Risk Management of U.S. Risk Management of U.S. Money Center BanksMoney Center Banks

Presented Presented by:by:

Wei Chen Wei Chen Bridge HuBridge Hu Eric Song Eric Song Jing ZhangJing ZhangYuan Su ZhiYuan Su Zhi

AgendaAgenda

Industry OverviewIndustry Overview Market DynamicsMarket Dynamics Risk Management Risk Management

EnvironmentEnvironment JP Morgan ChaseJP Morgan Chase Merrill LynchMerrill Lynch Bank of AmericaBank of America RecommendationRecommendation

Definition of Money Center BankDefinition of Money Center Bank

Money center bankMoney center bank: a large bank in a : a large bank in a major financial center which borrows from major financial center which borrows from and lends to governments, corporations, and lends to governments, corporations, and other banks, rather than consumersand other banks, rather than consumers

Market makerMarket maker: a brokerage or bank that : a brokerage or bank that maintains a firm bid and ask price in a maintains a firm bid and ask price in a given security by standing ready, willing, given security by standing ready, willing, and able to buy or sell at publicly quoted and able to buy or sell at publicly quoted prices (from their own accounts)prices (from their own accounts)

Products and ServicesProducts and Services

Personal banking Personal banking Business bankingBusiness banking Investment banking – advisory, debt and Investment banking – advisory, debt and

equity underwriting, market making, equity underwriting, market making, trading and investing of debts and trading and investing of debts and equitiesequities

Treasury and Securities Services – cash Treasury and Securities Services – cash management, institutional trust services, management, institutional trust services, treasury services, clearing servicestreasury services, clearing services

Investment management and private Investment management and private bankingbanking

Private equity – venture capitalPrivate equity – venture capital

Market DynamicsMarket Dynamics

Global money Global money center banks center banks

- market market capitalization = capitalization = 1,221B1,221B

- ROE = 16.9%ROE = 16.9%

Merrill Lynch Merrill Lynch (56B)(56B)

U.S. Money U.S. Money Center BanksCenter Banks

Market Market CapitalizationCapitalization

CitigroupCitigroup 246B246B

Bank of Bank of AmericaAmerica

114B114B

Wells FargoWells Fargo 95B95B

JP Morgan JP Morgan ChaseChase

73B73B

WachoviaWachovia 61B61B

US BankcorpUS Bankcorp 52B52B

Bank OneBank One 47B47B

Important RegulationsImportant Regulations

The The Securities Exchange ActSecurities Exchange Act - - established the Securities and Exchange established the Securities and Exchange Commission (SEC) as the primary Commission (SEC) as the primary regulator of US securities markets, regulator of US securities markets, including investment banks as well as including investment banks as well as non-banks that broker and/or deal non-non-banks that broker and/or deal non-exempt securitiesexempt securities

Financial Services Competition ActFinancial Services Competition Act in in 1999 permitted commercial banks to 1999 permitted commercial banks to have affiliated securities firmshave affiliated securities firms

Bank of International Settlements - Bank of International Settlements - Basel Basel Capital AccordCapital Accord

Financial Accounting Standards Board – Financial Accounting Standards Board – FASB Statement 133FASB Statement 133

Basel CommitteeBasel Committee

Basel Committee Basel Committee The Committee's members come from Belgium, The Committee's members come from Belgium,

Canada, France, Germany, Italy, Japan, Luxembourg, Canada, France, Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United the Netherlands, Spain, Sweden, Switzerland, United Kingdom and United States Kingdom and United States

Countries are represented by their central bank and Countries are represented by their central bank and also by the authority with formal responsibility for the also by the authority with formal responsibility for the prudential supervision of banking business where this prudential supervision of banking business where this is not the central bank. is not the central bank.

The Committee does not possess any formal The Committee does not possess any formal supranational supervisory authority supranational supervisory authority

It formulates broad supervisory standards and It formulates broad supervisory standards and guidelines and recommends statements of best guidelines and recommends statements of best practice in the expectation that individual authorities practice in the expectation that individual authorities will take steps to implement them through detailed will take steps to implement them through detailed arrangements - statutory or otherwise - which are best arrangements - statutory or otherwise - which are best suited to their own national systems suited to their own national systems

FAS 133FAS 133

Accounting for Derivative Accounting for Derivative Instruments and Hedging Instruments and Hedging Activities (1998)Activities (1998)

Result: substantially enhanced Result: substantially enhanced information about derivatives information about derivatives positions is now available in positions is now available in annual reportsannual reports

FAS 133 has been amended FAS 133 has been amended twice already, by FAS 137 and twice already, by FAS 137 and FAS 138 FAS 138

The Major Risks Banks The Major Risks Banks Face Face

1.1. Liquidity riskLiquidity risk

2.2. Interest riskInterest risk

3.3. Market riskMarket risk

4.4. Credit riskCredit risk

5.5. Off-balance sheet riskOff-balance sheet risk

6.6. Foreign exchange riskForeign exchange risk

7.7. Operating riskOperating risk

Liquidity RiskLiquidity Risk

Definition: Definition: risk of not be able to risk of not be able to honor bank’s financial honor bank’s financial commitments promptlycommitments promptly

