Presented by D. Sykes Wilford Chief Investment Officer Bankers Trust Company Private Bank Implications of Changing Sources of Revenues in the Banking Industry Forces of Change in International Banking

OBJECTIVES l Examine how managers make investment decisions in banks l Draw conclusions about the structure of those investment decisions under different Accounting systems. l Raise implications for individual bank risks and where they are taken. l Examine how managers react to regulations. l Draw some conclusions about the riskiness of the system.

ASSUMPTIONS l Shares are widely held in portfolios. l Banks operate in a lenders of last resort system. l It is difficult to "take-over" a bank. l The Bank has access to capital.

LENDER OF LAST RESORT l The Moral Hazard Issue l Lenders have a put on the Authorities

BANK FCA l Duration Mismatched l 4% Spread l Positive Cash Flow with any accounting system 8% A L LOL's Loans 12%

BANK FCA l Duration Mismatched l 4% Spread but Negative l Negative Cash Flow l Under MTM probably in default 16% A L LOL's Loans 12%

l Lenders have no incentive to place controls on managers l Equity holders want to maximize the values of their shares l The Government has the Risk THE FCA PROBLEM

CAPITAL STRUCTURE AS OPTIONS Equity Debt Value of the Firm

l Equity holders maximize their call option by taking Risk. l This implies the put holders has greater potential Loss.

VALUING THE CALL Equity Holders Risk A Risk B

LENDERS RISK l Does not change under A or B l The Government has written the lenders a Put l Lenders do not monitor Risk

l Base Salary l Stock l Stock Options l Accounting Based MANAGER'S COMPENSATION Compensation

COMPENSATION AS THE STOCK PRICE RISES FROM OPTIONS x Strike Value of the Firm

CHANGE IN COMPENSATION AS THE STOCK PRICE MOVES Base Salary (-) (+) Value of the Firm

COMPENSATION FROM ACCOUNTING EARNINGS Value of the Accounting Earnings Base Compensation

ACCOUNTING BASED COMPENSATION l Volatility Implications l Accounting System MTM Non-MTM

ECONOMIC RISK VS. ACCOUNTING RISK l 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.

l Equity holders have a diversified portfolio of risks. l Managers have Concentrated Equity risk Leverage Equity risk through Options Job risk l Managers should be more conservative than Equity holders and seek low correlation risky projects l 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 l Take more economic risk l Push risk into future accounting periods l Take profits to maximize bonuses

l Bond A MTM = 120 l Bond B MTM = 80 EXAMPLE: DECISION-MAKING WITH NON-MTM ACCOUNTING

Base Accounting Income Sell Bond B Sell Bond A

EXAMPLE: DECISION-MAKING WITH NON-MTM ACCOUNTING l Managers own the option on the timing to sell a valuable asset l Managers can leverage their income by moving risk across time l Managers want to maximize the value of this option l Non-MTM accounting dominates

X = Accounting Value Needed to be bonusable Y = Level of loan portfolio equal to MTM value Accounting Loan Value Accounting Value of Loan Portfolio if income can be taken at manager's discretion Time X t 0 MTM Value at Time Zero VALUE OF THE PORTFOLIO INCOME AT ACCOUNTING LEVEL X

MTM ACCOUNTING l Shareholder risk closer to Manager's risk l Managers can diversify risk by choosing low correlation projects l Managers face downside risk l Managers tend to reduce exposures near the end of an accounting period

NON-MTM ACCOUNTING l Managers tend to leverage more to maximize their accounting bonus l Managers can take more concentrated risk l The need to diversify risks are reduced l Managers will move risks across accounting dates where possible l Losses will be concentrated in "Bad Years"

REGULATORS MUST BEWARE l Non-MTM accounting and government debt vs. equity l Non-MTM accounting of Debt and MTM accounting of trading activities l Inexperienced regulators Concentrations of Risk

CONCLUSIONS l 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 l Managers and Share holders Have their risks better lined up under MTM accounting Managers will tend to take less risk than Shareholders under MTM accounting Managers will desire to diversify risks when shareholders will not under MTM accounting l Lenders still don't care

CONCLUSIONS l Regulators Have an incentive to reduce riskiness May increase concentration of risk through certain capital adequacy rules Often intimidate management by not understanding the value of diversification May raise risk by differential accounting procedures May promote system risk by imposing measure for capital adequacy under a system of "Lender of last resort"