fis risk management19

8/10/2019 FIs Risk Management19

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2007, The McGraw-Hill Companies, All Rights Reserved19-1McGraw-Hill/Irwin

Chapter NineteenTypes ofRisks IncurredbyFinancial Institutions


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Why Financial Institutions Need to

Manage Risk

The goal of a FI is the same as any for profitcorporation, namely to maximize shareholderwealth.

The major difference between a financialinstitution and a nonfinancial corporation is inthe nature of their assets and liabilities and thedegree of regulation.

A majority of financial firms assets are piecesof paper. They are not readily differentiablefrom assets of competitors; this leads to verylow ROAs.


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In order to offer shareholders a competitive rate ofreturn, FIs must therefore incur substantial risk.

This risk takes the form of using a high amount ofleverage, investing in assets riskier than the liabilitypositions funding them and maintaining minimal

liquidity positions. Consequently, small errors in judgement can have

seriously negative consequences for the solvency ofFIs.

Because many institutions depend upon the publics

perception of their soundness to attract business,events that erode the publics confidence in one orseveral large domestic or foreign FIs can quicklyspread and lead to major profit and solvency problemsin many FIs.


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Why FIs Need to Manage Risk

why foreign FIs

Risks of financial intermediation have

increased as the U.S. and overseas economies

have become more integrated

FIs that have no foreign customers can still be

exposed to foreign exchange and sovereign

risk if their customers have dealings with

foreign countries


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Risks Faced by Financial Intermediaries

Credit Risk Liquidity Risk

Interest Rate Risk

Market Risk Off-Balance-Sheet Risk

Foreign Exchange Risk

Country or Sovereign Risk

Technology Risk

Operational Risk

Insolvency Risk


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Credit risk

Credit risk is the possibility that aborrower will not repay principle andinterest as promised in a timely fashion.

To limit this risk, FIs engage in creditinvestigations of potential fundsborrowers, or in the case of investments

they may rely on externally generatedcredit ratings.


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Diversify away Credit Risk

FIs lend to many different borrowers todiversify away firm specific (borrower specific)credit risk.

But the Systematic credit risk will remain(credit risk due to systemic or economy widerisks such as inflation and recession) even in awell diversified portfolio.

Many of the S&L problems of the 1980s can beattributed to an underdiversified loan portfoliooverexposed to certain types of lending incertain regions.



Banks, thrifts and life insurers usually facemore credit risk than certain otherintermediaries

Tip: What may appear to be relatively smallloss rates can quickly bring about the threat ofinsolvency at depository institutions (DIs). Forinstance, unexpected loss rates of 5% to 6% of

the total loan portfolio can easily cause a bankto fail.



Highest Risk

credit card loss rates are significantlyhigher than most other types of domesticloans.

Foreign lending, particularly sovereignlending, has traditionally been the mostrisky throughout all of the history ofbanking (you would think they wouldlearn eventually) and has led to the lossof many fortunes and caused manyfailures.


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Liquidity Risk

Liquidity risk

Liquidity risk arises when an FIs

liability holders demand immediate cashfor their financial claim

Serious liquidity problems may result in

a run


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Not to turn away customers

Even if the existing assets and liabilitieswere perfectly maturity matched, loancommitments and the undesirability of

turning away potential loan customerswould lead to liquidity risk as borrowersincreased their take downs or new loan

customers arrived unexpectedly at the FI


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Interest Rate Risk

Interest rate risk(These changes caused by

unexpected movements in interest rates give rise)

Federal Reserves influence on interest rate

volatility through daily open-market operations Effect of increased globalization of financial market

Refinancing risk

Reinvestment risk



maturity intermediation

many intermediaries invest in direct claimsissued by borrowers (assets) while providingseparate claims to individual savers

(liabilities). This process is called maturityintermediation

The maturity of a FIs assets will then normally

differ from the maturity of its liabilities. When

this is the case, changes in interest rates canlead to changes in profitability and/or equityvalue


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refinancing risk

The institution has refinancing riskbecause the liabilities must be rolledover or reborrowed before the assets

mature. Refinancing risk is the risk thatat rollover dates the liability cost will riseabove the asset earning rate.