It arises from an uncertainty of It arises from an uncertainty of the timing of cash flowsthe timing of cash flows

Liability-side risk results from Liability-side risk results from unexpectedly high rates of unexpectedly high rates of deposit redemptiondeposit redemption

Asset-side risk results from Asset-side risk results from borrowers unexpectedly drawing borrowers unexpectedly drawing down loan commitment down loan commitment

Liquidity RiskLiquidity Risk

Useful measurementsUseful measurements

The net liquidity position, which The net liquidity position, which measures sources and uses of measures sources and uses of liquidityliquidity

Peer group financial ratiosPeer group financial ratios

The financing gap, which show The financing gap, which show the degree to which loans are not the degree to which loans are not financed by core fund financed by core fund

Liquidity Risk Liquidity Risk ManagementManagement

The fundamental dilemma The fundamental dilemma of liquidity risk managementof liquidity risk management

low yield of reserve assetslow yield of reserve assets Liquidating investment Liquidating investment

Liquidity Risk Liquidity Risk ManagementManagement

Liquidity risk management is Liquidity risk management is carriedcarried

out at both the retail and wholesaleout at both the retail and wholesale

levellevel

1.1. Demand depositDemand deposit

2.2. Term depositTerm deposit

3.3. Purchased moneyPurchased money

4.4. Interbank borrowing Interbank borrowing

5.5. ReposRepos

Interest RiskInterest Risk

Definition: Definition: is the impact on is the impact on banks earnings and market banks earnings and market value of equity of changes in value of equity of changes in interest ratesinterest rates

Refinancing riskRefinancing risk

Reinvestment risk Reinvestment risk

Interest Risk Interest Risk (measurements)(measurements)

Gap analysisGap analysis

Duration analysisDuration analysis

Simulation modelSimulation model

Interest Risk Interest Risk ManagementManagement Matching average life of assets Matching average life of assets

and liabilities reduces interest and liabilities reduces interest rate risk, but it is not perfect rate risk, but it is not perfect hedgehedge

Immunization requires dynamic Immunization requires dynamic rebalancing of the portfolio, rebalancing of the portfolio, which may be costlywhich may be costly

To immunize the equity, set the To immunize the equity, set the leverageleverage adjusted duration adjusted duration gap to zerogap to zero

Market RiskMarket Risk

DefinitionDefinition: the: the risk of bank risk of bank losses from movement of losses from movement of market prices on its trading market prices on its trading inventoryinventory

Market Risk Market Risk MeasurementMeasurement Two ways to measureTwo ways to measure

Value-at-cost models (VAR)Value-at-cost models (VAR)

The BIS standardized The BIS standardized measurement method measurement method

Credit RiskCredit Risk

DefinitionDefinition: the risk of loss : the risk of loss due to the failure of a due to the failure of a borrower, endorser, borrower, endorser, guarantor or counterparty to guarantor or counterparty to repay a loan or honor repay a loan or honor another predetermined another predetermined financial obligationfinancial obligation

Credit Risk Credit Risk MeasurementMeasurement Traditional approachTraditional approach

Quantitative approachQuantitative approach

Credit Risk ManagementCredit Risk Management

Available collaterals Available collaterals

Customers creditworthiness Customers creditworthiness

Off-balance Sheet RiskOff-balance Sheet Risk

Definition of off-balance sheet Definition of off-balance sheet activities:activities: activities that do not activities that do not appear on the current balance appear on the current balance sheet because it does not concern sheet because it does not concern holding a currency primary holding a currency primary claim(asset) or issuing a current claim(asset) or issuing a current secondary(liability)secondary(liability)

Two categories: 1) Credit Two categories: 1) Credit substitutessubstitutes

2) Derivatives2) Derivatives

Foreign Exchange RiskForeign Exchange Risk

The potential adverse The potential adverse impact on a bank’s earning impact on a bank’s earning and value of its equity from and value of its equity from foreign exchange rate foreign exchange rate movement movement 

Operating RiskOperating Risk

It is business risk which It is business risk which includes organizational includes organizational behavior, technological behavior, technological systems and legal aspects systems and legal aspects of managing a bankof managing a bank

About JP Morgan ChaseAbout JP Morgan Chase Leading global financial services firm with Leading global financial services firm with

operations in more than 50 countriesoperations in more than 50 countries The merger of The Chase Manhattan The merger of The Chase Manhattan

Corporation and J.P. Morgan & Co. Incorporated Corporation and J.P. Morgan & Co. Incorporated was completed in December 2000was completed in December 2000

Assets of $793 billion; component of DJIAAssets of $793 billion; component of DJIA No. 1 in global syndicated loans and asset No. 1 in global syndicated loans and asset

backed securitiesbacked securities No. 1 private bank in the U.S. No. 1 private bank in the U.S. No. 5 in global M&ANo. 5 in global M&A No. 1 in U.S. dollar clearing and commercial No. 1 in U.S. dollar clearing and commercial

paymentspayments No. 4 originator of residential mortgage loans in No. 4 originator of residential mortgage loans in

the U.S.the U.S. Fourth largest domestic credit card issuerFourth largest domestic credit card issuer

