J. K. Dietrich - FBE Fall, 2006 Risk Review & Costs and Synergies Week 13 –November 16, 2006

J. K. Dietrich - FBE Fall, 2006 Risk Management Review u Three kinds of risk: –Market risk (interest rate, exchange rate, asset and commodity price risks) –Credit risk –Operating risks u Risk measurement u Risk management

J. K. Dietrich - FBE Fall, 2006 Market Risk u Interest-rate risk –Duration as a measure of bond and portfolio risks –Maturity gaps –Simulation-based risk measures u 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

J. K. Dietrich - FBE Fall, 2006 Risk Management: Derivatives u 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 u 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 u Swaps –Change character of cash flow sensitivity to interest rate changes

J. K. Dietrich - FBE Fall, 2006 Credit Risk u 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) u Measure of portfolio credit risk –Use as example RiskMetrics analysis

J. K. Dietrich - FBE Fall, 2006 Management of Credit Risk u Better pricing to achieve risk-adjusted return on capital (RAROC) u Diversification and use of portfolio risk measures u Credit derivatives –Swaps (as credit-default swap in FAB case) –Options –Credit-linked notes

J. K. Dietrich - FBE Fall, 2006 Strategic Issues u How to exploit competitive advantages and identify them u How do you maximize return on investors’ wealth (maximize share value)? u Relationship of growth and size to goal of management of financial institutions

J. K. Dietrich - FBE Fall, 2006 Possible Strategies to Increase ROI

J. K. Dietrich - FBE Fall, 2006 Driving forces u Technology –Cheap telephony/satellites »Telephone service centers –Cheap computing »Internet u Regulation/taxation –Roth accounts, 401Ks –Bank holding company/Glass-Steagall u Demographics

J. K. Dietrich - FBE Fall, 2006 Key questions for management u Where are synergies, revenues or costs? –Economies of scale –Economies of scope –Cross-selling –Cost of inputs u More important: What are we good at? u Requires a rigorous framework for analysis

J. K. Dietrich - FBE Fall, 2006 Economies of Scale Level of Output 0 Slope = Average Cost Total Costs

J. K. Dietrich - FBE Fall, 2006 Determinants of Scale Economies Units and complexity of output Fixed cost/unit Complexity cost/unit Average Unit Cost

J. K. Dietrich - FBE Fall, 2006 Issues in Economies of Scale u 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 u Fixed vs. variable costs –Branches and computers –Labor expense (including system developers) u Complexity - E.g. variable vs. fixed, etc.

J. K. Dietrich - FBE Fall, 2006 Multiple Outputs Level of Output A 0 Slope = Ray Average Cost Level of Output B Total Costs

J. K. Dietrich - FBE Fall, 2006 X-efficiency: Allocation and Managerial Inefficiencies Level of Output A 0 Slope = Ray Average Cost Total Costs X

J. K. Dietrich - FBE Fall, 2006 Multiple Outputs, Efficiencies, and Economies of Scope u Measurement of outputs, again u Efficiency –Most efficient combination along ray, but are rays different technologies –Not on cost surface = X-inefficiency u Evidence from statistical cost studies –Not much evidence of economies of scale –Not any evidence of economies of scope

J. K. Dietrich - FBE Fall, 2006 Some Evidence of Costs and Size u Deloite & Touche 1995: –“O ur core conclusion is that the retail banking industry, owing to a variety of factors, is currently not susceptible to scale economies.” u 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...” u Clyde Osler, WFC, “After a certain size of telephone service center, you open a new one…”

J. K. Dietrich - FBE Fall, 2006 Next (Last) Class – November 30 u Read Chapter 24 u Prepare Charles Schwab case u Finish group project and be prepared to hand in by December 7 u Review examinations and course materials and raise questions concerning final or identify point needing clarification