IB Topic 2 Financial risks 2020 Finale PDF

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International Banking - 30178 Academic year 2020-2021

Topic 2 Financial risks Prof. Vittoria Cerasi

Objectives of Topic 2 • Understand the financial institutions (FIs)

faced by

– Their variety and complexity – Implications for the profitability, for bank failure and the need of financial regulation

• Note: – not a course of risk management Chap. 7 and Chap. 10 – SC Textbook Chap.2 – De Haan et al. (2014) Aldasoro et al. (2020) BIS Wp No.840 2

Risks of financial institutions 1. Interest rate risk 2. Market risk 3. Credit risk 4. Foreign exchange risk 5. Country or sovereign risk 6. Off-balance sheet risk 7. Technology risk 8. Operational risk 9. Liquidity risk (preliminary, more in Topic 3) 10. Insolvency risk 3

1. Interest rate risk Risk incurred by an FI when the maturities of its assets and liabilities are mismatched

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Remember FIs perform asset transformation function by raising short term liabilities and investing in longer term assets • Interest rate risk can be – Refinancing risk: the cost of borrowing future funds could be more than the return earned on asset investment – Reinvestment risk: the return of future assets could be less than the cost of funding – Market value risk: the present value of current and future cash flows decreases because of interest rate changes 5

Refinancing risk • An FI is “short-funded”

when the maturity of liabilities is shorter than maturity of assets • Suppose – Cost of funds: 9% per year – Return on assets is fixed at 10% per year 6

Refinancing risk (cont.) • What is the profit spread over the first year? (10% - 9%) x $100 million = $1 million • How about profits for the second year? • Consider following examples for the second year: • Cost of funds rise to 11% • Cost of funds to more than 11% • What happens in either case?

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Refinancing risk (cont.) • To sum up, profits for the second year are uncertain – If interest rates are stable or decline, the maturity transformation between (shorter) liabilities and (longer) assets earning fixed rates is not a problem – If interest rates rise, the profit in the second year decreases and overall profits may become negative

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Reinvestment risk • An FI is “long-funded”

when the maturity of liabilities is longer than maturity of assets • Suppose – Cost of funds is fixed at 9% per year – Return on assets: 10% per year 9

Reinvestment risk (cont.) • What is profit spread over the first year? (10% - 9%) x $100 million = $1 million

• Consider the following examples for the second year: • Assets return only 8% • Assets return less than 8% • What happens in either case?

• To sum up, profits for the second year are uncertain – If interest rates fall, the profits in the second year decreases and overall profits may become negative

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Also market values are affected • Interest rate fluctuations change the Market Value (MV) of an asset • Recall: MV of any security is equal to the present value of current and future cash flow CF +

!"#

+ (#%&)

!") #%&

) +

!"* #%& *

+…

• Thus, – Rising interest rates reduces MV – Decreasing interest rates increases MV • Note: interest rate changes may affect market value of assets and liabilities differently due to mismatching maturities 11

The level and movement of interest rates • Monetary policy strategy is the primary factor for – the level and movement of interest rates – and, in turn, an FI’s cost of funds and return on assets – and economic decisions such as whether to consume or save

• Monetary policy affects short term interest rates, which then feed through the whole term structure of interest rates • Central banks tighten monetary policy (i.e., increase interest rates) to slow down the economy – Decrease in business and business spending (especially if financed by credit or borrowing)

• The opposite happens when economy needs stimulus • You will see more in Topic 9 (Low Interest Rate Environm) 12

Main central banks • • • • • • •

USA – Federal Reserve Euroarea- European Central Bank (ECB) UK – Bank of England Sweden – Riksbank Switzerland – Swiss National Bank Japan – Bank of Japan China – People’s Bank of China

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the difference between the grey and red lines is the spread that banks earn —> this shows how the profitability of banks has shrinked

main refinancing rate

marginal ledning rate

Negative rates

The CB set negative rates on deposits —> to incentivize banks to lend to the economy rather than holding liquidity at the CB

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Who bears interest rate risk? • When interest rates rise: – Banks raising short term deposits and investing in fixed-rate loans are exposed – Households borrowing at variable interest rate

