Q. 1. What were the major factors that led to the recent financial crisis? How did we get here? Answer: One of the primary factors that can be attributed as to have led the recent financial crisis is the financial deregulation allowing financial institutions a lot of freedom in the way they operated. The manifestation of this was seen in the form of: a) Financial innovations that were not backed up with adequate risk controls and management. b) Too much reliance on Quantitative Risk Management ultimately leading to mispricing of risk across different financial and non-financial investments that were the product of the financial innovations made feasible by financial deregulation. c) The influx of liquidity both original and fabricated that led to significant price appreciation particularly in the real estate sector creating real estate bubble. d) The ever increasing prices of assets allowed ever increasing capacity to borrow. e) The sub-prime mortgage market where it was allowed to originate loans of poor credit quality by one player and sell it to others in a mortgage pool. Hence creating an incentive problem where the one who originates poor quality credit did not bear the credit risk for it. f) All these led financial institutions to the fallacy of being “too big to fail”. g) The fallacy that every risk can be quantified and managed led financial institutions into the trap and they started to lend and finance in ways that were unique and complex resulting in exposure risks that were least understood by them. h) The ever increasing financial innovations leading to severe competition among different types of financial institutions for the same buck also played a critical role as well as creating problems of moral hazard and ethics in general.
2. Do you think that the final cost of the government bailout was worth it? Do you think that the initial response was necessary to prevent a collapse of the financial system? Answer: According to the U.S. Department of the Treasury, 8.80 million jobs were lost and $19.2 Trillion were lost in household wealth. The estimated total potential exposure from the financial rescue was estimated to b $24 trillion by the Special Inspector General for TARP in July 2009. The IMF estimated cost of the U.S. response to be $1.90 trillion. If the government had not intervened then, the final cost of the financial crisis would have been much higher than this. The U.S. GDP grew over 2% on average as a result of the comprehensive response and prevented the economy from a total collapse. According to the U.S. Department of the Treasury, a total of $245 billion were disbursed to stabilize the financial institutions and the treasury recovered $264 billion including repayments of $230 billion and $34 billion as realized income in April 2012.
3. How can we prevent this from happening again?

Answer:

A look at the factors that led to the financial crisis gives an idea of what needs to be done to prevent such crisis from happening in future. These include but are not limited to: 1. There should be a limit to financial deregulation and financial innovation particularly in areas where the prevailing risks are least understood. 2. The regulatory regimes must be strengthened and their monitoring and response capabilities enhanced to levels possible subject to being too restrictive and rigid. 3. Risk management systems should be updated and made dynamic continuously to cover both qualitative and quantitative factors. The use of triggers for different responses at different levels of risk exposure should be made an integral part of any risk management systems in place. 4. The incentives in the financial system should be actively monitored and corrective actions taken when needed.

4. What would be a likely solution? Do we need some form of regulation? Do we need this regulation? Why or why not? What are the key points that regulation should address?
How appropriate of a response to the financial crisis was the Dodd-Frank Act? What is the likely impact of the Dodd-Frank Act?

Answer:

The Glass-Steagall Act of 1933 that defined the roles for commercial banks, investments banks and insurance firms was over ridden by the Gramm-Leach-Bliley Act (1999) which repealed the provisions that restricted affiliations in financial institutions. Hence one solution is to overcome the incentive problem and the conflict of interests that arise when financial institutions simultaneously undertake financial activities of varied nature.

In addition to the above the internal incentive to bank should be reduced by requiring greater capital requirements as well as improving upon the definition of what qualifies to be capital. Further in line with the answer to question 3, risk management systems in financial institutions need to be redefined and strengthened to more comprehensively identify, evaluate, manage and monitor risks.

Yes we need to have some form of regulation. The proposed regulation is not bad as it covers most of the recommendations discussed in this write up earlier. It reinforces the regulatory role as outlined earlier and requires improving the capital requirements as well as the risk management systems in place in financial institutions. At the same time the focus is mostly on large, complex financial institutions that have a systematic impact so it allows some flexibility particularly for smaller and medium size financial institutions.

