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Ch 7 Risks of Fis Overview

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Ch 7 Risks of Fis Overview 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. 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. 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 Risk of 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. Example: Interest rates and credit risk. Interest rates and derivative counterparty risk z Discrete Risks Examples include effects of war or terrorist acts, market crashes, theft, malfeasance. 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. 9.
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