Money and Banking Lecture 25

Review of the Previous Lecture Balance Sheet of Commercial Banks Assets: Uses of Funds Liabilities: Sources of Funds Bank Capital and Profitability Off-Balance-Sheet Activities

Topics under Discussion Bank Risk Liquidity Risk Credit Risk Interest Rate Risk Trading Risk Other Risks

Bank Risk Banking is risky because depository institutions are highly leveraged and because what they do In all the lines of banking trades, the goal of every bank is to pay less for the deposits the bank receives than for the loan it makes and the securities it buys.

Liquidity Risk Liquidity risk is the risk of a sudden demand for funds and it can come from both sides of a bank’s balance sheet (deposit withdrawal on one side and the funds needed for its off-balance sheet activities on the liabilities side If a bank cannot meet customers’ requests for immediate funds it runs the risk of failure; even with a positive net worth, illiquidity can drive it out of business

Liquidity Risk

Liquidity Risk One way to manage liquidity risk is to hold sufficient excess reserves (beyond the required reserves mandated by the central bank) to accommodate customers’ withdrawals. However, this is expensive (interest is foregone).

Liquidity Risk Two other ways to manage liquidity risk are: adjusting assets adjusting liabilities.

Liquidity Risk If a customer makes a $5 million withdrawal, the bank cant simply deduct it from reserves. Rather it will adjust another part of balance sheet

Liquidity Risk A bank can adjust its assets by selling a portion of its securities portfolio, or by selling some of its loans, or by refusing to renew a customer loan that has come due

Liquidity Risk

Liquidity Risk Banks do not like to meet their deposit outflows by contracting the asset side of the balance sheet because doing so shrinks the size of the bank Banks can use liability management to obtain additional funds by borrowing (from the central bank or from another bank) or by attracting additional deposits (by issuing large CDs)

Liquidity Risk

Credit Risk This is the risk that loans will not be repaid and it can be managed through diversification and credit-risk analysis Diversification can be difficult for banks, especially those that focus on certain kinds of lending

Credit Risk Credit-risk analysis produces information that is very similar to the bond-rating systems and is done using a combination of statistical models and information specific to the loan applicant Lending is plagued by adverse selection and moral hazard, and financial institutions use a variety of methods to mitigate these problems

Credit Risk Screen loan application Monitor borrowers after they have received loan Collateral or high net-worth demand Developing long term relationships

Interest-Rate Risk The two sides of a bank’s balance sheet often do not match up because liabilities tend to be short-term while assets tend to be long-term; this creates interest-rate risk In order to manage interest-rate risk, the bank must determine how sensitive its balance sheet (assets and liabilities) is to a change in interest rates;

Interest-Rate Risk If we think of bank’s assets and liabilities as bonds, the change in interest rate will affect the value of these bonds, more importantly due to the term of bonds So if interest rate rises, the bank face the risk that the value of their assets may fall more than the value of their liabilities (reducing the bank’s capital)

Interest-Rate Risk Suppose 20% of bank’s assets fall into the category of assets sensitive to changes in the interest rate. While rest of 80%are not sensitive to changes in interest rate If interest rate is stable 5%, then each $100 yields $5 in interest Now suppose 50% of bank’s deposits (liabilities) are interest rate sensitive and 50% are not Half of the liabilities are deposits that earn variable returns so costs vary with market rate

Interest-Rate Risk For making profit, interest rate on liabilities must be lower than the interest rate on assets. The difference is the bank’s margin! Assuming interest rate on liabilities is 3%, the net interest margin is 5 – 3 = 2% What happens as interest rate rises by 1%

Interest-Rate Risk When bank has more interest rate sensitive liabilities than does interest rate assets, an increase in interest rate will cut into the bank’s profits

Summary Bank Risk Liquidity Risk Credit Risk Interest Rate Risk