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A GlobeRisk Perspective on Investment Banking

Recent years have seen massive growth in invest banks profits driven by a unique combination of factors:

Investment banks have grown and many have outstripped the capacity of their control frameworks.

Until the second half of 2007 most firms had a large structural long position in credit assets seeking to benefit further from carry and declining spreads. Whilst July 2007 has seen some unwinding of these positions, the huge inventory across the trader/hedge fund sector means that spreads are likely to widen much further. Volatility will be the order of the day with "fear" and "greed" alternating as the primary market force

A further issue for Investment banks arises from Credit Derivatives. When these were first developed in the early 1990's they were linked to specific actual traded bond instruments and volumes were small in relation to the issued credit instrument base.

As at 2007 factors are very different:

The net impact is that banks have valuation and risk modelling issues whilst the underlying instrument market is too small to sustain significant hedging without collapse. Arguably, this effect explains much of the widening in investment grade credit spreads in June/July 2007.

The market standard for modelling basket options is to use a single factor copula model to measure the relationship between the components of the basket. This has the advantage that tranching can easily be accommodated within the model but the disadvantage that it works badly - especially for the senior or junior tranches - must inevitably respond badly to economic cycle effects

Moving to Interest Rate derivatives, the last 10 years has seen considerable progress. The Heath Jarrow Morton model is now the most widely used full term structure interest rate derivatives model in its discrete or "LIBOR model" form. More recent innovations include the BGM model which adds in mean reversion and stochastic volatility (although GlobeRisk has long held the view that stochastic volatility models do not work well preferring "jump" style models which are capable of replicating the increase in volatility smile that normally occurs as contract expiration decreases rather then the opposite effect, as generated by stochastic volatility models). The modelling technology has enabled a large increase in volume, but only at the expense of two key issues:

An older problem which continues to grow, despite the introduction of formal "day1 profit recognition standards" is that of "valuation adjustments", that is to say the adjustments that one need to make to inventory marked-to-market at mid price to deliver an overall valuation that is consistent with the firms accounting policy

To be fair many adjustments have been introduced since the early 1990's. However two major areas remain - in the context that an off balance sheet book essentially represent a future revenue stream conditional on certain management/IT/Operations "conditions" being met. These areas are

For banks with long average life derivatives portfolios, these adjustment could be very large.

GlobeRisk has developed several consultancy services to assist Investment banks as they address these issue areas

GlobeRisk has unparalleled experience in assisting banks to recover from trading disaster situations, whether structural or (more commonly) rogue trader.

In 2007 we can offer the following services: