Financial institutions manage various types of risks: 1) Credit risk is the risk of loss from borrower defaults and can be mitigated through loan diversification, credit analysis of borrowers, and adjusting interest rates. 2) Liquidity risk is the risk that a financial institution cannot meet demands for withdrawals, loans or claims and can be managed through effective asset-liability management. 3) Interest rate risk exists due to variability in interest rates and can be caused by maturity mismatches between assets and liabilities. Financial institutions use interest rate derivatives to hedge this risk.

1. Chapter Five
Financial Institutions and risk management

2. The only alternative to risk management is crisis
management --- and crisis management is much
more expensive, time consuming and
embarrassing.
JAMES LAM, Enterprise Risk Management, Wiley
© 2003

3. In the financial world, risk
management is the process of
identification, analysis, and
acceptance or mitigation of
What Is Risk Management?

4. Essentially, risk management
occurs when financial institutions
analyzes and attempts to quantify
the potential for losses in the
institutions and then takes the
What Is Risk Management?

5.  A solid understanding of risk in its different forms can help FI to
better understand
The opportunities,
Trade-offs, and
Costs involved
with different investment approaches.

6. Managing credit risk
Managing liquidity risk
Managing interest rate risk
Managingrisk

7. • Because of this they have
higher degree of exposure
to credit risk than anyother

8. • Credit risk is the possibility of a loss resulting from a borrower's
failure to repay a loan or meet contractual obligations.
• Traditionally, it refers to the risk that a lender may not receive the
owed principal and interest, which results in an interruption of cash
flows and increased costs for collection.

9. •When a lender faces heightened credit risk,
it can be mitigated via a higher coupon rate,
which provides for greater cash flows.
 Interest payments from the borrower or issuer of a debt obligation
are a lender's reward for assuming credit risk.
•Securities with long-term maturity
maturity pose more credit risk than
than securities with short-term
maturity

10. Causes
• The problem of information asymmetry
•Asymmetric information—a situation that arises when one
party’s have insufficient knowledge about the other party.
Adverse selection and Moral hazard

11. Although it's impossible to know exactly
who will default on obligations, properly
assessing and managing credit risk can
can lessen the severity of a loss.
Managerial efficiency and credit risk management strategy
affects credit risk of a loan portfolio.

12. What mechanism can management follow to eliminate credit risk?
Loan diversification can help to eliminate firm specific credit risk.
FIs make loans to corporations, individuals, and governments
Making credit risk analysis

13. Credit Analysis
The system weighs five characteristics of the borrower and conditions of the loan, attempting to estimate the
chance of default and, consequently, the risk of a financial loss for the lender by analyzing the C‘s .

14. • The five C's of credit are used to convey the creditworthiness of potential borrowers.
 Character—The applicant's credit history which is a borrower's reputation or track
record for repaying debts.
 Capacity—The applicant's debt-to-income ratio.
 Capital—The amount of money an applicant has. Lenders also consider any capital the
borrower puts toward a potential investment. A large contribution by the borrower decreases the
chance of default.
 Collateral—An asset that can back or act as security for the loan. It gives the lender the
assurance that if the borrower defaults on the loan, the lender can get something back by
repossessing the collateral.
 Conditions—The purpose of the loan, the amount involved, and prevailing
interest rates.

15.  The likelihood that a FI becomes unable to meet demand for withdrawal, loan, or
indemnity.
 Liquidity is the ability of FI to pay its debts without suffering catastrophic
losses.
 If a financial institution cannot meet its short-term debt obligations, it is
experiencing liquidity risk.
 FI manage their liquidity risk through effective asset liability management
ManagingLiquidityrisk

16. May enforce FIs to dispose illiquid assets at a cheap price
May cause a ‘bank run‘
ManagingLiquidityrisk

17. Interest rate risk exists in an interest-bearing asset, such
as a loan or a bond, due to the possibility of a change in
the asset's value resulting from the variability of interest
rates.
Caused by maturity mismatch of assets and liabilities
coupled with interest rate volatility
Managing Interest Rate Risk

18. oRefinancing risk –Assets have long-term maturity and
liabilities of short-term maturity. Cost of refinancing may
exceed return on assets
oReinvestment risk–holding short-term assets relative to
liabilities. Uncertainity about interest rate at which borrowed
funds will be reinvested.
oPrice risk—effect of change in interest rate on value of an
asset or liability

19. Interest rate risk management has become very important, and
assorted instruments have been developed to deal with interest
rate risk.
FI manage interest rate risk using various interest rate derivative
instruments.
Certain products and options, such as forward and futures
contracts, help investors hedge interest rate risks.

20. As with any risk-management assessment, there is always the
option to do nothing, and that is what many people do.
However, in circumstances of unpredictability, sometimes
not hedging is disastrous.

21. End of Ch-5