Finance

Finance
Since 2009, financial firms deemed “systemically important” have been required to undergo annual “stress tests” in the United States, Europe and certain other countries. The objective is to determine the risk of bank failure in the event of adverse and severely adverse economic and financial circumstances, and the consequent exposure to negative externalities and government-financed bailouts. Early stress tests were insufficiently severe, and a number of banks that passed ultimately required government support. More recently they have become much more stressful and include both quantitative and qualitative factors. Quantitative stress test results conducted by the banks themselves by bank regulators often differ materially, with bank interpretations usually more optimistic than those of regulators. Qualitative factors probe the fundamental strategies of banks, how they are executed, the degree of complexity and conflicts of interest that may arise, sovereign risk issues, as well as the cultural and reputational context of the bank and similar considerations. These are rarely spelled-out explicitly, intentionally so, and bank management must figure out how to stay well inside the parameters that define “safe and sound” strategies and policies.
US financial institutions that are considered systemically important are subject to annual CCAR stress tests under Federal Reserve regulations and DFAST tests under the 2010 Dodd-Frank financial stability law. Both are conducted simultaneously – using a single dataset – by the Board of Governors of the Federal Reserve System.

The specific wording used by the Fed is as follows:
“The Comprehensive Capital Analysis and Review (CCAR) is an annual exercise by the Federal Reserve to assess whether the largest bank holding companies operating in the United States have sufficient capital to continue operations throughout times of economic and financial stress and that they have robust, forward-looking capital- planning processes that account for their unique risks.
“As part of this exercise, the Federal Reserve evaluates institutions’ capital adequacy, internal capital adequacy assessment processes, and their individual plans to make capital distributions, such as dividend payments or stock repurchases. Dodd-Frank Act stress testing (DFAST)–a complementary exercise to CCAR–is a forward-looking component conducted by the Federal Reserve and financial companies supervised by the Federal Reserve to help assess whether institutions have sufficient capital to absorb losses and support operations during adverse economic conditions.

“While DFAST is complementary to CCAR, both efforts are distinct testing exercises that rely on similar processes, data, supervisory exercises, and requirements. The Federal Reserve coordinates these processes to reduce duplicative requirements and to minimize regulatory burden.”
Failure of stress tests may involve aggressive efforts to improve capital ratios, funding stability, liquid asset holdings, credit risk metrics, counterparty and concentration risk, etc. and may result in rejection of a bank’s capital plan, including bans on acquisitions, dividends, and share buybacks.
In 2004 the Santander banking group of Spain joined Citigroup in failing the so- called “qualitative” part of the 2014 CCAR and was prohibited from returning capital from the US unit, Santander Holdings USA, to the parent bank in Spain. The US unit was required to make major improvements in its operations and risk management in order to successfully pass the 2015 stress test. However, in direct violation of the Fed’s directive, Santander Holdings USA returned capital to its parent in Spain, visibly angering the US regulators, and was forced to reverse the transaction.
In the 2015 stress test, announced in March 2015, Santander Holdings USA again failed the stress test (as did Deutsche Bank Trust, the US operating unit of Deutsche Bank AG), because of poor operational controls and poor risk management. The implication was that a third stress test failure in 2016 would cost Santander USA Holdings its license to operate in the United States. Overall stress test results for 2014 and 2015 are presented below.
As stress testing has evolved for systemically important financial institutions, a vigorous debate has developed regarding governance and cultural factors in financial services firms. Many of these are reflected in massive fines, penalties and class-action judgments imposed across a wide range of financial businesses. These include rigging benchmark interest and exchange rates, lack of due diligence and fiduciary violations, exploitation of conflicts of interest and various other types of conduct that violate common standards of fairness and in some cases civil or criminal law. Such issues may impair the reputational capital of the firm, its share price, its ability to conduct business and ultimately its viability as a going concern. Consequently

“qualitative factors” have increasingly been incorporated in stress testing alongside “quantitative factors” focusing on capital adequacy and other regulatory metrics.
Make 5 recommendations (bullet points are fine) to Santander Chairman Ana Patricia Botín, intended to insure that “qualitative factors” do not again impede a successful CCAR stress test – the results of which will be released in late March 2016. Write-up not to exceed two (2) single-spaced European A4 or US letter-format pages. You may use any and all sources at your disposal (carefully footnoted)

