Bank risks
Saunders – Chapter 7
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Risks at Financial Institutions
• A major objective of FI management is to increase the FI’s
returns for its owners, but increased returns typically come at the
cost of increased risk:
• Credit risk
• Liquidity risk
• Interest rate risk
• Market risk
• Off-balance sheet risk
• Foreign exchange risk
• Country or sovereign risk
• Technology risk
• Operational risk
• Fintech risk
• Insolvency risk
Risks Faced by Financial
Institutions
Credit Risk at FIs
• Credit risk is the risk that the promised cash flows from loans and securities held
by FIs may not be paid in full
• Virtually all types of FIs face this risk, but FIs that make loans or buy bonds
with long maturities are more exposed than are FIs that make loans or buy
bonds with short maturities
• Even as losses due to credit risk increase, FIs continue to willingly give
loans because they charge a rate of interest on a loan that compensates for
the risk of the loan
• Important element in the credit risk management process is pricing
• Managerial (monitoring) efficiency and credit risk management strategies
directly affect the returns and risks of the loan portfolio
Credit Risk at FIs (Continued)
• Advantage that FIs have over individual investors is their ability to diversify credit
risk exposures from a single asset by exploiting the law of large numbers in their
asset investment portfolios
• Diversification reduces firm-specific credit risk, the risk of default for the
borrowing firm associated with the specific types of project risk taken by that firm
• E.g., risk specific to holding the bonds or loans of GM
• Diversification does not reduce systemic credit risk, the risk of default associated
with general economy-wide or macro-conditions affecting all borrowers
• E.g., an economic recession
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Charge-Off Rates for Commercial Bank
Lending Activities
Credit Card Loss Rates and
Personal Bankruptcy Filings
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reserved. Authorized only for instructor use in
the classroom. No reproduction or further
Impact of Credit Risk on an FI’s
Equity Value
Liquidity Risk
• Liquidity 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 and at low prices
• On the asset side of the balance sheet, loan requests and
the exercise by borrowers of their loan commitments and
other credit lines causes liquidity risk
• Most liquid asset of all is cash
• To meet the demand for cash by liability holders, FIs must
either liquidate assets or borrow additional funds
• When all, or many, FIs face abnormally large cash
demands, the cost of purchased of borrowed funds rises
and the supply of such funds becomes restricted
• FIs may have to sell some of their less liquid assets to meet
the withdrawal demands, resulting in serious liquidity risk
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Impact of Liquidity Risk on Equity Value
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Interest Rate Risk
• Interest rate risk is the risk incurred by an FI when the
maturities of its assets and liabilities are mismatched and
interest rates are volatile
• Asset transformation involves an FI buying primary
securities/assets and issuing secondary securities/liabilities to
fund the assets
• Primary securities that FIs purchase often have maturity
characteristics different from the secondary securities that FIs sell
• Refinancing risk is the risk that the cost of rolling over or
reborrowing funds will rise above the returns being earned on
asset investments
• Type of interest rate risk that occurs when an FI holds longer-term
assets relative to liabilities
• By holding shorter-term assets relative to its liabilities, an FI
faces reinvestment risk, the risk that the returns on funds to be
reinvested will fall below the cost of funds
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Interest Rate Risk
(Continued)
• Price risk is the risk that the price of the security will change when interest rates
change
• Rising (falling) interest rates increase (decrease) the discount rate on future asset
or liability cash flows and reduce (increase) the market price or present value of
that asset or liability
• Mismatching maturities by holding longer-term assets than liabilities means that when
interest rates rise, the economic or present value of the FI’s assets falls by a larger
amount than its liabilities
• FIs can seek to hedge or protect themselves against interest rate risk by matching the
maturity of their asset and liabilities, but this strategy is not necessarily consistent with
an active asset transformation function for FIs
• Matching maturities hedges interest rate risk only in a very approximate rather
than complete fashion
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Market Risk
• Market risk is the risk incurred in trading assets and liabilities
due to changes in interest rates, exchange rates, and other
asset prices
• Closely related to interest rate and foreign exchange risk
• Adds another dimension of risk: trading activity
• Market risk is the incremental risk incurred by an FI when interest
rate and foreign exchange risks are combined with an active
trading strategy, especially on that involves short trading horizons
such as a day
• FI’s trading portfolio can be differentiated from its investment
portfolio on the basis of time horizon and liquidity
• Trading portfolio contains assets, liabilities, and derivative
contracts that can be quickly bought or sold on organized
financial markets, whereas investment portfolio contains assets
and liabilities that are relatively illiquid and held for longer periods
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The Investment (Banking) Book and
Trading Book of a Commercial Bank
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Market Risk
(Continued)
• Traditional roles of many FIs have changed in recent years
• For large commercial banks such as money center banks, decline
in income from traditional deposit taking and lending activities has
been matched by an increased reliance on income from trading
• Decline in underwriting and brokerage income for large investment
banks has also been met by more active and aggressive trading in
securities, derivatives, and other assets
• Mutual fund managers, who actively manage their asset portfolios, are
also exposed to market risk
• FIs are concerned about fluctuations in value, or 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
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Off-Balance-Sheet Risk
• Off-balance-sheet (OBS) risk is the risk incurred by an FI
as the result of activities related to contingent assets and
liabilities
• In 2019, commercial banks had $16.457 trillion in on-balance-
sheet items, while the face or notional value of their off-
balance-sheet derivative items was $204.874 trillion
• OBS activities do not appear on an FI’s current balance sheet
since it does not involve holding a currency primary claim
(asset) or the issuance of a current secondary claim (liability)
• OBS activities involve the creation of contingent assets and
