Unit 6: Risk for Financial Institutions

and their Management

 Chapter outline
• Types of Risks:
• Market risk (interest rate risk and exchange rate risk)
• Credit risk
• Liquidity risk and
• Operational risk
• Management of this risk
Chapter Preview
• Managing financial institutions has never
been an easy task, but in recent years it has
become even more difficult because of
greater uncertainty in the economic
environment.
• Interest rates have become much more
volatile, resulting in substantial fluctuations
in profits and in the value of assets and
liabilities held by financial institutions .
Chapter Preview
• Furthermore, as we know that the defaults on loans and other
debt instruments have also climbed dramatically, leading to
decline in profit of financial institutions.
• In light of these developments, it is not surprising that
financial institution managers have become more concerned
about the managing the risk their institutions face as result of
greater interest rate fluctuations and defaults by borrowers .
Chapter Preview
• In this chapter we examine how managers
of financial institutions cope with different
types of risk.
• We will study the tools that these managers
use to measure risk and the strategies that
they employ to reduce it.
 Risks at Financial Institutions
• One of the major objectives of a financial institution’s
(FI’s) managers is to increase the FI’s returns for its
owners
• Increased returns often come at the cost of increased
risk, which comes in many forms.
 Risks at Financial Institutions
• Types of risk
• Interest rate risk
• Foreign exchange risk
• Credit risk
• Liquidity risk
• Operational risk
• Country or sovereign risk
• Technology risk
• Market risk
• Insolvency risk
• Off-balance-sheet risk
 Risks at Financial Institutions
• 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 issuing
secondary securities or liabilities to fund
the purchase of primary securities or
assets
Risks at Financial Institutions
• if an FI’s assets are longer-term than its
liabilities, it faces refinancing risk
• the risk that the cost of rolling over or re-
borrowing funds will rise above the returns
being earned on asset investments
• if an FI’s assets are shorter-term than its
liabilities, it faces reinvestment risk
• the risk that the returns on funds to be
reinvested will fall below the cost of funds
 Risks at Financial Institutions
• Interest rate risk (cont.)
• all FIs face price risk (or market value risk)
• the risk that the price of the security
changes when interest rates change
• FIs can hedge or protect themselves against
interest rate risk by matching the maturity of
their assets and liabilities
• this approach is inconsistent with their asset
transformation function
 Risks at Financial Institutions
• 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
• FIs can reduce risk through domestic-foreign
activity/investment diversification
• FIs expand globally through
• acquiring foreign firms or opening new branches in foreign
countries
• investing in foreign financial assets
• returns on domestic and foreign direct and portfolio
investment are not perfectly correlated
• underlying technologies of various economies differ
• exchange rate changes are not perfectly correlated across
countries
 Risks at Financial Institutions
• FX risk (cont.)
• a net long position in a foreign currency involves
holding more foreign assets than foreign 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
holding fewer foreign assets than foreign 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
• an FI is fully hedged if it holds an equal amount of
foreign currency denominated assets and liabilities (that
have the same maturities)
 Risks at Financial Institutions
• Credit risk is the risk that the promised cash
flows from loans and securities held by FIs
may not be paid in full
• FIs that make loans or buy bonds with long
maturities are relatively more exposed to
credit risk
• thus, banks, thrifts, and insurance
companies are more exposed than
MMMFs and property-casualty
insurance companies
Risks at Financial Institutions
• many financial claims issued by individuals or
corporations have:
• limited upside return with a high probability
• large downside risk with a low probability
• a key role of FIs involves screening and
monitoring loan applicants to ensure only the
creditworthy receive loans
• FIs also charge interest rates commensurate
with the riskiness of the borrower
 Risks at Financial Institutions
Credit risk (cont.)
• the effects of credit risk are evidenced by charge-offs
• the Bankruptcy Reform Act of 2005 makes it more
difficult for consumers to declare bankruptcy
• FIs can diversify away some individual firm-specific credit risk, but
not systematic credit risk
• firm-specific credit risk is the risk of default for the
borrowing firm associated with the specific types of
project risk taken by that firm
• systematic credit risk is the risk of default associated
