Chapter 4 Risks of Financial Intermediation

4-2 Overview This chapter introduces the fundamental risks faced by modern FIs. We identify the key features of the risks FIs face in the modern financial world. We learn about the key sources of these risks. We gain a basic understanding of the variety and complexity of these risks. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-3 Introduction Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-4 Interest Rate Risk Interest rate risk is the risk incurred by an FI if it mismatches the maturities of its assets and liabilities. Refinancing risk: the costs of rolling over funds or reborrowing funds will rise above the returns generated on investments. Reinvestment risk: the returns on funds to be reinvested will fall below the cost of funds. Example: An FI grants a five-year maturity loan at a fixed rate of 12% p.a. and funds the loan with one-year maturity fixed-rate term deposits that pay 10% p.a. Is the FI exposed to increasing or decreasing interest rates? Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-5 Interest Rate Risk Solution: The FI is exposed to increasing interest rates and refinancing risk. Would the FI still be exposed to the same risks if the loan had a one-year maturity, while the maturity of deposits was three years? In this case, the FI would be exposed to decreasing interest rates and reinvestment risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-6 Additional Interest Rate Risk: Market Value Risk As interest rates increase the market value of assets and liabilities decreases. As interest rates decrease the market value of assets and liabilities increases. If the FI mismatches the maturities of its assets and liabilities, the change in the market value of assets and liabilities will not be the same. As E = A – L, changing interest rates can have an adverse impact on the FI’s net worth. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-7 Additional Interest Rate Risk: Market Value Risk Assume the maturity of assets exceeds the maturity of liabilities: a. An increase in interest rates causes a fall in the market value of both assets and liabilities, but assets are more severely affected. b. A decrease in interest rates causes an increase in the market value of both assets and liabilities, and liabilities will increase less than assets. Assume the maturity of liabilities exceeds the maturity of assets: a. A decrease in interest rates causes a rise in the market value of both assets and liabilities, but liabilities are more severely affected. b. An increase in interest rates causes a fall in the market value of both assets and liabilities, and assets will decrease less than liabilities. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-8 Additional Interest Rate Risk: Market Value Risk FIs should match the maturities of assets and liabilities. Balance sheet hedging by matching maturities of assets and liabilities is problematic for FIs. For most FIs the maturity of assets exceeds the maturity of liabilities. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-9 Market Risk This is the risk incurred when trading assets and liabilities. Risk is incurred due to changes in interest rates, exchange rates or other asset prices. Example of the dangers of market risk: –Barings Bank collapsed due to a wrong bet on the movement of the Japanese Nikkei Stock Market Index. –A single individual caused losses that forced the bank into insolvency. –See Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-10 Credit Risk This is the risk that promised cash flows on loans and securities held by the FI are not repaid in full. Most financial claims held by FIs offer limited upside risk and a large downside risk. Limited upside risk: principal and interest payment. Downside risk: loss of loan principal and promised interest. Examples: –Fixed-income coupon bonds, –Bank loans. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-11 Credit Risk Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-12 Credit Risk Two different types of credit risk: –firm-specific credit risk, and –systematic credit risk. Firm-specific credit risk affects a particular company. Systematic credit risk affects all borrowers. Firm-specific credit risk can be managed through diversification. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-13 Off-Balance-Sheet Risk Arises if FIs enter into contingent liability or asset contracts. Increased importance of off-balance-sheet activities –Letters of credit –Loan commitments –Derivative positions Speculative activities using off-balance-sheet items create considerable risk Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-14 Technology and Operational Risks According to the Bank for International Settlements (BIS), operational risk (inclusive of technological risk) is defined as “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”. Some FIs include reputational and strategic risk. Technological innovation has seen rapid growth –Automated clearing houses (ACH) –CHIPS Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-15 Technology and Operational Risks Major objectives of technological expansion: –To lower operating costs, –To increase profits, and –To capture new markets for the FI. Economies of scale imply an FI’s ability to lower its average costs of operations by expanding its output to financial services. Economies of scope imply an FI’s ability to generate cost synergies by producing more than one output with the same inputs. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-16 Technology and Operational Risks Technology risk: technological investments may not produce the cost savings anticipated, e.g. diseconomies of scale. Operational risk: existing technology or support systems may malfunction or break down. Examples of operational risk: Bank of New York (1985), Wells Fargo Bank and First Interstate Bank (1996), Citibank (2001). Operational risk also includes fraud and errors. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-17 Foreign Exchange Risk The risk that changes in exchange rates may adversely affect the value of an FI’s assets and/or liabilities. Returns on foreign and domestic investment are not perfectly correlated. FX rates may not be correlated. –Example: A$/€ may be increasing while A$/¥ is decreasing. Undiversified foreign expansion creates FX risk. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-18 Country or Sovereign Risk The risk that repayments from foreign borrowers may be interrupted. These interruptions may be caused, for instance, by the interference of foreign governments. Note that hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well. –Otherwise, exposure to foreign interest rate risk is created. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-19 Country or Sovereign Risk Example: In 1982 the Mexican and Brazilian Governments announced a debt moratorium on Western creditors. This debt moratorium caused significant losses in some of the lending banks, such as Citicorp (now Citigroup). There is little recourse for lenders if a foreign government restricts repayments in form of rescheduling or outright prohibitions to repay. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-20 Liquidity Risk The risk that a sudden surge in liability withdrawals may pressure the FI into liquidating parts of its assets. The liquidation of assets may have to happen in a very short period and at very low prices. Problematic for illiquid assets such as loans. Serious liquidity problems can cause a ‘run’ on the FI. A ‘run’ can turn a simple liquidity problem into a solvency problem, and might threaten the FI’s survival. Risk of systematic bank panics. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-21 Insolvency Risk The risk that an FI may not have sufficient capital to offset a sudden decline in its asset values relative to its liabilities. –Continental Illinois National Bank and Trust –In Australia: National Mutual Life Association (NMLA) Original cause may be excessive interest rate, or market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks. Both FI management and regulators focus on an FI’s capital and capital adequacy as key measures to ensure FI solvency. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-22 Other Risks and the Interaction of Risks Most risks are correlated or interdependent: –Example: liquidity risk is related to interest rate risk and credit risk. Other risks, such as discrete or event-type risks, may impact on the FI’s profitability and risk exposure. Regulatory changes or sudden changes in the economic or financial environment are types of discrete risk. –Example: Stock market collapses in 1929 and Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher

4-23 Other Risks and the Interaction of Risks Macroeconomic risks can directly or indirectly impact on an FI’s level of interest rate, credit and liquidity risk exposure. Increased inflation or an increase in its volatility. –Affects interest rates. Increase in unemployment –Affects credit risk, among other things. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Institutions Management 2e, by Lange, Saunders, Anderson, Thomson and Cornett Slides prepared by Maike Sundmacher