Future of Treasury in Investment Banking

OCTOBER 2004
FUTURE OF TREASURY IN INVESTMENT BANKING Vaidya Nathan

O N LY F O R R E S TR ICT E D C I RC U LATI ON
Future of Treasury in Investment Banking
Agenda
Page
Executive Summary Treasury capability in banking

B A N KI N G
1 4 8 16 37 40 48
Understanding a typical treasury Market overview of asset classes Measuring risks the metrics Case Study National Australia Bank in 2004 Future of Banking and Treasury
F UT U R E
O F
T R E A S U R Y
I N
I N V E S T M EN T
VAIDYA NATHAN
Executive Summary
Understanding treasury capability in a banking context
Future of banking is not about loans growth and margins, but rather about
treasury capability, innovative financial products and advisory

Consequently, a sophisticated Treasury is a distinctive competitive advantage
that would differentiate future players in the banking space

The infamous treasury failures of some financial institutions have heightened
sensitivity surrounding the management of treasury operations

These widely reported failures have almost always resulted in loss of investor
confidence along with exaggerated decline in shareholder value

However, banks are steadily increasing their involvement in capital markets and
committing capital to treasury as they regard it as an essential core competence

S U MM ARY
Banks whose treasury is small but growing present the greatest potential risk,
because risk management capabilities may be immature

The objective of this presentation is to understand what are the characteristics
E X E C U T I VE
of a good treasury, the risks that come with it and the challenges they have
VAIDYA NATHAN
Overview
Outline of presentation
We first analyse the trends in banking across regions and motivate the
importance of treasury as an essential core competence for banks

We understand the functions of a typical treasury and examine how treasury
organisation is inextricably linked to its business model

We explore the value drivers for treasury in terms of asset class, how they add-
up in terms of risk and revenue, with a special focus on structured products

We evaluate how the risks are reported, how they conceal more than they
reveal, and consider metrics that can be derived from reported information to possibly get a glimpse of the actual underlying risks
We investigate the case of a recent treasury failure and study a real-life
example of how and why things go wrong at treasury

S U MM ARY
We conclude by looking at what the future bodes for treasury
E X E C U T I VE
VAIDYA NATHAN
Agenda
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B A N KI N G
1 4 8 16 37 40 48
F UT U R E
O F
T R E A S U R Y
I N
I N V E S T M EN T
VAIDYA NATHAN
Generic Bank Business Model

Increased specialization and sophistication: super-growth segments in global banking
Domestic Retail Banking Retail Financial Services Retail Banking

B AN K I N G
International Retail Banking
Securitizing & Corporate and Investment Specialised Banking Financing
Asset Management and Services
Private Banking Asset Management
C A P A B I L I T Y
Treasury: Capital Markets
I N
Corporate Banking
Insurance Securities Services
T R E A S U R Y
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Banks as Deposit Taking Institutions

Assets Assets of of DTIs DTIs (US$ (US$ bn) bn)
2500 2000 1500 1000 500 0 835 364 105 1990 766 188 1999 847 247 2003 5,638 5,477 1917 2489 6,000 5,316 5,000 4,000 3,000 2,000 1,000 0
No. No. of of DTIs DTIs which which are are Banks Banks
2,000 1,500 1,000 500 0 1990 1999 2003 1,148 24,441 1059 929 1,819 34,660 40,000 30,000 970 20,000 16,311 639 10,000 281 0
Banks Banks return return on on assets assets

2.50% 2.00% 1.50% 1.00% 0.50% 0.00% -0.50% -1.00% -1.50% -2.00% 1990 1999 -1.80% 1.40% 1.10% 0.90% 2.50% 1.80% 0.80% 0.50% 1.60% 0.70% 0.20% 2003
323
302
Trends in banking systems East Asia