with general economy-wide or macroeconomic
conditions affecting all borrowers
 Risks at Financial Institutions
• 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 of time and at low prices
• day-to-day withdrawals by liability holders are generally
predictable
• unusually large withdrawals by liability holders can
create liquidity problems
• the cost of purchased and/or borrowed funds rises for FIs
• the supply of purchased or borrowed funds declines
• FIs may be forced to sell less liquid assets at “fire-sale” prices
 Risks at Financial Institutions
• 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 trading activity—i.e., market risk is the
incremental risk incurred by an FI (in addition to
interest rate or foreign exchange risk) caused by
an active trading strategy
Risks at Financial Institutions
• FIs’ trading portfolios are differentiated from
their investment portfolios on the basis of time
horizon and liquidity
• trading assets, liabilities, and derivatives are highly
liquid
• investment portfolios are relatively illiquid and are
usually held for longer periods of time
• declines in traditional banking activity and
income at large commercial banks have been
offset by increases in trading activities and
income
 Risks at Financial Institutions
• Off-balance-sheet (OBS) risk is the risk incurred
by an FI as the result of activities related to
contingent assets and liabilities
• OBS activity can increase FIs’ interest rate risk, credit
risk, and foreign exchange risk
• OBS activity can also be used to hedge (i.e., reduce)
FIs’ interest rate risk, credit risk, and foreign exchange
risk
• large commercial banks (CBs) in particular engage in
OBS activity
• on-balance-sheet assets of all U.S. CBs totaled $10.8 trillion in 2007
• the notional value of OBS items totaled $180.6 trillion in 2007
 Risks at Financial Institutions
OBS risk (cont.)
• OBS activities can affect the future shape of FIs’ balance sheets
• OBS items become on-balance-sheet items only if some future event
occurs
• a letter of credit (LOC) 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 LOC
• other examples include:
• loan commitments by banks
• mortgage servicing contracts by savings institutions
• positions in forwards, futures, swaps, and other
derivatives held by almost all large FIs
 Risks at Financial Institutions
• Country or sovereign risk is the risk that repayments from
foreign borrowers may be interrupted because of
interference from foreign governments
• differs from credit risk of FIs’ domestic assets
• with domestic assets, 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 would desire to do so
• foreign governments may limit or prohibit debt repayment due to foreign
currency shortages or adverse political events
 Risks at Financial Institutions
• Country or sovereign risk (cont.)
• thus, an FI claimholder may have little or no recourse to local
bankruptcy courts or to an international claims court
• measuring sovereign risk includes analyzing:
• the trade policy of the foreign government
• the fiscal stance of the foreign government
• potential government intervention in the economy
• the foreign government’s monetary policy
• capital flows and foreign investment
• the foreign country’s current and expected inflation rates
• the structure of the foreign country’s financial system
 Risks at Financial Institutions
• Technology risk and operational risk are closely related
• technology risk is the risk incurred by an FI when its
technological investments do not produce anticipated cost
savings
• the major objectives of technological expansion are to allow the FI to
exploit potential economies of scale and scope by:
• lowering operating costs
• increasing profits
• capturing new markets
• operational risk is the risk that existing technology or support
systems may malfunction or break down
• The operational risk as “the risk of loss resulting from inadequate or
failed internal processes, people, and systems or from external events”
 Risks at Financial Institutions
• 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/or liquidity risk
• generally, the more equity capital to borrowed funds an FI has the
less insolvency risk it is exposed to
• both regulators and managers focus on capital adequacy as a
measure of a FI’s ability to remain solvent
 Risks at Financial Institutions
• Other risks and interactions among risks
• in reality, all of the previously defined risks are interdependent
• e.g., liquidity risk can be a function of interest rate and credit risk
• when managers take actions to mitigate one type of risk, they
must consider such actions on other risks
• changes in regulatory policy constitute another type of discrete or
event-specific risk
• other discrete or event specific risks include
• war, revolutions, sudden market collapses, theft, malfeasance, and breach
of fiduciary trust
• macroeconomic risks include increased inflation, inflation
volatility and unemployment
RISK MANAGEMENT IN FINANCIAL INSTITUTIONS

