Risk Review

1
Risk Review Costs and Synergies

• Week 13 November 16, 2006

2
Risk Management Review

• Three kinds of risk
• Market risk (interest rate, exchange rate, asset
  and commodity price risks)
• Credit risk
• Operating risks
• Risk measurement
• Risk management

3
Market Risk

• Interest-rate risk
• Duration as a measure of bond and portfolio risks
• Maturity gaps
• Simulation-based risk measures
• Interest-rate risk management
• Matching portfolio duration to holding period to
  manage interest-rate risk
• Choosing asset-liability mix to make equity
  duration zero, called immunization
• Derivatives off balance sheet approaches to
  interest-rate risk management

4
Risk Management Derivatives

• Futures and forwards
• Equivalent but different
• Futures require margin and marking to market
• Forwards are bilateral contracts
• Lock in a yield when hedge is made
• Options
• Insurance against bad outcomes
• Calls (option to buy) and puts (option to sell)
  are most common
• Hedge against bad outcomes, allow participation
  in good outcomes, but at costs of a premium
• Swaps
• Change character of cash flow sensitivity to
  interest rate changes

5
Credit Risk

• Measurement of asset risk
• Credit event is change in risk assessment,
  including downgrades and defaults
• KMV estimates of probability of default (PD) and
  change of ratings used as an example
• Require also loss given defaults (LGD) and
  exposure at default (ED)
• Measure of portfolio credit risk
• Use as example RiskMetrics analysis

6
Management of Credit Risk

• Better pricing to achieve risk-adjusted return on
  capital (RAROC)
• Diversification and use of portfolio risk
  measures
• Credit derivatives
• Swaps (as credit-default swap in FAB case)
• Options
• Credit-linked notes

7
Strategic Issues

• How to exploit competitive advantages and
  identify them
• How do you maximize return on investors wealth
  (maximize share value)?
• Relationship of growth and size to goal of
  management of financial institutions

8
Possible Strategiesto Increase ROI
9
Driving forces

• Technology
• Cheap telephony/satellites
• Telephone service centers
• Cheap computing
• Internet
• Regulation/taxation
• Roth accounts, 401Ks
• Bank holding company/Glass-Steagall
• Demographics

10
Key questions for management

• Where are synergies, revenues or costs?
• Economies of scale
• Economies of scope
• Cross-selling
• Cost of inputs
• More important What are we good at?
• Requires a rigorous framework for analysis

11
Economies of Scale
Total Costs
Slope Average Cost
0
Level of Output
12
Determinants of Scale Economies
Average Unit Cost
Complexity cost/unit
Fixed cost/unit
Units and complexity of output
13
Issues in Economies of Scale

• Measurement of output
• E.g., checking accounts, checks cleared, number
  of accounts, value of deposits, etc.
• E.g. credit, number of loans, value of loans, or
  other loan services provided
• Fixed vs. variable costs
• Branches and computers
• Labor expense (including system developers)
• Complexity - E.g. variable vs. fixed, etc.

14
Multiple Outputs
Level of Output B
Total Costs
Slope Ray Average Cost
0
Level of Output A
15
X-efficiency Allocation and Managerial
Inefficiencies
X
Total Costs
Slope Ray Average Cost
0
Level of Output A
16
Multiple Outputs, Efficiencies,and Economies of
Scope

• Measurement of outputs, again
• Efficiency
• Most efficient combination along ray, but are
  rays different technologies
• Not on cost surface X-inefficiency
• Evidence from statistical cost studies
• Not much evidence of economies of scale
• Not any evidence of economies of scope

17
Some Evidence of Costs and Size

• Deloite Touche 1995
• Our core conclusion is that the retail banking
  industry, owing to a variety of factors, is
  currently not susceptible to scale economies.
• Academic merger analysis (1992, 1994)
• ...overall gains ... slightly positive but
  statistically indistinguishable from zero. This
  lends support to recent studies which fail to
  find any significant cost savings...
• Clyde Osler, WFC, After a certain size of
  telephone service center, you open a new one

18
Next (Last) Class November 30

• Read Chapter 24
• Prepare Charles Schwab case
• Finish group project and be prepared to hand in
  by December 7
• Review examinations and course materials and
  raise questions concerning final or identify
  point needing clarification