Bank capital optimisation, stability and control

1. “Bank Capital
Optimisation , Stability and Control”
(KOSC)
Introduction
Recent market events have focused attention on the ability of
banks and financial institutions to remain in control of the
dynamic capital effects of their businesses especially in the world
of derivative and financial products. Goldman and Morgan have
succeeded in maintaining tight control while Citibank and UBS
have been less astute. Goldman are under heavy criticism for the
way that this result was achieved which raises the issue of “moral
hazard” and potentially trading under MNPI*.
The Score So Far (what a difference a year makes)
The international banking sector is continually being tested by
market events and cycles The score card for the current credit
crunch is:-
Jan 2008 Dec 2008
JPMorgan net +4b Bear Sterns
Goldman Sachs -2.10b (+2b) net
Lehman Brothers -1.11b adieu
Credit Suisse -2.34b -7b
RBS -3.10b -23b
Barclays -3.26b -12b
Bank of America -4.72b -9b
Deutsche Bank -5.67b -7b
Merrill Lynch -11.60b adieu
Morgan Stanley -12.36b -23b
UBS -16.32b -22b
Citigroup -18.44b -320b
would have been cheaper to bail Lehman
JPMorgan

2. While JPMorgan can be commended for its position today, the
roots of this success were less in the intellectual capital of its
senior management and more in the less elegant past - Asia,
Russia, LTCM, CSLT, Internet, Telecom, Worldcom, Enron.
JPMorgan has paid dearly for these episodes over the years with
true costs often many times the actual legal and balance-sheet
disclosures.
This sea-change of results is no accident but was achieved
by the committed application of internal controls, retained capital
and credit management and across business optimisation. Bill
Demchek and Rob Standing played early roles while Blythe
Masters lead the long climb from a 15USD share price and an
effective single A credit rating. This activity first appeared in the
2003 annual report and has been a strong component of investor
relations since that inclusion. Bertrand de Paliers and Tim Frost
built the derivatives and credit derivatives businesses which lead
the charge in dual reporting, a key component of COSC.
Proposed Approach -
Significant features of the COSC approach to core
bank management
Retained Portfolio Capital Optimisation

Capital stabilisation

Enhanced leverage of business franchises

Balance sheet buffering and export

Retained Credit Re-cycling

Tight Corporate Governance


3. How do we achieve these goals?
Optimisation on three levels
Refined CVA* model – Basic requirements for Basle II need true

credit costing and management over time. However this CVA
allocation needs to be adjusted for diversification and correlation (both
internal and external) and needs to be weighted appropriately for the
different phases of the business cycle.
Non-adverse DRE* model. Seeking equivalence across credit, balance

sheet and term components often generates adverse P&L functions.
Implementations of DRE models must not limit their ability to
optimise the balance sheet and the bank portfolio yield.
(static/dynamic credit alignment, normalised credit curve, excess
management, always positive yield function)
ALE* allows co-management of static, dynamic and impaired credait

components throughout the entire work-out boundary. The work-out
boundary must be the target domain of all bank business. This is a
dynamic, across-business, across-asset-class function which needs to
be proactive rather than reactive.
Dynamic optimisation, adjustment and re-cycling of the three levels will
require trading of all asset classes, efficient use of proxy asset classes and
inclusion of residual asset classes. (credit derivatives, derivative/OTC
trading, peak lopping, boundary trading, cross-gamma) A COSC team
would build this skill set to avoid moral hazard risk and ensure that no
MNPI trading takes place in full anticipation of market phenomena.
The team
Past teams have included trading, portfolio management, sales, legal,
credit and technology skill sets. Past teams have produced a significant
number of MDs in major institutions globally as well as a few world class
tenures. Team building has mostly been organic with middle office,
technology, legal, credit, trading and sales desk recruitment. Major
awards have been won while significant contributions to the intellectual
capital of institutions are paramount to the proscribed approach.
A balanced trade-off between infrastructure, core bank function and
bottom line contribution requires a sophisticated remuneration structure
for the team.

4. Core functions
The implementation of the COSC approach will depend on the structure
and objectives of the importing institution and its component businesses
combined with the objectives and mandate of the COSC team.
Some possible functions are outlined below:-
Assignment of CVA, DRE, ALE, INPV, capital use and funding down

to individual business level would require education and over-sight.
The COSC approach would seek an objective to push these functions
down to business level while promoting a senior management pallet of
across portfolio optimisation, business growth directing and cycle
compensation.
Core credit portfolios can produce significant opportunities for COSC

techniques which would be paramount to ensuring that components of
the team are profit motivated.
Cross Gamma and correlation trading of the retained portfolio and

proxy trading of the residual components would all be normal
activities of a COSC team.
Corporate/Sovereign transition management through the entire “work-

out boundary” would be a limited basket component or a combined
portfolio function in conjunction with existing work-out or credit
teams.
JPMorgan have invested heavily over the last decade in infrastructure for
managing COSC components. However, a significant sub-set of the
COSC infra-structure can be implemented for relatively low cost using
state-of-the-art techniques and assignment down to business level.
Objectives
 COSC – Capital Optimisation, Stability and Control are the primary
objectives. They impact on the bank retained credit portfolio and the
balance sheet use of the component businesses.
Significantly enhanced leverage of selected business franchises

Obviation of the need for time-risky business self-insurance practices


5. Implementation and enhancement of sound management control,

compliance and corporate governance functions
Generation of pre-allocation trading revenue from the enhanced

businesses and core retained portfolio of 300mUSD.
Allocation of 20% of this revenue to fund the required infrastructure

over 5 years. NB COSC would not inherit responsibility for core bank
infra-structure (although it may assist in this process) but would create
a dynamic intra-lay which would allow integration and optimisation
across a continually evolving landscape.
Key advisory roles fulfilled by the team
By definition, the team will impact on certain management functions and
would expect to be tasked to participate in these functions.
Senior management
Corporate governance
Credit Strategy
Legal structure, enforceability and scale
Allocation of INPV
Allocation of balance sheet and funding
Businesses (typically EM, Rates Derivatives, High Yield,
Commodities, Structured Products, Equity)
Enhanced leverage.
Enhanced INPV transactions.
Enhanced credit structures.
CVA, DRE, ALE right-way/wrong-way trades.
Capital , balance sheet and funding optimisation and compensation.
Regulatory Functions
Capital and Basle 2
Balance sheet
Compliance (material non public information, moral hazard)
Pedigree
The back-bone of the technologies and trading techniques for COSC were
developed under such market leaders as Alan Wheat, Chris Gokjian and
Bob Diamond. The core effective techniques at JPMorgan were
developed under the aegis of Rob Standing and Blythe Masters.

6. • 10Yrs JPM and heritage institutions.
• JPM Derivatives Deal of the Year 2002.
• 15yrs straight A audit with substantial P/L.
• Recovery Rate post default greater than 150%.
• Record post default deal P/L greater than 72mUSD.
Key to Terms *
CVA - credit value adjustment
DRE - derivative risk equivalent
ALE - adjusted loss equivalent
INPV - input PV
EVD - Extractable value difference
RR - Recovery rate
LGD - Loss given default
MNPI – Material non-public information
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