drake drake university fin 286 finance 286 financial risk management

DrakeDRAKE UNIVERSITY

Fin 286

Finance 286

Financial Risk Management

DrakeDrake University

Fin 286Syllabus

TextbooksFinancial Institutions Management

PrerequisitesRules of the GameOffice Hours /Contact InformationGradesWebsite

AssignmentsExaminations DisabilitiesAcademic Misconduct Evaluations


Fin 286Grades

Individual Assignments 100 points (33.33%)Due Approximately at the middle and end of semester.

Short Group Assignments (2 per group) 5 @ 20 points each, total=100 points (33.33%)

Due every Monday starting July 10

Semester Long Group Project (4 per group)100 points each


Fin 286Course Description

Bank Vs. Financial Institutions Management

Financial Services Modernization Act 1999 (Gramm-Leach Bliley Act)

Breaking down the barriers between Banking, Investment Banking and Insurance.


Fin 286The Modern Bank

Services Provided:Credit (loan) servicesThrift (savings) servicesPayment (transaction) servicesInvestment and financial planning servicesInvestment Banking (security underwriting)Brokerage (trading) servicesInsurance ServicesOther


Fin 286Course Topics

Depository Institutions and the Financial System.Introduction, financial intermediation

Intro to ManagementUBPR, Dupont Analysis, Financial Analysis

Measuring Risk in FI’sGAP analysis (Rate sensitive assets and liabilities)Market, Liquidity, Credit, Operational and other Risks

Managing RiskLiability and Liquidity Risk, Capital Adequacy

International AspectsForeign Exchange and Sovereign Risk Geographic Diversification


Fin 286Background

Financial Institutions (FI) – Channel funds from individuals and institutions with a surplus of funds to (suppliers) to those with a shortage or funds (users of capital).

BanksCredit UnionsInsurance CompaniesMutual Funds

Total assets 2000 = $14.75 trillion


Fin 286Categories of FI’s

Depository InstitutionsBanks, Savings and loans, Thrifts, Credit Unions

Nondepository InstitutionsInsurance Co’s, Investment Banks, securities firms, mutual funds and finance companies


Fin 286Similar Risks and Rewards

All Financial Institutions:Hold Assets that are subject to default (or credit) riskAre exposed to interest rate risk based on maturity of assets and liabilitiesExposed to liquidity (withdraw) risksFace operational costs and risks


Fin 286Without FIs

Corporations

(net borrowers))

Households

(net savers)

Cash

Equity & Debt

©2003 McGraw-Hill Companies Inc. All rights reserved


Fin 286Problems w/o FI’s

Monitoring is costlyExposes households to increased risk

Lack of LiquidityHouseholds may not be able to easily convert claims to cash

Price RisksPrices fluctuate


Fin 286With FIs as Intermediaries

Cash

Households Corporations

Equity & Debt

FI

(Brokers)

FI

(Asset Transformers)

Deposits/Insurance Policies

Cash

©2003 McGraw-Hill Companies Inc. All rights reserved


Fin 286Special Roles played by FI’s

Economy - Wide ServicesInformation, Liquidity, Price risk reduction, Transaction cost and Maturity intermediation services

Institution Specific ServicesMonetary policy transmission (depository Institutions), Credit allocation (thrifts, farm banks), Intergenerational Transfers (Insurance and pensions, payments services (depository institutions) and Denomination intermediation



Brokerage FunctionResearch and information provider (reduces information costs such as agency costs)Economies of Scale (decreases transaction costs and information costs)

Asset – Transformation FunctionPurchase primary claims and issue secondary claims (reducing contracting costs)Allows for risk sharing via diversification (reduces price and liquidity risk)



Transmission of Monetary PolicyThe liquid nature of depository institutions make them the main way monetary policy is transmitted to the public

Credit AllocationPrimary suppliers of capital to special sectors of the economy (Residential lending for example)

Intergenerational Transfer of WealthInsurance and pension funds


Fin 286Other Functions

Maturity IntermediationProvides households with desirable maturitiesIntermediaries are willing to accept longer term risks and finance them with short term deposits.

Denomination IntermediationCommercial paper is issued in $250,000 units, too large for most households

Payment MechanismFacilitate the payment of claims w/o cash.


Fin 286

The Impact of FI’s on Economic Growth

Traditional Economic Theories of GrowthLabor Usage and Capital AccumulationLimited explanation due to decreasing marginal returns to capital, sustained growth requires productivity growth

New Growth TheoryTechnological change increases productivity that offsets diminishing marginal returnsTermed “Endogenous Growth”


Fin 286

The Impact of FI’s on Economic Growth

Financial Development’s ImpactPromotes Capital Accumulation & Productivity GrowthRajan and Zingales (1998)

Young firms in higher productivity sectors depend upon external financing and benefit from low cost financing associated with financial development

Galindo, Schiantarelli, and Weiss (2002)Financial liberalization in developing economies improves capital allocation

Both Studies stress the importance of the quality of regulation, supervision and enforcement.