As for as the key points to consider, the regulation that is to be put in place in the financial sector is: 1. Expected to be value adding i.e. must have a specific aim or set of aims to fulfil. In other words the regulation should result in improved regulation and supervision. 2. Increase ambiguity and uncertainty for financial institutions over short term as its usefulness is debated and the implications assessed in the financial sector. 3. To probably result in an acquisition or merger wave in the financial sector. 4. Cost the financial institutions to comply with the requirements of the regulation. 5. To influence the cost of capital of the financial institutions where certain type of financial securities are excluded to qualify as capital and new type of financial securities have been allowed to be considered as Tier 1.

If we compare the factors that are attributed with the financial crisis, we will find that the Dodd-Frank Act does address these factors and hence is an objective response. It covers areas such as incentives and compensation in the financial system and imposes restrictions on compensation for firms receiving TARP in the bailout. The introduction of Orderly Liquidation Authority and Volker Rule are targeted towards the fallacy of “too big to fail”. The Volker Rule and other provisions also limit the means to financial innovation. Newer and tougher capital requirements are introduced and the definition of qualifying capital made stringent. The Financial Stability Oversight Council, enhanced role of SEC and Civil Suit Liability all are aimed to ensure adequate risk management and manage the conflict of interests. With all these pertinent factors being adequately considered by this regulation it can be expected that it will bring stability to the financial system in the future. However, constant monitoring and evaluation are necessary.

5. How effective will the Financial Stability Oversight Council (FSOC) be in regulating large financial institutions and limiting systemic risk?

Answer:

It appears that FSOC will oversee the larger picture of the financial system and its role will have its role contingent on and triggered by financial crisis. Hence it will not be directly supervising financial institutions in any way but will be concerned with the regulators of the financial system in general. Hence the FSOC is in line with the concept of one regulator of all. The role prescribed suggests that it will work as a monitor of the regulators of financial system. In addition it will have concerns only with large financial institutions that have the potential to instigate systematic risk.

The regulation entitles FSOC to oversee other regulators. For example under the regulation FSOC can direct any other regulator to do any required action(s) to prevent any crisis and insure financial stability. In this regard the role of Federal Reserve is of particular importance as FSOC can delegate it the objective to oversee any financial institution considered to be a source of systematic risk.

6. How will the Volcker Rule affect JPMorgan? What strategic initiatives can JPMorgan implement to address the Volcker Rule?

Answer:

Given the size of JPMorgan, the 3% cap should not be a problem. However, the main concern for JPMorgan with respect to the Volker Rule will be its proprietary trading business. Firstly it can simply close out its proprietary business but that will result in reduced revenue and diversification and also depriving itself completely from a potentially profitable line of business. The other way around is a spin-off of its proprietary business but that again is subject to regulations that are even more stringent and involves additional external capital to be raised. However, a relatively attractive and feasible option given the Volker Rule is to shift it proprietary business to its other line of business i.e. asset management. It will subject its trades to clients’ trades. Though it will not lose the proprietary income completely, it will still experience significant fall in it.

7. What effect will the new asset securitization requirements regarding risk retention by originators and securitizers have on financial institutions? On lending?

Answer:

These requirements were specifically given to correct for the incentive problem related with risk origination and risk bearing. Under the new requirements originators of risk will experience a higher level of assets on their balance sheet as it is required that at least 5% of such origination be kept on the balance sheet as an asset. This will increase the capital requirements for such originators of risky assets and hence reduce the incentive for excessive risk taking by such originators who do not ultimately face the consequences of the investment risk. It also implies that lending or credit will be reduced as the originators of credit will not be able to receive full value of the amount lent through securitization. Given these originators will have an active economic exposure to the risks of the credit, it is expected that the quality of assets will improve as well as the credit standards adopted to originate such assets.

8. How will JPMorgan fare in the new environment? Would you consider it a winner or loser?

Answer:

Given the role of FSOC and the other provisions of the Dodd-Frank Act it can be easily ascertained that this regulation is particularly targeted towards financial institutions such as JPMorgan. The implications of the Dodd-Frank Act outlined in the response to question 4 such as lower returns, higher costs and capital requirements as well as enhanced supervision requirements and compliance costs are inevitable realities for JPMorgan in this context. Of these the most significant ramification is the elimination of TRUPs as Tier 1 capital and requires JPMorgan to replace it in the coming year to fulfil the capital requirements. On the positive side, it can be said that every threat is an opportunity at the same time. Given the performance of JPMorgan over the period of financial crisis one would expect it to cash on opportunities offered by the regulation. Mergers and acquisitions are a part of it.

