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CH 7 Risks of Fis: Faced by All Global Firms

This chapter discusses the various risks faced by financial institutions, including interest rate risk, market risk, credit risk, off-balance sheet risk, foreign exchange risk, sovereign risk, technology risk, operational risk, liquidity risk, and insolvency risk. It notes that these risks are interrelated and that one risk can exacerbate another. For example, changes in interest rates can impact credit risk. The chapter examines each risk in turn and how financial institutions aim to manage and mitigate these risks.

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Abdelnasir Haider
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81 views9 pages

CH 7 Risks of Fis: Faced by All Global Firms

This chapter discusses the various risks faced by financial institutions, including interest rate risk, market risk, credit risk, off-balance sheet risk, foreign exchange risk, sovereign risk, technology risk, operational risk, liquidity risk, and insolvency risk. It notes that these risks are interrelated and that one risk can exacerbate another. For example, changes in interest rates can impact credit risk. The chapter examines each risk in turn and how financial institutions aim to manage and mitigate these risks.

Uploaded by

Abdelnasir Haider
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
You are on page 1/ 9

Ch 7 Risks of FIs 7-1

Overview
‹ This chapter discusses the risks associated
with financial intermediation:
z Interest rate risk, market risk, credit risk,

off-balance-sheet risk, foreign exchange


risk, country or sovereign risk, technology
risk, operational risk, liquidity risk,
insolvency risk
‹ Note that these risks are not unique to FIs
z Faced by all global firms

7-2
Risks of Financial Intermediation

‹ Interest
rate risk resulting from
intermediation:
z Mismatch in maturities of assets and liabilities.
ƒ Interest rate sensitivity difference exposes equity to
changes in interest rates
z Balance sheet hedge via matching maturities of
assets and liabilities is problematic for FIs.
ƒ Inconsistent with asset transformation role
z Refinancing risk.
z Reinvestment risk.

1
7-3
Market Risk

‹ Incurred in trading of assets and liabilities


(and derivatives).
‹ Distinction between Investment Book and
Trading Book of a commercial bank
z Heightened focus on Value at Risk (VAR)
z Heightened focus on short term risk measures
such as Daily Earnings at Risk (DEAR)
‹ Role of securitization in changing liquidity of
bank assets and liabilities

7-4
Market Risk

‹ Distinction
between Investment Book and
Trading Book of a commercial bank
z Heightened focus on Value at Risk (VAR)
z Heightened focus on short term risk measures
such as Daily Earnings at Risk (DEAR)
‹ Role of securitization in changing liquidity of
bank assets and liabilities

2
7-5
Credit Risk

‹ Risk that promised cash flows are not paid


in full.
z Firm specific credit risk
z Systematic credit risk
‹ High rate of charge-offs of credit card debt
in the 1980s, most of the 1990s and early
2000s
‹ Credit card loans (and unused balances)
continue to grow

7-6
Charge Off Rates for Commercial Banks

3
7-7
Implications of Growing Credit Risk

‹ Importance of credit screening


‹ Importance of monitoring credit extended

‹ Role for dynamic adjustment of credit risk


premia
‹ Diversification of credit risk

7-8
Off-Balance-Sheet Risk

‹ Striking growth of off-balance-sheet


activities
z Letters of credit
z Loan commitments
z Derivative positions
‹ Speculative activities using off-balance-
sheet items create considerable risk

4
7-9
Foreign Exchange Risk

‹ FI may be net long or net short in various


currencies
‹ Returns on foreign and domestic investment
are not perfectly correlated.
‹ FX rates may not be correlated.

‹ Undiversified foreign expansion creates FX


risk.

7-10
Foreign Exchange Risk

‹ Note that completely hedging foreign


exposure by matching foreign assets and
liabilities requires matching the maturities as
well*.
z Otherwise, exposure to foreign interest rate risk
remains.

*More correctly, FI must match durations, rather


than maturities. See Chapter 9.

5
7-11
Country or Sovereign Risk

‹ Result of exposure to foreign government


which may impose restrictions on repayments
to foreigners.
‹ Often lack usual recourse via court system.

‹ In the event of restrictions, reschedulings, or


outright prohibition of repayments, FIs’
remaining bargaining chip is future supply of
loans
‹ Role of IMF
z Extends aid to troubled banks
z Increased moral hazard problem if IMF bailout expected

7-12
Technology and Operational Risk

‹ Economies of scale.
‹ Economies of scope.

‹ Operational risk not exclusively


technological
z Employee fraud and errors
z Losses magnified since they affect reputation
and future potential
‹ Risk of losses resulting from inadequate or
failed internal processes, people, and
systems or from external events.

6
7-13
Technology and Operational Risk

‹ Risk that technology investment fails to


produce anticipated cost savings.
‹ Risk that technology may break down.
z CitiBank’s ATM network, debit card system and
on-line banking out for two days
z Prudential Financial fined $600 million due to
allegations of improper mutual fund trades

7-14
Liquidity Risk
‹ Risk of being forced to borrow, or sell assets
in a very short period of time.
z Low prices result.
‹ May generate runs.
z Runs may turn liquidity problem into solvency
problem.
z Risk of systematic bank panics.
z Role of FDIC (see Chapter 19)

7
7-15
Insolvency Risk
‹ Riskof insufficient capital to offset sudden
decline in value of assets to liabilities.
z Continental Illinois National Bank and Trust
‹ Original
cause may be excessive interest
rate, market, credit, off-balance-sheet,
technological, FX, sovereign, and liquidity
risks.

7-16
Risks of Financial Intermediation
‹ Other Risks and Interaction of Risks
z Interdependencies among risks.
ƒ Example: Interest rates and credit risk.
ƒ Interest rates and derivative counterparty risk
z Discrete Risks
ƒ Examples include effects of war or terrorist acts,
market crashes, theft, malfeasance.
ƒ Changes in regulatory policy

8
7-17
Macroeconomic Risks
‹ Increased inflation or increase in its volatility.
z Affects interest rates as well.
‹ Increases in unemployment
z Affects credit risk as one example.

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