Fin 286Regulation

Given their vital role in the economy FI’s are highly regulated. The goal of this regulation is to protect against a disruption in the services they offer (provide confidence in the system).Some segments of the population could be discriminated against without regulation (race, gender etc)The difference the private benefits and private costs of regulation are the net regulatory burden.


Fin 286

Safety and Soundness Regulation

Protects borrowers and depositors against failure of the FIDiversification requirementsMinimum capital to asset ratiosGuaranty funds provisionsMonitoring and surveillance


Fin 286Monetary Policy Regulation

Since Financial Intermediaries serve as a conduit for monetary policy they merit special regulation.Reserve requirements, for example.Might make control of monetary policy more predictable.


Fin 286Credit Allocation Regulation

Supports lending to portions of the economy deemed socially important (housing and farming are two examples).

Requiring a % of assets in a particular sector of the economy for example. Also interest rate restrictions.


Fin 286

Consumer Protection Regulation

Home Mortgage Disclosure ActPrevents discrimination in lending based upon gender, race, age, or income. Requires standardized form on why credit is granted or deniedMay provide a heavy net regulatory burden without an offsetting social benefit.


Fin 286

Investor Protection Regulation

Protection of investors that use investment banks directly. Insider trading restrictions, lack of disclosure and breach of fiduciary responsibility are examples.


Fin 286Entry Regulation

Barriers to entry can promote safety and soundness.Also impose costs on current market participants.


Fin 286Trends in the US

1860 1880 1900 1922 1939 1960 1980 2000

Commercail Banks 71.4% 60.6% 62.9% 63.3% 51.2% 38.2% 34.8% 35.6%Thrift Institutions 17.8% 22.8% 18.2% 13.9% 13.6% 19.7% 21.4% 10.0%Insurance Companies 10.7% 13.9% 13.8% 16.7% 27.2% 23.8% 16.1% 16.8%investment co's 0.0% 1.9% 2.9% 3.6% 17.0%Pension Funds 0.0% 0.0% 2.1% 9.7% 17.4% 10.7%Finance Co's 0.0% 0.0% 0.0% 2.0% 4.6% 5.1% 7.9%Securities Brokers 0.0% 0.0% 3.8% 5.3% 1.5% 1.1% 1.1% 1.5%Mortgage Co's 0.0% 2.7% 1.3% 0.8% 0.3% 0.0% 0.4% 0.3%Real Estate Ivest. Trusts 0.0% 0.1% 0.2%Total 99.9% 100.0% 100.0% 100.0% 99.8% 100.0% 100.0% 100.0%Total Trillion dollars 0.00 0.01 0.02 0.08 0.13 0.60 4.03 14.75

% Share of Total Assets for US Financial Institutions

DrakeDRAKE UNIVERSITY

Fin 286

Risks of Financial Intermediation


Fin 286Common Risks

All Financial Intermediaries face similar risks from their operations.The importance of each type of risk depends upon the intermediary and business linesWe will spend today introducing the types of risk present. The remainder of the semester is spent detailing each type of risk and discussing management techniques used by firms to limit the impact of each risk.


Fin 286Margin Income

Most financial institutions serving an intermediary role make some income from interest margins.They borrow funds at a given level of interest rates then generate a higher interest rate from their business (making loans for example).They then receive interest income due to the difference in interest rates.


Fin 286Interest Rate Risk

The Interest rates on both Assets and Liabilities are tied to the length of the commitments.Interest rate risk results from a mismatch in maturities of assets and liabilities.

Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs.

Refinancing risk.Reinvestment risk.


Fin 286

Interest Rate Risk: Refinancing Risk

Assume you have $100 million in liabilities financed at 9% per year and the rate that you pay resets at the end of the year. Your FI also has $100 million in assets that mature in 2 years paying 10% per year.What happens if the interest rate increases?The cost of refinancing your liabilities increases, but your income from assets stays the same.


Fin 286

Interest Rate Risk:Reinvestment Rate Risk

Assume you have $100 million in liabilities financed at 9% per year that mature in 2 years. Your FI also has $100 million in assets that mature in 1 years financed at a cost of 10% per year.What happens if the interest rate decreases?The cost of your liabilities stays fixed but in year two your income from assets decreases.


Fin 286Matching Maturities

It is difficult for the FI to match maturities and it may not eliminate interest rate risk anyway:

Not consistent with asset transformation planMatching maturities may reduce profitability (one of the functions of intermediation is accepting some of this risk. Assets are financed with both debt and equityDuration and Portfolios


Fin 286

Interest Rate Risk:Market Value Risk

Market value is tied to the level of interest rates.

As rates increase market value decreases, as rates decrease market value increases

The impact of rate changes is tied to maturity


Fin 286Market Risk

The combination of interest rate, foreign exchange, and equity return risks are combined with an active trading strategy.

