asifkhan_56_16097_1_Ch 12 Risk Management in FIs and Basel III.ppt

© 2012 Pearson Prentice Hall. All rights reserved. 23-0
Risk Management in Financial
Institutions

Chapter Preview
 We examine how financial institutions
manage credit risk, interest rate risk, etc.
We explore the tools available to managers
to measure these risks and strategies to
reduce them. Topics include:
─ Managing Credit Risk
─ Managing Interest-Rate Risk

Managing Credit Risk
 A major part of the business of financial
institutions is making loans, and the major
risk with loans is that the borrower will
not repay.
 Credit risk is the risk that a borrower will
not repay a loan according to the terms of
the loan, either defaulting entirely or making
late payments of interest or principal.

 Once again, the concepts of adverse
selection and moral hazard will provide
our framework to understand the principles
financial managers must follow to minimize
credit risk, yet make successful loans.

 Solving Asymmetric Information Problems:
1. Screening and Monitoring:
─ collecting reliable information about prospective
borrowers. This has also lead some institutions
to specialize in regions or industries, gaining
expertise in evaluating particular firms
─ also involves requiring certain actions, or
prohibiting others, and then periodically
verifying that the borrower is complying with the
terms of the loan contract.

 Specialization in Lending helps in
screening. It is easier to collect data on
local firms and firms in specific industries. It
allows them to better predict problems by
having better industry and location
knowledge.

 Monitoring and Enforcement also helps.
Financial institutions write protective
covenants into loans contracts and actively
manage them to ensure that borrowers are
not taking risks at their expense.

2. Long-term Customer Relationships:
past information contained in checking
accounts, savings accounts, and previous
loans provides valuable information to
more easily determine credit worthiness.

3. Loan Commitments: arrangements
where the bank agrees to provide a loan
up to a fixed amount, whenever the firm
requests the loan.
4. Collateral: a pledge of property or other
assets that must be surrendered if the
terms of the loan are not met ( the loans
are called secured loans).

5. Compensating Balances: reserves that a
borrower must maintain in an account that
act as collateral should the borrower default.
6. Credit Rationing:
 lenders will refuse to lend to some borrowers,
regardless of how much interest they are willing to pay,
or
 lenders will only finance part of a project, requiring that
the remaining part come from equity financing.

Managing Interest-Rate Risk
 To see how financial institutions can
measure and manage interest-rate risk
exposure, we will examine the balance
sheet for First National Bank (next slide).
 We will develop two tools, (1) Income Gap
Analysis and (2) Duration Gap Analysis, to
assist the financial manager in this effort.

Managing Interest-Rate Risk
Risk Management Association home page http://www.rmahq.org

Income Gap Analysis: Determining Rate
Sensitive Items for First National Bank
 Assets
─ assets with maturity
less than one year
─ variable-rate mortgages
─ short-term commercial
loans
─ portion of fixed-rate
mortgages (say 20%)
 Liabilities
─ money market deposits
─ variable-rate CDs
─ short-term CDs
─ federal funds
─ short-term borrowings
─ portion of checkable
deposits (10%)
─ portion of savings (20%)

Income Gap Analysis: Determining Rate
Sensitive Items for First National Bank
Rate-Sensitive Assets = $5m + $ 10m + $15m + 20%  $10m
RSA = $32m
Rate-Sensitive Liabs = $5m + $25m + $5m + $10m + 10%  $15m
+ 20%  $15m
RSL = $49.5m
if i  5% 
Estimate of % of checkable
deposits and savings
accounts that will
experience rate change

Income Gap Analysis
If RSL > RSA, i  results in: NIM , Income 
GAP = RSA  RSL
=
Income = GAP  i
=
This is essentially a short-term focus on interest-rate risk
exposure. A longer-term focus uses duration gap analysis.

Duration Gap Analysis
 Owners and managers do care about the
impact of interest rate exposure on current
net income.
 They are also interested in the impact of
interest rate changes on the market value
of balance sheet items and on net worth.
 The concept of duration, plays a role here.

 Duration Gap Analysis: measures the
sensitivity of a bank’s current year net
income to changes in interest rate.
 Requires determining the duration for assets
and liabilities, items whose market value will
change as interest rates change. Let’s see
how this looks for First National Bank.

Duration of First
National Bank's
Assets and
Liabilities

 The basic equation for determining the change in
market value for assets or liabilities is:

 Consider a change in rates from 10% to
11%. Using the value from Table 24.1,
we see:
 Assets:

 Liabilities:
 Net Worth:

 For a rate change from 10% to 11%, the net
worth of First National Bank will fall,
changing by $1.6m.
 Recall from the balance sheet that First
National Bank has “Bank capital” totaling
$5m. Following such a dramatic change in
rate, the capital would fall to $3.4m.

What is "Basel III":
" A global regulatory standard to achieve following objectives :
 bank capital adequacy
 stress testing and
 market liquidity risk
Through;
 Minimizing the probability of recurrence of crises to greater
extent.
 Improving the banking sector's ability to absorb shocks arising
from financial and economic stress.
 Improving risk management and governance.
 Strengthening banks' transparency and disclosures .

A. Capital Reform
A new definition of capital.
Capital conservation buffer.
Countercyclical capital buffer.
Minimum capital standards.

A new definition of capital
 Total regulatory capital will consist of the sum of
the following elements:
1. Tier 1 Capital (going-concern capital)
a. Common Equity Tier 1
b. Additional Tier 1
2. Tier 2 Capital (gone-concern capital)

Capital conservation buffer
 The capital conservation buffer is designed to ensure that
banks build up capital buffers outside periods of stress
which can be drawn down as losses are incurred.
 A capital conservation buffer of 2.5%, comprised of
Common Equity Tier 1, is established above the
regulatory minimum capital requirement.
 Outside of periods of stress, banks should hold buffers of
capital above the regulatory minimum.

Countercyclical capital buffer
 The countercyclical buffer aims to ensure that banking
sector capital requirements take account of the macro-
financial environment in which banks operate.
 It will be deployed by national jurisdictions when excess
aggregate credit growth is judged to be associated with a
build-up of system-wide risk to ensure the banking system
has a buffer of capital to protect it against future potential
losses.

B. Liquidity Standards:
1. Short-term: Liquidity Coverage Ratio(LCR)
 to hold high quality liquid assets in order to survive in emergent
stress scenario.
1. Long-term: Net Stable Funding Ratio(NSFR)
 To promote more medium and long-term funding activities of banking
organizations.
 Ensure that the investment activities are funded by stable liabilities.
 To limit the over-reliance on wholesale short-term funding(money
market)

C. Systemic risk and
interconnectedness
(Counterparty risk)
 Capital incentives for using Central Party Clearing
House (CCPs) for OTC.
 Higher capital for systemic derivatives.
 Higher capital for inter-financial exposures.
 Contingent capital.
 Capital surcharge for systemic banks.

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