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1、Ch.7 Risks faced by FIs (Saunders et al,2006)OutlineThis chapter discusses the risks associated with financial institutions7.1 Uncertainty vs.Risk7.2 Interest rate risk7.3 Market risk7.4 Credit Risk7.5 Off-balance sheet risk7.6 Operating risk7.7 Foreign exchange risk7.8 Liquidity risk7.9 Other risks
2、The main objective of FIs is the proper management of these risks17.1 Uncertainty vs.RiskUncertainty.A situation where an action has more than one possible result and the probability of each result is unkwnownunkwnown.nRisk.A situation where an action has more than one possible result and the probab
3、ility of each result is known.known.Alternatively,Alternatively,Risk is the degree of uncertainty associated to the outcome of an eventnUsually FIs make decisions under uncertainty in terms of risk,i.e.,they know(estimate)the probability of the results of a course of action.2 7.2 Interest rate risk
4、Interest rate risk is the potential impact on an FIs earnings and market value of equity of changes in interest ratesThis risk is incurred by an FI when the maturities of its assets and liabilities are mismatched.na)Reinvestment risk.The risk that the returns on funds to be reinvested will fall belo
5、w the originally anticipated returns Example:1-year loans at 10%annual funded with 2-year deposits at 9%Profit spread 1st year=10%-9%=+1%.2nd year:?-9%Other example of reinvestment risk:mortgage refinancing at a lower interest rate I.e.,FI pays deposits at a fix-rate,investing in floating-rate loans
6、 0 1 year 2 years Assets(Loans at 10%)01 year2nd year i=?i=8%i=11%Liabilities(Deposits at 9%)3nb)Refinancing riskThe risk that the cost re-borrowing funds will rise above the originally estimated cost of borrowingExample:2-year loans at 10%annual funded with 1-year deposits at 9%Profit spread 1st ye
7、ar=10%-9%=+1%.2nd year:10%-?1-year2-yearAssets(loans 10%)0 Liabilities(Deposits at 9%)012nd year i=?i=8%i=11%4nFirms should try to match maturities of assets and liabilities fixed rate assets Eliminates interest rate risk Disadvantage of matching?A:?57.3 Market RiskThe risk of losses in on-and off-b
8、alance-sheet positions arising from movements in market prices.nIncurred in active trading(risky investing)of assets and liabilities(and derivatives).a)What type of FIs are more prone to market risk?A:?b)What type of activities?A:?b)What type of financial claims?A:?6 7.4 Credit Risk or Default RiskT
9、he risk that the promised cash flows from loans and securities held by FIs may not be paid in full I.e.,payments of principal and interest on their promised dates.a)What type of FIs are more prone to default risk?A:?b)What type of financial claims?A:?c)How this problem can be reduced?A:?7 7.5 Off-Ba
10、lance-sheet RiskThe risk incurred by an FI due to activities related to contingent assets and liabilitiesTypes:Credit substitutes(e.g.,standby line of credits,loan commitments,loan guarantees)and positions on derivatives The OBS activities could eventually appear in the future Balance Sheet Examples
11、:Defaulted guaranteed loan(would appear as a liability of the FI).If a Finance Company(FC)has credit guarantees by an insurance company to back the FCs commercial paper and it defaults the insurance company will have to pay the FC debts.8Subprime crisisnMany Subprime mortgage-backed securities were
12、held in off-balance sheet vehicles of U.S.Banks.Funded mostly by asset backed commercial paper to money market funds and other investorsThose funds stopped buying paper during last quarter of 2008.originating a liquidity crisis to the U.S.banks97.6 Technology and Operational Risk“It is the risk of l
13、osses resulting from inadequate or failed internal processes,people,and systems or from external events”(BIS)It includes technology system,organizational behaviour and other legal aspects of managing an FI,as well as reputational risk and strategic risk.nTechnology Risk.Risk that technology investme
14、nt fails to produce anticipated cost savings.nOperational Risk.Risk that technology or support systems may fail.Examples?107.7 Foreign Exchange RiskThe risk that exchange rate(XR)changes can affect the value of an FIs assets and liabilities denominated in foreign currencies.nDiversification:domestic
15、 and foreign(direct or portfolio)investment return riskConditions:1)Uncorrelated returns 2)Uncorrelated exchanges rates Example:C$/Euro may be decreasing while C$/increasingUndiversified foreign expansion creates FX risk.nA FI is fully hedged only if the average lives and amounts of foreign assets a
16、nd liabilities are the same and by the same amount.11nExample Consider a Canadian FI that holds US$200-million loans as assets and finance US$100 of them with CDs(liabilities in US$).The remaining US$are funded with C$CDs.In this case,the Canadian FI is net long US$100M.It holds more foreign assets
17、than liabilitiesnWhat would happen to the Cdn FIs profits(in C$)if the US$depreciates?What is the total foreign exchange profit(loss)incurred in 2008 from above net position if the loans are charged a US interest rate of 8%,and the exchange rates are C$1.538 and C$1.282 at the beginning and at the e
18、nd of 2008,respectively?What was the actual rate of return obtained?What types of additional risks is the Cdn FI exposed?What if the Cdn FI instead of being net long is short long?nBeginning End of XR profit Of 2008of 2008 (loss)US$100-million (2)US$108-million (1)=(US$100 M)(1.538)=C$153.8 M (3)=(U
19、S$108M)(1.282)=C$138.456 M (4)=(C$15.344 M)127.8 Liquidity RiskRisk of an FI of being forced to borrow,or sell assets,in a very short period of time to meet unexpected liability withdrawals,with a substantial loss.nThis problems is inherent in depositary institutions Reason:Mismatching of maturities
20、 of assets and liabilities(and Off-balance-sheet claims).Example:Short Term Liabilities:Demand deposits and short term deposits offered by a bank.Off-balance-sheet claims:loan guarantees.Short Term Assets:For example,Cash,T-bills,short term loans(overnight),reverse repos.If there is an unexpected(an
21、d unplanned)large withdrawal of demand deposits the bank can face a liquidity crisis.A LSTLTLTSTB Sheet13How would the bank react to solve this problem?A:?If the bank cannot meet its obligations,what is the most likely outcome?A:?Contagion effect:Other banksRisk of systematic bank panics.14 7.9 Othe
22、r risksCountry sovereign risk.The risk that repayments from foreign borrowers may be interrupted because of interference or problems faced by foreign governments.Examples:?Event risks.Sudden changes in taxation,changes in regulatory policies,unexpected changes in financial markets caused by war,terrorism,storms,earthquakes.Macroeconomic risks:unexpected inflation,inflation volatility.nInteraction of risksIf interest rates increase default risk,liquidity risk,FX Insolvency risk(Assets Liabilities),15