• When interest rates fall: – Banks borrowing fixed-rate deposits and investing in floating-rate loans are exposed – Households borrowing at fixed interest rate

• Banks hedge interest rate risk with the use of derivatives but only imperfectly, so that they retain residual interest rate risk exposures 17

Fixed vs. variable interest rate on mortgages • In the Euro area economy, banks’ interest rate risk exposure is small relative to their loss absorption capacity on aggregate • • Variation is driven by loan rate fixation practices at the country level – In fixed-rate countries, banks are vulnerable to rising interest rates – In variable-rate countries, households are predominantly affected

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Share of new mortgages with variable interest rate averaged over the period 2011-15. A loan has a variable rate if the initial period of rate fixation is not more than one year. Source: Hoffmann, Klaus and Langfield (2018), Financial Stability Review 19 https://ideas.repec.org/a/ecb/fsrart/201800013.html

What is the impact of 1% increase in interest rates on the net worth (PV of assets – PV of liabilities) of banks. The banks that lend on a fixed-rate base suffer the most

Data on 104 euro significant institutions. Changes in net worth sensitivity and income gap are expressed in basis points as a fraction of a bank’s total assets Fixed- rate countries include Belgium, Germany, France, the Netherlands and Slovakia. Source: Hoffmann, Klaus and Langfield (2018), Financial Stability Review 21 https://ideas.repec.org/a/ecb/fsrart/201800013.html

2. Market risk Risk that arise when FIs actively trade assets and liabilities (and derivatives) rather than hold them for longer-term investment or hedging purposes. If prices in financial markets fall, the bank is exposed to losses due to systemic risk. 23

• Market risk is related to interest rate, foreign exchange, equity return risks but with the additional dimension resulting from trading. – Incremental risk combined with an active trading strategy – The greater asset price volatility, the greater is market risk

• Trading and investment portfolios are different in terms of time horizon and secondary market liquidity – Trading portfolio includes assets, liabilities and derivative contracts that can be quickly bought or sold on the market – Investment portfolio includes (…) that are illiquid and held for longer holding periods 24

Example of banking and trading books • Uncertainty of an FI’s earning on its trading book due to changes in market conditions (prices, interest rates, market volatility, etc.)

Banking book

Assets Cash Loans

Liabilities Deposits Other illiquid funds

Evaluated at book values

Premises and equipment Capital Other illiquid assets _______________________________________________________________ Trading book Bonds Bonds (short) Commodities Commodities (short) Evaluated at market values FX FX Equities Equities ____________________________________________ Derivatives Derivatives (short) 25

• Securitization has increased liquidity of bank loans (e.g., mortgages), thus making assets more tradable and liquid • Remember: with time, every asset can be sold! – Liquidity refers to the possibility of selling in a short period of time without incurring into large losses due to low sale prices

• FIs care about daily fluctuations in the value of their trading assets and liabilities • Example: market meltdown of 2008-2009 and losses of FIs holding mortgages and mortgage-backed securities – “Toxic” assets when the market froze up – Asset prices fell down and banks had to “write-off ” the assets on their trading book 26

3. Credit risk Risk that promised cash flows from loans and securities held by FIs may not be paid in full Chap. 10 (up to pg. 296) – SC Textbook 29

• Longer maturities of loans and bonds are more exposed to credit risk • Given borrower’s default risk, loans have – Fixed upside return (principal plus interest) – Downside risk (loss of interest and maybe of principal)

• If the borrower defaults, the priority of the claim in the bankruptcy procedure becomes crucial – Senior, junior, etc.