2) The main objectives of the corporate finance and risk management session were to explore how risk management can contribute to value creation (and, more specifically, how it affects the intrinsic value drivers of a firm) and to provide an overview of the tools that can be used to incorporate risk in financial analysis and valuation.
We developed a framework (process) which allows us to identify and classify relevant risks and assess a firm’s exposure to these risks, guides decisions on which risks to eliminate, which risks to pass through to investors, and which risks to strategically exploit, and facilitates an evaluation the costs and benefits of alternative ways to mitigate or exploit risk. We then applied this framework to the oil exploration and pharmaceutical industries and discussed risk management practices in these industries.
Using a similar approach, identify up to five of the most relevant risks that your company (or a company or organization of your choice, except an oil or gas company) faces, and categorize these risks into the following groups: macro-economic versus micro-economic, discrete versus continuous, and small versus catastrophic risks, respectively.
For each of these risks, subsequently assess whether you would pass the risk through to investors, hedge the risk or seek out and exploit the risk. Clearly motivate your decision using arguments you believe are most relevant.
Finally, briefly discuss the best approach to manage the respective risks, and also assess your company’s capability to exploit risks and identify potential areas for improvement.
In order to keep this risk profiling exercise manageable, I suggest that you lay out the risks, the decision whether to hedge, pass through or exploit the specific risk, and the recommended hedging alternative (where applicable) in a summary table, and provide the motivation in an executive summary style essay of at most 500-1000 words.

3)

Consider an investor who holds a position that includes $500,000 invested in a 10-year Japanese government bond futures contract (YGB) and $500,000 invested in a Japanese stock index futures contract (YXF). Their annual volatilities are 6 and 18 percent respectively, with a correlation of -0.4. Assume that returns are normally distributed and VaR should be measured at 99 percent level.

a) What is the portfolio VaR?

b) What is the portfolio gain from diversification benefits?

c) What is the marginal and component VaR of YGB and YXF?

d) Which of the two assets is better to be removed if you want to reduce VaR?

e) What is the incremental VaR from setting YGB to zero?
4)

A large all-equity pension fund company with AUM of $500Billion that is closely following S&P 500 index is facing a possibility of new regulatory changes in its management of market risk. The new regulation would require capital charges to cover possible tail event losses based on the realistic assessment of market risk of the company. A CRO of the fund is given a task to assess a range of possible costs with regard to such charges.

It turns out that the CRO of the fund is an old buddy of yours from school times and regards you as a world-class expert. With no hesitation she then turns to you for help. Given your close friendship (and a hefty paycheck she offers) you eagerly decide to provide feedback.

In your recommendation, you may want to consider the following:
• – Access to daily price data of the S&P 500 index (Data_1.xlsx)

• – Various choices of risk measures

• – Specificity of the data in terms of its distribution and volatility structure

• – Tradeoffs between profitability and risk of the implemented charges

• – Possible adjustments in the portfolio strategy

– Supporting your answers with graphs / tables
5) Whatis theexpectedReturnonEquityfortheequitytrancheineachof thefirsttwoyearsofafiveyearCLO(CollateralizedLoanObligation)?
Information:

•$2.0billiondollarpool.

• Feesarepaidat theendoftheyearandare1%(of facevalue)inthefirstyearand1%(of face value)inthesecondyear.
•Assumethatthedefaultsoccuratthebeginningof thesecond-halfofeachyear.

•The recoveryfrom thedefaultsisinvestedimmediatelyat(5%).

• The annual interest on the pool of loans(i=10%)is paidsemiannuallyandis based on the remaining balanceof loansinthepool.
•Thedefaultratesandrecoveryratesareprovidedbelow:Lossesarenotreducedfrom equityuntil

theendof theCLO.
YearOne YearTwo
DefaultRate 3% 8%
RecoveryRate 40% 40%

CLOExample
Trustee

Pool ofloansfrombank
•100 Loans
•$2BillionPool
•AverageRating=BBB
•Averagei=0.10

Sell loans
$2Billion

Fee =1% of pool SPV

Fee 1%
6) After reading the“Mountain Federal Savings andLoan”case,answer the following questions.
1. Based on available information about Mountain assess a Camel rating of 1 to 5 for each of the 5 Camel variables and an overall Camel rating(see weights of Table19A-3below).

2. Given that rating,what regulatory action if any should be taken against Mountain?
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