Industry Standing

Five Business SegmentsFive Business Segments

Investment Bank Investment Bank Investment Management & Private Investment Management & Private

banking banking Treasury & Securities Services Treasury & Securities Services JPMorgan PartnersJPMorgan Partners Chase Financial ServicesChase Financial Services

Two BrandsTwo Brands

JPMorganJPMorgan Investment bank, research, private Investment bank, research, private

equity, treasury and securities equity, treasury and securities services, asset management, private services, asset management, private bankingbanking

ChaseChase Auto loans, checking, credit cards, Auto loans, checking, credit cards,

education loans, home equity, education loans, home equity, investments, mortgage, online investments, mortgage, online services, savings, insuranceservices, savings, insurance

Revenue StructureRevenue Structure

Business segment: 44% of total Business segment: 44% of total revenue from fixed income revenue from fixed income capital marketscapital markets

Client segment: 50% of total Client segment: 50% of total revenue from financial revenue from financial institutionsinstitutions

Geographic region: 59% of total Geographic region: 59% of total revenue from North America revenue from North America

Revenue Structure

Risk Management StructureRisk Management Structure

Risk Policy Committee of Board of Risk Policy Committee of Board of DirectorsDirectors – oversees risk – oversees risk managementmanagement

Capital CommitteeCapital Committee – deal with firm- – deal with firm-wide capital planning, internal capital wide capital planning, internal capital allocation, and liquidity managementallocation, and liquidity management

Risk Management CommitteeRisk Management Committee – – deal with credit risk, market risk, deal with credit risk, market risk, operational risk, private equity risk, operational risk, private equity risk, and fiduciary riskand fiduciary risk

Risk Management Structure

Capital ManagementCapital Management

Economic risk capitalEconomic risk capital: assess : assess capital adequacy utilizing internal risk capital adequacy utilizing internal risk methodologiesmethodologies

The methodology quantifies credit, The methodology quantifies credit, market, and operating risk (and market, and operating risk (and private equity risk for its private private equity risk for its private equity business) for each business, equity business) for each business, and assigns capital accordinglyand assigns capital accordingly

Liquidity ManagementLiquidity Management Utilize liquidity monitoring tools through normal Utilize liquidity monitoring tools through normal

and stress periodsand stress periods Analytics rely on management’s judgment about Analytics rely on management’s judgment about

ability to liquidate assets or use them as ability to liquidate assets or use them as collateral for borrowingscollateral for borrowings

Three primary measures of liquidity: holding Three primary measures of liquidity: holding company short-term surplus, cash capital company short-term surplus, cash capital surplus, and basic surplussurplus, and basic surplus

Derivatives: enter into derivative contracts to Derivatives: enter into derivative contracts to swap fixed-rate debt to floating-rate obligations swap fixed-rate debt to floating-rate obligations and vice versaand vice versa

Funding plan: use a variety of both short-term Funding plan: use a variety of both short-term and long-term instruments (including deposits, and long-term instruments (including deposits, federal funds purchased, repurchase federal funds purchased, repurchase agreements, commercial paper, bank notes, agreements, commercial paper, bank notes, medium- and long-term debt, capital securities medium- and long-term debt, capital securities and stockholders’ equity)and stockholders’ equity)

Credit Ratings for Funding Plan

Off-balance Sheet ArrangementsOff-balance Sheet Arrangements

Report off-balance sheet obligations Report off-balance sheet obligations and commitmentsand commitments

Special-purpose entities (or special-Special-purpose entities (or special-purpose vehicles)purpose vehicles)

SPE involves a company selling assets SPE involves a company selling assets to the SPE, which funds the purchase to the SPE, which funds the purchase by selling securities to investorsby selling securities to investors

Critical to markets such as mortgage-Critical to markets such as mortgage-backed securities, asset-backed backed securities, asset-backed securities, and commercial papersecurities, and commercial paper

Off Balance-sheet Obligations and Commitments

Credit Risk Credit Risk ManagementManagement

Ensure that credit risks are accurately Ensure that credit risks are accurately assessed, properly approved, continually assessed, properly approved, continually monitored and actively managedmonitored and actively managed

Assess on- or off-balance sheet Assess on- or off-balance sheet exposures including loans, derivative exposures including loans, derivative receivables and lending-related receivables and lending-related commitmentscommitments

To measure these risks, estimates are To measure these risks, estimates are made of both expected and unexpected made of both expected and unexpected losses for each segment of the portfolio losses for each segment of the portfolio using statistical techniquesusing statistical techniques

Two functions: Two functions: Credit Risk PolicyCredit Risk Policy and and Global Credit ManagementGlobal Credit Management

Credit Risk PolicyCredit Risk Policy

Formulate credit policies, limits, Formulate credit policies, limits, allowance adequacy and guidelinesallowance adequacy and guidelines

Independent from the groups that Independent from the groups that approve and support credit activitiesapprove and support credit activities

Manage problem creditsManage problem credits

Global Credit ManagementGlobal Credit Management

Three functions: Three functions: Credit Risk Credit Risk ManagementManagement, , Corporate BankingCorporate Banking, , and the and the Credit Portfolio GroupCredit Portfolio Group

