Chapter Twenty of by 20-1

Chapter Twenty
Types of Risks Incurred
by Financial Institutions
McGraw-Hill /Irwin
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Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.
Why FIs Need to Manage Risk
• Major objective of FI management is to increase the
FI’s returns for its owners
• Risks of financial intermediation have increased as
the U.S. and overseas economies have become more
integrated (i.e., weak economic conditions in Asia
and South America)
• FIs that have no foreign customers can still be
exposed to foreign exchange and sovereign risk if
their customers have dealings with foreign countries
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Risks Faced by Financial Intermediaries
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Credit Risk
Liquidity Risk
Interest Rate Risk
Market Risk
Off-Balance-Sheet Risk
Foreign Exchange Risk
Country or Sovereign Risk
Technology Risk
Operational Risk
Insolvency Risk
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Credit Risk
• Credit risk - the risk that the promised cash flows
from loans and securities held by FIs may not be
paid in full
• Firm-specific credit risk - the risk of default by the
borrowing firm associated with the specific types of
project risk taken by that firm
• Systematic credit risk - the risk of widespread
defaults associated with general economy-wide or
macroeconomic conditions affecting all borrowers
(e.g., an economic recession)
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Liquidity Risk
• Liquidity risk - the risk that a sudden surge in
liability withdrawals may require an FI to liquidate
assets in a very short period of time and at low
prices
• Liquidity risk arises when an FIs liability holders
demand immediate cash for their financial claim
• Serious liquidity problems may result in a “run” in
which all liability claimholders seek to withdraw
their funds and can lead to a solvency problem
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Interest Rate Risk
• Interest rate risk - the risk incurred by an FI when
the maturities of its assets and liabilities are
mismatched
• Federal Reserve tries to have an influence on
interest rate volatility through its daily open-market
operations
• Increased globalization of financial market flows
has made the measurement and management of
interest rate risk a prominent concern
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Maturity Mismatching and Interest Rate
Risk
• Asset transformation involves an FI buying
primary securities or assets and issuing
secondary securities or liabilities to fund the
assets, can often have differing maturities
• Economic or present-value uncertainty arises
when interest rates change
• FIs can seek to hedge by matching the maturity
of their assets and liabilities
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Market Risk
• Market risk - the risk incurred in trading assets and
liabilities due to changes in interest rates, exchange
rates, and other asset prices
• Closely related to interest rate and foreign exchange
risk
• Decline in income from deposit taking and lending
has been matched by increased reliance on income
from trading
• FI management required to establish controls or
limits on day-to-day exposure to risk
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Off-Balance-Sheet Risk
• Off-balance-sheet risk - risk incurred by an FI as the
result of activities related to contingent assets and
liabilities
• Letter of credit - credit guarantee issued by an FI for a
fee on which payment is contingent on some future
even occurring, most notably default of the agent
• Loan commitments by banks, mortgage servicing
contracts by thrifts, and positions in forwards, futures,
swaps, options, etc., are structured to reduce an FI's
exposure to credit, interest rate, or foreign exchange
risk, but increase an FI’s OBS risk
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Foreign Exchange Risk
• Foreign exchange risk - the risk that exchange
rate changes can affect the value of an FI’s
assets and liabilities denominated in foreign
currencies
• Returns on domestic and foreign direct
investments not perfectly correlated
– underlying technologies of various economies differ
– exchange rate changes are not perfectly correlated
across countries
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Country or Sovereign Risk
• Country or Sovereign Risk - the risk that
repayments from foreign borrowers may be
interrupted because of interference from foreign
governments
• When a foreign country is unwilling or unable to
repay a loan, the FI has little recourse
• The leverage available to ensure or increase
repayment probabilities is control over the future
supply of loans or funds to the country
concerned
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Technology and Operational Risk
• Technology risk - the risk incurred by an FI
when its technological investments do not
produce anticipated cost savings
• Operational risk - the risk that existing
technology or support systems may malfunction
or break down
• Major objective of technological expansion is to
increase economies of scale and scope
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Insolvency Risk
• Insolvency risk - the risk that an FI may not have
enough capital to offset a sudden decline in the value of
its assets relative to its liabilities
• A consequence or an outcome of one or more of these
risks: interest rate, market, credit, OBS, technological,
foreign exchange, sovereign, and liquidity
• Occurs when the capital or equity resources of an FI’s
owners are driven to, or near to, zero
• The lower an FI’s leverage, the better able it is to
withstand losses due to risk exposures
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Interaction Among Risks
• These risks are all interdependent
• Various other risks, often more discrete or event-type,
impact an FI’s profitability and risk exposure
– sudden changes in taxation
– changes in regulatory policy
– sudden and unexpected changes in financial market
conditions due to war, revolution, or market collapse
– theft, malfeasance, and breach of fiduciary trust
– increased inflation, inflation volatility, and unemployment
McGraw-Hill /Irwin
20-14
Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved.