Types of Risks Incurred by Financial Institutions

8-1McGraw-Hill/IrwinChapter NineteenTypes of Risks Incurred by Financial Institutions19-2McGraw-Hill/IrwinRisks at Financial InstitutionsOne of the major objectives of a financial institution’s (FI’s) managers is to increase the FI’s returns for its ownersIncreased returns often come at the cost of increased risk, which comes in many forms:credit risk – foreign exchange risk liquidity risk – country or sovereign riskinterest rate risk – technology riskmarket risk – operational riskoff-balance-sheet risk – insolvency risk19-3McGraw-Hill/IrwinRisks at Financial InstitutionsCredit risk is the risk that the promised cash flows from loans and securities held by FIs may not be paid in fullFIs that make loans or buy bonds with long maturities are relatively more exposed to credit riskthus, banks, thrifts, and insurance companies are more exposed than MMMFs and property-casualty insurance companiesmany financial claims issued by individuals or corporations have:limited upside return with a high probabilitylarge downside risk with a low probabilitya key role of FIs involves screening and monitoring loan applicants to ensure only the creditworthy receive loansFIs also charge interest rates commensurate with the riskiness of the borrower19-4McGraw-Hill/IrwinRisks at Financial InstitutionsCredit risk (cont.)the effects of credit risk are evidenced by charge-offsthe Bankruptcy Reform Act of 2005 makes it more difficult for consumers to declare bankruptcyFIs can diversify away some individual firm-specific credit risk, but not systematic credit riskfirm-specific credit risk is the risk of default for the borrowing firm associated with the specific types of project risk taken by that firmsystematic credit risk is the risk of default associated with general economy-wide or macroeconomic conditions affecting all borrowers19-5McGraw-Hill/IrwinRisks at Financial InstitutionsLiquidity risk is the risk that a sudden and unexpected increase in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low pricesday-to-day withdrawals by liability holders are generally predictableunusually large withdrawals by liability holders can create liquidity problemsthe cost of purchased and/or borrowed funds rises for FIsthe supply of purchased or borrowed funds declinesFIs may be forced to sell less liquid assets at “fire-sale” prices19-6McGraw-Hill/IrwinRisks at Financial InstitutionsInterest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched and interest rates are volatileasset transformation involves an FI issuing secondary securities or liabilities to fund the purchase of primary securities or assetsif an FI’s assets are longer-term than its liabilities, it faces refinancing riskthe risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset investmentsif an FI’s assets are shorter-term than its liabilities, it faces reinvestment riskthe risk that the returns on funds to be reinvested will fall below the cost of funds19-7McGraw-Hill/IrwinRisks at Financial InstitutionsInterest rate risk (cont.)all FIs face price risk (or market value risk)the risk that the price of the security changes when interest rates changeFIs can hedge or protect themselves against interest rate risk by matching the maturity of their assets and liabilitiesthis approach is inconsistent with their asset transformation functionMarket risk is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset pricesclosely related to interest rate and foreign exchange risk19-8McGraw-Hill/IrwinRisks at Financial InstitutionsMarket risk (cont.)adds trading activity—i.e., market risk is the incremental risk incurred by an FI (in addition to interest rate or foreign exchange risk) caused by an active trading strategyFIs’ trading portfolios are differentiated from their investment portfolios on the basis of time horizon and liquiditytrading assets, liabilities, and derivatives are highly liquidinvestment portfolios are relatively illiquid and are usually held for longer periods of timedeclines in traditional banking activity and income at large commercial banks have been offset by increases in trading activities and income19-9McGraw-Hill/IrwinRisks at Financial InstitutionsMarket risk (cont.)declines in underwriting and brokerage income at large investment banks have been offset by increases in trading activity and incomeactively managed MFs are also exposed to market riskFIs are concerned with fluctuations in trading account assets and liabilitiesvalue at risk (VAR) and daily earnings at risk (DEAR) are measures used to assess market risk exposuremarket risk exposure has caused some highly publicized lossesthe failure of the 200-year old British merchant bank Barings in 1995$7.2 billion in market risk related loss at Societe Generale in 200819-10McGraw-Hill/IrwinRisks at Financial InstitutionsOff-balance-sheet (OBS) risk is the risk incurred by an FI as the result of activities related to contingent assets and liabilitiesOBS activity can increase FIs’ interest