An institution in this situation willhowever benefit from declining interestrates


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Reinvestment risk

institutions with an asset maturityshorter than the liability maturity willbenefit from rising interest rates, but will

be hurt by falling interest rates. If the assets mature more rapidly than

the liabilities then the institution facesreinvestment risk.

Reinvestment risk is the risk that thereturns on funds to be reinvested will fallbelow the cost of those funds


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Example

A FI has $100 million of fixed earning assetsthat mature in 2 years. The assets earn anaverage of 7%. These are funded by 6 monthCD liabilities paying 4%. So we are in the

former case where the asset maturity is longerthan the liability maturity. The banks NetInterest Margin (NIM) = [(7%4%)*$100million] / $100 million = 3%. If in 6 monthsinterest rates increase 100 basis points, the 2

year assets will still be earning 7%, but thenew 6 month CDs will have to pay 5%,reducing the NIM by 1/3 to 2%. This illustratesrefinancing risk.


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present value uncertainty

The effect of a change in interest rates can be moredirectly measured by examining how the present valueof the existing assets and liabilities will change asinterest rates change.

A FI with longer term (duration) assets funded byshorter term (duration) liabilities will suffer a decline inthe market value of equity if interest rates rise.

This occurs because the market value of the assetswill decline more sharply than the market value of the

liabilities. present value uncertainty arises from a difference in

the duration of the FIs assets and liabilities.


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Maturity Mismatching and Interest Rate

Risk

Asset transformation can involve differingmaturities

One type of asset transformation is the creation of a mutual fund - a portfolio of securitiesthat are "transformed" into fund shares. These shares are available for purchase by

persons who generally do not have the means to purchase a range of securities for

diversification purposes.

Economic or present-value uncertainty ariseswhen interest rates change

FIs can seek to hedge by matching thematurity of their assets and liabilities


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Market Risk

Market risk

Closely related to interest rate and foreignexchange risk

Decline in income from deposit taking andlending matched by increased reliance onincome from trading

FI management required to establishcontrols or limits on day-to-day exposureto risk


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Market risk arises when FIs takeunhedged positions in securities,currencies and derivatives.

Income from trading activities hasincreased in importance during recentyears.

In general, the volatility of asset pricesand currency values causes market risk.


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Bank assets and liabilities can be separatedinto banking book assets or liabilities and

trading book assets or liabilities based on theaccounts maturity and liquidity.

Trading book accounts are on and off balancesheet accounts that are held for a short time

period and are generally speculative in nature.They are held in hopes of generating pricegains or as part of making a market in a givensecurity or contract.

Banking book accounts are those held forlonger time periods and generate interestincome or provide long term funding


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Assets Liabilities

Banking Book Loans Capital

Other illiquid assets Deposits

Trading Book Bonds (long) Bonds (short)

Commodities (long) Commodities (short)

FX (long) FX (short)

Equities (long) Equities (short)Off BS Derivatives (long) Derivatives (short)


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Tip: The failure of Barings bank is anextreme example of market risk (see theOff Balance Sheet section).


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Daily Earnings At Risk or DEAR

Value at Risk (VAR) is a relatively newmethod of assessing overall institutionalrisks.

VAR attempts to measure the maximumdollar amount a FI is likely to lose in agiven short time period, usually a day,

with some probability

Tip: The VAR is a probabilistic method that


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Tip: The VAR is a probabilistic method thatestimates the likely loss that could occur at agiven confidence interval (usually 95%).

A simple VAR model would attempt to identifyand estimate likely values for the majorportfolio risk factors, such as stock pricechanges, currency changes, interest ratechanges, etc.

Based on either the factors historicalvariability or the use of Monte Carlo simulationthe VAR model attempts to estimate the likelychanges of each variable over the timeinterval, incorporating the correlationsbetween the variables so that the FI can morerealistically estimate the maximum loss likelyto occur with 95% confidence


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Off-Balance-Sheet Risk

Off-balance-sheet risk

Interest rate risk ,Credit risk, Currency risk abe Uniquerisks

Off-balance activity

Letter of credit

Loan commitmentsby banks (Unfunded loancommitments are those commitments made by aFinancial institution that are contractual obligationsfor future funding

mortgage servicing contracts by thrifts,

and positions in forwards, futures, swaps, options,etc


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The last twenty years have brought abouttremendous growth in off balance sheetactivities ranging from loan commitments to

swaps to OTC derivatives. Off balance sheet activities are contingent

claims that can affect the balance sheet in thefuture

EX: A letter of credit issued by a FI is acontingent promise to pay off a debt if theprimary claimant fails to pay.


