B8361 – Banking Fundamentals: Value and Risk
Spring Term 2014
PROFESSOR NAME
David Beim
Professor Office Location:
Uris 312
Office Phone:
212-854-3484
Fax:
212-854-3816
E-mail:
dob1@columbia.edu
Office Hours:
Tuesdays 9:00am-12:00pm
TEACHING ASSISTANT
Fangzhou (Ark) Shi
fshi13@gsb.columbia.edu
REQUIRED COURSE MATERIAL
Casebook readings (see below)
REQUIRED PREREQUISITES AND CONNECTION TO THE CORE
The learning in this course will utilize, build on and extend concepts covered in the following core courses:
Core Course
Corporate Finance
Global Economic
Environment
Managerial Statistics
Strategy Formulation
Decision Models
Connection with Core
Risk and risk management
Discounted cash flow analysis
Role of central and private banks in money creation
Financial markets and exchange rate movements
Causes of financial crises and the role of regulation
Random variables and distributions
Decision making under uncertainty
Sources of economic value
Creation of value through strategy.
Decision making under uncertainly
Value at risk
Students will be expected to have mastered these concepts and be able to apply them in the course.
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COURSE DESCRIPTION
This course is about the business of large banks in developed countries. It begins with the question of why banks exist
and explores the two leading theories: information asymmetries and liquidity provision. We focus on what make bank
analysis different from standard corporate finance. Most companies have inherent operating risks and select an optimal
mix of debt and equity financing given those risks. Banks select their risks and acquire them when expected returns are
sufficient. But do banks manage risk intelligently?
For many years, banks and their regulators believed that they had learned to manage risk very well, but this has turned
out to be an illusion. Indeed, some of the tools that were understood as safety devices (e.g. CDOs and CDS) were at the
center of the financial crisis of 2007-2009. We will study the tools of risk management with a view to understanding
both their utility and their limitations. We will revisit the crisis and ask what went wrong, what could be done better in
the future.
Underlying all modern bank strategy is the question, how does a bank make money in a relatively efficient financial
market? A critical reference point is the “market bank”, which does nothing but buy market assets and sell market
liabilities. By understanding the characteristics of this model, the actual sources of value in real banks are more clearly
seen. The course emphasizes VaR analysis, RAROC, and the international rules for bank capital, as well as the markets
for loan trading, credit derivatives and securitization. It ends with a review of recent banking reforms.
COURSE OBJECTIVES
The goal is to provide students with tools with which to analyze and understand banks in the industrialized world, and to
provide insights into the reasons for bank fragility and the nature of financial crises.
ASSIGNMENTS
The main deliverable is a research paper, which is written in teams of up to maximum four students. This is a Type A
assignment with full collaboration and a single grade for all team members. The research paper focuses on the three
largest private banks of some country, examining their strategy, their risks and their returns. It is written in two parts,
with revision of the first part after its return.
In addition there are three individual Type B assignments which students are to prepare by themselves. One involves
trying to figure out the strategy and sources of value of a real bank (Commerce Bank); another involves analyzing a
proposal to take on some foreign exchange risk; and the third is a problem set about the Basel capital rules.
All assignments are submitted online.
METHOD OF EVALUATION
Class Participation
Assignments
Research Project
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20%
30%
50%
CLASSROOM NORMS AND EXPECTATIONS
Class attendance and participation is important in this course – 20% of the grade, assessed both qualitatively and
quantitatively. Each class includes a polling question, frequently at the start of the class, which serves to record
attendance. Each student is expected to have a functioning clicker to respond to these questions. Everyone is expected
to speak up and join the classroom discussions.
Students are expected to arrive in the classroom before the class begins. Late arrival will usually be recorded as
absence.
CASEBOOK READINGS
Class #2:
The Economist Special Report: “Twilight of the Gods” (May, 2013)
Class #3:
Andrew G. Haldane, “Banking on the State” (September, 2009)
Class #4:
Stephen M. Frost, excerpt from The Bank Analyst’s Handbook (June, 2004)
Class #5:
DOB, “The Market Bank” (October, 2006)
Class #6
DOB, “Introduction to Bank Analysis” (June, 2013)
Class #10:
DOB, “VaR: The RiskMetrics Implementation” (October, 2000)
Class #15:
Willem Buiter, “Is Sovereign Default Unnecessary, Undesirable and Unlikely for all Advanced Economies?”
(September, 2010)
Class #16:
DOB, “Europe and the Financial Crisis” (March, 2009); and DOB, “Can the Euro Be Saved?” (October, 2011)
Class # 17:
DOB, “Landsbanki ĺslands” (June, 2012)
Class #20:
HBS, “Atlantic National Bank” (1981)
Class #21:
Paul Tucker, “Shadow Banking, Capital Markets and Financial Stability” (October, 2010)
Class #23:
Marianne Ojo, “Basel III: Responding to the Recent Financial Crisis” (June, 2011)
Morgan Stanley, “Risks of Deleveraging” (November 2011)
Class #24:
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The Economist, “Retail Renaissance” (May, 2012)
DAILY CALENDAR
The nature of banking
1/29
1. Introduction to the course. What are banks and why do they exist? Financial intermediation in various
forms. The information theory of banking and its implications.
2/3
2. Banks as liquidity providers. Implications of the liquidity theory of banking. Runs, central banking and
government involvement. Central banking and monetary control. Deposit insurance and moral hazard.
Recurring bank failures and their resolution. (Reading: Twilight of the Gods).
2/5
3. Banks, markets and governments. The evolution of banking toward markets. Risk-taking as a business
definition. The Glass-Steagall world and its demise. The government embrace of banking. Government funding
and the banking system. (Reading: Banking on the State). Research papers, Part 1 assigned.
Bank analysis
2/10
4. Review of bank accounting. Loss allowance, provisions and chargeoffs. The importance of capital.
(Reading: excerpt from The Bank Analyst’s Handbook).
2/12
5. Value analysis. Relationship of book value to market value. The market bank idea: available returns and
expected loss rates. Strategies for value creation. (Reading: The Market Bank).
Assignment: Figure out
Commerce Bank.
2/17
6. How to analyze a bank. Spreads and leverage. Ratios to use and not to use. A detailed analysis of
Deutsche Bank. Projections. (Reading: Introduction to Bank Analysis).
2/19
7. A case study: Commerce Bank 2007. What was its strategy? How did it make money? What happened to
it? What was it worth? Commerce Bank write-ups due.
Market risk and VaR
2/24
8. Foreign exchange markets. Spot and forward rates. How banks make money in FX risk. The interest
parity relationship. Aggregate FX risk of a bank.
2/26
9. Importance of risk measures. A unified way of thinking about risk. How various risks can be compared.
Institutionalizing risk management in banks. The Value at Risk (VaR) as a proxy for capital required. Riskadjusted Return on Capital (RAROC) and its impact on banking. Problem Set 1 assigned.
3/3
10. The RiskMetrics framework. Portfolio risk and incremental contribution to portfolio risk. Problems with
VaR. (Reading: VaR: The RiskMetrics Implementation).
3/5
11. The carry trade in Icelandic krónur: applying RAROC to an open FX risk. Can an open medium-term FX
risk make economic sense? Problem Set 1 due.
3/10
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12. Guest Speaker. Research papers, Part 1 due.
[Break]
Capital and credit risk
3/24
13. Why capital is regulated. The Basel Agreement of 2002 (Basel II). Risk-based assets and off-balance
sheet items. Risk weights and conversion factors. Examples of calculations under the rules. Problem Set 2
assigned.
3/26
14. Models of corporate credit risk. Probability of default and recovery upon default. Classic default risk
models. KMV and the option-based models. CreditMetrics and other commercially available models
3/31
15. The marginal-VaR regulatory model that underlies Basel II. The problem of sovereign risk; history and
patterns of sovereign default. (Reading: Is Sovereign Default Unnecessary, Undesirable and Unlikely for all
Advanced Economies?). Problem Set 2 due.
4/2
16. The crisis of banks and sovereign debt in Europe. (Readings: Europe and the Financial Crisis, Can the
Euro Be Saved?).
4/7
17. Landsbanki ĺslands 2008: a case study in bank growth and bank collapse. (Reading: Landsbanki ĺslands).
Interest rate risk
4/9
18. How banks make money on IR risk. Interest rate gapping and the yield curve. Is interest rate risk similar
to FX risk? VaR estimates for interest rate risk.
4/14
19. Tools for dealing with interest rate risk. FRAs and Eurodollar futures. Interest rate swaps. Locking in
rates. Gap tables.
4/16
20. Atlantic National Bank case. Understanding the risks and values implied by this bank’s strategy.
(Reading: Atlantic National Bank).
Risk management
4/21
21. Shadow banking, CLOs and CDS. Does securitization have a future? Can CDS be made safe? (Reading:
Shadow Banking, Capital Markets and Financial Stability).
4/23
22. The three major British banks: Class discussion of the British environment and how these banks have
differed in strategy, risk and value through the financial crisis. Research papers due.
4/28
23. Why do banks keep crashing? Why don’t they find equilibrium as other industries do? Has financial
reform legislation made a difference? Basel III. What further steps would make stability more likely? (Readings:
Basel III: Responding to the Recent Financial Crisis, Risks of Deleveraging).
4/30
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24. The future of banking. Review of the course. (Reading: Retail Renaissance).