Risks of Financial Intermediation Chapter 7 Risks of Financial Intermediation

Overview This chapter discusses the risks associated with financial intermediation: Interest rate risk, market risk, credit risk, off-balance-sheet risk, technology and operational risk, foreign exchange risk, country risk, liquidity risk, insolvency risk

Risks of Financial Intermediation Interest rate risk resulting from intermediation: Mismatch in maturities of assets and liabilities. Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs. Refinancing risk. Reinvestment risk.

Market Risk Incurred in trading of assets and liabilities (and derivatives). Examples: Barings & decline in ruble. Trend to greater reliance on trading income rather than traditional activities increases market exposure. Trading activities introduce other perils as was discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses on foreign exchange positions

Credit Risk Risk that promised cash flows are not paid in full. Firm specific credit risk Systematic credit risk High rate of charge-offs of credit card debt in the 80s and 90s Obvious need for credit screening and monitoring Diversification of credit risk

Off-Balance-Sheet Risk Increased importance of off-balance-sheet activities Letters of credit Loan commitments Derivative positions Speculative activities using off-balance-sheet items create considerable risk

Technology and Operational Risk Risk of direct or indirect loss resulting form inadequate or failed internal processes, people, and systems or from external events. Some include reputational and strategic risk Technological innovation has seen rapid growth Automated clearing houses CHIPS

Technology and Operational Risk Risk that technology investment fails to produce anticipated cost savings. Risk that technology may break down. Bank of New York Well’s Fargo Economies of scale. Economies of scope.

Foreign Exchange Risk Returns on foreign and domestic investment are not perfectly correlated. FX rates may not be correlated. Example: $/DM may be increasing while $/¥ decreasing. Undiversified foreign expansion creates FX risk.

Foreign Exchange Risk 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.

Country or Sovereign Risk Result of exposure to foreign government which may impose restrictions on repayments to foreigners. Lack usual recourse via court system. Examples: South Korea, Indonesia, Thailand. More recently, Argentina.

Liquidity Risk Risk of being forced to borrow, or sell assets in a very short period of time. Low prices result. May generate runs. Runs may turn liquidity problem into solvency problem. Risk of systematic bank panics.

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

Risks of Financial Intermediation Other Risks and Interaction of Risks Interdependencies among risks. Example: Interest rates and credit risk. Discrete Risks Example: Tax Reform Act of 1986. Other examples include effects of war, market crashes, theft, malfeasance.

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

Pertinent Websites Bank for International Settlements www.bis.org Federal Reserve www.federalreserve.gov Federal Deposit Insurance Corporation www.fdic.gov Web Surf