rate risk, credit risk, and foreign exchange riskOBS activity can also be used to hedge (i.e., reduce) FIs’ interest rate risk, credit risk, and foreign exchange risklarge commercial banks (CBs) in particular engage in OBS activityon-balance-sheet assets of all U.S. CBs totaled $10.8 trillion in 2007the notional value of OBS items totaled $180.6 trillion in 200719-11McGraw-Hill/IrwinRisks at Financial InstitutionsOBS risk (cont.)OBS activities can affect the future shape of FIs’ balance sheetsOBS items become on-balance-sheet items only if some future event occursa letter of credit (LOC) is a credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring, most notably default of the agent that purchases the LOCother examples include:loan commitments by banksmortgage servicing contracts by savings institutionspositions in forwards, futures, swaps, and other derivatives held by almost all large FIs19-12McGraw-Hill/IrwinRisks at Financial InstitutionsForeign exchange (FX) risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currenciesFIs can reduce risk through domestic-foreign activity/investment diversificationFIs expand globally throughacquiring foreign firms or opening new branches in foreign countriesinvesting in foreign financial assetsreturns on domestic and foreign direct and portfolio investment are not perfectly correlatedunderlying technologies of various economies differexchange rate changes are not perfectly correlated across countries19-13McGraw-Hill/IrwinRisks at Financial InstitutionsFX risk (cont.)a net long position in a foreign currency involves holding more foreign assets than foreign liabilitiesFI loses when foreign currency falls relative to the U.S. dollarFI gains when foreign currency appreciates relative to the U.S. dollara net short position in a foreign currency involves holding fewer foreign assets than foreign liabilitiesFI gains when foreign currency falls relative to the U.S. dollarFI loses when foreign currency appreciates relative to the U.S. dollaran FI is fully hedged if it holds an equal amount of foreign currency denominated assets and liabilities (that have the same maturities)19-14McGraw-Hill/IrwinRisks at Financial InstitutionsCountry or sovereign risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governmentsdiffers from credit risk of FIs’ domestic assetswith domestic assets, FIs usually have some recourse through bankruptcy courts—i.e., FIs can recoup some of their losses when defaulted firms are liquidated or restructuredforeign corporations may be unable to pay principal and interest even if they would desire to do soforeign governments may limit or prohibit debt repayment due to foreign currency shortages or adverse political events19-15McGraw-Hill/IrwinRisks at Financial InstitutionsCountry or sovereign risk (cont.)thus, an FI claimholder may have little or no recourse to local bankruptcy courts or to an international claims courtmeasuring sovereign risk includes analyzing:the trade policy of the foreign governmentthe fiscal stance of the foreign governmentpotential government intervention in the economythe foreign government’s monetary policycapital flows and foreign investmentthe foreign country’s current and expected inflation ratesthe structure of the foreign country’s financial system19-16McGraw-Hill/IrwinRisks at Financial InstitutionsTechnology risk and operational risk are closely relatedtechnology risk is the risk incurred by an FI when its technological investments do not produce anticipated cost savingsthe major objectives of technological expansion are to allow the FI to exploit potential economies of scale and scope by:lowering operating costsincreasing profitscapturing new marketsoperational risk is the risk that existing technology or support systems may malfunction or break downthe BIS defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events”19-17McGraw-Hill/IrwinRisks at Financial InstitutionsInsolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilitiesinsolvency risk is a consequence or an outcome of one or more of the risks previously described:interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and/or liquidity riskgenerally, the more equity capital to borrowed funds an FI has the less insolvency risk it is exposed toboth regulators and managers focus on capital adequacy as a measure of a FI’s ability to remain solvent19-18McGraw-Hill/IrwinRisks at Financial InstitutionsOther risks and interactions among risksin reality, all of the previously defined risks are interdependente.g., liquidity risk can be a function of interest rate and credit riskwhen managers take actions to mitigate one type of risk, they must consider such actions on other riskschanges in regulatory policy constitute another type of discrete or event-specific riskother discrete or event specific risks includewar, revolutions, sudden market collapses, theft, malfeasance, and breach of fiduciary trustmacroeconomic risks include increased inflation, inflation volatility and unemployment