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the incentive

Profitability is the incentive driving the offbalance sheet business.

FIs are generating fee income to reduce thedependence on interest rate spreads andbecause of the increased competitivepressures on their traditional lines ofbusiness.

Off balance sheet assets and liabilities havegrown so much that ignoring them maygenerate a significantly misleading pictureabout the value of stockholders equity.


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Many off balance sheet activities areused including:

Loan commitments

Mortgage servicing contracts

Positions in forwards, futures, swapsand other derivatives (mostly by thelargest FIs


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Why derivatives lead to risk

Two aspects of certain types of derivatives lead toadditional risks involved with their usage.

First, calculating derivative values and payouts iscomplicated. This is particularly true for many OTC

derivatives that banks sell. The selling banks typicallyunderstand the risks better than the clients.

Second, derivatives typically involve large amounts ofleverage. These two attributes imply that misuse ofderivatives is likely to occur, and can result in extreme

losses (or extreme gains, but rarely are the winnersupset about those).


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cases in recent years 2

In 1995, a trader at Sumitomo incurredlosses of $2.6 billion from commodityfutures trading.

Losses of this size just shouldnthappen if the banks internal controls

are functioning properly.


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Bankers Trust sold several complicated OTC swaps tocustomers.

In one of the swap deals the customer (Gibson GreetingCards) had to make variable rate payments based on

Libor2.In the second swap deal with Procter and Gamble, P&Gwould have to make high variable rate payments ifeither short term or long rates rose, and extremelyhigh variable rate payments if both rose, which is

what happened.Both customers sued Bankers Trust claiming they did

not understand the risks they were facing. Thefallout helped lead to the Deutsche Bank takeover ofBT.


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Orange County investment advisor Bob Citron, aportfolio manager with very little formal finance orinvestment training, purchased structured notes fromCredit Suisse First Boston.

The notes were a type of inverse floater that would

drop in value if rates increased, which of course theydid. Citron had used an extreme amount of leverage in an

attempt to earn higher returns (which he did for severalyears).

When rates rose, losses mounted quickly and hecould not repay the borrowings and the municipalitywent bankrupt, losing $1.5 billion.

Twenty banks were sued; CSFB paid $52 million tosettle charges


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Tip: To what extent do these problemsimply we should limit derivatives usage?Are we comfortable with the caveat

emptor "Let the buyer beware".[philosophy currently employed?


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Foreign Exchange Risk

Foreign exchange risk

Net current and contingent asset (assetdepend on future) exposures are at risk

from declining currency values and netliability exposures are at risk from risingcurrency values

n Example o an FI s Exposure to


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n Example o an FI s Exposure toForeign Exposure Risk

An FI that makes a foreign currency loan (asset) is atrisk from a declining foreign currency. For instance, aU.S. FI lends 100 million when the /$ exchange rateis 110. The interest rate is fixed at 9% and the loan isfor one year. Suppose that in a year the exchange rate

is 120 to the dollar, The original dollar amount lent by the bank is:

100,000,000 / 110 = $909,090.91

In one year the borrower repays

(100,000,000 1.09) = 109,000,000 In dollar terms this is now worth:

109,000,000 / 120 = $908,333.33

thus the bank earns a negative rate of return.

Analysis: The dollar depreciated by (120/110)1 =


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The risk of a declining yen could beoffset various ways. The FI couldacquire yen deposits or other yen

denominated liabilities or the FI couldsell the yen forward.

or Suppose the FI procures a 100 million

6 month Euro yen liability to fund theloan


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In this case the exchange rate risk isreduced because the change in $ valueof the loan asset should be at least

partially offset by a similar change in the$ value of the Euro yen liability.


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Some exchange rate risk remainsbecause the 6 month rate may changedifferently than the 1 year rate.

Moreover, the FI faces interest rate risk ifwe presume that the FI must roll over theCD borrowings for six more months.


