Bank of America

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Texas State Technical College, Brown *

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Finance

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Apr 3, 2024

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Spring 2022 Bank of America Market Risk Management Analysis Intro To Risk Management 2022 DESCRIPTION Bank of America (NYSE: BAC) is one of the biggest financial institutions in the United States. Bank of America also known as BOA to may has had a meteoric rise since its establishment in 1956. They have come along way that as of 2022 they have over $1.5 trillion assets under management and current revenue of over $85 billion dollars. With over 200,000 employees and more than 4,300 branches all over the U.S they are held to a higher standard than most institutions and must be able to manage their risk effectively if they want to continue to excel even more and not slow down. Bank of America as well as other financial institutions has been no stranger to scandals where one really questions the ethicalness of bankers and financial service companies alike. For instance, in 2000 they agreed to pay $35 million dollars to settle a class action suit alleging that it had charged excessive fees to trust account beneficiaries. In addition, they also had to pay $69 million and $460 million for dealing with corporate criminals Enron and WorldCom respectively. However, one of the biggest scandals that they have been caught in has been when they had to pay $16.5 billion to the justice department for financial fraud leading up to and during the financial crisis. This settlement being that they were involved in the packaging, marketing, sale, arrangement, structuring and issuance of RBMS, Collaterized Debt Obligations (CDOS), and the bank’s practices concerning the underwriting and origination of mortgage loans. In the Picture above you can see how expensive the financial crisis was for Bank of America. Many of the deals that Bank of America goes through are too complicated for the average consumer and would have wonder if they are even real and how would they even manage them in the first place. Managing Risk Bank of America is nowhere close to being a favorable institution to the American consumer 1

due to mistrust in the financial system but one thing that they do well is managing risk. In their 10-k they have a section strictly devoted to risk and there able to manage it soundly in order to serve their customers and deliver for their shareholders. As we have learned in class and in real life if risk is not managed well it can result in financial loss, in some extreme cases bankruptcy such as Lehman Brothers. Bank of America has seven key types of risk that they face are strategic , credit , market , liquidity , compliance , operational , and reputational . The risks that we have been going over in class and that I will further expand later on in this report are interest rate and market risk Management The Risk Framework describes delegations of authority whereby the Board and its committees may delegate authority to management-level committees or executive officers. The figure below shows the relationship among the board, board committees, and management comittees that have the majority of risk oversight in the bank. At the top you have the Board of directors and board committees who are in charge of maintaining an effective Risk Framework and making sure the bank has safe practices. One of the committees here that caught my attention was the audit committee which I have personally heard where I work at. The audit committee is usually in charge of overseeing the performance and independence of the public accounting firm that is performing the audit functions so for instance they would be in charge of seeing that an accounting firm such as EY is performing their job well and keeping integrity with compliance, of legal and regulatory requirements. Enterprise Risk Committee The enterprise risk committee is primarily responsible for the Risk Framework and key risks that Bank of America faces as well as their overall risk appetite. After approving the Risk Framework and Risk Appetite Statement it recommends them to the board for approval. The ERC also oversees the responsibilities of senior managements for the identification, measurement, monitoring, and control of key risks the bank faces. Other Board Committees/Management Committees Bank of America has either committee such as Corporate Governance, ESG, Sustainability, and Compensation and Human Capital Committee as well. The sustainability and Human Capital Committee are particularly interesting to me as I can connect to them with real life events (great resignation, sustainable businesses). Lines of Defense In addition to their Board committees and Management Committees, Bank of America has ownership and accountability across three lines of defense: Front Line Units (FLUs), Independent Risk Management (IRM) and Corporate Audit. They are in charge of protecting Bank of America from external as well as internal risks. Front Line Units 2

Front Line units include the line of businesses as well as the Global Technology and Operations Group are responsible for identifying risk and being able to manage it. They are essentially the first line of defense. There are organizational units that include FLU activities and control function activities are, the Chief Financial Officer Group; Second, Environmental and Social Governance, Capital Deployment, and public policy; and third, the Chief Administrative Offer (CAO) Group. What has been more important as of recently is the Environmental and Social Governance Group as the public has shifted to see if companies are not only making profits but doing what is best for the planet and if they are functioning ethically. Independent Risk Management The second line of defense would be Independent Risk Management. IRM establishes written enterprise policies and procedures that include concentration risk limits, where appropriate. These policies outline how risks are identified, measured, monitored, and controlled. Corporate Audit Corporate Audit reports directly to the audit committee and the board, Corporate Audit provides independent assessment and validation through testing of key process and controls across the corporation. They in periodically test and examine credit processes. To go further into this, all public companies have an internal audit function, and what they do is they set controls for all aspects of the corporation from operations to investments. So, for instance one control could be that internal audit sets a control for their override commissions. A simple control for this would me that a member of management signs off on override commissions on a timely basis. Another example could be that accounts payable pays their vendors within a reasonable amount of time. Controls such as this one ensures that the bank is running in a way that prevents another scandal such as Enrons. Market Risk Definition As per the financial statement the definition of market risk for Bank of America is “ Market risk is the risk that changes in market conditions may adversely impact the value of assets or liabilities, or otherwise negatively impact earnings.” As learned in class the impact of the value of assets or liabilities is particularly important as it can cause a bank to go under. This risk is primarily present in withing their global markets segment. In the event that there is stress in the market, these risks could have a material impact on the banks results. The tools that Bank of America uses in order to measure and mitigate potential losses are Value- at-Risk (VaR) and Stress testing. Periods of extreme market stress influence the reliability of these tools to varying degrees. Measure: Value-at-Risk(VaR) One of the two market risk measurement tools that Bank of America uses is Value-at-Risk which per the firm is defined as: “ VaR is a common statistic used to measure market risk as it allows the aggregation of market risk factors, including the effects of portfolio diversification” Without a doubt Value at risk is one of the most popular statistics in measuring risk as you can see it within the financial statements of other banks as well such as J.P Morgan. 3

