Lecture 1 – OVERVIEW OF THE RISKS FACED BY FIS
Commercial bank charge-off rate – loans charged off as a percentage of total loans
THE 10 TYPES OF RISKS FACED BY FINANCIAL INSTITUTIONS:
1. CREDIT RISK – the risk that promised cash flows from loans and securities held by FIs
may not be paid in full or in part. Accordingly, a key role of FIs involves screening
and monitoring loan applicants to ensure that FI managers fund the most
creditworthy loans. However even as losses due to credit risk increase, FIs continue
to give loans. This is because the FI charges a rate of interest on a loan that
compensates for the risk of the loan. Moreover, one of the advantages that FIs have
is their ability to diversify credit risk exposures from a single asset. This
diversification across assets, such as loans exposed to credit risk, reduces the overall
credit risk in the asset portfolio and thus increases the probability of partial of full
repayment of principal or interest. In particular, diversification reduces individual
firm-specific credit risk, such as the risk specific to holding the bonds or loans of
General Motors, while still leaving the FI exposed to systematic credit risk, such as
factors that simultaneously increase the default risk of all firms in the economy.
2. LIQUIDITY RISK – the risk that sudden and unexpected increase in liability
withdrawals may require an FI to liquidate assets in a very short period of time and
at low prices or when holders of off-balance-sheet loan commitments suddenly
exercise their right to borrow. The FI must either liquidate assets or borrow
additional funds to meet the demand for the withdrawal of funds. This results in a
more serious liquidity risk, especially as some assets with thin markets generate
lower prices when the sale is immediate than when FI has more time to negotiate
the sale of an asset. As a result, the liquidation of some assets at low prices could
threaten an FI’s profitability and solvency.
3. INTEREST RATE RISK – the risk incurred by FI when the maturities of its assets and
liabilities are mismatched and interest rates are volatile. Consider an FI that issues
$100 million of liabilities with one year maturity to finance the purchase of $100
million of assets with two year maturity:
Suppose the cost of the funds (liabilities) is 9% in Year 1 and interest yield on assets
is 10% per year. Over the Year 1, the FI can lock in a profit of yield of 1% (10% - 9%).
However its profit for the Year 2 is uncertain. If the interest rate for the liabilities
does not change, the FI can refinance its liabilities again at 9% and lock in 1% yield.
The risk however always exists. If interest rate rises and the FI can borrow new one
year liability at only 11% in the Year 2, its profit spread in the Year 2 is actually
negative (10% - 11% = -1%). The positive spread earned in the Year 1 from holding
assets with longer maturity than its liabilities is offset by a negative spread in the
Year 2. When an FI holds longer-term assets relative to short-term liabilities, it
potentially exposes itself to refinancing risk because of a rise in interest rates in
liabilities (borrowed funds) when the asset is refinanced again (liability interest rate
becomes greater than income generating asset interest rate).
The FI is also exposed to reinvestment risk, by holding shorter-term assets relative
to liabilities when reinvesting the borrowed funds in assets again (the interest rate
1
, of income generating assets decreases (from 10% to 8%) and can no longer fund the
long-term liability interest payments (9%)):
In addition, FI faces price risk as well as when interest rates change. Remember that
the fair value of an asset is equal to PV of the future cash flows on that asset.
Therefore, rising interest rates reduce the market price or present value of that
asset/liability. Conversely, falling interest rates increase the present value of the
cash flows from assets/liabilities. Moreover, mismatching maturities by holding
longer term assets than liabilities means than when interest rates rise, the present
value of the FI’s assets fall by a larger amount than do its liabilities. This exposes the
FI to the risk of economic loss and potentially to the risk of insolvency. If holding
assets and liabilities with mismatched maturities expose FIs to interest rate risk, FIs
can seek to hedge or protect themselves against interest rate risk by matching the
maturity of their assets and liabilities. Although it does reduce exposure to interest
rate risk, matching maturities may reduce the FIs profitability. Finally, matching
maturities hedges interest rate risk only in a very approximate rather than complete
fashion. The reasons for this is because the FI can choose to partly fund its assets
both with equity capital and with liabilities.
