Chapter 13 – Bank
Risk Management
and Performance
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13-1a Credit Risk in General
• How do lenders evaluate credit risk?
• The 5C’s of credit risk
• Character
• Capacity
• Capital
• Collateral
• Conditions
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13-1b Credit Risk with Consumers
• 3 major credit bureaus in the United States
• Equifax
• Experian
• TransUnion
• Credit report = credit history
• Credit score = numerical value that is a measurement of how an
individual has used credit in the past
• FICO Scores
• Fair, Isaac and Company: the entity that first created these scores
• FICO score range: 300-800
• The higher the FICO score, the lower the borrower’s credit risk
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13-1c Credit Risk with Business Borrowers
• Lenders attempt to minimize credit risk using the
following techniques:
• Specialized lending
• Understanding cash flows
• Secondary sources of repayment
• Collateral
• Compensating Balance
• Personal Guarantees
• Close monitoring
• Geographic diversification
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Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
13-2a Interest Rate Risk in General
• Interest rate risk: The chance that the value
of an asset will change because of a change
in interest rates.
• As interest rates change, bank assets and
other investments change
• Interest rates do not remain constant
IR spread IR loans IR deposits
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website, in whole or in part.
13-2b Gap Analysis
• Measure interest rate exposure:
• Compare amount of interest rate–sensitive assets a
bank has with the amount of interest rate–sensitive
liabilities
• Gap = Amount of IR-sensitive assets - Amount
of IR-sensitive liabilities
• They want to hold more interest rate–sensitive assets
than interest rate–sensitive liabilities because as interest
rates increase, they will experience an increase in their
income (more interest-sensitive assets) more than an
increase in their interest expense.
Income Gap IR
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Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
13-2c Duration Analysis
• Duration measures the time it takes for the bondholder or debt holder to recover the price paid for the bond or
amount lent from all of the discounted future cash flows from the bond or debt instrument.
• The discount rate for calculating the present value of the cash flow is the bond’s or debt instrument’s yield. So, if the
bond price and yield changes, so does its duration.
• A two-step process:
• Then Plug those weights into the formula for each time period (1, 2, 3, etc.)
Duration = W1 + 2W2 + 3W3 + 4W4 + … + TWt
Payment
W
1 r
t
Bond price
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Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
13-2d Banks, Duration, & Interest Rate
Risk
• Duration gap = Asset duration - Liability duration
(Liability/Asset)
• The duration gap is the difference between the weighted
(by the assets) duration of the bank’s assets and the
weighted (by the liabilities) duration of the liabilities,
adjusted for the bank’s asset size.
• If the duration gap is zero, interest rate changes affect the
value of the bank’s assets and liabilities equally, leaving the
value of the bank unchanged.
• Thus, bank management has to make a decision about the
size of the duration gap it wants. By doing so, bank
management is deciding how much interest rate risk they
Brandl, Money, Banking, Financial Markets & Institutions, 2nd Edition. © 2021 Cengage. All Rights
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13-2e Reducing Interest Rate Risk
• If bank management decides that the bank has too much
interest risk exposure, they have a couple of different
options as to what to do. These include:
• Asset/Liability Maturity Matching.
• Write Adjustable Interest Rate Loans.
• Use Interest Rate Derivative Contracts.
• Thus, bank management has to make a decision about the
size of the duration gap it wants. By doing so, bank
management is deciding how much interest rate risk they
want to face.
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Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
13-3a Sources of Liquidity
• Liquidity risk: The risk that a financial firm will not be able to meet its
current and/or future cash needs.
• Liquidity risk is one of the oldest risks in factional reserve banking.
• Sources of Liquidity:
• Primary Reserves
• Secondary Reserves
• Bank loan
• Securities
• To lower liquidity risk, a bank has to accept lower returns. But those
lower returns could hurt its profitability and thus its ability to continue
in business.
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Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
13-3b Solutions to lack of Liquidity
• Some of the downsides to these solutions can be
very costly indeed.
• Borrow Federal Funds
• Borrow from the FED
• Increase deposits
• Sell liquid assets
• Issue commercial paper
• Securitization of assets
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Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.
13-3c How Much Liquidity is
•Enough?
Liquidity coverage ratio: The ratio of a financial firm’s liquid
assets to its projected net cash outflows.
• Liquidity coverage ratio: compares the level of easy-to-sell
liquid assets to the total cash outflows that are expected over
the next 30 calendar days
• Net stable funding ratio: The proportion of a bank’s long-term
assets funded by stable, long-term sources, including bank
customer deposits, long-term bank borrowing, and bank
capital.
• Basel III - This requires banks to maintain a certain level of
stable funding that depends on the liquidity of their assets and
the extent of off-balance exposures over the next 12 months.
The goal is a ratio equal to or greater than 1.
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13-4 Other Risks
• Operational risk: The risk of loss resulting
from an inadequate or failed internal process
or external event.
• Foreign exchange and country risk
• Market risk: The risk of a loss occurring as a
result of the decline in the market value of
an asset.
• Risk management is an important
responsibility of bank management.
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13-5a Income Statement
• A bank’s income statement looks at explicit revenues and
expenses over a specific time period, usually a year.
• The different parts of an income statement are:
• Gross interest income
• Gross interest expense
• Net interest income (NII) Gross interest income Gross interest expense
• Noninterest income
• Noninterest expense
• Pretax net income = NII + Noninterest income - Noninterest
expense
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whole or in part.
13-5b Balance Sheet
• Return on assets (ROA): ROA Net income
Total assets
Net income
• Return on equity ROE
Equity capital
(ROE):
• A higher ROA suggests that the bank is generating
more net income
• A higher ROE suggests that the bank is generating
more net income
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CRITICAL THINKING / GROUP
DISCUSSION QUESTIONS:
• 1. One of the tools that is used to evaluate a
potential borrower is collateral. What is
collateral? Why can some assets not function
as collateral?
• 2. What is your FICO score? How is your score
interrupted?
• 3. One piece of evidence of how well a bank is
managing its risks is the bank’s performance.
What are two ways that a bank examiner can
look to see how a bank is performing?
Brandl, Money, Banking, Financial Markets & Institutions, 2nd Edition. © 2021 Cengage. All Rights
Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part.