What is risk management?

• Risk management is the act of dealing with
risk. It includes planning for risk, identifying
risk, analyzing risks, developing risk response
strategies, and monitoring and controlling
risk to determine how they have changed.
 RISK MANAGEMENT IN FINANCIAL
INSTITUTION
Management of Interest Rate Risk
• If a financial institution has more interest rate sensitive assets
than interest rate sensitive liabilities, a rise in interest rates will
raise the net interest margin and income.
• If a financial institution has more interest rate sensitive
liabilities than interest rate sensitive assets, a rise in interest
rates will reduce the net interest margin and income.
• Financial institutions, banks in particular, specialize in earning a
higher rate of return on their assets relative to the interest paid
on their liabilities.
 Managing Interest-Rate Risk
• To see how financial institutions can measure and manage
interest-rate risk exposure, we will examine the items of
balance sheet.
• We can use different tools such as Income Gap Analysis or
Reprising gap model, maturity model and Duration Gap
Analysis, to assist the financial manager in this effort.
 Managing Interest-Rate Risk
Reprising Gap
• The reprising gap is a measure of the difference between
the rupees value of assets that will reprice and the rupees
value of liabilities that will reprice within a specific time
period:
• where repricing can be the result of a roll over of an asset
or liability (e.g., a loan is paid off at or prior to maturity and
the funds are used to issue a new loan at current market
rates)
• because the asset or liability is a variable rate instrument
(e.g., a variable rate mortgage whose interest rate is reset
every quarter based on movements in a prime rate).
 Income Gap Analysis
• Income Gap Analysis: measures the sensitivity of a bank’s
current year net income to changes in interest rate.
• The Gap is the difference between interest rate sensitive
liabilities and interest rate sensitive assets
GAP = rate-sensitive assets – rate-sensitive liabilities
GAP = RSA – RSL
• A change in the interest rate (Δi) will change bank income
(I) depending on the Gap
Income = GAP  i
 Example
Consider the following balance sheet positions for example depository
institutions:
1. Rate-sensitive assets = $200 million. Rate-sensitive liabilities = $100
million
2. Rate-sensitive assets = $100 million. Rate-sensitive liabilities = $150
million
3. Rate-sensitive assets = $150 million. Rate-sensitive liabilities = $140
million
a. Calculate the repricing gap and the impact on net interest income of a 1
percent increase in interest rates for each position.
b. Calculate the impact on net interest income on each of the above
situations assuming a 1 percent decrease in interest rates.
c. What conclusion can you draw about the repricing model from these
results?
Example (Cont…)
a. 1. Rate-sensitive assets = $200 million. Rate-sensitive
liabilities = $100 million.
• Repricing gap = RSA - RSL = $200 - $100 million = +$100
million.
• ΔNII = ($100 million)(.01) = +$1.0 million, or $1,000,000.
Example (Cont…)
2.Rate-sensitive assets = $100 million. Rate-sensitive
liabilities = $150 million.
• Repricing gap = RSA - RSL = $100 - $150 million = -$50
million.
• ΔNII = (-$50 million)(.01) = -$0.5 million, or -$500,000.
Example (Cont…)
3. Rate-sensitive assets = $150 million. Rate-sensitive
liabilities = $140 million.
• Repricing gap = RSA - RSL = $150 - $140 million = +$10
million.
• ΔNII = ($10 million)(.01) = +$0.1 million, or $100,000.
Example (Cont…)
b. 1 ΔNII = ($100 million)(-.01)
= -$1.0 million, or -$1,000,000.
2. ΔNII = (-$50 million)(-.01)
= +$0.5 million, or $500,000.
3. ΔNII = ($10 million)(-.01)
= -$0.1 million, or -$100,000.
Example (Cont…)
c. The FIs in parts (1) and (3) are exposed to interest rate
declines (positive repricing gap) while the FI in part (2) is
exposed to interest rate increases.
The FI in part (3) has the lowest interest rate risk exposure
since the absolute value of the repricing gap is the lowest,
while the opposite is true for part (1).
Managing Interest-Rate Risk
 Rate Sensitivity
Rate sensitivity represents the time interval
where repricing can occur.
The model focuses on the potential changes
in the net interest income variable.
In effect, if interest rates change, interest
income and interest expense will change as
the various assets and liabilities are repriced,
that is, receive new interest rates.
 Rate Sensitivity

• An important distinction should be made

between assets and liabilities that are rate
sensitive and those that are not (RSA, RSL)
• Sensitivity can be described in terms of the
effective time to repricing or duration
• Reserves and other liquid assets reprice
quickly while long-term, fixed-rate securities
and loans do not; since most deposits are
short term, they reprice quickly
 Income Gap Analysis: Determining Rate Sensitive Items
for First National Bank