4. MARKET RISK – the incremental (long-term) risk incurred when trading assets and
liabilities (to earn more profit from trading) due to changes in interest rates,
exchange rates and other prices. Conceptually, the FIs trading portfolio can be
differentiated from its investment portfolio on the basis of time horizon and liquidity.
The trading portfolio contains assets, liabilities and derivatives that can be quickly
bought or sold on organized financial markets. The investment portfolio contains
assets and liabilities that are relatively illiquid and held for longer periods. However,
FIs are concerned about the fluctuations in value – or value at risk (VAR) – of their
trading account assets and liabilities for periods as short as one day – so-called daily
earnings at risk (DEAR) – especially if such fluctuations pose a threat to their
solvency. As volatility of asset prices increases, the market risk faced by FIs that
adopt open trading positions increase.
5. OFF-BALANCE SHEET RISK – the risk incurred by FI as the result of its activities
related to off-balance sheet (OBS) activities. The ability to earn fee income while not
expanding the balance sheet has become an important motivation for FIs to pursue
OBS business. An example of an OBS activity is the issuance of standby letter of
credit guarantees by insurance companies and banks to back the issuance of
municipal bonds. Many state and local government could not issue such securities
without bank or insurance company letter of credit guarantees that promise
principal and interest payments to investors if the municipality defaults on its
obligations in the future. Thus, the letter of credit guarantees payment when a
municipal government faces financial problems in paying the promised interest or
principal payments on the bonds it issues. If a municipal government’s cash flow is
sufficiently strong so as to pay off the principal and interest on the debt is issues, the
letter of credit guarantee expires unused. Nothing appears on the FI’s balance sheet
today or in the future. However, the fee earned for issuing the letter of credit
guarantee appears on the FI’s income statement. Loan commitments and credit lines
2
, are also OBS activities that create risk for an FI. OBS activity can increase FI’s interest
rate risk, credit risk & FOREX risk
6. FOREX RISK – the risk that exchange rate changes can affect the value of an FI’s
assets and liabilities denominated in foreign currencies. Foreign exchange risks can
occur either directly as a result of trading in foreign currencies, making foreign
currency loans, buying foreign-issued securities or issuing foreign-currency
denominated debt. Suppose that a U.S. FI makes a $1000 loan to a UK company in
pounds. If the British pound depreciates in value relative to U.S dollar, (from 0.5 to
0.6), the principal and interest payments received by the U.S FI would be devalued in
dollar terms (before $1000 x £0.5 = £500 and after £500 / $0.6 = $833 ). Thus U.S. FI
looses from this.
In general, an FI can hold assets denominated in a foreign currency and issue foreign
liabilities.
Consider, a U.S. FI that holds £100,000,000 British pound loans as assets and funds
£80,000,000 of them with British pound deposits in the bank. The difference
between the £100,000,000 in loans and £80,000,000 in deposits is funded by dollar
deposits (£20,000,000 worth of dollar deposits). In this case, the U.S FI is in the NET
LONG POSITION of £20,000,000 in British assets; that is it holds more assets than
liabilities. The U.S. FI suffers losses if the exchange rate for pound falls in value (from
0.5 to 0.6) against the dollar over this period. In dollar terms, the value of British
loan assets falls in value by more than the British pound deposit liabilities do. That is,
FI is exposed to the risk that its net foreign assets may have to be liquidated at an
exchange rate lower than before(!!!).
Instead, the FI could have £20,000,000 more foreign deposit liabilities
(£100,000,000) than loan assets (£80,000,000); in this case, it would be holding a
NET SHORT POSITION in foreign assets (loans) (!!!). Under this circumstance, the FI
is exposed to FOREX risk if the pound appreciates against the dollar (from 0.5 to 0.4)
over the investment period. This occurs because the value of its British pound
liabilities in dollar terms rose faster than the return on its British assets.