B AN K I N G
East Asia
Latin America
Central Europe
Advanced
Latin America 2004 970 43% 2489 31 0.7 13.3 1990 323 47% 364 26 1.4 9 1999 302 59% 766 24 0.5 8.8 2004
Central Europe 1990 1999 929 55% 188 15 1.8 7.6 2004 1990
Advanced 1999 2004
1990 No. of Deposit Taking Institutions Of which are Banks Concentration Assets of DTIs ($bn) Branches of DTIs (000s) Banks return on assets (%) Banks simple capital ratio 1,148 44% 835 17 0.9 4.9
1999 1059 43% 1917 24 -1.8 10.9
10,100 11,761 13,422 1,344 1,741 2,138 2,087 1,154 281 1,819 63% 847 22 0.2 8.6 70% 105 17 2.5 8.2
821 39,766 30,361 20,956 639 34,660 24,441 16,311 42% 247 14 1.6 7 39% 5,638 275 1.1 7.6 42% 5,477 286 0.8 6.9 44% 5,316 297 0.7 5.7
C A P A B I L I T Y
I N
Deposit Taking Institutions (DTIs): Include commercial, savings and various types of mutual and cooperative banks, and similar intermediaries such as building societies, thrifts, savings and loan associations, credit unions, postbanks and finance companies but excluding insurance companies, pension funds, unit trusts `and mutual funds East Asia: Sum or simple average of Korea, Malaysia, the Philippines and Thailand; Latin America: Sum or simple average of Brazil, Chile, Colombia, Mexico and Peru; Central Europe: Sum or simple average of the Czech Republic, Hungary and Poland; Advanced: Sum or simple average of Australia, euro area, Hong Kong, Japan, Singapore, Switzerland, the United Kingdom and the United States; Concentration: Percentage share of DTIs assets held by five largest institutions.
T R E A S U R Y
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Evolution of banking business

Net Interest Interest Revenue Revenue Net
5.50% 4.50% 3.50% 3.10% 2.50% 1.50% 1990 1999 2.60% 2.00% 2.50% 2.20% 2.00% 2.30% 1.90% 1.80% 2003
1.00% 0.50% 0.00% 1990 1999 2003 0.70% 1.00% 0.80%
Other Other Income Income

5.40%
2.50% 2.00% 1.50% 1.20% 1.10% 2.30% 2.00% 1.80% 2.50% 2.10%
Loan Loan Losses Losses

2.00% 1.80% 1.70% 1.50% 1.20% 1.00% 0.50% 0.00% 1990 1999 2003 0.60% 0.20% 0.40% 0.30% 0.50% 0.40% 0.30% 1.90%
5.20%
5.40%
East Asia
B AN K I N G
Latin America
Central Europe
Advanced
In the last decade-and-a-half, banks have evolved from being mainly a deposit-
taking & lending institution to providing a wider range of value-added services

Consequently, as net interest revenue has decreased or remained stable, other
I N
C A P A B I L I T Y
sources of income have increased and now form a larger proportion of bank profits
One of the important services that banks provide which has contributed
T R E A S U R Y
substantially to revenues and which differentiates players in the banking space is Treasury capability
VAIDYA NATHAN
Agenda
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B A N KI N G
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F UT U R E
O F
T R E A S U R Y
I N
I N V E S T M EN T
VAIDYA NATHAN
Introduction to Treasury Function

Treasury Treasury operation operation Importance Importance of of Treasury Treasury
A typical Treasury performs the
Some of the centralized treasury
following functions
Asset and liability management
functions also do
policy formulation, group control
including day-to-day funding requirements

Risk management embracing
T R E A S U R Y
and co-ordination of liabilities and dealing operations

Improving funding through accessing
interest rate, equity, foreign exchange, credit, commodity, etc

Market making and proprietary
more diverse range of markets

Expanding product range and
T Y P I C AL
trading for profits, spanning various products and asset classes
innovation in financial products to meet diverse client requirements and risk management needs
Raising proportion of non-interest
UN D E R S T AN D I N G
income, in particular through customization, credit risk management & product innovation
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Organisational structure usually along either

Vertical Integration or Asset Class
Treasury
Fixed Income Bonds, FRAs, Swaps, Options,

T R E A S U R Y
Fx
Equity
Credit
Commodity
Spot, Forwards, Options, CCS,
Stocks, Options on Index,
CLN, CDS, FTDs,
Bullion, Oil, Options,
In this type of organization structure, the dealing room is segregated into separate,
vertically integrated groups determined by asset class

For illustration purposes, let's consider say, the foreign exchange group: In the vertically integrated foreign exchange group, the cash traders (i.e. the spot trader)
T Y P I C AL
sit next to the derivatives traders This improves the flow of information among dealers It putatively reduces transaction costs The spot trader has incentive to treat options trader well, in order to get as much information about indirect implications of options market flows for spot market Organizing along asset class lines also means that marketing is integrated for underlying and derivatives products Marketing teams are directed to sell all products in the asset class
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10
Or along
Functional Functional Products Products
Fixed Income Product 1 e.g. cash Treasury Product 2 e.g. derivatives Fx Equity Credit Commodity
Continuing with fx as an illustration, in an organization along functional products, trading

T R E A S U R Y
and sales team work together, dealing with clients who want cash products exclusively
They are also separated by asset class. For instance, foreign exchange spot team will not
enter into transactions in cash bonds

Derivatives traders and salespeople handle the sophisticated accounts, across all asset
T Y P I C AL
classes (while usually specializing in one or two of these asset classes)

