MGMT 3076-Managing Financial Institutions

Semester 2 2014/2015

Lecturer:

Mr. Terry Harris terry.harris@cavehill.uwi.edu Lectures:

Wednesdays 12:00 2:00 pm

Department of Management Studies University of the West Indies Cave Hill Campus

Lecture 4

Recap Last week

We analyzed the size, and structure of securities firms, investment banks, mutual and hedge

funds, and insurance companies; and

We discussed the activities of these firms.

Learning Objective By the end of this weeks lecture

students will be able to critically discuss

the various risks faced by financial

institutions:

Interest rate risk, market risk, credit risk, off-balance-sheet risk, foreign

exchange risk, country or sovereign

risk, technology risk, operational risk,

liquidity risk, and insolvency risk

Ch 7-3

Risks of Financial Intermediation

One of main objective FI management is to increase returns for owners. However, this

often comes at the costs of some risk.

Before we get into the quantitative assessment of these risk, we will first discuss them in this lecture.

Ch 7-4

Risks of Financial Intermediation

Interest rate risk is the risk that results from a mismatch in asset & liability maturities. Recall

that when playing the role of Asset

transformer FI buy primary secures and sell

secondary securities. This leads to:

Refinancing riskThe risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset

investments.

Reinvestment riskThe risk that the returns on funds to be reinvested will fall below the cost of funds.

and other asset prices

Interest rate risk

Interest rate risk

Interest rate risk

Class activity

Credit Risk This is the risk that promised cash flows on financial

claims (e.g. loans and bonds) are not paid in full.

Virtually all FI are exposed to this risk, but those FIs that make loans or buy bonds with long maturities are more exposed to it.

Credit risk results in the need to screen and monitor loan applicants. Thus, prudent credit risk

management strategies directly affect the risk-return

characteristics of the firms loan portfolio (e.g. credit scoring). In addition, diversification of the loan

portfolio also reduces the risk specific to the firm:

Firm specific credit risk: The risk of default of the borrowing firm associated with the specific types of project risk taken by that firm.

Systematic credit risk: The risk of default associated with general economy wide or macro conditions affecting all borrowers

Implications of Growing Credit Risk

Importance of credit screening & monitoring

Diversification of credit risk

Loan sales, reschedulings

Credit derivatives

Ch 7-11

Liquidity Risk This is the risk that a sudden surge in liability (e.g.

deposit) withdrawals (e.g. due to crisis of confidence

in the institution) of borrowings (OBS loan

commitments) force the FI to borrow additional funds

(at high prices) or sell assets (at a low price) in a very

short period of time.

When FIs face abnormal cash demands (runs) the cost of additional funds rises and the supply of such funds

becomes restricted. This can result in the FI having to

liquidate some assets at low or fire sale prices.

The persistence of a run could in turn threaten the profitability and solvency of the FI, thereby turning a

liquidity problem into a solvency problem. Ch 7-12

Liquidity Risk

Class activity

Foreign Exchange Risk Foreign exchange risk is that is the risk that exchange

rate changes can affect the value of FIs assets and liabilities denominated in foreign currencies. Here, a

FI may be net long or net short in various currencies.

Net long FI fears FX rate depreciation

Net shortFI fears FX rate appreciation

Returns on foreign and domestic investment are not perfectly correlated (countries are different). Thus

there is the potential for gains and an exposure to FX

risk.

Further, FI may profit as FX rates may not be perfectly correlated.

Example: $/ may be increasing while $/ decreasing and relationship between and time varying

Ch 7-15

To understand how foreign exchange risk arises, suppose that a U.S. based FI makes a loan to a British company in pounds

sterling (). Should the British pound depreciate in value

relative to the U.S. dollar, the principal and interest payments

received by U.S. investors would be devalued in dollar terms.

Indeed, were the British pound to fall far enough over the

investment period, when cash flows are converted back into

dollars, the overall return could be negative.

