Presented by D. Sykes Wilford Chief Investment Officer Bankers Trust Company Private Bank...
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Transcript of Presented by D. Sykes Wilford Chief Investment Officer Bankers Trust Company Private Bank...
Presented by D. Sykes Wilford
Chief Investment OfficerBankers Trust Company
Private Bank
Implications of Changing Sources of Revenues in theBanking Industry
Forces of Change in International Banking
OBJECTIVES
Examine how managers make investment decisions in banks
Draw conclusions about the structure of those investment decisions under different Accounting systems.
Raise implications for individual bank risks and where they are taken.
Examine how managers react to regulations.
Draw some conclusions about the riskiness of the system.
ASSUMPTIONS
Shares are widely held in portfolios.
Banks operate in a lenders of last resort system.
It is difficult to "take-over" a bank.
The Bank has access to capital.
BANK FCA
Duration Mismatched
4% Spread
Positive Cash Flowwith any accountingsystem
8%
A L
LOL's
Loans12%
BANK FCA
Duration Mismatched
4% Spread but Negative
Negative Cash Flow
Under MTM probably in default
16%
A L
LOL's
Loans12%
Lenders have no incentive to place controlson managers
Equity holders want to maximize the valuesof their shares
The Government has the Risk
THE FCA PROBLEM
Equity holders maximize their call optionby taking Risk.
This implies the put holders has greater potential Loss.
LENDERS RISK
Does not change under A or B
The Government has written thelenders a Put
Lenders do not monitor Risk
ECONOMIC RISK VS. ACCOUNTING RISK
MTM
Volatility the same for Managers and Shareholders
Accounting Risk based compensation similar to Equity Options
Maximize individual project risk but look at correlation of risks to protect Equity value.
Equity holders have a diversified portfolio of risks.
Managers have
Concentrated Equity risk Leverage Equity risk through Options
Job risk
Managers should be more conservative than Equity holders and seek low correlation risky projects
Lenders do not monitor risk
ECONOMIC RISK VS. ACCOUNTING RISK
EQUITY HOLDERS VERSUS MANAGERS
Riskiness for managers under Non-MTM Accounting
Share holders and Managers incentives differ
Accounting Period Risk
Shareholder Risk
E(R)
MANAGER'S INCENTIVES
Take more economic risk
Push risk into future accounting periods
Take profits to maximize bonuses
EXAMPLE: DECISION-MAKING WITH NON-MTM ACCOUNTING
Managers own the option on the timing to sell a valuable asset
Managers can leverage their income by moving risk across time
Managers want to maximize the value of this option
Non-MTM accounting dominates
X = Accounting Value Needed to be bonusableY = Level of loan portfolio equal to MTM value
AccountingLoan Value
Accounting Value of LoanPortfolio if income can betaken at manager's discretion
Time
X
t0MTM Value atTime Zero
VALUE OF THE PORTFOLIO INCOME AT ACCOUNTING LEVEL X
MTM ACCOUNTING
Shareholder risk closer to Manager's risk
Managers can diversify risk by choosing low correlation projects
Managers face downside risk
Managers tend to reduce exposures near the end of an accounting period
NON-MTM ACCOUNTING
Managers tend to leverage more to maximize their accounting bonus
Managers can take more concentrated risk The need to diversify risks are reduced
Managers will move risks across accounting dates where possible
Losses will be concentrated in "Bad Years"
REGULATORS MUST BEWARE
Non-MTM accounting and government debt vs. equity
Non-MTM accounting of Debt and MTM accounting of trading activities Inexperienced regulators
Concentrations of Risk
CONCLUSIONS
Managers take new projects to maximize income
Non-MTM projects are superior to MTM projects
Manager increases economic risk when Non-MTM accounting allows near term period risk to be reduced
Managers shift risks across time by selective selling and buying in the investment portfolio with no MTM.
CONCLUSIONS
Managers and Share holders
Have their risks better lined up under MTM accounting
Managers will tend to take less risk thanShareholders under MTM accounting
Managers will desire to diversify risks whenshareholders will not under MTM accounting
Lenders still don't care
CONCLUSIONS
Regulators
Have an incentive to reduce riskiness
May increase concentration of risk throughcertain capital adequacy rules
Often intimidate management by not understandingthe value of diversification
May raise risk by differential accountingprocedures
May promote system risk by imposing measure forcapital adequacy under a system of "Lender of last resort"