Advantages:
Clients get seamless service across products, i.e. instead of talking to five different contacts at a bank, they talk to one person, get one integrated price and confirmation It is easy for the bank to structure products that encompass more than one asset class
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11
Disadvantages Vertical integration

Asset Asset Class Class
Difficulties arise when customers expect horizontally integrated products There are management issues that come into play If the bank chooses its asset class line managers from the ranks of cash
traders or generalist salespersons, it is an impediment to business

Having non-derivatives specialists in charge of derivatives operations is like
T R E A S U R Y
asking a cab driver to fly an aircraft

The manager has to explain losses or other problems to superiors without any
remotely sophisticated comprehension of what is going on

Many managers who should not be responsible for derivatives operations hang
T Y P I C AL
on to them tenaciously because of the cachet of being perceived as sophisticated and cutting-edge
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Disadvantages - Organization along functional products

Functional Functional Products Products
Coordination among groups can be problematic In a dealing room organized along functional lines, the cash trader may have
no incentive to see the derivatives desk do well

In certain cases, the cash desk may not be obligated to provide a competitive
price for internal transactions with derivatives desk

T R E A S U R Y
This can make customer transactions uneconomical, hindering derivatives
desks business
The derivatives desk, for its part, has no incentive to share information about
T Y P I C AL
flows on the cash side, impeding their ability to trade and sell competitively
The dealing room may lack an environment of partnership and can lead to
management problems
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13
Vertically integrated treasury business model

Proprietary Proprietary trading trading orientation orientation
In a vertically integrated dealing room, source of profits generally, is more from
proprietary trading than customer deals

Cash markets for most instruments are commoditized in most cases. Hence, the
spread that banks can hope to earn is small

Winning in a commoditized market often means being very aggressive in terms
of the bid/offer price, in an attempt to get the dominant amount of flow

T R E A S U R Y
Institutions that have a spotty track record in terms of recommending products
that make money for their clients find that they cannot afford to charge hefty spreads
Institutions organized by asset class are generally not the ones providing
T Y P I C AL
consistently well planned ideas and strategies

Money is made on Volume
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14
Horizontally integrated treasury business model

Focus Focus on on customer customer deals deals
Typically bid/offer spreads are proportional to complexity and service rendered Highly structured products command hefty spreads, in part because of difficulty
in hedging them and lesser competition due to increased sophistication required

Investors do not mind paying for competence/sophistication if it is consistently
good, and prefer to deal with functionally-oriented treasuries

In the case where the dealing room is organized by function, engine of
T R E A S U R Y
profitability is customer transaction on the more complex products

In a Treasury organized along functional lines, money is made by executing a
small number of lucrative deals

A treasury which generates bulk of its revenues from customer trades, on
T Y P I C AL
average, would be more consistently profitable than a treasury with a proprietary trading orientation
VAIDYA NATHAN
15
Agenda
Page

B A N KI N G
1 4 8 16
Understanding a typical treasury Market overview of asset classes

Special Focus: Structured Notes
I N V E S T M EN T
Measuring risks the metrics Case Study National Australia Bank in 2004 Future of Banking and Treasury
37 40 48
F UT U R E
O F
T R E A S U R Y
I N
VAIDYA NATHAN
16
Treasury is in the business of taking risk

Overview Overview of of asset asset classes classes that that they they deal deal in in
Treasuries predominantly have exposure to market and credit risk They also have liquidity, legal & operational risks which can be perilous if not
managed well. A case study in the latter part of presentation highlights these risks
To understand better the asset classes that Treasuries deal in, lets preview the
global capital markets and understand how the risks are split
C L A S S E S
OTC products have been a good source of income for Treasuries Except for structured notes, risks are split across a large number of market
MAR K E T
O V E RVI E W
O F
A S S E T
participants
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17
International Debt Securities Market

All All Countries Countries total total outstanding outstanding (US$ (US$ bn) bn)
3,500
United States
Germany
Italy
Japan
United Kingdom
France
Canada
All Countries
14,000 12,332
3,000
12,000
2,500
10,274 8,618
10,000
2,000 6,867 1,500 4,757 5,829
8,000
6,000
C L A S S E S
1,000
4,000
500
2,000
0 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04
A S S E T
Fixed Income market is one of the largest markets in terms of outstanding notional of
O F
securities though a large segment of the market is not traded actively

US - biggest market. Extremely liquid markets in Treasury, Agencies & Corporate bonds FI markets typically, not as volatile as fx or equity markets. They tend to be more trending In the last couple of years, Treasuries have made money on roll-down of the yield curve
MAR K E T
O V E RVI E W
some value transfer from governments & corporates to banks

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Classification of Debt Securities Market

(US$ bn) TOTAL ISSUES FLOATING RATE US dollar Euro Yen Pound sterling Financial institutions Governments International organisations Corporate issuers
C L A S S E S
Jun-98 3,647 809.8 494.5 153 65.7 80 687.4 57.8 25.8 38.8 2,647.1 1,072.7 794.3 317.3 212.2 110.8 1,421.1 482.4 298.3 445.4
Jun-99 4,472.9 1,019.9 586.6 249.8 81.3 84.4 900.8 58.6 23.3 37.2 3,233.8 1,427.7 954.4 330 256 116.6 1,833.3 521.7 340.2 538.6
Jun-00 5,416.1 1,321.9 715.9 394.9 91.9 98.5 1,185 55.5 21.7 59.7 3,858.9 1,785.6 1,140.6 383.1 290.7 111.3 2,311.7 567.1 349.8 630.3
Jun-01 6,419.3 1,613 855.1 531.8 92.4 110.3 1,459.6 52.4 18.1 82.9 4,556.5 2,322.1 1333 320.3 335.7 102.3 2852 598.4 344.3 761.8
Jun-02 8,194.4 2,071.7 947.1 847.1 104.9 139.3 1,911.6 53.3 19.7 87 5,815.3 2,820.4 1,964.8 319.6 412.4 128.8 3,732.5 742.2 396.4 944.2
Jun-03 9,755.6 2,430 951.8 1,171.5 100.2 162.1 2,253.2 72.4 19.4 85 7,003.9 3121.1 2,702.8 306.6 495.6 144 4,559.5 928.9 455.6 1060
Jun-04 11,736 3,112.7 1,111.8 1,604.3 105.4 224.5 2,899.9 96.3 24.9 91.7 8,267.4 3,446.3 3,386.3 356.2 623.4 168.6 5,485.5 1,123.3 488.4 1,170.3
STRAIGHT FIXED RATE US dollar Euro Yen Pound sterling Swiss franc Financial institutions Governments International organisations Corporate issuers
MAR K E T
O V E RVI E W
O F
A S S E T
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Asian Fixed Income Markets

Term Term structure structure of of Korea Korea Treasury Treasury Bonds Bonds Term Term structure structure of of Singapore Singapore Govt Govt Bonds Bonds Hong Hong Kong Kong exchange exchange fund fund notes notes
Term Term structure structure of of Taiwan Taiwan Govt Govt Bonds Bonds
Term Term structure structure of of China China Govt Govt Bonds Bonds
Term Term structure structure of of Thailand Thailand Govt Govt Bonds Bonds
A S S E T
C L A S S E S
MAR K E T
O V E RVI E W
O F
Indonesian Govt Govt Bonds Bonds term term structure structure Indonesian
The The Philippines Philippines Govt Govt Bonds Bonds
Term Term structure structure of of Indian Indian Govt Govt Bonds Bonds
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20
Global Derivatives Position
O V E RVI E W
O F
A S S E T
C L A S S E S
Inspite of higher transaction cost, OTC market is more than quadruple in size to the
exchange traded
Exchange traded instruments tend to be simpler, more liquid and shorter dated than their
MAR K E T
OTC siblings
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21
Global Over-the-counter Derivatives Market
Fx contracts tend to be more volatile and create more exposure as a percentage of outstanding notional vis--vis IR contracts
MAR K E T
O V E RVI E W
O F
A S S E T
C L A S S E S
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22
OTC derivatives turnover by counterparty

2004 2004 Daily Daily Average Average Turnover Turnover (US$ (US$ bn) bn) 2001 2001 Daily Daily Average Average Turnover Turnover (US$ (US$ bn) bn)
Non FIs - Local, Non FIs International, 18, 3% Other FIs Local, 63, 11% Dealers International, Dealers - Local, 146, 26% Other FIs 96, 17% 24, 4%
Non FIs International, Non FIs - Local, 62, 5% 42, 4% Dealers - Local, 210, 18%
International,
Other FIs International, 288, 25%
209, 39%
C L A S S E S
1998 1998 Daily Daily Average Average Turnover Turnover (US$ (US$ bn) bn)
Dealers International, 345, 30% Other FIs Local, 211, 18%
Non FIs - Local 8% Other FIs International 15% Other FIs Local 15% Non FIs International 6% Dealers - Local 25%
A S S E T
O F
Dealers International 31%
O V E RVI E W
Turnover with other financial institutions rose to 43% of global OTC derivatives turnover,
up from 29% in April 2001

The decreased importance of inter-dealers relative to 2001 reflects greater use of
MAR K E T
derivatives by smaller commercial banks, mutual funds, hedge funds & insurance firms
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23
OTC Foreign Exchange Derivatives

