Risks of FinancialRisks of Financial
IntermediationIntermediation
Chapter 7
© 2008 The McGraw-Hill Companies, Inc., All Ri...
7-2
Overview
 This chapter discusses the risks associated
with financial intermediation:

Interest rate risk, market ris...
7-3
Risks of Financial Intermediation
 Interest rate risk resulting from
intermediation:

Mismatch in maturities of asse...
7-4
Market Risk
 Incurred in trading of assets and liabilities
(and derivatives).

Example: Barings Bank’s Nick Leeson &...
7-5
Market Risk
 Distinction between Investment Book and
Trading Book of a commercial bank

Heightened focus on Value at...
7-6
Credit Risk
 Risk that promised cash flows are not paid
in full.

Firm specific credit risk

Systematic credit risk...
7-7
Charge Off Rates for Commercial Banks
7-8
Implications of Growing Credit Risk
 Importance of credit screening
 Importance of monitoring credit extended
 Role...
7-9
Off-Balance-Sheet Risk
 Striking growth of off-balance-sheet
activities

Letters of credit

Loan commitments

Deri...
7-10
Foreign Exchange Risk
 FI may be net long or net short in various
currencies
 Returns on foreign and domestic inves...
7-11
Foreign Exchange Risk
 Note that completely hedging foreign
exposure by matching foreign assets and
liabilities requ...
7-12
Country or Sovereign Risk
 Result of exposure to foreign government
which may impose restrictions on
repayments to f...
7-13
Country or Sovereign Risk
 In the event of restrictions, reschedulings, or
outright prohibition of repayments, FIs’
...
7-14
Technology and Operational Risk
 Economies of scale.
 Economies of scope.
 Operational risk not exclusively
techno...
7-15
Technology and Operational Risk
 Risk of losses resulting from inadequate or
failed internal processes, people, and
...
7-16
Technology and Operational Risk
 Risk that technology investment fails to
produce anticipated cost savings.
 Risk t...
7-17
Liquidity Risk
 Risk of being forced to borrow, or sell
assets in a very short period of time.

Low prices result.
...
7-18
Insolvency Risk
 Risk of insufficient capital to offset sudden
decline in value of assets to liabilities.

Continen...
7-19
Risks of Financial Intermediation
 Other Risks and Interaction of Risks

Interdependencies among risks.
 Example: ...
7-20
Macroeconomic Risks
 Increased inflation or increase in its
volatility.

Affects interest rates as well.
 Increase...
7-21
Pertinent Websites
Bank for International Settlements
www.bis.org
Board of Governors of the Federal Reserve
www.feder...
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Chap7 mng of fi

  1. 1. Risks of FinancialRisks of Financial IntermediationIntermediation Chapter 7 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin
  2. 2. 7-2 Overview  This chapter discusses the risks associated with financial intermediation:  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  Faced by all global firms
  3. 3. 7-3 Risks of Financial Intermediation  Interest rate risk resulting from intermediation:  Mismatch in maturities of assets and liabilities.  Interest rate sensitivity difference exposes equity to changes in interest rates  Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs.  Inconsistent with asset transformation role  Refinancing risk.  Reinvestment risk.
  4. 4. 7-4 Market Risk  Incurred in trading of assets and liabilities (and derivatives).  Example: Barings Bank’s Nick Leeson & decline in Nikkei Stock Market Index.  Heavier focus on trading income over traditional activities increases market exposure.  Trading activities introduce other perils as was discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses and fraudulent activities involving foreign exchange positions
  5. 5. 7-5 Market Risk  Distinction between Investment Book and Trading Book of a commercial bank  Heightened focus on Value at Risk (VAR)  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
  6. 6. 7-6 Credit Risk  Risk that promised cash flows are not paid in full.  Firm specific credit risk  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. 7. 7-7 Charge Off Rates for Commercial Banks
  8. 8. 7-8 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
  9. 9. 7-9 Off-Balance-Sheet Risk  Striking growth of off-balance-sheet activities  Letters of credit  Loan commitments  Derivative positions  Speculative activities using off-balance- sheet items create considerable risk
  10. 10. 7-10 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.  Example: $/€ may be increasing while $/¥ decreasing  and relationship between ¥ and € time varying.  Undiversified foreign expansion creates FX risk.
  11. 11. 7-11 Foreign Exchange Risk  Note that completely hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well*.  Otherwise, exposure to foreign interest rate risk remains. *More correctly, FI must match durations, rather than maturities. See Chapter 9.
  12. 12. 7-12 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.  Examples:  Argentina  Russia  South Korea • Indonesia • Malaysia • Thailand.
  13. 13. 7-13 Country or Sovereign Risk  In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs’ remaining bargaining chip is future supply of loans  Weak position if currency collapsing or government failing  Role of IMF  Extends aid to troubled banks  Increased moral hazard problem if IMF bailout expected
  14. 14. 7-14 Technology and Operational Risk  Economies of scale.  Economies of scope.  Operational risk not exclusively technological  Employee fraud and errors  Losses magnified since they affect reputation and future potential
  15. 15. 7-15 Technology and Operational Risk  Risk of losses resulting from inadequate or failed internal processes, people, and systems or from external events.  Some include reputational and strategic risk  Technological innovation has seen rapid growth  Automated clearing houses (ACH)  CHIPS  Real time interconnection of global FIs via satellite systems
  16. 16. 7-16 Technology and Operational Risk  Risk that technology investment fails to produce anticipated cost savings.  Risk that technology may break down.  CitiBank’s ATM network, debit card system and on-line banking out for two days  Prudential Financial fined $600 million due to allegations of improper mutual fund trades  Bank of America breakdown in security of tapes  Bank of New York: Computer system failed to recognize incoming payment messages sent via Fedwire although outgoing payments succeeded
  17. 17. 7-17 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.  Example: 1985, Ohio savings institutions insured by Ohio Deposit Guarantee Fund  Interaction of credit risk and liability risk  Role of FDIC (see Chapter 19)
  18. 18. 7-18 Insolvency Risk  Risk of insufficient capital to offset sudden decline in value of assets to liabilities.  Continental Illinois National Bank and Trust  Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.
  19. 19. 7-19 Risks of Financial Intermediation  Other Risks and Interaction of Risks  Interdependencies among risks.  Example: Interest rates and credit risk.  Interest rates and derivative counterparty risk  Discrete Risks  Examples include effects of war or terrorist acts, market crashes, theft, malfeasance.  Changes in regulatory policy
  20. 20. 7-20 Macroeconomic Risks  Increased inflation or increase in its volatility.  Affects interest rates as well.  Increases in unemployment  Affects credit risk as one example.
  21. 21. 7-21 Pertinent Websites Bank for International Settlements www.bis.org Board of Governors of the Federal Reserve www.federalreserve.gov Federal Deposit Insurance Corporation www.fdic.gov

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