The first two participate in client The first two participate in client coverage, are responsible for coverage, are responsible for approving and monitoring all credit approving and monitoring all credit exposures exposures

The last one manages the firm’s The last one manages the firm’s credit exposures resulting from both credit exposures resulting from both traditional lending and derivative traditional lending and derivative trading activitiestrading activities

Credit Portfolio

Commercial Portfolio

Consumer Portfolio

Credit Management in DerivativesCredit Management in Derivatives Use the same credit risk management Use the same credit risk management

procedures to assess and approve procedures to assess and approve potential credit exposures when potential credit exposures when entering into derivative transactions entering into derivative transactions as those used for traditional lendingas those used for traditional lending

Use Use mark-to-marketmark-to-market value of the value of the contract, or the cost to replace the contract, or the cost to replace the contracts at current market rates contracts at current market rates should the counterparty default, to should the counterparty default, to measure credit risk exposuremeasure credit risk exposure

Dynamic management: adjust and Dynamic management: adjust and rebalance hedges as market rebalance hedges as market conditions change, such as conditions change, such as counterparty’s credit qualitycounterparty’s credit quality

Mark-to-market Fair Value of Derivative Contracts

Risk Profile of Derivative Receivables

Use of Credit Derivatives

Allowance for Credit LossesAllowance for Credit Losses

Intended to cover probable credit Intended to cover probable credit losseslosses

The Risk Management Committee The Risk Management Committee reviews the allowance for credit reviews the allowance for credit losses relative to the risk profile of losses relative to the risk profile of the firm’s credit portfolio and current the firm’s credit portfolio and current economic conditions, and adjusts it economic conditions, and adjusts it accordinglyaccordingly

Summary of Allowance and Provision for Credit Losses

Market Risk ManagementMarket Risk Management

Corporate function: identify, measure, Corporate function: identify, measure, monitor and control market riskmonitor and control market risk

Seek to facilitate efficient risk/return Seek to facilitate efficient risk/return decisions and to reduce volatility in decisions and to reduce volatility in operating performanceoperating performance

Individual coverage teams are Individual coverage teams are assigned to particular businesses assigned to particular businesses where they have expertise in the where they have expertise in the specific types of riskspecific types of risk

Market Risk MeasurementMarket Risk Measurement

Statistical risk measures:Statistical risk measures:

1.1. Value-at-Risk (VAR)Value-at-Risk (VAR)

2.2. Risk identification for large Risk identification for large exposures (RIFLE)exposures (RIFLE)

Nonstatistical risk measures:Nonstatistical risk measures:

1.1. Economic value stress testsEconomic value stress tests

2.2. Net interest income stress testsNet interest income stress tests

3.3. Other measures of position size and Other measures of position size and sensitivity to market movessensitivity to market moves

Value-at-RiskValue-at-Risk Measure the dollar amount of potential Measure the dollar amount of potential

loss from adverse market moves in an loss from adverse market moves in an ordinary market environmentordinary market environment

Used to compare risks across Used to compare risks across businesses, to monitor limits and to businesses, to monitor limits and to allocate economic capitalallocate economic capital

Back-testing of VAR against actual Back-testing of VAR against actual financial results to evaluate the financial results to evaluate the soundness of the modelsoundness of the model

Stress-testingStress-testing: capture exposure to : capture exposure to unlikely but plausible events in unlikely but plausible events in abnormalabnormal markets (VAR – loss due to markets (VAR – loss due to unlikely events in unlikely events in normalnormal markets) markets)

VAR and stress-testing are important VAR and stress-testing are important determinants in capital allocation for determinants in capital allocation for market riskmarket risk

Value-at-Risk: Aggregate Portfolio

Daily Market Risk-related Losses VS. VAR

Market Risk Monitoring Market Risk Monitoring andand Control Control

LimitsLimits – examine factors such as market – examine factors such as market volatility, product liquidity, business volatility, product liquidity, business track record, and managementtrack record, and management

Qualitative risk managementQualitative risk management – – review business strategy, market review business strategy, market conditions, product details and conditions, product details and effectiveness of risk controlseffectiveness of risk controls

Model reviewModel review – review risk models to – review risk models to assess appropriateness and consistency assess appropriateness and consistency across businessesacross businesses

Policies and proceduresPolicies and procedures – specify a – specify a clear set of objectives, responsibilities, clear set of objectives, responsibilities, and proceduresand procedures

Operational Risk ManagementOperational Risk Management

Maintain a system of comprehensive Maintain a system of comprehensive policies and a control framework policies and a control framework designed to provide a sound and well-designed to provide a sound and well-controlled operational environmentcontrolled operational environment

Reputational riskReputational risk: during 2002, the : during 2002, the firm put in place an additional firm put in place an additional structure to take account of the structure to take account of the potential for adverse reputational potential for adverse reputational impact of transactions with clients, impact of transactions with clients, especially complex derivatives and especially complex derivatives and structured finance transactionsstructured finance transactions

