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Ch.7 RisksfacedbyFIs(Saundersetal,2006)Outline Thischapterdiscussestherisksassociatedwithfinancialinstitutions7.1 Uncertaintyvs.Risk7.2 Interestraterisk7.3 Marketrisk7.4 CreditRisk7.5 Off-balancesheetrisk7.6 Operatingrisk7.7Foreignexchangerisk7.8 Liquidityrisk7.9OtherrisksThemainobjectiveofFIsisthepropermanagementoftheserisks17.1Uncertaintyvs.RiskUncertainty.Asituationwhereanactionhasmorethanonepossibleresultandtheprobabilityofeachresultisunkwnown.Risk.Asituationwhereanactionhasmorethanonepossibleresultandtheprobabilityofeachresultisknown.Alternatively,RiskisthedegreeofuncertaintyassociatedtotheoutcomeofaneventUsually

FIs

makedecisionsunderuncertaintyintermsofrisk,i.e.,theyknow(estimate)theprobabilityoftheresultsofacourseofaction.27.2Interestraterisk

InterestrateriskisthepotentialimpactonanFI’searningsandmarketvalueofequityofchangesininterestratesThisriskisincurredbyanFIwhenthematuritiesofitsassetsandliabilitiesaremismatched.a)Reinvestmentrisk.TheriskthatthereturnsonfundstobereinvestedwillfallbelowtheoriginallyanticipatedreturnsExample:1-yearloansat10%annualfundedwith2-yeardepositsat9%

Profitspread1styear=10%-9%=+1%.2ndyear:??-9% [Otherexampleofreinvestmentrisk:mortgagerefinancingatalowerinterestrate]I.e.,FIpaysdepositsatafix-rate,investinginfloating-rateloans

01year

2years

Assets(Loansat10%)01year2ndyeari=?i=8%i=11%Liabilities(Depositsat9%)3Firmsshouldtrytomatchmaturitiesofassetsandliabilities–fixedrateassetsEliminatesinterestrateriskDisadvantageofmatching?

A:?57.3MarketRisk

Theriskoflossesinon-andoff-balance-sheetpositionsarisingfrommovementsinmarketprices. Incurredinactivetrading(riskyinvesting)of assetsandliabilities(andderivatives).a)WhattypeofFIsaremorepronetomarketrisk?A:?b)Whattypeofactivities?A:?b)Whattypeoffinancialclaims?A:?67.4CreditRiskorDefaultRisk TheriskthatthepromisedcashflowsfromloansandsecuritiesheldbyFIsmaynotbepaidinfull

I.e.,paymentsofprincipalandinterestontheirpromiseddates. a)WhattypeofFIsaremorepronetodefaultrisk?

A:?

b)Whattypeoffinancialclaims?

A:?

c)Howthisproblemcanbereduced?

A:?7SubprimecrisisManySubprimemortgage-backedsecuritieswereheldinoff-balancesheetvehiclesofU.S.Banks.FundedmostlybyassetbackedcommercialpapertomoneymarketfundsandotherinvestorsThosefundsstoppedbuyingpaperduringlastquarterof2008.originatingaliquiditycrisistotheU.S.banks97.6TechnologyandOperationalRisk“Itistheriskoflossesresultingfrominadequateorfailedinternalprocesses,people,andsystemsorfromexternalevents” (BIS)Itincludestechnologysystem,organizationalbehaviourandotherlegalaspectsofmanaginganFI,aswellasreputationalriskandstrategicrisk.TechnologyRisk.Riskthattechnologyinvestmentfailstoproduceanticipatedcostsavings.OperationalRisk.Riskthattechnologyorsupportsystemsmayfail.Examples?107.7ForeignExchangeRisk Theriskthatexchangerate(XR)changescanaffectthevalueofanFI’sassetsandliabilitiesdenominatedinforeigncurrencies.Diversification:domesticandforeign(directorportfolio)investment↑return↓risk Conditions:1)Uncorrelatedreturns 2)Uncorrelatedexchangesrates

Example:C$/EuromaybedecreasingwhileC$/¥increasingUndiversifiedforeignexpansioncreatesFXrisk.AFIisfullyhedgedonlyiftheaveragelivesandamountsofforeignassetsandliabilitiesarethesameandbythe

sameamount.117.8LiquidityRisk RiskofanFIofbeingforcedtoborrow,orsellassets,inaveryshortperiodoftimetomeetunexpectedliabilitywithdrawals,withasubstantialloss.

ThisproblemsisinherentindepositaryinstitutionsReason:Mismatchingofmaturitiesofassetsandliabilities(andOff-balance-sheetclaims).Example:ShortTermLiabilities:Demanddepositsandshorttermdepositsofferedbyabank.Off-balance-sheetclaims:loanguarantees.ShortTermAssets:Forexample,Cash,T-bills,shorttermloans(overnight),reverserepos.

Ifthereisanunexpected(andunplanned)

largewithdrawalof demanddepositsthebankcanfacealiquiditycrisis.ALSTLTLTSTBSheet13Howwouldthebankreacttosolvethisproblem? A:?Ifthebankcannotmeetitsobligations,whatisthemostlikelyoutcome?

A:?Contagioneffect:OtherbanksRiskofsystematicbankpanics.14

7.9OtherrisksCountrysovereignrisk.Theriskthatrepaymentsfromforeignborrowersmaybeinterruptedbecauseofinterferenceorproblemsfacedbyforeigngovernments.Examples:?Eventrisks.Suddenchangesintaxation,changesinregulatorypolicies,unexpectedch

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