Greater reliance on trading income rather than traditional activities has increased market exposure for FI’s.Anytime an FI takes an unhedged speculative position it is exposed to market risk


Fin 286Credit Risk

Risk that promised cash flows are not paid in full.

Firm specific credit riskSystematic credit riskHigh rate of charge-offs of credit card debt in the 80s and 90sObvious need for credit screening and monitoringDiversification of credit risk


Fin 286Off-Balance-Sheet Risk

Risk associated with contingent claims that do not show up on the balance sheet. It is not on the Balance sheet since it does not involve holding a current primary claim or issuing a current secondary claim. Increased importance of off-balance-sheet activities

Letters of creditLoan commitmentsDerivative positions

Speculative activities using off-balance-sheet items create considerable risk


Fin 286

Technology and Operational Risk

Risk of direct or indirect loss 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 housesCHIPS


Fin 286

Technology and Operational Risk

Technology Risk: Technology investment may fail to produce anticipated cost savings.Operational Risk: The risk that support systems (often based on new technology) may break down.

Bank of New York – failed to register incoming payments on Fedwire, but continued to process outgoing paymentsWell’s Fargo – Failure to correctly post deposits to acquired firms account holders – cost $180 Million


Fin 286

Economies of Scale and Scope

Economies of Scale: Goal of the FI is to lower its average cost per unit via new technology or operations

Economies of Scope: The generation of cost synergies by offering more services using the same inputs


Fin 286Foreign Exchange Risk

Foreign Assets and Foreign Liabilities change in value with changes in exchange rates.Net Long Asset Position – Exposure to foreign denominated assets is greater than foreign liabilitiesNet Short Asset Position – Exposure to foreign denominated assets is less than exposure to foreign liabilities



Returns on foreign and domestic investment are not perfectly correlated.

FX rates may not be correlated.Example: $/DM may be increasing while $/¥ decreasing.



Note that hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well.

Otherwise, exposure to foreign interest rate risk is created.


Fin 286Country or Sovereign Risk

Result of exposure to foreign government which may impose restrictions on repayments to foreigners.Lack usual recourse via court system.


Fin 286Liquidity 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.


Fin 286Insolvency Risk

Risk of insufficient capital to offset sudden decline in value of assets to liabilities.

Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.


Fin 286

Risks of Financial Intermediation

Other Risks and Interaction of RisksInterdependencies among risks.

Example: Interest rates and credit risk.

Discrete RisksExample: Tax Reform Act of 1986.Other examples include effects of war, market crashes, theft, malfeasance.


Fin 286Macroeconomic Risks

Increased inflation or increase in its volatility.

Affects interest rates as well.

Increases in unemployment Affects credit risk as one example.

Changes in Consumer ConfidenceChanges in home building


Fin 286

Risk Management Techniques

Deciding what risks to accept and how to manage themSet Asides

Financial firms often set aside funds to cover potential losses, this requires the ability to estimate the possibility and size of loss

Limits on Risky PositionsHedgingBusiness Lines vs. Total Operations


Fin 286Risk Measurement Tools

Value at Risk and Earnings at RiskModels that predict the probability and magnitude of potential loss from market risk

Stress TestingWhat is the worst case Scenario

GAP, Duration GAPFinancial Statement AnalysisImpact of Regulation

*Cumming and Hirtle, The Challeng*Cumming and Hirtle, The Challenges of Risk Management in DIversifies of Risk Management in DIversified Financial Compaies.ed Financial Compaies.


Fin 286

Consolidated Risk Management

“A coordinated process of measuring and managing risk on firm wide basis.”*Requires a system that includes identification of risks, measurement of risk, methods for controlling the level of risk accepted, checks and balances, review and oversight at all levels of management (including the board of directors)


Fin 286

Benefits of Consolidating Risk Management

Diversification benefits are ignored without consolidation, leading to increased risk management costsLack of coordination can increase firm wide risk in times of market problems (unwinding similar position in different business lines for example).Without consolidation contagion risks are ignored Improves the “internal capital market” of the firm.Promote more transparency and better risk analysis by creditors.


Fin 286

Barriers to Consolidated Risk Management

Consolidation of financial firms has produced increased product and geographic diversification which has made business wide risk management more difficult.Information Costs

The cost of integrating, recording and analyzing risk across separate business lines.


Fin 286

Barriers to Consolidated Risk Management

Regulatory CostsConsolidation has created a framework where firms are required to respond to multiple regulators. Capital and Liquidity requirements may prohibit the movement of funds from one business line to another.Cost associated with managing the separate regulatory requirements including opportunity costs

drake drake university fin 286 finance 286 financial risk management

Documents

drake drake university

credit risk

liquidity risk

rights reserved slide

financial system

rate risk

risk liability

modern bank services