HOORCOLLEGE 1 – FINANICAL RISK MANAGEMENT Bruno Iksli is known as the London whale Nature of banking You have commercial banks. They take deposits and make loans (wholesale or retail). There are also money center banks who operate in the wholesale market and often fund themselves by borrowing. You also have investment banking. They raise debt and equity for companies, advice on mergers, tradings etc. Some banks do both some banks do only one thing. In the US investment banking and commercial banking was separate due to regulation. In the late ‘90s this wall was dismantled by new regulation and people say this contributed to the crisis. Loan losses must be written off the balance sheet. You have a provision for this. If the bank makes a loss you need to decrease the equity capital. You have some cash change and the loans will change (because of loan losses). With a not so aggressive balance sheet the bank will be able to survive a bad year. But if they have a more aggressive balance sheet (less equity capital). All equity would be wiped out and the bank would have no equity left and it becomes insolvent. So equity financing matters a lot for banks. Insolvency A firm is insolvent when it’s not able to pay its debts. One test is to see whether liabilities exceed assets (see what was done in the slides before). Imprecision: the balance sheet is in book value and the income statement is in market value. It’s better to look if the bank can raise new equity. If it can it’s not insolvent if it can’t it’s insolvent. This new equity should come from private investors, it should not be government. If a government steps up the bank is still insolvent. Regulation Regulators set minimum capital levels the bank is required to keep. However, subordinate debt is also a form to keep capital, but the primary source of capital is equity. Keep is misleading. The bank doesn’t need to hold any equity, it can be used in the same way as debt financing. It’s only about the way you finance your company, not about keeping your money inside the bank. Regulators also have deposit insurance. This insures depositors against losses up to a certain level. When looking at the balance sheet 90% of the financing comes from the safe, insured deposits. This is a very secure debt. In this way deposit insurance encourages a bank to take more risks. They don’t bear the risk of the debt like a normal company would. JP Morgan Chase’s ‘Fortress balance sheet’ The CEO said that this was a very strong balance sheet. The equity ratio is 8%. They had a large share of short-term debt and there was only a small share of loans. They focused on trading assets. It turned out to look not so good if you change the way it was presented (from GAAP to IFRS). Under IFRS JP Morgan only had 4.5% equity. The difference is due to the netting of derivatives. Under GAAP you can cancel derivatives out when you have the same counterparty (you can cancel them out). Under IFRS this is not allowed. Chief investment office at JPM JPM had excess deposits (they had more deposits than sales). They needed to invest these funds. They invested in treasury bonds and other investment grade fixed income securities. This was done via credit default swaps. Buy more protection if the economic outlook worsens and less if the outlook is good.