1. Risks of Financial Intermediation Chapter 7
Financial Institutions Management, 3/e
By Anthony Saunders

2. Risks of Financial Intermediation
Interest rate risk
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.

3. Risks of Financial Intermediation
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.

4. Risks of Financial Intermediation
Credit Risk
Risk that promised cash flows are not paid in full.
Firm specific credit risk
Systematic credit risk
Off-balance-sheet risk
Letters of credit, loan commitments, derivative positions, etc.

5. Risks of Financial Intermediation
Technology and operational risk
Risk that technology investment fails to produce anticipated cost savings.
Risk that technology may break down.
Economies of scale.
Economies of scope.

6. Risks of Financial Intermediation
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.

7. Risks of Financial Intermediation
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: Korea, Indonesia, Thailand 1998.

8. Risks of Financial Intermediation
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.

9. Risks of Financial Intermediation
Insolvency Risk
Risk of insufficient capital to offset sudden decline in value of assets to liabilities.
Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.

10. 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.

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