Total Total outstanding outstanding (US$ (US$ bn) bn)
25,000
US Dollar
Canadian Dollar
Euro
Australian Dollar
Japanese Yen
Hong Kong Dollar
Pound Sterling
Other
Swiss Franc
All Currencies
24,475
20,000 18,011 16,748 15,000 15,666 14,344 18,448
10,000
C L A S S E S
5,000
A S S E T
0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03
O F
Most actively traded asset class in terms of turnover and volume of transaction Comprises four different markets Spot market, forwards, options and cross currency swaps The profits that Treasuries make from foreign exchange markets on client trades is not high
O V E RVI E W
as bid-offer spreads, especially in cash market, is negligible (in part because of e-fx)
MAR K E T
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Classification: OTC Foreign Currency Derivatives

Total Total Contracts Contracts All All Counterparties Counterparties (US$ (US$ bn) bn)
Total Contracts 25,000 20,000 15,000 10,000 5,000 0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Maturity of one year or less Maturity over 1 year and up to 5 years Maturity over 5 years 10,000 8,000 6,000 4,000 2,000 0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03
Total Total Contracts Contracts Dealers Dealers

Total Contracts Maturity of one year or less Maturity over 1 year and up to 5 years Maturity over 5 years
C L A S S E S
Forwards and and Swaps Swaps (US$ (US$ bn) bn) Forwards
Forwards and swaps 20,000 15,000 10,000 5,000 0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Maturity of one year or less Maturity over 1 year and up to 5 years Maturity over 5 years
Foreign Foreign Exchange Exchange Options Options (US$ (US$ bn) bn)
6,000 5,000 4,000 3,000 2,000 1,000 0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Options Maturity of one year or less Maturity over 1 year and up to 5 years Maturity over 5 years
O V E RVI E W
O F
A S S E T
A simple rule of thumb is that if a Bank is very active in the fx market, either as a market
maker or in taking proprietary positions, the income/loss volatility from this part of the Treasury operation would be greater as compared to a fixed-income or equity portfolio
Fx positions generally tend to be of shorter maturity than that in other asset classes. Banks
MAR K E T
dont have to warehouse the risks for too long except in structured notes like PRDCs
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Turnover - Global foreign exchange market

Average Average Daily Daily Turnover Turnover Fx Fx markets markets (US$ (US$ bn) bn)
1,000 800 600 400 200 0 Apr-89 Apr-92 Apr-95 Apr-98 Apr-01 Apr-04 Spot Transactions Outright Forwards Fx Swaps
Average Average Daily Daily Turnover Turnover Spot Spot (US$ (US$ bn) bn)
350 300 250 200 150 100 50 0 Apr-95 Apr-98 Apr-01 Apr-04 Dealers Other Fis Non-Financial Institutions
C L A S S E S
Average Daily Daily Turnover Turnover Outright Outright Forward Forward (US$ (US$ bn) bn) Average
75 60 45 30 15 0 Apr-95 Apr-98 Apr-01 Apr-04 Dealers Other Fis Non-Financial Institutions
Average Average Daily Daily Turnover Turnover Fx Fx Swaps Swaps (US$ (US$ bn) bn)
600 500 400 300 200 100 0 Apr-95 Apr-98 Apr-01 Apr-04 Dealers Other Fis Non-Financial Institutions
O V E RVI E W
O F
A S S E T
Turnover has increased in fx markets in the last three years across instruments Factors that boosted turnover include investors interest in foreign exchange as an asset
MAR K E T
class, the more active role of asset managers, and the growing importance of hedge funds
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OTC Interest Rate Derivatives (Notional outstanding)

Notional Notional outstanding outstanding (US$ (US$ bn) bn)
60,000
Euro
US Dollar
160,000
Japanese Yen
50,000
Pound Sterling
141,991
140,000
Swiss Franc
40,000
Canadian Dollar
120,000
Australian Dollar
Hong Kong Dollar

101,658
Other
30,000
All Currencies
77,568 60,091 64,668
100,000
80,000
C L A S S E S
60,000
20,000
50,015 40,000
10,000 20,000
A S S E T
O V E RVI E W
O F
After the Euro came into effect, it became the dominant currency for IRD. In Asia and
MAR K E T
America, the number and volume of Euro trades are rather low; most of the EUR IR trades are done out of London & Frankfurt
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OTC Single-Currency Interest Rate Derivatives