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Loans in more detail • Different types of loans – Commercial and Industrial (C&I) – Real estate (commercial and residential) – Loans to individuals (consumer loans)

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Commercial and Industrial loans • Short (maturity below one year) versus long • Single versus syndicated loans • Secured versus unsecured – Backed by a specific asset versus by general claim

• Fixed versus floating rates of interest – Transfer of interest rate risk to the borrower – Trade off interest/credit risk

• Spot versus loan commitment

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Contractual return on a loan • FI’s return on a loan (1+k) depends on – – – –

Interest rate on the loan (Base lending rate “BR”) Credit risk premium on the loan (“!”) Any fees relating to the loan (originating fee “of ”) Other non price terms (especially compensating balances “b” and reserve requirements “RR”) &' + ()* + !) 1+$ =1+ 1 − [. 1 − ** ]

– Collateral backing of the loan (we ignore now it for simplicity) 33

Contractual return on a loan (cntd.) • Example – – – –

Interest rate on the loan BR=6% Credit risk premium on the loan ! = #% Originating fee of=0.125% Compensating balances b=8% (with reserve requirement on it RR=10%) --> to obtain 1000$ the bank requires 80$ in deposit and 8$ must be kept as reserves at the Central Bank 0.125 + (0.06 + 0.04) 1+' =1+ 1 − [0.08 1 − 0.1 ]

The contractual return (k) is 10.91% even though the loan rate was BR+ 4 =10% 34

Contractual return on a loan (cntd.) • Credit risk premium – Fixed-rate loans: base lending rate + credit risk margin – Floating-rate loans: benchmark + spread – It depends on rating (of the loan/borrower) or bank assessment), collateral, maturity, etc. – Pricing increases as one moves down the credit risk spectrum

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Credit risk ratings Moody’s Aaa Aa A

S&P AAA AA A

Quality of Issue Highest quality. Very small risk of default. High quality. Small risk of default. High-Medium quality. Strong attributes, but potentially vulnerable.

Baa

BBB

Medium quality. Currently adequate, but potentially unreliable.

Ba

BB

Some speculative element. Long-run prospects questionable.

B

B

Able to pay currently, but at risk of default in the future.

Caa Ca C

CCC CC C

D

-

Poor quality. Clear danger of default. High speculative quality. May be in default. Lowest rated. Poor prospects of repayment. In default. 36

Expected return on a loan The promised return on a loan (1+k) however may not be returned in case of default of the borrower. ⎼ Assume there is a probability (1-p) of default. ⎼ The expected return for the bank 1+ E(r) is 1 + #(%) = ( 1 + ) + 1 − ( 0 However default is not independent from the contractual interest rate: as k increases the less likely it is that the borrower can afford to repay. 38

Loan interest rate and default

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Implications for bank lending policies • Because of the potential losses from lending, FIs need to collect information about borrowers and monitor them – Managerial monitoring efficiency and credit risk management strategies affect return and risk of loan portfolio

• FIs can diversify some credit risk by exploiting law of large numbers in their portfolios – Diversification limits the probabilities of the bad outcomes in the portfolio, thus reducing firm-specific credit risk – However, FI is still exposed to systematic credit risk, that is factors that increase simultaneously the default risk of all firms

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Syndicated loans • Provided by a group of FIs as opposed to a single lender • Structured by the lead FI(s) and the borrower • Once the terms are set (rates, fees, covenants), pieces of the loan are sold to other FIs – Every syndicate member has a separate claim on the borrower, although there is only a single loan contract

• Typically, the minimum size of a syndicated loan is $50 million

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Syndicated loans (cont.) • Pricing of the loan = interbank rate (usually LIBOR) + spread • Spread depends on the borrowers’ credit risk – 35% of syndicated loans are given a credit risk – Around 60% use rating of the borrowing firm – Only 5% or so are ‘high-risk’ or speculative grade

• The lead bank(s) obtains(obtain) a fee also for arranging (and managing) the loan – Recall what done in Topic 1 when talking about investment banks

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Advantage of syndicated loans • Lower arrangement fees compared with a bond issuance • Lower spreads than on individual loans • Widen group of lending banks (sometimes also foreign) – More diversification among borrowers for each bank

• More stable source of funds, in particular in times of disruptions

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Real estate loans • Residential versus commercial – The former are more important

• Different characteristics – Size, ratio of the loan to the property’s price (loan to value ratio), maturity – Fixed or flexible rate (Adjustable rate mortgages – ARMs)

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Financial crisis?