Operational Risk Management PracticesOperational Risk Management Practices

Governance structureGovernance structure- Operational risk policies and proceduresOperational risk policies and procedures- Operational Risk CommitteeOperational Risk Committee- Business Control CommitteesBusiness Control Committees Self-assessment processSelf-assessment process- Focused on business-specific key risks and Focused on business-specific key risks and

controlscontrols- Automated using Horizon software applicationAutomated using Horizon software application- Develop and monitor action plansDevelop and monitor action plans Operational risk event monitoringOperational risk event monitoring- Internal error and loss data reported and Internal error and loss data reported and

analyzed to determine causal effectsanalyzed to determine causal effects- Enables comparative analysis with external Enables comparative analysis with external

datadata Alignment with internal audit activitiesAlignment with internal audit activities New capital allocation methodology New capital allocation methodology

(2003 Implementation)(2003 Implementation)

Merrill Lynch

Company OverviewCompany Overview

Merrill Lynch: Merrill Lynch: One of the world's leading financial One of the world's leading financial management and advisory companies, management and advisory companies, with offices in 36 countries and private with offices in 36 countries and private client assets of approximately $1.1 client assets of approximately $1.1 trillion. As an investment bank, it is a trillion. As an investment bank, it is a leading global underwriter of debt and leading global underwriter of debt and equity securities and strategic advisor equity securities and strategic advisor to corporations, governments, to corporations, governments, institutions and individuals worldwide. institutions and individuals worldwide. Through Merrill Lynch Investment Through Merrill Lynch Investment Managers, the company is one of the Managers, the company is one of the world's largest managers of financial world's largest managers of financial assets.assets.

Risk Management Risk Management PhilosophyPhilosophy Risk-taking is an integral part of Risk-taking is an integral part of

Merrill Lynch’s core business Merrill Lynch’s core business activities. activities.

In the course of conducting its In the course of conducting its business operations, Merrill Lynch is business operations, Merrill Lynch is exposed to a variety of risks exposed to a variety of risks including market, credit, liquidity, including market, credit, liquidity, operational, and other risks that are operational, and other risks that are material and require comprehensive material and require comprehensive controls and ongoing management.controls and ongoing management.

The Corporate Risk Management The Corporate Risk Management (“CRM”) group, along with other (“CRM”) group, along with other control units, works to ensure that control units, works to ensure that these risks are properly identified, these risks are properly identified, monitored, and managed throughout monitored, and managed throughout Merrill Lynch.Merrill Lynch.

Corporate Risk Management Corporate Risk Management ProcessProcess

A formal risk governance organization A formal risk governance organization that defines the oversight process that defines the oversight process and its componentsand its components

A regular review of the entire risk A regular review of the entire risk management process by the Audit management process by the Audit Committee of the Board of DirectorsCommittee of the Board of Directors

Clearly defined risk management Clearly defined risk management policies and procedures supported by policies and procedures supported by a rigorous analytical framework;a rigorous analytical framework;

Corporate Risk Corporate Risk Management Process - contManagement Process - cont

Communication and coordination between Communication and coordination between the business, executive, and risk functions the business, executive, and risk functions while maintaining strict segregation of while maintaining strict segregation of responsibilities, controls, and oversightresponsibilities, controls, and oversight

Clearly articulated risk tolerance levels as Clearly articulated risk tolerance levels as

defined by a group composed of defined by a group composed of executive management (“the executive management (“the Management Group”) which are regularly Management Group”) which are regularly reviewed to ensure that Merrill Lynch’s reviewed to ensure that Merrill Lynch’s risk-taking is consistent with its business risk-taking is consistent with its business strategy, capital structure, and current strategy, capital structure, and current and anticipated market conditions.and anticipated market conditions.

Risk Governance StructureRisk Governance Structure

Merrill Lynch’s risk governance Merrill Lynch’s risk governance

structure is comprised of the structure is comprised of the Audit CommitteeAudit Committee, the , the Management GroupManagement Group, the Risk , the Risk Oversight Committee (“Oversight Committee (“ROCROC”), ”), the the business unitsbusiness units, , CRMCRM, and , and various corporate various corporate governance committeesgovernance committees. .

Risk Governance StructureRisk Governance Structure

The Audit CommitteeThe Audit Committee The Management Group The Management Group The ROCThe ROC Various other governance Various other governance

committeescommittees

Corporate Risk Corporate Risk ManagementManagement CRM is an independent control CRM is an independent control

function responsible for Merrill function responsible for Merrill Lynch’s market and credit risk Lynch’s market and credit risk management processes both management processes both within and across the firm’s within and across the firm’s business unitsbusiness units

The co-heads of The co-heads of Risk management Risk management joined by other units such as joined by other units such as Finance and Legal Corporate AuditFinance and Legal Corporate Audit

RisksRisks

Market riskMarket risk Credit riskCredit risk Operational riskOperational risk Liquidity riskLiquidity risk

Market Risk (VaR)Market Risk (VaR) TradingTrading

Market Risk (VaR)Market Risk (VaR) Non-tradingNon-trading

Credit Risk Credit Risk ManagementManagement CRM’s Credit Risk Group assesses CRM’s Credit Risk Group assesses

the creditworthinessthe creditworthiness

Credit risk mitigation techniques Credit risk mitigation techniques include the right to require initial include the right to require initial collateral or margin, the right to collateral or margin, the right to terminate transactions or obtain terminate transactions or obtain collateral should unfavorable events collateral should unfavorable events occur, the right to call for collateral occur, the right to call for collateral when certain exposure thresholds when certain exposure thresholds are exceeded, and the purchase of are exceeded, and the purchase of credit default protection. credit default protection.