Notional Notional Amount Amount Total Total Contracts Contracts (US$ (US$ bn) bn)
Total Contracts 150,000 100,000 Reporting Dealers Other Financial Institutions Non-Financial Costumers 12,000 10,000 8,000 6,000 50,000 0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 4,000 2,000 0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03
Forward Forward Rate Rate Agreements Agreements (US$ (US$ bn) bn)
Forward Rate Agreements Reporting Dealers Other Financial Institutions Non-Financial Costumers
C L A S S E S
Interest Rate Rate Swaps Swaps (US$ (US$ bn) bn) Interest
120,000 100,000 80,000 60,000 40,000 20,000 0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Swaps Reporting Dealers Other Financial Institutions Non-Financial Costumers
Interest Interest Rate Rate Options Options (US$ (US$ bn) bn)
Options 20,000 15,000 10,000 5,000 0 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Reporting Dealers Other Financial Institutions Non-Financial Costumers
MAR K E T
O V E RVI E W
O F
A S S E T
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OTC Equity-linked Derivatives

Notional Notional outstanding outstanding (US$ (US$ bn) bn)
2500 US Equities Japanese Equities 2000 Latin American Equities Total Contracts 2,500 2,309 2,000 European Equities Other Asian Equities Other Equities 3,787 3,500 4,000
3,000
1500
C L A S S E S
1,809 1000 1,488
1,891
1,881
1,500
A S S E T
1,000 500 500
O F
O V E RVI E W
MAR K E T
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Equity linked Derivatives Distribution

Forwards Forwards and and Swaps Swaps (US$ (US$ bn) bn)
350 US Equities European Equities Japanese Equities 300 Other Asian Equities Latin American Equities Other Equities 250 Forwards and swaps 400 364 200 283 150 200 100 146 400 50 100 200 500 335 320 300 1200 1,944 1000 1,527 800 600 1,342 1,000 1,555 1,561 1,500 2,000 1400 500 1800 1600 600 600
Equity Equity Options Options (US$ (US$ bn) bn)

2000 US Equities European Equities Japanese Equities Other Asian Equities Latin American Equities Other Equities Total Options 2,500 3,186 3,000 3,500
O F
A S S E T
C L A S S E S
O V E RVI E W
MAR K E T
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Credit Derivatives positions

Global Global Positions Positions by by product product (US$ (US$ mm) mm)
C L A S S E S
Global Global Banks Banks Motivations Motivations
Global Global Reference Reference Entity Entity by by Type Type
MAR K E T
O V E RVI E W
O F
A S S E T
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Special Focus: Structured notes

Characteristics Characteristics of of structured structured notes notes
Broadly, a structured note is a bond (potentially, fixed rate, floating rate or
zero coupon) combined with one or more options or forwards linked to market prices or indices
They have existed for many years, but the variety of structures is almost
limitless and constant innovation, at least at levels of bells and whistles, is a feature of the market
C L A S S E S
Exotic derivatives markets have developed hand-in-hand with the production
and distribution of increasingly complex structured notes

Potentially, trading of exotic derivatives fills missing markets, leading to a
A S S E T
more efficient distribution of risk

But liquidity in structured notes markets has so far been shallow and may dry up
O F
MAR K E T
O V E RVI E W
in stressed conditions
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Risk profile of structured notes

Risk Risk management management of of structured structured notes notes
Dealers sometimes design structured notes with intention of obtaining market
risk exposures that offset existing exposures that they cannot hedge easily
For the most part, however, the pattern of issuance is driven by investor
preferences
Innovation to find new structures that attract investors is a feature of the
C L A S S E S
market, but returns to innovation dissipate quickly as new structures are matched by competitors
Though a large part of the risk can be hedged, the toxic risks largely are
A S S E T
warehoused as there exists no market to hedge them, or the bid-offers may be too wide to render hedging uneconomical
These warehoused risks may affect the long-term Treasury profits since a large
O F
MAR K E T
O V E RVI E W
proportion of structured notes tend to be long dated (10-years and above)
VAIDYA NATHAN
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Types and Asset Classes of Structured Notes
MAR K E T
O V E RVI E W
O F
A S S E T
C L A S S E S
VAIDYA NATHAN
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Case Study: Structured Notes & 1994

Would Would it it be be a a case case of of history history repeating repeating itself itself
Between September 1992 and February 1994, the US Federal Funds target rate
was 3%, and the US$ yield curve was generally upward sloping
Investors sought to enhance coupons on their investments by selling options via
structured notes, speculating that short-term rates would not rise rapidly
The Fed raised its target rate to 4.25% by June 1994 and to 5.50% by end of 1994
C L A S S E S
By summer 1994, several money market funds sustained major losses on these
investments, in some cases jeopardising the US$1 nav of the funds shares (breaking the buck)
Colorado-based Community Bankers Mutual Fund Inc., which offered a single
A S S E T
O F
institutional money market fund, had invested 27.5% of its portfolio in structured notes
Beginning in March 1994, value of these notes began to decline due to sharp
O V E RVI E W
MAR K E T
rises in interest rates. The funds nav fell to 96 cents and resulted in the liquidation of the fund in September 1994, as the sponsor of the fund could not maintain its nav above US$1
VAIDYA NATHAN
35
Case Study: Structured Notes & 1994