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Volume of US subprime mortgages

Subprime mortgages to individuals with • uncertain income • high loan to value LTV • little or no collateral 46

percentage of defaults

Percentage of mortgages in default after # months, for given date of origination

months

The quality of US mortgages has deteriorated along with the year of origination (ex-post evaluation, though) 47

Default and LTV

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Loan to value ratio • Important tool of macro prudential regulation to avoid “bubbles”/overheating in real estate market Country LTV Cyprus 70-80% Czech 100% Republic Denmark 95% Estonia 85% or 90% Finland 90-95% Hungary 35-80% Ireland 75%-90% Latvia 90-95% Lithuania 85% Luxembourgh 80% Malta 70% Netherlands 100-106% Norway 85% Poland 95% Romania 60-85% Slovakia 100%

REMEMBER The higher the ratio the more borrowers can borrow! IMPLICATION The higher the ratio the more likely the creation of bubbles is 49

Non-performing asset ratio for US banks

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NPLs in Europe • Major banks in the Euro Area had € 921 bn of troubled loans in September 2016 – 6.4% of total loans or 9% of Euro Area GDP – The ratio of NPLs is still at two digit level in Cyprus, Greece, Italy, Ireland, Portugal and Slovenia

• The NPL problem has no comparable dimension in the U.S. (Constâncio, 3 Feb 2017)

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NPL: a European problem

(Euro Area)

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4. Foreign exchange risk Risk that exchange rate changes can adversely affect the value of a bank’s assets and liabilities denominated in non-domestic currencies

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• Banks invest abroad for diversification reasons – Different underlying economies – Exchange rate changes are not perfectly correlated

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• Consider a US bank holding 100 million in pounds loans and funds 80 million with pound certificates of deposits

• The difference is funded by liabilities in dollar • The bank is net long 20 million in pound assets – It holds more foreign assets than foreign liabilities 57

• What risk is the US bank exposed to? And why? • The US bank suffers losses if the exchange rate for pounds depreciates against the dollar – In dollar terms the value of the pound assets decreases in value by more than the liabilities do – Risk of having to liquidate its net foreign assets at a lower exchange rate than the initial one

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• Consider now the same US bank holding 80 million in pound assets and 100 million in pounds liabilities

• The bank has net short position of 20 million in pound assets • The US bank suffers losses if the pound appreciates against the dollar over the investment period – In dollar terms the value of the pound liabilities increases more than the value of the assets 59

• How can a bank hedge itself against foreign exchange risk? • Is size enough? That is, is it enough that the bank has 100 million pound both in assets and liabilities – for example: • 100 million pound assets and 100 million liabilities • Different maturities: – Pound assets have 6 months maturity – Pound liabilities have 3 months maturity

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• NO! • The bank would then be exposed to foreign interest rate risk – Risk that UK interest rates rise when liabilities have to be renewed

• Both size and maturities of assets and liabilities have to be matched for the bank to be hedged against foreign currency and (foreign) interest rate risk!!

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5. Country or sovereign risk Risk a FI faces when it purchases assets such as bonds/loans of foreign corporations or country

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• What is the difference between investing in domestic corporations/country and foreign corporations/country? – Of course both can default! – But lenders cannot recourse to domestic bankruptcy courts or seize assets as easily – Moreover, repayments to foreign investors (both on corporate and sovereign bonds) may be interrupted because of restrictions, intervention or interference from foreign governments, also for political reasons – Importantly, sovereign risk on corporate bonds can be independent of the firm’s credit risk 63

Examples of country or sovereign risk • Risk for foreign investors is typical of emerging countries – 1982: Mexican and Brazil announced debt moratoria – Late 1990s: Russia defaulted on its short-term government bonds – foreign investors received less than 5 cent per dollar – 2001/02: Argentina defaulted on $130 billion government bonds and passed legislation that led to defaults on $30 billion of corporate bonds due to foreign creditors

• This shows the importance of assessing sovereign risk of a foreign country or firm with a two-step procedure – Assessment of the underlying credit risk of the corporate/borrower – Assessment of the sovereign risk quality in which borrower resides 64

Sovereign default in the Eurozone • More generally, sovereign risk is meant as the (credit) risk that a government defaults on its debt • Greek default – – largest-ever sovereign default – Despite having received massive bailout before the default – unprecedented $147 billion rescue by Eurozone and IMF – Interestingly, (and not on tho...