Credit Risk Credit Risk ManagementManagement

Merrill Lynch enters into Merrill Lynch enters into International Swaps and Derivatives International Swaps and Derivatives Association, Inc. master agreements Association, Inc. master agreements or their equivalent (“master netting or their equivalent (“master netting agreements”) with substantially all agreements”) with substantially all of its derivative counterparties as of its derivative counterparties as soon as possible. The agreements soon as possible. The agreements are negotiated with each are negotiated with each counterparty and are complex in counterparty and are complex in nature.nature.

Credit Risk Credit Risk ManagementManagement In addition, to reduce default risk, In addition, to reduce default risk,

Merrill Lynch requires collateral, Merrill Lynch requires collateral, principally cash and U.S. principally cash and U.S. Government and agency Government and agency securities, on certain derivative securities, on certain derivative transactions. transactions.

To further mitigate its default risk To further mitigate its default risk on derivatives whenever possible on derivatives whenever possible by entering into transactions with by entering into transactions with provisions that enable Merrill provisions that enable Merrill Lynch to terminate or reset the Lynch to terminate or reset the terms of its derivative contracts.terms of its derivative contracts.

• Credit exposure from derivative transactions

Credit Risk Management

Operational RiskOperational Risk

Maintaining a comprehensive Maintaining a comprehensive system of internal controlssystem of internal controls

Using technology to Using technology to automate processes and automate processes and reduce manual errors, reduce manual errors, monitoring risk events,monitoring risk events,

Employing experienced Employing experienced personnelpersonnel

Operational Risk - contOperational Risk - cont

Monitoring business activities Monitoring business activities by compliance professionalsby compliance professionals

Maintaining fully operational, Maintaining fully operational, off-site backup facilities, off-site backup facilities, conducting internal audits, conducting internal audits, requiring educationrequiring education

Training of employees, and Training of employees, and emphasizing the importance emphasizing the importance of management oversight. of management oversight.

Liquidity RisksLiquidity Risks

Liquidity risks include both Liquidity risks include both being unable to raise being unable to raise funding with appropriate funding with appropriate maturity and interest rate maturity and interest rate characteristics or being characteristics or being unable to liquidate an asset unable to liquidate an asset in a timely manner at a in a timely manner at a reasonable price. reasonable price.

Liquidity Risks Liquidity Risks ManagementManagement

Maintain appropriate mix of short- Maintain appropriate mix of short- and long-term capitaland long-term capital

Maintain sufficient alternative Maintain sufficient alternative funding sourcesfunding sources

Concentrate unsecured financing Concentrate unsecured financing at ML & Co.at ML & Co.

Diversify unsecured funding Diversify unsecured funding sourcessources

Adhere to prudent governance Adhere to prudent governance processesprocesses

Non-Investment Grade Non-Investment Grade Holdings andHoldings andHighly Leveraged TransactionsHighly Leveraged Transactions(high-risk assets)(high-risk assets) Non-investment grade Non-investment grade

holdings holdings have been defined as have been defined as debt and preferred equity debt and preferred equity securities rated as BB+ or lower or securities rated as BB+ or lower or equivalent ratings by recognized equivalent ratings by recognized credit rating agencies, sovereign credit rating agencies, sovereign debt in emerging markets, debt in emerging markets, amounts due under derivative amounts due under derivative contracts from non-investment contracts from non-investment grade counterparties, and other grade counterparties, and other instruments that, in the opinion of instruments that, in the opinion of management, are non-investment management, are non-investment grade.grade.

Trading ExposuresTrading Exposures

Non-Trading ExposuresNon-Trading Exposures

Valuation of Financial Valuation of Financial InstrumentsInstruments

Fair values for exchange Fair values for exchange traded securities and certain traded securities and certain exchange-traded derivatives, exchange-traded derivatives, principally futures and principally futures and certain options, are based on certain options, are based on quoted market prices.quoted market prices.

Valuation of Financial Valuation of Financial Instruments - contInstruments - cont

Fair values for OTC derivative Fair values for OTC derivative financial instruments, which financial instruments, which represent amounts estimated to represent amounts estimated to be received from or paid to a third be received from or paid to a third party in settlement of these party in settlement of these instruments, are valued using instruments, are valued using pricing models based on the NPV pricing models based on the NPV of estimated future cash flows, of estimated future cash flows, and directly observed prices from and directly observed prices from exchange-traded derivatives, exchange-traded derivatives, other OTC trades, or external other OTC trades, or external pricing services. pricing services.