The FI can fully hedge this risk only if it holds foreign assets and liabilities of exactly
the same size & maturity. Consequently, an FI that matches both the size and
maturities of its exposures in assets and liabilities of a given currency is immunized
against foreign currency and foreign interest rate risk.
7. SOVEREIGN RISK - the risk that repayments by foreign borrowers may be
interrupted because of interference from foreign governments or other political
entities. For example, when a domestic corporation is unable to repay a loan, FI
usually has resource to the domestic bankruptcy court and eventually may recoup at
least a portion of its original investment when the assets of the defaulted firm are
liquidated or restructured. By comparison, a foreign corporation may be unable to
repay the principal or interest on a loan even if it would like to do so. In this case,
the government of the country in which the corporation is headquartered may
prohibit or limit debt repayments due to foreign currency shortages and adverse
political events; and FI claimholder has little resource to local bankruptcy courts or
to an international civil claims court.
3
, 8. TECHNOLOGY RISK – the risk incurred by an FI when its technological investments
do not produce anticipated cost savings. In recent years, FIs have sought to improve
their operational efficiency with major investments in internal and external
communications, computers, and expanded technological infrastructure in order to
lower operating costs, increase profits and to capture new markets. The objective is
to allow the FI to exploit, to the fullest extent possible, potential economies of scale
and economies of scope in selling its products. Technological risk can result in major
losses in an FI’s competitive efficiency and ultimately result in its long-term failure.
Similarly, gains from technological investments can produce performance superior
to an FI’s rivals and allow and FI to develop new and innovative products enhancing
its long-term survival chances.
9. OPERATIONAL RISK – the risk that existing technology or support systems may
malfunction, for example a fraud that impacts the FI’s activities may occur or
external shocks such as hurricane and floods may occur.
10. 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 as a result of one or
more of the risks described above. In general, the more equity capital to borrowed
funds an FI has – that is, the lower its leverage – the better it is able to withstand
losses. Thus, both the management and regulators of FIs focus on an FI’s capital as a
key measure of its ability to remain solvent.
4
Commercial bank charge-off rate – loans charged off as a percentage of total loans
THE 10 TYPES OF RISKS FACED BY FINANCIAL INSTITUTIONS:
1. CREDIT RISK – the risk that promised cash flows from loans and securities held by FIs
may not be paid in full or in part. Accordingly, a key role of FIs involves screening
and monitoring loan applicants to ensure that FI managers fund the most
creditworthy loans. However even as losses due to credit risk increase, FIs continue
to give loans. This is because the FI charges a rate of interest on a loan that
compensates for the risk of the loan. Moreover, one of the advantages that FIs have
is their ability to diversify credit risk exposures from a single asset. This
diversification across assets, such as loans exposed to credit risk, reduces the overall
credit risk in the asset portfolio and thus increases the probability of partial of full
repayment of principal or interest. In particular, diversification reduces individual
firm-specific credit risk, such as the risk specific to holding the bonds or loans of
General Motors, while still leaving the FI exposed to systematic credit risk, such as
factors that simultaneously increase the default risk of all firms in the economy.
2. LIQUIDITY RISK – the risk that sudden and unexpected increase in liability
withdrawals may require an FI to liquidate assets in a very short period of time and
at low prices or when holders of off-balance-sheet loan commitments suddenly
exercise their right to borrow. The FI must either liquidate assets or borrow
additional funds to meet the demand for the withdrawal of funds. This results in a
more serious liquidity risk, especially as some assets with thin markets generate
lower prices when the sale is immediate than when FI has more time to negotiate
the sale of an asset. As a result, the liquidation of some assets at low prices could
threaten an FI’s profitability and solvency.
3. INTEREST RATE RISK – the risk incurred by FI when the maturities of its assets and
liabilities are mismatched and interest rates are volatile. Consider an FI that issues
$100 million of liabilities with one year maturity to finance the purchase of $100
million of assets with two year maturity:
Suppose the cost of the funds (liabilities) is 9% in Year 1 and interest yield on assets
is 10% per year. Over the Year 1, the FI can lock in a profit of yield of 1% (10% - 9%).
