CHAPTER 20 RISK MANAGEMENT IN FINANCIAL INSTITUTIONS Copyright© 2012 John Wiley & Sons, Inc.

2 Dilemma: Profitability versus Safety A bank must balance the demands of three constituencies: shareholders—mainly interested in profitability depositors—mainly interested in safety regulators—mainly interested in safety One way for a bank to increase expected profits is to take on more risk. However, this can jeopardize bank safety. Copyright© 2012 John Wiley & Sons, Inc.

3 Solvency and Liquidity Solvency: Maintaining the momentum of a going concern, attracting customers and financing. A firm is insolvent when the value of its liabilities exceeds the value of its assets. Banks have relatively low capital/asset ratios but generally high-quality assets. Liquidity: The ability to fund deposit withdrawals, loan requests, and other promised disbursements when due. A bank can be profitable and still fail because of illiquidity. Copyright© 2012 John Wiley & Sons, Inc.

4 Conflicting Demands A bank must balance profitability, liquidity, and solvency. Bank failure can result from excessive losses on loans or securities -- from over-aggressive profit seeking. But a bank that only invests in high-quality assets may not be profitable. Failure can also occur if a bank cannot meet liquidity demands. If assets are profitable but illiquid, the bank also has a problem. Bank insolvency often leads to bank illiquidity. Copyright© 2012 John Wiley & Sons, Inc.

Profitability versus Liquidity and Solvency 5 Copyright© 2012 John Wiley & Sons, Inc.

6 Liquidity Management Banks rely on both asset sources of liquidity and liability sources of liquidity to meet the demands for liquidity. The demands for liquidity include accommodating deposit withdrawals, paying other liabilities as they come due, and accommodating loan requests. Copyright© 2012 John Wiley & Sons, Inc.

7 Asset Management Classifies bank assets from very liquid/low profitability to very illiquid/profitable. Primary Reserves are noninterest bearing, extremely liquid bank assets. Secondary Reserves are high-quality, short-term, marketable earning assets. Bank loans are made after absolute liquidity needs are met. After loan demand is satisfied, funds are allocated to income investments that provide income, reasonable safety, and some liquidity, if needed. Copyright© 2012 John Wiley & Sons, Inc.

8 Asset Management (cont.) The bank must manage its assets to provide a compromise of liquidity and profitability. Primary and secondary reserve levels relate to: deposit variability other sources of liquidity (e.g. fed funds) bank regulations - permissible areas of investment risk posture that bank management will assume Copyright© 2012 John Wiley & Sons, Inc.

Summary of Asset Management Strategy 9 Copyright© 2012 John Wiley & Sons, Inc.

10 Liability Management (LM) Assumes bank can borrow its liquidity needs at will in money markets by paying market rate or better. Liability levels (borrowing) may be quickly adjusted to loan (asset) needs or deposit variability. Bank liability liquidity sources include “non- deposit borrowing” (e.g. fed funds). LM supplements asset management, but does not supersede it. Copyright© 2012 John Wiley & Sons, Inc.

Operational Risk The risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems, or from external events. Includes losses from fraud, theft, terrorism, litigation, and even reputation problems. Large international banks are required to hold capital against their operational risk. 11 Copyright© 2012 John Wiley & Sons, Inc.

12 Managing Credit Risk The credit risk of an individual loan concerns the losses the bank will experience if the borrower does not repay the loan. The credit risk of a bank’s loan portfolio concerns the aggregate credit risk of all the loans in the bank’s portfolio. Banks must manage both dimensions effectively to be successful. Copyright© 2012 John Wiley & Sons, Inc.

13 Managing Credit Risk of Individual Loans Begins with lending decision (and 5 Cs as discussed before). Requires close monitoring to identify problem loans quickly. The goal is to recover as much as possible once a problem loan is identified. Copyright© 2012 John Wiley & Sons, Inc.

14 Managing Credit Risk of Loan Portfolio Internal Credit Risk Ratings are used to identify problem loans; determine adequacy of loan loss reserves; price loans. Loan Portfolio Analysis is used to ensure that banks are well diversified. Concentration ratios measure the percentage of loans allocated to a given geographic location, loan type, or business type. Copyright© 2012 John Wiley & Sons, Inc.

Loan Sales, Securitization, and Brokerage Buy originating loans and securitizing them, lenders exploit their comparative advantage in originating loans but not commit to fund the loan for the entire term of the loan. Selling loans into the secondary market is another way that financial institutions may reduce their credit risk exposure. FIs also form syndicates to fund a large loan which reduces the credit risk exposure. 15 Copyright© 2012 John Wiley & Sons, Inc.

Credit Derivatives Lenders use these to minimize their credit risk exposure. In a credit default swap (CDS), the holder of a loan makes periodic payments to the seller of the swap in exchange for a promise to pay the holder of the loan the face amount of the loan in the event that the borrower defaults. Credit insurance offers the same kind of protection that the CDS offers but in the form of an insurance contract. 16 Copyright© 2012 John Wiley & Sons, Inc.

Effects of Changing Interest Rates on Commercial Banks 17 Copyright© 2012 John Wiley & Sons, Inc.

Effects of Changing Interest Rates on Commercial Banks, cont. 18 Copyright© 2012 John Wiley & Sons, Inc.