What What kind kind of of risks risks does does it it take take
Several sponsors that employed similar strategies were obliged to support their
funds at that time; for example, Paine Webber injected US$268.0 mm into its money market funds and BankofAmerica US$67.9 mm
Regulators responded in June by instructing money managers to plan to dispose
in an orderly manner of any holdings of notes that involved selling options

More significantly, Orange County, a district in California, declared bankruptcy
C L A S S E S
in December 1994, principally as a result of losses of more than US$1.5 bn

The investment strategy had been to enhance the relatively low short-term
A S S E T
interest rates, by speculating that these rates would continue to remain low for some time
The investment pool used leverage and invested around US$2.8 billion in
O F
O V E RVI E W
structured notes
While structured note buyers lost money, it was largely a profitable exercise for
MAR K E T
the Banks providing these structured notes. It is not unlikely that history repeats itself if the interest rate environment becomes less benign
VAIDYA NATHAN
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Agenda
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Measuring Risk the metrics

Risk Risk as as is is reported reported
Having discussed some of the instruments that get traded and warehoused, we
now turn our attention to how the risks arising from them are actually reported
Value-at-Risk: most widely used and published indicator, though woefully
incomplete measure
VaR is merely a point in time assessment taken at the same time each day They do not include intraday trading positions
M E T RI C S
VaR assumes that a position is held frozen for a period of time and estimates
loss that the positions would have at a given probability

VaR numbers represent an estimate of probability of loss under normal trading
M EA S UR I N G
RI SK S
TH E
conditions. These numbers do not estimate results during periods of illiquidity
VAIDYA NATHAN
38
Example DBS Group - Analysis on VaR

AAVaR VaRanalysis analysisusing usingaahigh highto tolow low VaR VaRratio ratiocan canindicate indicateactive active turnover turnoverof ofinventory inventorypositions positions which whichis ispreferable preferableto tolonger longer inventory inventoryholds holds Inventory Inventorycan canbecome becomequickly quickly stale staleand andsome somereluctance reluctanceat at selling sellingat ataaloss losscan cangenerate generate stale staleinventory. inventory.AAmeasure measurefor for this thiscan canbe beobtained obtainedby bydividing dividing the thehigh highVaR VaRagainst againstthe thelow lowVaR VaR in inthe thequarter quarter An Anactive activemovement movementin inaverage average VaR VaRcan canalso alsoseen seenas aspositive positive Ratio Ratioof ofnon-interest non-interestincome incometo to VaR VaRfor fortrading tradingbook bookis isaameasure measure for forquality qualityof oftrading tradingearnings. earnings.AA low lowratio ratiomay mayindicate indicateaagreater greater proportion proportionof ofprofits profitsfrom from proprietary proprietarytrading trading
M EA S UR I N G
RI SK S
TH E
M E T RI C S
VAIDYA NATHAN
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NAB: pressure on profits

The The background background
National Australia Bank (NAB), like the other three major banks in Australia, had
been in a desperate struggle to maintain its profit levels

2 0 0 4
Australian banks saw their gross incomes as a ratio of assets fall from 4.2% to
2.9% between 1993 and 2003, a faster decline than the world average
Profit margins against total assets remained steady through the 1990s only
I N
B AN K
because the banks cut costs

The deregulation of banking industry in 80s and 90s, opened Australian banks to
A U S T R A L I A
greater global competition, leading in decreased interest margins

NAB increasingly attempted to move outside its traditional Australian banking
N ATI ON AL
business by acquiring companies in the United States, Britain, Ireland and Asia
However, its expansion into the US home lending market by buying Homeside
Lending ended disastrously. NAB wrote down Homeside Lendings value by US$ 4 bn before eventually selling it in 2002
NAB suffered foreign exchange losses in 2004 due to the underlying pressure to
S T UD Y
turn to speculative activity, as profits declined from its traditional business

VAIDYA NATHAN
C AS E
41

To To put put things things in in perspective perspective
On a world scale, the daily trade in foreign exchange more than doubled
between 1990 and 2003. This has been despite the introduction of the Euro, which diminished the need for trades within much of Europe exchange scandals
2 0 0 4
The increase in speculative trading has been reflected in several foreign
B AN K
In 1999, the Barings Bank collapsed after its Singapore trader, Nick Leeson, lost US$1.3 billion in derivative trading and In 2002, Allfirst Financial, a subsidiary of Allied Irish Bank, lost US$690 million on foreign currency trades
The financial damage in the case of NAB could have been far greater, with the
A U S T R A L I A
I N
potential to trigger the worst banking crisis in Australian history
C AS E
S T UD Y
N ATI ON AL
Despite large losses, profits were reported
VAIDYA NATHAN
42