However its profit for the Year 2 is uncertain. If the interest rate for the liabilities
does not change, the FI can refinance its liabilities again at 9% and lock in 1% yield.
The risk however always exists. If interest rate rises and the FI can borrow new one
year liability at only 11% in the Year 2, its profit spread in the Year 2 is actually
negative (10% - 11% = -1%). The positive spread earned in the Year 1 from holding
assets with longer maturity than its liabilities is offset by a negative spread in the
Year 2. When an FI holds longer-term assets relative to short-term liabilities, it
potentially exposes itself to refinancing risk because of a rise in interest rates in
liabilities (borrowed funds) when the asset is refinanced again (liability interest rate
becomes greater than income generating asset interest rate).
The FI is also exposed to reinvestment risk, by holding shorter-term assets relative
to liabilities when reinvesting the borrowed funds in assets again (the interest rate
1
, of income generating assets decreases (from 10% to 8%) and can no longer fund the
long-term liability interest payments (9%)):
In addition, FI faces price risk as well as when interest rates change. Remember that
the fair value of an asset is equal to PV of the future cash flows on that asset.
Therefore, rising interest rates reduce the market price or present value of that
asset/liability. Conversely, falling interest rates increase the present value of the
cash flows from assets/liabilities. Moreover, mismatching maturities by holding
longer term assets than liabilities means than when interest rates rise, the present
value of the FI’s assets fall by a larger amount than do its liabilities. This exposes the
FI to the risk of economic loss and potentially to the risk of insolvency. If holding
assets and liabilities with mismatched maturities expose FIs to interest rate risk, FIs
can seek to hedge or protect themselves against interest rate risk by matching the
maturity of their assets and liabilities. Although it does reduce exposure to interest
rate risk, matching maturities may reduce the FIs profitability. Finally, matching
maturities hedges interest rate risk only in a very approximate rather than complete
fashion. The reasons for this is because the FI can choose to partly fund its assets
both with equity capital and with liabilities.
4. MARKET RISK – the incremental (long-term) risk incurred when trading assets and
liabilities (to earn more profit from trading) due to changes in interest rates,
exchange rates and other prices. Conceptually, the FIs trading portfolio can be
differentiated from its investment portfolio on the basis of time horizon and liquidity.
The trading portfolio contains assets, liabilities and derivatives that can be quickly
bought or sold on organized financial markets. The investment portfolio contains
assets and liabilities that are relatively illiquid and held for longer periods. However,
FIs are concerned about the fluctuations in value – or value at risk (VAR) – of their
trading account assets and liabilities for periods as short as one day – so-called daily
earnings at risk (DEAR) – especially if such fluctuations pose a threat to their
solvency. As volatility of asset prices increases, the market risk faced by FIs that
adopt open trading positions increase.
5. OFF-BALANCE SHEET RISK – the risk incurred by FI as the result of its activities
related to off-balance sheet (OBS) activities. The ability to earn fee income while not
expanding the balance sheet has become an important motivation for FIs to pursue
OBS business. An example of an OBS activity is the issuance of standby letter of
credit guarantees by insurance companies and banks to back the issuance of
municipal bonds. Many state and local government could not issue such securities
without bank or insurance company letter of credit guarantees that promise
principal and interest payments to investors if the municipality defaults on its
obligations in the future. Thus, the letter of credit guarantees payment when a
municipal government faces financial problems in paying the promised interest or
principal payments on the bonds it issues. If a municipal government’s cash flow is
sufficiently strong so as to pay off the principal and interest on the debt is issues, the
letter of credit guarantee expires unused. Nothing appears on the FI’s balance sheet
today or in the future. However, the fee earned for issuing the letter of credit
guarantee appears on the FI’s income statement. Loan commitments and credit lines
2
, are also OBS activities that create risk for an FI. OBS activity can increase FI’s interest
rate risk, credit risk & FOREX risk
6. FOREX RISK – the risk that exchange rate changes can affect the value of an FI’s
assets and liabilities denominated in foreign currencies. Foreign exchange risks can
occur either directly as a result of trading in foreign currencies, making foreign
currency loans, buying foreign-issued securities or issuing foreign-currency
denominated debt. Suppose that a U.S. FI makes a $1000 loan to a UK company in
pounds. If the British pound depreciates in value relative to U.S dollar, (from 0.5 to
0.6), the principal and interest payments received by the U.S FI would be devalued in
dollar terms (before $1000 x £0.5 = £500 and after £500 / $0.6 = $833 ). Thus U.S. FI
looses from this.