Categorized Categorized AssetsAssets

1.1. Highly liquid cash and derivative Highly liquid cash and derivative instruments for which quoted market instruments for which quoted market prices are readily availableprices are readily available

2.2. Liquid instruments Liquid instruments

3.3. Less liquid instruments that are priced Less liquid instruments that are priced using management’s best estimate of using management’s best estimate of fair value, and instruments which are fair value, and instruments which are valued using a model, where either valued using a model, where either the inputs to the model and/or the the inputs to the model and/or the models themselves require significant models themselves require significant judgment by managementjudgment by management

Special Purpose Entities Special Purpose Entities (“SPEs”)(“SPEs”)

SPEs are trusts, partnerships, or SPEs are trusts, partnerships, or corporations established for a corporations established for a particular limited purpose. particular limited purpose. Merrill Lynch engages in Merrill Lynch engages in transactions with SPEs for a transactions with SPEs for a variety of reasons. Many of variety of reasons. Many of these SPEs are used to facilitate these SPEs are used to facilitate the securitization of client the securitization of client assets whereby mortgages, assets whereby mortgages, loans or other assets owned by loans or other assets owned by clients are transformed into clients are transformed into securities (“securitized”). securities (“securitized”).

Company OverviewCompany Overview

No. 2 in U.S. in terms of No. 2 in U.S. in terms of revenuesrevenues

No. 2 in U.S. in terms of assetsNo. 2 in U.S. in terms of assets No. 3 debt arranger (underwriter) of No. 3 debt arranger (underwriter) of

global loans, international bonds, global loans, international bonds, and medium-term notes.and medium-term notes.

More than 100,000 Bank of More than 100,000 Bank of America associates provide America associates provide financial products, servicesfinancial products, services

Cont’dCont’d

Their consumer and commercial Their consumer and commercial banking operations serve more than banking operations serve more than one in four households in the United one in four households in the United StatesStates

Bank of America is U.S.’s No. 1 Bank of America is U.S.’s No. 1 small business lendersmall business lender

Bank of America Investment Bank of America Investment Services Inc., offers more than Services Inc., offers more than 820,000 account holders for wealth 820,000 account holders for wealth managementmanagement

Risk Management Risk Management OverviewOverview

Corporate Governance StructureCorporate Governance Structure

-Liquidity-Liquidity

-Credit-Credit

-Market-Market

-Operational-Operational

Governance StructureGovernance Structure

Begins with Board of Directors. Begins with Board of Directors. The Board of Directors evaluates The Board of Directors evaluates risk through the Chief Executive risk through the Chief Executive Officer (CEO) and three Board Officer (CEO) and three Board committees:committees:--Finance Committee reviews market, Finance Committee reviews market, credit, liquidity and operational riskcredit, liquidity and operational risk-Asset Quality Committee reviews -Asset Quality Committee reviews credit riskcredit risk-Audit Committee reviews scope and -Audit Committee reviews scope and coverage of external and corporate coverage of external and corporate audit activitiesaudit activities

Three Lines of DefenseThree Lines of Defense

Lines of businessLines of business Risk management joined by Risk management joined by

other units such as Finance and other units such as Finance and LegalLegal

Corporate AuditCorporate Audit

Senior Management Senior Management CommitteesCommittees The Risk and Capital The Risk and Capital

Committee (RCC)Committee (RCC) The Asset and Liability The Asset and Liability

Committee (ALCO)Committee (ALCO) The Credit Risk Committee The Credit Risk Committee

(CRC)(CRC)

Liquidity Risk Liquidity Risk ManagementManagement

Two primary levels:Two primary levels:

-parent company-parent company

-banking subsidiaries-banking subsidiaries

Finance CommitteeFinance Committee is is responsible for establishing the responsible for establishing the liquidity policy as well as liquidity policy as well as approving operating and approving operating and contingency procedures and contingency procedures and monitoring liquidity on an monitoring liquidity on an ongoing basisongoing basis

Parent company:Parent company:--Source: dividends received from its Source: dividends received from its banking subsidiaries and proceeds banking subsidiaries and proceeds from the issuance of senior and from the issuance of senior and subordinated debt, commercial paper subordinated debt, commercial paper and equityand equity

-Uses: repayment of maturing debt -Uses: repayment of maturing debt and commercial paper, share and commercial paper, share repurchases,dividends paid to repurchases,dividends paid to shareholders and subsidiary funding.shareholders and subsidiary funding.

Primary measure: Primary measure: Time to Time to required fundingrequired funding

Banking subsidiariesBanking subsidiaries::--Source: Source: customer deposits, customer deposits, wholesale funding and asset wholesale funding and asset securitizations and salessecuritizations and sales-Uses: repayment of maturing -Uses: repayment of maturing obligations and growth in the core obligations and growth in the core and discretionary asset portfolios, and discretionary asset portfolios, including loan demand. Discretionary including loan demand. Discretionary portfolio consists of securities, portfolio consists of securities, certain residential mortgages held certain residential mortgages held for asset and liability management for asset and liability management purposes, and our swap portfoliopurposes, and our swap portfolio

ALCO regularly reviews the funding ALCO regularly reviews the funding plan for the banking subsidiaries and plan for the banking subsidiaries and focuses on maintaining prudent focuses on maintaining prudent levels of wholesale borrowinglevels of wholesale borrowing