Extent Extent and and scale scale of of manipulation manipulation
Since 2001, four traders had been concealing actual profits using incorrectly recorded trades
or false trades
While the majority of losses were incurred since October 2003, there were profit
2 0 0 4
overstatements prior to this September 2001: A$ 4m; September 2002: A$ 8m; September 2003: A$42m
The NABs currency traders had breached trading limits on 800 occasions and, at one stage,
B AN K
I N
had unhedged foreign exchange exposures of more than US$1.5 bn
C AS E
S T UD Y
N ATI ON AL
A U S T R A L I A
VAIDYA NATHAN
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Reported versus actual profits

The The spoils spoils (literally) (literally)
From 1 October 2003 to 31 December 2003, the US$ exposure increased dramatically from
US$ 271mm to US$ 1,548mm. The resulting loss in December was A$49mm
From 1 January 2004 to 9 January 2004, a further A$85m of losses were incurred
2 0 0 4
On 13 January 2004 false transactions were discovered and reported. These totalled A$185m The portfolio was subsequently revalued which generated further losses of A$175m. The
I N
C AS E
S T UD Y
N ATI ON AL
A U S T R A L I A
B AN K
total loss was A$360m
VAIDYA NATHAN
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How it happened
People People Issues Issues
Traders had open contempt for controls and this was condoned by their supervisors Traders input false data into systems to manipulate profit numbers
2 0 0 4
The Traders involved were motivated, at least in part, to protect their bonuses The Traders used three methods to manipulate the system
I N
B AN K
Incorrect rates were entered into the system to move profits from one period to another taking advantage of the one-hour window Internal (false) one-sided spot trades were entered and rolled on a daily basis taking advantage of the one-hour window Internal one-sided option trades were created. These occurred only after mid October when the back office stopped matching off internal trades
C AS E
S T UD Y
N ATI ON AL
A U S T R A L I A
VAIDYA NATHAN
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How it happened
Risk Risk and and Control Control Framework Framework
Large and unusual activity was not investigated Numerous control measures were in place, but proved ineffective
2 0 0 4
Measurement systems were weak and results were largely ignored. One such measure was
C AS E
S T UD Y
N ATI ON AL
A U S T R A L I A
B AN K
I N
Value at Risk (VaR). The VaR limit for currency option trading was A$3.25mm, which meant that the ultimate loss of A$360 mm was 110 times the maximum VaR
VAIDYA NATHAN
46
How it happened
Governance Governance and and Culture Culture
Escalation through senior management to the Board was inadequate Communication was biased towards good news rather than bad news
2 0 0 4
Culturally there was a focus on process rather than substance
B AN K
I N
A U S T R A L I A
Summary Summary of of process process failures failures
Currency options trading activity lacked adequate management supervision Risk management failed There was an absence of financial controls There were significant gaps and omissions in back office procedures
C AS E
S T UD Y
N ATI ON AL
VAIDYA NATHAN
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Future Outlook
Assessing future challenges
As smaller players give competition to top houses, leaders will continue to
innovate and move up the curve

Through access to better human resources, technology & capital, leaders will
continue to push the envelope, whereas smaller banks will constantly strive to catch up
Banks that marry delivery of traditional banking products combined with good
T R E A S U R Y
treasury credentials, will have greater scope for being a one-stop-shop through increased cross-selling, in the process gaining market share
As products get more complicated litigation and arbitration costs may
increase. Arbitration may be a significant cost for private client businesses

Technology will save costs to banks and will help build better client
B A N K I N G
AN D
relationships, but it will erode profitability from plain vanilla products

Regulatory changes may negatively impact profitability. Historically, banks have
F UT U R E
O F
quickly adapted and created products to maintain high profit margins
VAIDYA NATHAN
49
Thank you for your attention
I N
I N V E S T M EN T
B A N KI N G
T R E A S U R Y
If you have any questions or clarifications, please feel free to e-mail at vaidya@athenafinance.com
F UT U R E
Additional information is available upon request. Information herein is believed to be reliable but the author does not warrant its completeness or accuracy. Data is from varied sources including among other Bank of International Settlements, International Monetary Fund, World Bank, Bank of England, Fitch & JPMorgan. Opinions and estimates constitute authors judgments and are subject to change without notice. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This presentation should not be distributed to others or replicated in any form without prior consent of the author.
O F
VAIDYA NATHAN

Future of Treasury in Investment Banking

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OCTOBER 2004