19 Measuring Interest Rate Risk: Maturity GAP Analysis Assets and liabilities which “reprice” (change interest rate in a specified period of time) are identified as “rate-sensitive”. A bank's Maturity GAP is computed by subtracting rate sensitive liabilities (RSL) from rate sensitive assets (RSA). Copyright© 2012 John Wiley & Sons, Inc.

Rate-Sensitive GAP for a Bank Balance Sheet 20 Copyright© 2012 John Wiley & Sons, Inc.

21 GAP = RSA – RSL; Positive Gap Positive GAP = RSA > RSL Net interest income will decline if interest rates fall. More assets than liabilities reprice downward if interest rates decline, thus reducing net interest income. Copyright© 2012 John Wiley & Sons, Inc.

22 GAP = RSA – RSL; Negative Gap Negative GAP = RSA < RSL Net interest income will decline if interest rates increase. More liabilities than assets reprice upward if interest rates increase, thus reducing net interest income. Copyright© 2012 John Wiley & Sons, Inc.

23 Managing Interest Rate Risk: Duration GAP Analysis Maturity GAP provides only an approximate rule for analyzing interest rate risk. Duration GAP analysis matches cash flows and their repricing capabilities over a period of time. The percentage change in the value of a portfolio, given a change in interest rates, is proportional to the duration of the portfolio multiplied by the change in interest rates. Copyright© 2012 John Wiley & Sons, Inc.

24 Managing Interest Rate Risk: Duration GAP Formula whereD G = duration gap D A = duration of assets D L = duration of liabilities MV A = market value of assets MV L = market value of liabilities Duration GAPs are opposite in sign from maturity GAPs for the same risk exposure. Copyright© 2012 John Wiley & Sons, Inc.

25 Positive Duration GAP Assets have longer duration than liabilities; bank expects interest rates to fall. If interest rates rise- More assets than liabilities will lose value, Thus reducing the value of the bank’s equity. If interest rates fall- More assets than liabilities will gain value, Thus increasing the value of the bank’s equity. Copyright© 2012 John Wiley & Sons, Inc.

26 Negative Duration GAP Liabilities have longer duration than assets; bank expects interest rates to rise. If interest rates rise— More liabilities than assets will lose value, Thus increasing the value of the bank’s equity. If interest rates fall— More liabilities than assets will gain value, Thus reducing the value of the bank’s equity. Copyright© 2012 John Wiley & Sons, Inc.

27 Zero Duration Gap Bank is immunized against interest rate risk. Easier in theory than in practice. Duration GAP manipulation is a complex tool, used more by large banks. Copyright© 2012 John Wiley & Sons, Inc.

Assessing Risk: Value at Risk VaR measures the loss potential up to a certain probability within a given time period. It helps estimate how much a change in interest rates might affect the firm’s value within a given confidence limit. Disadvantage: It does not account for the kinds of events that occur outside most firms’ confidence intervals. 28 Copyright© 2012 John Wiley & Sons, Inc.

Value at Risk 29 The sensitivity of changes in asset values to changes in the risk factor. The potential adverse change in the risk factor within the relative time period for a given confidence level. Copyright© 2012 John Wiley & Sons, Inc.

Hedging Interest Rate Risk Microhedging: Hedging a specific transaction. Macrohedging: Involves using instruments of risk management, such as financial futures, options on financial futures, and interest rate swaps to reduce the interest rate risk of the firm’s entire balance sheet. 30 Copyright© 2012 John Wiley & Sons, Inc.

31 Hedging Interest Rate Risk: Asset-Sensitive Asset-sensitive with positive maturity GAP; negative duration GAP; hurt by falling rates: Buy financial futures -- falling rates increase value of contract, offsetting negative impact of GAP; Buy call options on financial futures; Swap to increase their variable rate cash outflows and increase their fixed rate (long term) cash inflows; Lengthen repricing of assets; shorten repricing of liabilities. Copyright© 2012 John Wiley & Sons, Inc.

32 Hedging Interest Rate Risk: Liability-Sensitive Liability-sensitive with negative maturity GAP; positive duration GAP; hurt by rising rates: Sell financial futures -- increasing rates would increase value of futures contracts, offsetting the negative impact of GAP situation; Buy put options on financial futures; Swap long term, fixed rate payments for variable rate payments; Shorten repricing of assets; lengthen repricing of liabilities. Copyright© 2012 John Wiley & Sons, Inc.

33 Copyright© 2012 John Wiley & Sons, Inc.

Caps, Floors, and Collars A cap on interest rates is created by purchasing a put option on a financial futures contract. This limits increases in the cost of liabilities. A floor on interest rates is created by selling a call option on a financial futures contract. This sets a lower limit for liability costs. Buy simultaneously buying a cap and selling a floor, the bank creates a collar. This limits the movement of a bank’s liability costs within a specified range. 34 Copyright© 2012 John Wiley & Sons, Inc.

Using Options on Financial Futures 35 Copyright© 2012 John Wiley & Sons, Inc.

Using Options on Financial Futures 36 Copyright© 2012 John Wiley & Sons, Inc.

Using Options on Financial Futures 37 Copyright© 2012 John Wiley & Sons, Inc.

Using Collars to Manage Interest Rate Risk 38 Copyright© 2012 John Wiley & Sons, Inc.