In general, an FI can hold assets denominated in a foreign currency and issue foreign
liabilities.
Consider, a U.S. FI that holds £100,000,000 British pound loans as assets and funds
£80,000,000 of them with British pound deposits in the bank. The difference
between the £100,000,000 in loans and £80,000,000 in deposits is funded by dollar
deposits (£20,000,000 worth of dollar deposits). In this case, the U.S FI is in the NET
LONG POSITION of £20,000,000 in British assets; that is it holds more assets than
liabilities. The U.S. FI suffers losses if the exchange rate for pound falls in value (from
0.5 to 0.6) against the dollar over this period. In dollar terms, the value of British
loan assets falls in value by more than the British pound deposit liabilities do. That is,
FI is exposed to the risk that its net foreign assets may have to be liquidated at an
exchange rate lower than before(!!!).
Instead, the FI could have £20,000,000 more foreign deposit liabilities
(£100,000,000) than loan assets (£80,000,000); in this case, it would be holding a
NET SHORT POSITION in foreign assets (loans) (!!!). Under this circumstance, the FI
is exposed to FOREX risk if the pound appreciates against the dollar (from 0.5 to 0.4)
over the investment period. This occurs because the value of its British pound
liabilities in dollar terms rose faster than the return on its British assets.
The FI can fully hedge this risk only if it holds foreign assets and liabilities of exactly
the same size & maturity. Consequently, an FI that matches both the size and
maturities of its exposures in assets and liabilities of a given currency is immunized
against foreign currency and foreign interest rate risk.
7. SOVEREIGN RISK - the risk that repayments by foreign borrowers may be
interrupted because of interference from foreign governments or other political
entities. For example, when a domestic corporation is unable to repay a loan, FI
usually has resource to the domestic bankruptcy court and eventually may recoup at
least a portion of its original investment when the assets of the defaulted firm are
liquidated or restructured. By comparison, a foreign corporation may be unable to
repay the principal or interest on a loan even if it would like to do so. In this case,
the government of the country in which the corporation is headquartered may
prohibit or limit debt repayments due to foreign currency shortages and adverse
political events; and FI claimholder has little resource to local bankruptcy courts or
to an international civil claims court.
3
, 8. TECHNOLOGY RISK – the risk incurred by an FI when its technological investments
do not produce anticipated cost savings. In recent years, FIs have sought to improve
their operational efficiency with major investments in internal and external
communications, computers, and expanded technological infrastructure in order to
lower operating costs, increase profits and to capture new markets. The objective is
to allow the FI to exploit, to the fullest extent possible, potential economies of scale
and economies of scope in selling its products. Technological risk can result in major
losses in an FI’s competitive efficiency and ultimately result in its long-term failure.
Similarly, gains from technological investments can produce performance superior
to an FI’s rivals and allow and FI to develop new and innovative products enhancing
its long-term survival chances.
9. OPERATIONAL RISK – the risk that existing technology or support systems may
malfunction, for example a fraud that impacts the FI’s activities may occur or
external shocks such as hurricane and floods may occur.
10. 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 as a result of one or
more of the risks described above. In general, the more equity capital to borrowed
funds an FI has – that is, the lower its leverage – the better it is able to withstand
losses. Thus, both the management and regulators of FIs focus on an FI’s capital as a
key measure of its ability to remain solvent.
4