Assets Liabilities
• assets with maturity less
than one year – money market deposits
• variable-rate mortgages – variable-rate CDs
• short-term commercial – short-term CDs
loans
• portion of fixed-rate – federal funds
mortgages (say 20%) – short-term borrowings
– portion of checkable
deposits (10%)
– portion of savings (20%)
 Income Gap Analysis: Determining Rate Sensitive Items
for First National Bank
Rate-Sensitive Assets = $5m + $ 10m + $15m + 20%  $20m
RSA = $32m

Rate-Sensitive Liabs = $5m + $25m + $5m+ $10m + 10%  $15m

+ 20%  $15m
RSL = $49.5m

if i  5% 
Asset Income = +5%  $32.0m = +$ 1.6m
Liability Costs = +5%  $49.5m = +$ 2.5m
Income = $1.6m  $ 2.5 = $0.9m
 Income Gap Analysis
If RSL > RSA, i  results in: NIM , Income 
GAP = RSA  RSL
= $32.0m  $49.5m = $17.5m

Income = GAP Δi

= $17.5m  5% = $0.9m

This is essentially a short-term focus on interest-rate risk

exposure. A longer-term focus uses duration gap analysis.
 Net Interest Income (NII)
• Loan interest and fees represent the main source of bank
revenue, followed by interest on investment securities.
• Interest paid on deposits is the largest expense, followed
by interest on other borrowings.
• Net interest income is the difference between gross
interest income and gross interest expense. This margin is
relatively stable because the interest rates banks earn and
pay are largely set by the market.
NII = Interest Income – Interest Expense
 Gap Analysis
GAP = RSA – RSL; Positive Gap
• Positive GAP = RSA > RSL
• Net interest income will decline if interest rates fall
• More assets than liabilities reprice downward if interest
rates decline, thus reducing net interest income
• GAP = RSA – RSL; Negative Gap
• Negative GAP = RSA < RSL
• Net interest income will decline if interest rates increase.
• More liabilities than assets reprice upward if interest
rates increase, thus reducing net interest income.
 The Maturity Model
• Maturity of portfolio of assets (liabilities) equals weighted
average of maturities of individual components of the
portfolio.
• Typically, maturity gap, MA - ML > 0 for most banks and
thrifts.
Market Value Accounting: The assets and liabilities of the
FI are revalued according to the current level of interest
rates.
Rise (fall) in interest rates leads to fall (rise) in market
price.
The longer the maturity, the greater the effect of interest
rate changes on market price.
 The Maturity Model
Examples:
• How interest rate changes affect bond value:
1 year bond, 10% coupon, $100 face value,
R=10%
• Sells at par, $100
• if interest rates go up, R=11%, sells at 99.10
• capital loss (P1) = $0.90 per $100 value
• (P / R)< 0
• Rising interest rates generally lower the market
values of both assets and liabilities of an FI.
 The Maturity Model
Show the effect of the same interest rate change if the
bond is a two-year bond, all else equal.
• At R=10%, still sells at par
• At R=11%, P2 = $98.29
But P2 = 98.29 - 100 = -1.71%
Thus, the longer the maturity of a fixed-income asset or
liability, the greater its fall in price and market value for any
given increase in the level of market interest rates.
But, this increase in the fall of value happens at a diminishing
rate as time to maturity goes up.
 The Maturity Model

Maturity Model with a Portfolio of Assets & Liabilities

MA or ML designates the weighted average of assets and
liabilities.
If bank has $100 in 3 year, 10% coupon bonds, and had raised
$90 with 1-year deposits paying 10%,
• Show effects of a 1% rise in R.
• Show effects of a 7% rise in R.
The Maturity Model
• Original B/S • 7% rise in Int. rates
___A________L______ ___A________L______
A=100 L=90 (1 year) A=84.53 L=84.62
(3 year) E=10
E=-0.09
• 1% rise in Int. rates  E = A  L
___A________L______ -10.09 = -15.47 - (-5.38)
A=97.56 L=89.19 Bank is insolvent.
E=8.37 The situation is tragic if bank
 E = A  L has extreme Asset Liability
-1.63 = (-2.44) - (-0.81) mismatch
The Maturity Model
Maturity matching, by setting MA = ML, and having a
maturity gap of 0, seems like might help.
Let’s see:
Maturity Matching and Interest Rate Risk Exposure
Example:
• Bank issues a one-year CD to a depositor, with a face value of
$100, and 15% interest. So, $115 is due the depositor at year 1.
• Same bank lends to borrower $100 for one year at 15%, But
requires half to be repaid in six months, the other half at end of
year (plus interest, of course).
The Maturity Model
Maturities are matched, and if interest rates remain at
15% throughout the year:
• at half-year, bank receives $50 + $7.5 in interest (100 x .5 x .15),
$57.5
• at end-of-year, bank receives $50 + $3.75 in interest (50 x .5 x
.15) plus the reinvestment income from the $57.5 received at
half-year, (57.5 x .5 x .15), $4.3125, for a total of $58.06.
• Bank pays off the CD at $115, and has made $0.5625
 The Maturity Model
But, if interest rates decreased to 12% in the middle of the year, this
would not affect the 15% on the loan, nor the 15% on the CD, but
reinvestment of the $57.5 will have to be at 12%,
Thus:
• at half-year bank still gets $57.50
• at end of year, bank receives $53.75 from loan, but $3.45 from reinvestment
of the $57.50 (57.5 x .5 x .12), a total of $114.7.
• Bank pays off CD at $115, and loses $0.3, despite maturity matching of assets
and liabilities.
 Example