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As growth slowed, currency speculators began bettingthat the currency values would have to fall. Once thelocal currencies began to depreciate, beginning withthe Thai baht, contagion effects quickly spread toother currencies, such as the Indonesian rupiah and

eventually the Russian ruble and Brazilian real. Thecrisis then fueled itself as local firms could no longerrepay their dollar denominated debts, leading tofurther currency devaluations. In the ensuing falloutof loan, investment and currency losses, the earningsof many worldwide FIs were hurt including Chase,which lost $160 million as a result, J.P. Morgan andmany Japanese and South Korean banks.


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The foreign exchange markets are the largestmarkets in the world and banks are majorparticipants. They engage in currencyarbitrage, taking positions in currencies tomeet customers needs and outright currencyspeculation. Participation in the currencymarkets can actually reduce risk of foreigncurrency loans. It is the unhedged positionsthat add to risk. Moreover, currency

movements are not perfectly correlated somaintaining positions in multiple countriesmay reduce overall risk given that someforeign exposure is inevitable.


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Losses in the 1980s and 1990s due tosovereign risk were quite large andwould have been even larger except for

huge amounts of emergency fundingprovided by the IMF to countriesexperiencing a crisis.

In 2001 Argentina defaulted on $130

billion of government issued debt and inSeptember 2003 it defaulted on a $3billion loan from the IMF.


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In 2005 Argentina unilaterally announced it would payonly $0.30 per dollar on loans and bonds outstandingfrom its 2001 debt restructuring. Apparently happy toget anything, about three fourths of the bondholderswere expected to accept the offer. Many other

countries have had similar difficulties, for instance,Mexico had two major crises in the last decades,Russia suddenly and with no explanation defaulted onits foreign loans in 1998, in the past Indonesia declareda debt moratorium, Malaysia instituted capital controlsafter the Asian currency crisis, Brazil has had difficultyrepaying debts several times, etc.


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Technology and Operational Risk

Technology risk arises from the possibilitythat new technology investments do not result

in profit improvements. Excess capacity andcustomer reluctance to use online services aretwo examples of this type of risk. Onlinebanking is currently facing these problems.

Major objective of technological expansion isto increase economies of scale and scope


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Operational risk arises when technology (ortechnology users) and other systems fail toperform properly. Major examples ofoperational risk include settlement risk,clearing risk, risks associated with custodialservices and outright computer breakdowns.In Wells Fargos merger with First Interstate

(FI), FIs customer account numbers were notproperly credited with incoming deposits.Wells Fargo incurred a $180 million operatingloss as a result.


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the definition of operational risk mayincluding employee fraud,misrepresentation and account errors in

operational risks In Wells Fargos merger with First

Interstate (FI), FIs customer account

numbers were not properly credited withincoming deposits. Wells Fargo incurreda $180 million operating loss as a result.


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Citibanks 2002 ATMs went down for severaldays, along with its online banking. InSeptember 2004 about one third of WachoviaSecurities brokers assistants could not

access customer records or even log ontotheir computers. In February 2005, Bank ofAmerica announced it had lost computer

backup tapes containing personal information(including social security numbers) of about1.2 million federal government employees

charge cards transactions


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Insolvency Risk

Insolvency risk (bankruptcy) occurs when aninstitutions assets are less than its liabilities.

Insolvency risk arises from each of the

aforementioned risks. The major safeguardsagainst insolvency are equity capital and

prudent management practices.


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A consequence or an outcome of one or

more of these risks:

interest rate

Market credit

OBS

Technological

foreign exchange

Sovereign

liquidity


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Events can also lead to multiple riskexposures. The most obvious forms ofevent risk for FIs are regulatory changesthat can affect multiple areas ofperformance. Terrorist attacks could fitin this category as well. FI losses due tothe September 11, 2001 attacks were

quite large. Large stock market movescan also result in increased credit,liquidity risk, interest rate risk and evenforeign exchange risk.


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Various other risks

sudden changes in taxation

changes in regulatory policy

sudden and unexpected changes in financial market

conditions due to war, revolution, or market collapse

theft, malfeasance, and breach of fiduciary trust

increased inflation, inflation volatility, andunemployment

fis risk management19

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