FIN 2420: Final Exam Theory Review

Commercial Banking

• taking deposits, making loans (wholesale or retail)

• money centre banks operate in the wholesale market and often fund themselves by borrowing

Investment Banking

• raising debt and equity for companies through…

  • public offerings

  • private placement

  • best efforts

  • firm commitment

• advice on mergers, acquisitions, restructurings, trading, etc…

Large International Banks

• small number

• e.g. JP Morgan Chase

Regional Banks

• several hundred

• e.g. M&T Bank (Buffalo, NY)

Small Community Banks

• several thousand

• e.g. Chelsea State Bank

McFadden Act (1927/1933)

restricted interstate branching

Glass-Steagall Act (1933)

separated commercial and investment banking

Douglas Amendment (1956)

blocked holding companies from crossing state lines

Bank Holding Company Act (1970)

put Federal Reserve oversight on BHC and restricted their non-banking activities

Riegle-Neal Act (1994)

legalized interstate banking and branching

Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

• regulators set minimum levels for the capital a bank is required to keep

  • equity is tier 1 capital

  • subordinated long-term debt is tier 2 capital

• liquidity requirements

• stress testing

Deposit Insurance

• most countries have deposit insurance programs that insure depositors against losses up to a certain level

• in the US the FDIC has provided protection for depositors since 1933

Private Placement

a new issue of securities that’s sold to a small number of large institutional investors

Best Efforts Deal

the investment bank does as well as it can to place securities with investors, but doesn’t guarantee that they can be sold

Firm Commitment Deal

the investment bank agrees to buy the securities from the issuing company for a particular price and attempts to sell them in the market for a higher price

Initial Public Offering (IPO)

• usually on a best efforts basis

• bank will set offering price sufficiently low that shares are almost certain to be sold

• price often rises immediately after IPO

• banks often offer shares to fund managers and their best customers

Dutch Auction IPO

• individuals and companies bid by indicating the number of shares they want and the price they are prepared to pay

• the price paid is the lowest bid that leads to all the shares being sold

Conflicts of Interest for a Bank

• bank recommends securities investments that the bank is trying to sell

• commercial bank passes confidential information on a client to investment bank

• stock recommended as a “buy” to please company’s management in order to get investment banking business

• investment bank sells securities for a company so the commercial bank can get rid of a loan

Originate to Distribute Model

• banks originated loans and then packaged them into products that were sold to investors

• this frees up funds to make more loans

• very popular way of handling mortgages in 2000 to 2007

Fund

• investors pool money to invest in stocks, bonds, real estate, etc…

• pro-rate ownership via shares/units

• fund handles selection, trading, admin

Index Funds

• track an index, i.e. copy a defined list of companies (no stock picking)

• indices are like scoreboards and represent market segments

• e.g. S&P 500, NASAQ, Dow Jones

Index Funds Management and Fees

• passive management, i.e. follow index rules, not manager picks

• low expense ratios (0.02% to 0.20%)

• major providers include Vanguard, BlackRock, and Fidelity

Index Funds Trading

• priced once per day

• orders execute at end-of-day net asset value (NAV)

• orders before cutoff execute same day; after cutoff execute next day

Index Fund Popularity

• broad diversification

• no need to pick individual stocks

• low cost, low effort

• historically solid long-term results

Mutual Funds

• pool of assets, often actively managed

• shares must be redeemable at any time

• NAV must be calculated daily

• investment policies must be disclosed

• use of leverage is limited

Mutual Funds Management and Fees

• managers aim to beat benchmarks (e.g. S&P 500)

• most don’t consistently beat the market, good performance by a manager in the past isn’t a good guide to future performance

• higher fees (0.5% to 1.5%)

• major providers are Vanguard, Fidelity, JP Morgan

Mutual Funds Trading

execution is end-of-day NAV like index funds

Hedge Funds

• private funds for accredited investors and institutions

• actively managed

• flexible strategies (e.g. short-selling, leverage, derivatives, multi-asset)

