Risk types (test 3 fin 460) PDF

Preview

Summary

Course materials...

Description

Module 9 - Risks of Financial Intermediation Risks associated with financial intermediation •interest rate risk – the risk banks have least control over •credit risk - loan may default, leads to liquidity, default/insolvency risk –country or sovereign risk included if operating internationally •market risk - market value of an outstanding loan or security may change due to changes in interest rate or currency exchange –foreign exchange (FX) risk •off-balance-sheet risk – including speculative derivatives that escape regulation and are not associated to an increase in capital requirements •technology risk, part of operational risk •liquidity risk – lack of assets that can quickly convert fairly to cash All risks increase liquidity risk and with it •insolvency risk - market value of assets less than value of liabilities, leading to rescue or failure Note that these risks are not unique to FIs

Interest Rate risk •Interest rate risk results from intermediation: –mismatch in maturities of assets and liabilities •There are two types of Interest Rate risk: –Refinancing risk is about rolling over debt, re-borrowing. It arises when maturity of liabilities is shorter than the maturity of assets. Banks need to hedge using derivatives given they have no control over changes in interest rates. –Reinvestment risk returns on reinvested assets fall below cost of duns. It arises when maturity of assets is shorter than maturity of liabilities

Credit Risk

•Risk that promised cash flows are not paid in full. –Firm specific credit risk –Systematic credit risk •Banks have control over the conditions to approve loans etc. –Solution: screening, monitoring, diversification, dynamic adjustment of credit risk premia –High rate of charge-offs of credit card debt in the 1980s, most of the 1990s and early 2000s •Credit card loans (and unused balances) continue to grow •Financial institutions that lend money for long period of time, are more susceptible to credit risk. For example, life insurance companies and depository institutions generally must wait longer time for returns to be realized than money market mutual funds and property-casualty insurance companies

Off-Balance-Sheet Risk •Striking growth of off-balance-sheet activities –Letters of credit –Loan commitments –Derivative positions •Speculative activities using off-balance-sheet items create considerable risk (as opposed to hedging) •Off-balance sheet activities are contingent commitments to undertake future on-balance sheet investments. The usual benefit of committing to a future activity is the generation of immediate fee income without the normal recognition of the activity on the balance sheet (avoiding capital requirement regulations). As cash, these contingent investments may be exposed to credit risk (if there is some default risk probability), interest rate risk (if there is some price and/or interest rate sensitivity) and foreign exchange rate risk (if there is a cross currency commitment)

Market Risk •Value of loan or security can change due to changes in interest rates, exchange rates and other prices. •Market risk can be minimized by using appropriate hedging techniques (derivatives such as futures, options and swaps), and by implementing controls that limit the exposure taken by market makers

•Note: Securitization increases liquidity of bank assets and liabilities

Operational Risk •Risk that technology, auditing, monitoring and support systems may malfunction or break down •Operational risk not exclusively technological –Employee fraud and errors –Losses magnified since they affect reputation and future potential •Risk of losses resulting from inadequate or failed internal processes, people, and systems or from external events. –Some include reputational and strategic risk

Technology Risk •Risk that technology investment fails to produce anticipated cost savings –Economies of scale –Economies of scope (cost synergies from multiple services) •Risk that technology may break down. Examples:

trades

–CitiBank’s ATM network, debit card system and on-line banking out for two days –Prudential Financial fined $600 million due to allegations of improper mutual fund –Bank of America breakdown in security of tapes

–Bank of New York: Computer system failed to recognize incoming payment messages sent via Fedwire although outgoing payments succeeded •Technological innovation has seen rapid growth –Automated clearing houses (ACH) –CHIPS (Clearing House Interbank Payments Systems) –Real time interconnection of global FIs via satellite systems (Citi in over 100 countries) –Fintech

Foreign Exchange Risk •FIs may be net long or net short in various currencies

•Returns on foreign and domestic investment are not perfectly correlated. •FX rates may not be correlated. –Example: $/€ may be increasing while $/¥ decreasing •and relationship between ¥ and € time varying. •Undiversified foreign expansion creates FX risk. •Note that completely hedging foreign exposure by matching foreign assets and liabilities requires matching the durations as well. –Otherwise, exposure to foreign interest rate risk remains.

Country or Sovereign Risk •Result of exposure to foreign government which may impose restrictions on repayments to foreigners, intervening or interfering. •Often lack usual recourse via court system. •In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs’ remaining bargaining chip is future supply of loans –Weak position if currency collapsing or government failing •Role of IMF –Extends aid to troubled banks –Increased moral hazard problem if IMF bailout expected •Examples: Argentina, Indonesia, Malaysia, Thailand, Russia, South Korea

Liquidity Risk •Risk of being forced to borrow, or to sell assets in a very short period of time. Increase in liability withdrawals, forcing quick liquidation of assets –Low unfair sale prices or fire sales of illiquid assets •May generate runs –Runs may turn liquidity problem into insolvency –Risk of systematic bank panics –Role of FDIC (moral hazard)

Risk type interdependence As a result of risk interdependencies, FIs use sophisticated models that attempt to measure all the risks faced by the FI at any point in time. •For example, to reduce interest rate risk FIs may increase floating rate products, which would increase credit risk, and in consequence default risk •Similarly, off-balance sheet risk encompasses several risks since contingent contracts typically have credit, interest rate and currency risk. •Technology risk can also influence credit risk if collection and payment systems fail and lead corporate customers into bankruptcy....