of the bank to another. greater oversight of financial institutions and reduce the risks they take. A cynic might argue that a bank will not (in practice) enforce In 2018, another act was passed that exempted some smaller banks from certain Dodd-Frank provisions. Chinese walls if they reduce profits. However, it is in the 11 Financial Conduct Authority. Ring-fencing. Retrieved from https:// bank's interest to enforce Chinese walls. Big fines can be (and www.fca.org.uk/consumers/ring-fencing. have been) levied for violations of conflict of interest rules. Chapter 1 Banks 9 Additionally, a bank's reputation is its most valuable asset. A bank that is seen to be ignoring conflict of interest rules Loan 1 can lose business. These fines and reputational costs are Loan 2 Loan 3 generally much greater than any gains arising from conflict of interest violations. The types of conflicts of interest mentioned earlier are the rea­ son why U.S. regulators have in the past separated investment Loan n banking from commercial banking. Under the Glass-Steagall Act of 1933, commercial banks could assist with the issues of Principal: Treasury and municipal bonds and handle private placements, USD 100 million but they were not allowed to handle public offerings and other investment banking activities. Similarly, investment banks were Uf.jljlJI Securitization of loans. not allowed to take deposits and make commercial loans. In2007, there were five large investment banks in the U.S.: paid off by the borrower earlier than expected.12 Prior to 1999, Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, the agencies only handled mortgages that had a low probability and Lehman Brothers. The2007-2008 financial crisis led to a big of default. In 1999, they started to accept subprime mortgages, upheaval. Lehman declared bankruptcy, Bear Stearns was taken which are much riskier. over by JPMorgan Chase, and Merrill Lynch was taken over by Bank of America. Goldman Sachs and Morgan Stanley became Since the 1990s, banks have used the originate-to-distribute banking holding companies with both commercial and invest­ model for a wide range of loans without the help of a government ment banking interests. agency (and in most cases without payment guarantees). This means that the loans originated by banks are converted into secu­ rities and the investors who buy the securities bear the credit risk. 1.6 THE ORIGINATE TO DISTRIBUTE This process is known as securitization. It enables banks to remove MODEL loans from their balance sheets and frees up funds so that more loans can be made. The bank earns a fee for originating the loan Traditionally, banks have originated loans and kept them on and a further fee if it services the loan after it has been originated. their balance sheet. An alternative to this is what has become Tranches are often created from loan portfolios so that each known as the originate-to-distribute mode/. Under this model, tranche contains different exposures to losses on the portfolio. banks use their expertise to originate loans and then sell them A simplified example is shown in Figure 1.1. A loan portfolio (directly or indirectly) to investors. with a total principal of USD 100 million is sold by the bank to a Originate-to-distribute arrangements have been used in the special purpose vehicle (SPV), which arranges for the cash flows U.S. mortgage market for many years. The U.S. government has from the loans to be passed to three tranches. The senior, mez­ sponsored the creation of three e