Ch 7 Risks of FIs 7-1

Overview
‹ This chapter discusses the risks associated
with financial intermediation:
z Interest rate risk, market risk, credit risk,

off-balance-sheet risk, foreign exchange

risk, country or sovereign risk, technology
risk, operational risk, liquidity risk,
insolvency risk
‹ Note that these risks are not unique to FIs
z Faced by all global firms

7-2
Risks of Financial Intermediation

‹ Interest
rate risk resulting from
intermediation:
z Mismatch in maturities of assets and liabilities.
ƒ Interest rate sensitivity difference exposes equity to
changes in interest rates
z Balance sheet hedge via matching maturities of
assets and liabilities is problematic for FIs.
ƒ Inconsistent with asset transformation role
z Refinancing risk.
z Reinvestment risk.

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 7-3
Market Risk

‹ Incurred in trading of assets and liabilities

(and derivatives).
‹ Distinction between Investment Book and
Trading Book of a commercial bank
z Heightened focus on Value at Risk (VAR)
z Heightened focus on short term risk measures
such as Daily Earnings at Risk (DEAR)
‹ Role of securitization in changing liquidity of
bank assets and liabilities

7-4
Market Risk

‹ Distinction
between Investment Book and
Trading Book of a commercial bank
z Heightened focus on Value at Risk (VAR)
z Heightened focus on short term risk measures
such as Daily Earnings at Risk (DEAR)
‹ Role of securitization in changing liquidity of
bank assets and liabilities

2
 7-5
Credit Risk

‹ Risk that promised cash flows are not paid

in full.
z Firm specific credit risk
z Systematic credit risk
‹ High rate of charge-offs of credit card debt
in the 1980s, most of the 1990s and early
2000s
‹ Credit card loans (and unused balances)
continue to grow

7-6
Charge Off Rates for Commercial Banks

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 7-7
Implications of Growing Credit Risk

‹ Importance of credit screening

‹ Importance of monitoring credit extended

‹ Role for dynamic adjustment of credit risk

premia
‹ Diversification of credit risk

7-8
Off-Balance-Sheet Risk

‹ Striking growth of off-balance-sheet

activities
z Letters of credit
z Loan commitments
z Derivative positions
‹ Speculative activities using off-balance-
sheet items create considerable risk

4
 7-9
Foreign Exchange Risk

‹ FI may be net long or net short in various

currencies
‹ Returns on foreign and domestic investment
are not perfectly correlated.
‹ FX rates may not be correlated.

‹ Undiversified foreign expansion creates FX

risk.

7-10
Foreign Exchange Risk

‹ Note that completely hedging foreign

exposure by matching foreign assets and
liabilities requires matching the maturities as
well*.
z Otherwise, exposure to foreign interest rate risk
remains.

*More correctly, FI must match durations, rather

than maturities. See Chapter 9.

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 7-11
Country or Sovereign Risk

‹ Result of exposure to foreign government

which may impose restrictions on repayments
to foreigners.
‹ Often lack usual recourse via court system.

‹ In the event of restrictions, reschedulings, or

outright prohibition of repayments, FIs’
remaining bargaining chip is future supply of
loans
‹ Role of IMF
z Extends aid to troubled banks
z Increased moral hazard problem if IMF bailout expected

7-12
Technology and Operational Risk

‹ Economies of scale.
‹ Economies of scope.

‹ Operational risk not exclusively

technological
z Employee fraud and errors
z Losses magnified since they affect reputation
and future potential
‹ Risk of losses resulting from inadequate or
failed internal processes, people, and
systems or from external events.

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 7-13
Technology and Operational Risk

‹ Risk that technology investment fails to

produce anticipated cost savings.
‹ Risk that technology may break down.
z CitiBank’s ATM network, debit card system and
on-line banking out for two days
z Prudential Financial fined $600 million due to
allegations of improper mutual fund trades

7-14
Liquidity Risk
‹ Risk of being forced to borrow, or sell assets
in a very short period of time.
z Low prices result.
‹ May generate runs.
z Runs may turn liquidity problem into solvency
problem.
z Risk of systematic bank panics.
z Role of FDIC (see Chapter 19)

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 7-15
Insolvency Risk
‹ Riskof insufficient capital to offset sudden
decline in value of assets to liabilities.
z Continental Illinois National Bank and Trust
‹ Original
cause may be excessive interest
rate, market, credit, off-balance-sheet,
technological, FX, sovereign, and liquidity
risks.

7-16
Risks of Financial Intermediation
‹ Other Risks and Interaction of Risks
z Interdependencies among risks.
ƒ Example: Interest rates and credit risk.
ƒ Interest rates and derivative counterparty risk
z Discrete Risks
ƒ Examples include effects of war or terrorist acts,
market crashes, theft, malfeasance.
ƒ Changes in regulatory policy

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 7-17
Macroeconomic Risks
‹ Increased inflation or increase in its volatility.
z Affects interest rates as well.
‹ Increases in unemployment
z Affects credit risk as one example.