• potentially large gains and losses

• not subject to the restrictions of mutual funds

Hedge Fund Fees

• typical structure is 2% plus 20%

  • 2% management fee plus an incentive fee equal to 20% of any net profits

• other features include hurdle rates, high-water marks, and clawbacks

Incentives of Hedge Fund Managers

• the incentive component of the manager’s fee gives them a call option on the performance of the fund each year

• the hedge fund manager has an incentive to take high risks

ETFs

• exchange traded funds, diversified funds that trade like a stock

• often track an index, some are active

• many brokers offer commission-free ETF trading

• efficient way to get index or sector exposure

ETF Fees and Trading

• buy and sell throughout the day at market prices

• 0.03% to 0.75% fee depending on strategy

Funds for Everyday Investors

• low cost, diversified, simple

• index funds or ETFs

Funds with Management and Strategy

• accept higher fees and uncertainty

• mutual funds

Funds for High and Volatile Returns

hedge funds

Climate Risk

the risks from climate changes that damage the environment so that the earth will become less habitable for future generations

Greenhouse Gases (GHGs)

• trap heat in the atmosphere

• CO2 is the most significant GHG from human activity, especially fossil fuel use

  • transportation emission → 27%

  • electricity emissions → 25%

  • industry emissions → 24%

  • residential/commercial emissions → 13%

  • agriculture emissions → 11%

The Paris Agreement (2015)

aim to limit warming to 1.5 degrees celsius in the 21st century

The Glasgow Climate Pact (2021)

strengthen the target of limiting warming to 1.5 degrees celsius by 2030 and aim to net-zero emissions by 2050

FI Exposure to Climate Risk

• physical risks (e.g. natural disasters)

• transition risks (e.g. costs on regulatory changes)

• financial institutions are now required to integrate climate risk into their decision-making frameworks

Business and Government Responses to Climate Risk

• Germany’s 2038 coal phase-out

• carbon taxes

• cap-and-trade systems

• these efforts have economic implications across different sectors and countries

• stress tests and scenario planning are now required for insurance and banking sector

Insurance Industry Climate Risks

increased claims from correlated disasters

Banking Industry Climate Risks

risks to credit, liquidity, operations, and reputation

ESG

• toolkit the market is using to asses climate risks

• framework for evaluating a company’s resilience and ethical impact

• economic pillar

  • emissions, energy use, waste

• social pillar

  • labour rights, working conditions, diversity

• governance pillar

  • ethics, transparency, governance structures

Brundtland Commission (1987)

• development that meets the needs of the present without compromising the ability of future generations to meet their own needs

• environmental pillar

  • key issues include plastic waste, overfishing, pollution

• social issues

  • care about people

• economic pillar

  • focuses on the long-term economic value a company creates for both itself and the society, ensuring its operations are financially viable and beneficial to the community

Enterprise Risk Management (ERM)

• a process effected by an entity’s board of directors, management, and other personnel, applied in strategy setting and across the enterprise, designed to identify potential events that may affect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives

• key elements…

  • board involvement

  • part of company’s strategy

  • identify adverse events

  • manage risks consistently with risk appetite

  • help achieve company’s objectives

Risk Appetite

• how much risk the organization is prepared to take

• regulators require banks to develop risk appetite frameworks

  • how much loss at what confidence level are we prepared to risk?

  • what reputation risk are we prepared to take?

  • what credit risk are we prepared to take?

  • how concentrated should we allow our risks to become

• key question should be ‘what is the return that we want to be exceeded with a high probability?’