That is, on the conversion of principal and interest payments from pounds into dollars, foreign exchange losses can offset

the promised value of local currency interest payments at the

original exchange rate at which the investment occurred.

Ch 7-16

Foreign Exchange Risk

Class activity

Country or Sovereign Risk This is the risk that repayment from foreign borrowers

may be interrupted because of interference from

foreign governments. These governments may

impose restrictions (rescheduling or outright

prohibition) on repayments to foreigners.

Foreign currency shortages

Adverse political reasons

Here the FI often lacks the usual recourse via court system; however, they can increase the probability

of repayment by influencing the future supply (and

costs) of funds to the countries concerned.

Examples:

Argentina and more recently Greece

Ch 7-18

As previously mentioned, in the event of restrictions, rescheduling, or outright

prohibition of repayments, a FIs remaining bargaining chip is future

supply of loans

However, you should not that this is a weak position if countrys currency is collapsing or if the government is failing

Ch 7-19

Country or Sovereign Risk

Market Risk

The risk incurred in actively trading (rather than holding for the long term)

assets and liabilities (and derivatives)

due to interest rates, exchange rates,

and other asset price movements. When facing market risk, FIs are concerned about the

fluctuation in valueor value at risk (VAR)of their trading

account assets and liabilities for periods as short as one day

so-called daily earnings at risk (DEAR)especially if such

fluctuations pose a threat to their solvency.

Ch 7-20

To be clear, a FIs trading portfolio can be differentiated from its investment portfolio on the

basis of time horizon and secondary market

liquidity. The trading portfolio contains assets,

liabilities, and derivative contracts that can be

quickly bought or sold on organized financial

markets.

The investment portfolio (or in the case of banks, the so-called banking book) contains assets and

liabilities that are relatively illiquid and held for

longer holding periods.

Market Risk

Market Risk

Off-Balance-Sheet Risk This is the risk incurred by FIs due to the

activities related to contingent assets and

liabilities E.g.,: Letters of credit

Loan commitments

Derivative positions

FIs engage in OBS activities for a number of reasons. One reason is the opportunity to earn revenue while

not expanding the BS (could have regulator

implication). However, it should be noted that OBS

activity is not risk free.

Ch 7-23

Off-Balance-Sheet Risk

Off-Balance-Sheet Risk

Technology and Operational Risk Risk of losses resulting from inadequate or failed

internal processes, people and systems, or from

external events

Loss of backup files

Unsecured wireless networks

Technology risk: The risk incurred by an FI when technological investments do not produce the cost savings

anticipated

Operational risk: The risk that existing technology or support systems may malfunction or break down. Operational risk are

not exclusively technological but includes risk of:

Employee fraud and errors

reputation risk and strategic risk (e.g. failed merger)

The objective of technological advancement is to lower operating costs, increase profits, and capture/create new

markets for the FI, thereby allowing the FI to exploit

economies of scale and economies of scope in selling its

products.

Economies of scale. The degree to which an FIs average unit costs of producing financial services fall

as its outputs of services increase.

Economies of scope. The degree to which an FI can generate cost synergies by producing multiple

financial service products.

Ch 7-27

Technology and Operational Risk

Insolvency Risk The risk that a FI may not have enough

capital to offset a sudden decline in

the value of its assets relative to its

liabilities. Put another way, the FI has

insufficient capital (equity) to offset a

sudden decline in value of assets

relative to liabilities: Original cause may be excessive interest rate, market,

credit, off-balance-sheet, technological, FX, sovereign,

and liquidity risks

Ch 7-28

Other Risks & Interaction of Risks

Interdependencies among risks Example: Interest rates and credit risk

Interest rates and derivative counterparty risk

Discrete or Event Risks Events external to the FI e.g. the effects of war

or terrorist acts, regulatory policy changes

market crashes, theft, and malfeasance

These risk may cause FI to fail or be severely harmed

Ch 7-29