Credit RatingCredit Rating

Balance SheetBalance Sheet

Deposits and Other funding Deposits and Other funding SourcesSources

Off-Balance Sheet Financing Off-Balance Sheet Financing EntitiesEntities

Facilitate customers’ access to Facilitate customers’ access to the commercial paper marketsthe commercial paper markets

Receive fees for providing Receive fees for providing combinations of liquidity, standby combinations of liquidity, standby letters of credit (SBLCs) or similar letters of credit (SBLCs) or similar loss protection commitments, and loss protection commitments, and derivatives to the commercial derivatives to the commercial paper financing entitiespaper financing entities

In January 2003, the FASB issued In January 2003, the FASB issued a new rule that addresses off-a new rule that addresses off-balance sheet financing entitiesbalance sheet financing entities

Capital ManagementCapital Management

Shares issued under employee Shares issued under employee plans and unrealized gains on plans and unrealized gains on securitiessecurities

These increases were offset by These increases were offset by share repurchases and share repurchases and dividends paiddividends paid

On October 23, 2002, the Board On October 23, 2002, the Board approved a $0.04 per share, or approved a $0.04 per share, or seven percent, increase in the seven percent, increase in the quarterly common dividend.quarterly common dividend.

Credit Risk Credit Risk ManagementManagement

Commercial Portfolio Credit Commercial Portfolio Credit Risk ManagementRisk Management

-Assessment of the credit risk profile of -Assessment of the credit risk profile of an individual borroweran individual borrower

-Risk rating-Risk rating Consumer Portfolio Credit Risk Consumer Portfolio Credit Risk

ManagementManagement

-Statistical techniques are used-Statistical techniques are used

-Statistical models are built using -Statistical models are built using detailed behavioral and demographic detailed behavioral and demographic informationinformation

Outstanding Loans and Outstanding Loans and LeasesLeases

Nonperforming Assets and Nonperforming Assets and Net Charge-offsNet Charge-offs

Routinely review the loan and Routinely review the loan and lease portfoliolease portfolio

These losses resulted from a These losses resulted from a multitude of factors:business multitude of factors:business failures as a result of financial failures as a result of financial reporting fraud, the prolonged reporting fraud, the prolonged weak economic environment weak economic environment and industry specific issues. and industry specific issues.

Nonperforming Assets

Nonperforming Assets Activity

Conduct periodic and Conduct periodic and systematic detailed reviewssystematic detailed reviews

The allowance for credit The allowance for credit losses represents losses represents management’s estimate of management’s estimate of probable losses in the probable losses in the portfolioportfolio

Allowance for Credit Allowance for Credit LossesLosses

Problem Loan Problem Loan ManagementManagement

Assist borrowing companies in Assist borrowing companies in refinancing with other lenders or refinancing with other lenders or through the capital marketsthrough the capital markets

Facilitate the sale of entire Facilitate the sale of entire borrowing companies or certain borrowing companies or certain assets/subsidiariesassets/subsidiaries-selling individual assets in the -selling individual assets in the secondary marketsecondary market

Market Risk Market Risk ManagementManagement

Trading Risk Trading Risk ManagementManagement Trading account assets and Trading account assets and

liabilitiesliabilities Derivative positionsDerivative positions Mortgage banking assetsMortgage banking assets

Trading Activities Market Risk

Interest Rate Risk Interest Rate Risk ManagementManagement

Goal: to manage interest rate Goal: to manage interest rate sensitivity so that movements sensitivity so that movements in interest rates do not in interest rates do not adversely affect net interest adversely affect net interest incomeincome

What involved: What involved: securities,rsecurities,residential esidential mortgage portfolio, Securitiesmortgage portfolio, Securities

TechniquesTechniques Complex sensitivity simulations Complex sensitivity simulations

are used to estimate the impactare used to estimate the impact The Balance Sheet Management The Balance Sheet Management

division maintains a net interest division maintains a net interest Income forecast utilizing Income forecast utilizing different rate scenariosdifferent rate scenarios

The overall interest rate risk The overall interest rate risk position and strategies are position and strategies are reviewed on an ongoing basis reviewed on an ongoing basis with ALCO and other with ALCO and other committees as appropriatecommittees as appropriate

Operational Risk Operational Risk ManagementManagement

TechniquesTechniques

Corporate wide or business Corporate wide or business segment specific policies and segment specific policies and procedures, controls and procedures, controls and monitoring tools.e.g. personnel monitoring tools.e.g. personnel management practices, data management practices, data reconciliation processes, fraud reconciliation processes, fraud management units, transaction management units, transaction processing monitoring and processing monitoring and analysis, systems interruptions analysis, systems interruptions and new product introduction and new product introduction processesprocesses

Company-wide quarterly self-Company-wide quarterly self-assessment processassessment process

Identify key risk indicatorsIdentify key risk indicators

StructureStructure

 

RecommendationsRecommendations

Disclose more detailed information Disclose more detailed information on specific derivative instruments on specific derivative instruments used in risk managementused in risk management

Generally well established risk Generally well established risk management models for each management models for each institution given respective risk institution given respective risk management philosophiesmanagement philosophies