Risk Culture

• how decisions should be made, in a disciplined way or not

• both short-term and long-term consequences should be considered

• sometimes decisions that are profitable in the short run can have adverse reputational and legal consequences in the long run

Abacus Deal

• a complex financial product known as a Collateralized Debt Obligation (CDO) designed and sold by Goldman Sachs in 2007

• core issue is that Goldman Sachs allowed one client to help design this product and bet against its failure, while Goldman failed to disclose this critical conflict of interest

• when the product rapidly lost value as expected, the client made huge profits while investors who bought it lost around $1 billion

• Goldman Sachs showed in the aftermath that it’s possible to change the risk culture

Internal Reforms and Business Practice Review

• business standards committee to conduct a comprehensive review of the firm’s business standards and practices

• implementing changes like enhanced client disclosure, increased oversight, clawback provisions

Cognitive Biases When Identifying Risks

• wishful thinking

• anchoring

• availability bias

• representativeness bias

• inverting conditionality

• sunk costs bias

Wishful Thinking

• believing something is true because you want it to be true, thereby overlooking potential risks

• e.g. an investor holds onto a plummeting stock, not because of the data, but because they want it to recover and can’t bear the thought of a loss

Anchoring

• rely too heavily on the first piece of information they receive (the ‘anchor’) when making decisions

• even when new, more relevant info becomes available, adjustments from this initial anchor are often insufficient

• leads to biased quantitative risk assessments, causing either overestimation or underestimation, and fails to reflect the true situation

Availability Bias

• to estimate the probability of an event based on how easily an example can be brought to mind (its availability)

• events that are more vivid, recent, or heavily covered by the media are perceived as more likely to occur

• leads to misallocation of resources towards addressing ‘high-profile’ but low-probability risks, while neglecting less obvious but more threatening risks

Representativeness Bias

• to judge the probability of an event by its similarity to a stereotype or a past experience (its representativeness), while ignoring base rates, sample sizes, and other statistical information

• leads to decisions based on superficial patterns rather than deep data, potentially resulting in over-trusting certain strategies or individuals and thereby introducing risk

Inverting Conditionality

• the confusion between the probability of A given B, and the probability of B given A; a misunderstanding of conditional probability

• leads to the misinterpretation of risk signals, which can trigger overreaction and a waste of resources

Sunk Cost Bias

• the tendency to irrationally factor in costs that have already been incurred and cannot be recovered (sunk costs) when making decisions about future actions

• leads to ‘throwing good money after bad’, an inability to cut losses promptly, and ultimately allows a small risk to escalate into a catastrophic failure

Strategic Risk Management

• important to decide what action, if any, should be taken after identifying major risks

• strategies…

  • avoid the risk

  • reduce the risk

  • mitigate the risk

  • transfer the risk

  • accept the risk

Avoid the Risk

• exit activity giving rise to risk

• completely eliminate the risk by not undertaking/ceasing the activity that causes it

• this is a zero-tolerance approach for risks that are too severe or misaligned with strategy

• choose this strategy when…

  • the potential impact is catastrophic and could threaten the organization’s survival

  • the risk cannot be effectively controlled or transferred at a reasonable cost

  • the activity is inconsistent with the company’s core strategy, values, or ethical standards

Reduce the Risk

• lower the probability of an adverse event

• implement preventative controls and measures to decrease the likelihood of a risk event occurring, i.e. ‘prevention is better than cure’ approach

• choose this strategy when the root cause of the risk can be proactively managed

Adjust the Impact

• modify plans to reduce risk

• develop contingency plans to lessen the severity of the impact if a risk event occurs, this focuses on building resilience and preparedness

• choose this strategy when a risk cannot be avoided or its probability is hard to reduce, but its negative consequences can be minimized

Share or Insure the Risk

• shift all or part of the risk

• shift the financial burden of the risk to a third party; the risk event might still happen, but another entity bears the cost

• choose this strategy when the potential loss is too great for the organization to bear alone, but it can be offloaded to a specialized part for a cost

Accept the Risk

• take no action

• consciously and deliberately retaining the risk

• this is typically done when the potential impact is within the organization’s risk appetite, or when the cost of controlling the risk outweighs the potential benefit