9. What effect will the higher capital requirements have on JPMorgan’s capital and profitability? How should JPMorgan address the new capital requirements? Prior to the
Dodd-Frank Act, what was the purpose of trust preferred securities (TRUPS) and what role did they play for banks? What were their shortcomings? What implications does their exclusion from Tier 1 capital have for JPMorgan and other banks?

Answer:

As JPMorgan has weathered out the most severe of the financial crisis of its time suggesting that it is financial sound and stable and that it has adequate capital to withstand such crisis, it can be expected that the new regulation will not have big affect on JPMorgan’s capital requirements. But it can be expected that the capital requirements will be more individually tailored due to the counter-cyclical provision in the new regulation. One implication is that the capital requirements will become quite volatile given the new regulation’s provisions. Uncertainty prevails regarding how will set the capital requirements and how. One possible way is the use of stress testing to enable the determination of required capital.

However, the new regulation is expected to affect profitability negatively in few ways. First JPMorgan’s proprietary trading business will be affected reducing its profitability as discussed earlier. Second stringent capital requirements and other provisions will reduce the lending function and hence result in lower profitability. There are two ways out to replace the reduced profitability from the regulation. One is to diversify into higher risk line of businesses such as real estate which given the recent history is not an attractive option. However, the second way out is to diversify into activities that are not asset intensive like services based. Due to the elimination of TURPs, JPMorgan and other banks are required to replace them in Tier 1 capital in the near future. For JPMorgan it will not result in financial distress as it is already well capitalized. However, to keep things as they are it may need to replace them in near future.

TURPs were capped at 25% of regulatory capital requirements i.e. Tier 1. They were considered as debt for tax purposes and equity for rating and regulatory requirement. However, they were not as efficient a source of capital for small banks as for large banks. There were four main advantages associated with the use of TURPs: 1. Allowed to raise Tier 1 Capital 2. Cheaper source of Tier 1 Capital 3. Tax deductibility of interest paid on TURPs 4. Considered as equity by rating agencies
The financial crisis also resulted in the collapse of TURPs as they were no better than the banks that originated them. The TURPs and the TURPs pools suffered from the same short comings as the conventional asset back securities did.

10. What is the structure and purpose of contingent convertibles (CoCos)? What is the proper capital structure taking into consideration these securities? How are these securities different from TRUPs? What are the advantages/disadvantages to using these securities? Will they serve their intended purpose? Who will be the investors?

Answer:

The CoCos are proposed to have a structure of convertible bond with mandatory conversions contingent upon pre-specified events e.g. decrease or fall in capital or decline in stock price to a certain level or certain percentage. Given the mandatory conversion the structure could be replicated by a plain vanilla bond and simultaneously selling a put option. In CoCos the conversion is forced and is triggered by a fall in the stock or capital. However, in simple convertible bonds, the conversion is non-mandatory and is contingent upon a rise in the stock.

Historically TURPs had been a cheaper source of capital given they provided downside protection. As CoCos replace them the banks cost of capital are expected to go up as CoCos will have higher interest costs due to their inability to provide downside protection. CoCos are expected to discipline banks in their attitudes towards quasi equity as CoCos have triggers that cannot be played down. Avoiding default and subsequently bankruptcy is the primary advantage with CoCos.

However, CoCos do not result in injecting capital and hence do not solve the problem of liquidity. Further CoCos are debt and hence may not qualify as regulatory capital like TURPs. This will also affect credit ratings by rating agencies. TURPs were considered as equity by rating agency and debt by tax authorities. Hence the ramifications of replacing TURPs with CoCos are unfavourable in many ways for banks. One of the most significant challenge that CoCos will face is their pricing which by the looks of things seems quite complex.

The likely investors could be fixed income investors, hedge funds (arbitrage and distress securities in particular), vulture funds.

11. Who are the winners after the Dodd-Frank Act? Why?

Answer:

The new regulation brings new challenges for large banks and hence also opportunities particularly in terms of consolidation through mergers and acquisitions. Small banks will also marginally benefit as they become more competitive as a result of the increased deposit insurance coverage. Given that the new regulation reinforces and enhances the role of regulators in general and the Federal Reserve in particular, such regulators will experience more power and authority. The general public may expect to see financial stability over longer period!!!!!!!