liabilities that give rise to their potential placement in the
future on the balance sheet
• Contingent assets and liabilities are assets and liabilities off the
balance sheet that potentially can produce positive or negative
future cash flows for an FI
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Valuation of an FI’s Net Worth with
and without Consideration of OBS
Activities
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Off-Balance-Sheet Risk
(Continued)
• More attention has been drawn to the OBS activities of banks,
especially large ones, as opposed to small depository
institutions or insurers
• Issuing a letter of credit (LC) is an OBS activity
• LC 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 LC
• Other examples of OBS activities are collateralized mortgage
obligations (CMOs), loan commitments by banks, mortgage
servicing contracts by depository institutions, and positions in
forwards, futures, swaps, and other derivative securities by
almost all large FIs
• Ability to earn fee income while not loading up or expanding
the balance sheet has become an important motivation for FIs
to pursue OBS business
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Foreign Exchange Risk
• Foreign exchange (FX) risk is the risk that exchange rate
changes can affect the value of an FI’s assets and liabilities
denominated in foreign currencies
• U.S. pension funds that held approximately 5% of their assets in
foreign securities in the early 1990s now hold close to 24% of
their assets in foreign securities
• Returns on domestic and foreign direct investments and portfolio
investments are not perfectly correlated for two reasons:
1. Underlying technologies of various economies differ, as do the
firms in those economies
2. Exchange rate changes are not perfectly correlated across
countries
• FIs expand globally through acquiring foreign firms or opening
new branches in foreign countries, as well as investing in foreign
financial assets
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Foreign Exchange Risk
(Continued)
• A net long position in a foreign currency involves an FI holding more foreign
assets than liabilities
• FI loses when foreign currency falls relative to the U.S. dollar
• FI gains when foreign currency appreciates relative to the U.S. dollar
• A net short position in a foreign currency involves an FI holding fewer foreign
assets than liabilities
• FI gains when foreign currency falls relative to the U.S. dollar
• FI loses when foreign currency appreciates relative to the U.S. dollar
• FI is fully hedged only if we assume that it holds foreign assets and liabilities of
exactly the same maturity
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Foreign Asset and Liability Positions
Net Long Asset Position in Pounds
Net Short Asset Position in Pounds
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Sovereign Risk
• Country, or sovereign, risk is the risk that repayments from foreign borrowers may be
interrupted because of interference from foreign governments
• Differs from the type of credit risk that is faced by an FI that purchases domestic
assets, such as the bonds and loans of domestic corporations
• With domestic defaults, FIs usually have some recourse through bankruptcy
courts (i.e., FIs can recoup some of their losses when defaulted firms are
liquidated or restructured)
• Foreign corporations may be unable to pay principal and interest even if they desire to
do so
• Foreign governments may limit or prohibit debt repayment due to foreign
currency shortages or adverse political events
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Sovereign Risk
(Continued)
• In the event of restrictions or outright prohibitions on the
payment of debt obligations by sovereign governments, the
FI claimholder has little if any recourse to local bankruptcy
courts or to an international civil claims court
• Measuring sovereign risk includes an analysis of
macroeconomic issues, such as the following:
• Trade policy;
• Fiscal stance (deficit or surplus) of the government;
• Government intervention in the economy;
• Its monetary policy;
• Capital flows and foreign investment;
• Inflation; and
• Structure of its financial system
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Technology and Operational Risk
• Technology risk is the risk incurred by an FI when its
technological investments do not produce anticipated cost
savings
• Major objectives of technological expansion are to lower
operating costs, increase profits, and capture new markets for
an FI
• Operational risk is the risk that existing technology or support
systems may malfunction or break down
• Not exclusively the result of technological failure
• Other sources of operational risk can result in direct costs,
indirect costs, and opportunity costs that reduce an FI’s
profitability and market value
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Fintech Risk
• Fintech risk is the risk that fintech firms could disrupt
business of financial services firms in the form of lost
customers and lost revenue
• Broader and wider ranging than technology risk
• Fintech services such as cryptocurrencies (e.g., bitcoin) and
blockchain provide a system that supports the exchange of value
between two parties unknown to each other in a swift and
effective way, without the need for financial intermediaries
• Largest fintech companies include the following:
• SoFi, an online personal finance company;
• Transferwise, an international money transfer provider; and
• Credit Karma, a platform that provides credit scores to users and
also serves as a portal for people to search and apply for various
financial services, like loans, credit cards, and insurance
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Insolvency Risk
• Insolvency 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 liabilities
• Insolvency 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 liquidity risk
• Generally, the more equity capital to borrowed funds an FI
has (i.e., the lower its leverage), the better able it is to
withstand losses due to risk exposures such as adverse
liquidity changes, unexpected credit losses, and so on
• Both regulators and managers focus on capital adequacy as
a key measure of an FI’s ability to remain solvent and grow
in the face of a multitude of risk exposures
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Other Risks and Interactions
Among Risks
• All of the previously defined risks are interdependent
• Each risk and its interaction with other risks ultimately affects
solvency risk
• Various other risks also impact FI’s profitability and risk exposure:
1. Discrete, or event-type, risks:
• Sudden change in taxation
• Changes in regulatory policy, including lifting the regulatory
barriers to lending or to entry or on products offered
• Sudden and unexpected changes in financial market conditions
due to war, revolutions, or sudden market collapse
• Theft, malfeasance, and breach of fiduciary trust
2. Macroeconomic risks:
• Increased inflation and inflation volatility
• Unemployment
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