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Bank of Americas Value at Risk model simulates the value of a portfolio under a range of scenarios in order to generate a distribution of potential gain and losses. The VaR is mainly based on historical data, in Bank of Americas case they use one VaR model across the trading portfolios and their historical approach is based on a 3-year window. Their primary VaR is equivalent to a 99 percent confidence level, this means that they expect their losses shouldn’t be in excess of VaR on average 99 out of 100 trading days. The VaR model assumptions will change from company to company, for instance J.P Morgan has a 95% confidence level meaning that they expect to be below the average 5 out of 100 trading days. The table on the previous page shows the total VaR market-based portfolio, which combines the total covered positions portfolio and the fair value portfolio. The covered portfolio including trading assets and liabilities, on both on and off the balance sheet. These are generally the most liquid trading positions. The fair value option portfolio includes all the funded and unfunded exposures for which the bank elects the fair value option and their corresponding hedges. The annual average of total covered positions and less liquid trading positions portfolio VaR decreased in 202 due to the increase in diversification across assets. Backtesting: The accuracy of VaR is evaluated by backtesting, which compares the daily VaR results utilizing a one- day holding period against a comparable subset of trading revenue. Backtesting is usually performed when a trading loss exceeds the VaR for the corresponding day. Backtesting is also performed daily on the VaR results used for the regulatory capital calculations as well as the VaR results for key legal entities, regions, and risk factors. Stress Testing Just like VaR, Stress testing is also a very popular tool that firms used in order to measure market risk. Contrary to VaR which measures the losses due to market changes by using historical data, stress testing uses scenario analysis. This analysis estimates the change in the value of the portfolio that can result from abnormal market movements. So, for instance it is a hypothesis of the volatility from the market. Stress Testing has a set of scenarios that are categorized as historical or hypothetical. These scenarios include shocks to underlying market factors that may be well beyond the shocks found in the historical data that is used to find VaR. So basically, stress testing goes to another extent that VaR does. Historical scenarios use historical market stress to stimulate the impact of market moves. So, for instance selecting a period of weeks representing the most severe point during a crisis for each historical scenario. Contrary to historical, hypothetical creates a potential future market stress scenario and tests how the estimated portfolio is impacted from it. Scenarios are constantly reviewed and updated in order to keep up with everchanging economic or political events. To reinforce this new scenario are developed to address specific market events or vulnerabilities in the portfolio so for instance more than sure there will be a scenario to test in a hypothetical event for something similar to Covid-19. Interest rates being one of those economic events, the bank is well aware that interest rates affect the entire 4

bank (income, trading activities, issuing debt, etc.) so they have to be prepared. With that being said interest rate risk represents the most significant market risk exposure to the balance sheet as the change in net interest income is caused by movements in market interest rates. In the figure below you can see the spot and 12-month forward rates that Bank of America uses in their baseline forecasts. This helps them to be able to better manage interest rate risk. In the next table (table 46) above you can see that the bank measures scenario using the U.S Dollar in order to calculate the duration of net worth and the change in dollar amount whenever interest rates rise or fall. Table 46 shows different scenarios such as Parallel shift, Flatteners, and Steepeners. It is safe to note however that interest rates falling don’t have an identical change in actual dollar amount to an increase in rates. This is mainly due to the fact that the convexity of the falling rates is higher. By implementing both VaR and Stress testing the bank is better able to locate where the risk is coming from and formulate a plan using one of its mitigation techniques. Mitigation Interest Rate and Foreign Exchange Derivative Contracts The bank actively uses interest rate and foreign exchange derivative contracts in their ALM activities in order to manage their interest rate and foreign exchange risk. For interest rate risk they usually have derivatives that are generally non-leveraged swaps tied to various benchmark rates. This is relatable as we have learned about interest rate swaps in our lecture and have even been tested on them so it would be interesting to see if Bank of America uses a similar method to the one, we were taught. For currency they usually mitigate by using foreign exchange basis swaps, options, futures, and forwards. They split the derivatives they use into two categories: designated accounting hedges and other risk management derivatives. Designated accounting hedges are for interest rate risk while other risk management derivatives are along the lines of options and futures. Conclusion 5

In conclusion as per what I was able to grasp from the 10-k it would be safe to say that Bank of America manages risk well but not to the extent that one would expect it to. The reason being that Bank of America only talks about Interest rate and foreign exchange Derivative contracts on their financial statements. Although diversification is mentioned they don’t go too deep as to explain what they do. However, as you can see, they are one of the elite banks in America and from what they have shown they are able to manage risk effectively. They have set forth a body with lines of defense that reinforce managements policies of implementing risk. As each committee works together within their subsection, they are able to work efficiently and spot risk, measure it then be able to mitigate it effectively with the tools that protect the banks balance sheet. 6

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