Nearby Bank has the following balance sheet (in millions):

Assets Liabilities and Equity
Cash $60 Demand deposits $140
5-year treasury notes$60 1-year Certificates of Deposit $160
30-year mortgages $200 Equity $20
Total Assets $320 Total Liabilities and Equity $320
What is the maturity gap for Nearby Bank? Is Nearby Bank
more exposed to an increase or decrease in interest rates?
Explain why?
Example (Cont..)
MA = [0*60 + 5*60 + 200*30]/320 = 19.69 years,
ML = [0*140 + 1*160]/300 = 0.533.
Maturity gap (MGAP) = 19.69 – 0.533 = 19.16 years.
Nearby bank is exposed to an increase in interest rates. If rates rise,
the value of assets will decrease much more than the value of
liabilities.
 Duration Gap Analysis
• Owners and managers do care about the impact of
interest rate exposure on current net income. They
are also interested in the impact of interest rate
changes on the market value of balance sheet items
and the impact on net worth.
• Duration Gap Analysis: measures the sensitivity of a
bank’s current year net income to changes in interest
rate.
• Requires determining the duration for assets and
liabilities, items whose market value will change as
interest rates change.
 Duration Gap Analysis
• The duration gap is a financial and accounting term and is
typically used by banks, pension funds, or other financial
institutions to measure their risk due to changes in the
interest rate. This is one of the mismatches that can occur
and are known as asset liability mismatches.
• Another way to define Duration Gap is: it is the difference
in the sensitivity of interest-yielding assets and the
sensitivity of liabilities (of the organization ) to a change in
market interest rates (yields).
• The duration gap measures how well matched are the
timings of cash inflows (from assets) and cash outflows
(from liabilities).
 Duration Gap Analysis
• When the duration of assets is larger than the duration of
liabilities, the duration gap is positive.
• In this situation, if interest rates rise, assets will lose more
value than liabilities, thus reducing the value of the firm's
equity.
• If interest rates fall, assets will gain value while liabilities
lose value, thus increasing the value of the firm's equity.
 Duration Gap Analysis
• Conversely, when the duration of assets is less than the
duration of liabilities, the duration gap is negative.
• If interest rates rise, liabilities will lose more value than
assets, thus increasing the value of the firm's equity.
• If interest rates decline, liabilities will gain more value than
assets, thus decreasing the value of the firm's equity.
 Duration Gap Analysis
• By duration matching, that is creating a zero duration gap, the firm
becomes immunized against interest rate risk. Duration has a double-
facet view. It can be beneficial or harmful depending on where
interest rates are headed.
• When the duration gap is zero, the firm is immunized only if the size
of the liabilities equals the size of the assets.
 Duration

Where, y = yield to maturity

c = coupon rate
t = time to maturity or maturity period
Or
Year (t) CF PVIF PV = CF x PVIF Weight of PV T x weight of PV
Example:
• Everest bank ltd issued a bond of Rs.1000 par value
with 5 years time to maturity. The coupon rate is 8
percent, paid annually and going market interest rate
on similar security is 10 percent. Calculate the
duration of the bond.
Duration Gap Analysis
The basic equation for determining the change in
market value for assets or liabilities is:
% Change in Value = – DUR x [Δi / (1 + i)]
Or
Change in Value = – DUR x [Δi / (1 + i)] x Original Value
 Duration Gap Analysis
Following equations are used:

DURgap = DURa  [L/A  DURl]

Where, DURa = average duration of assets

DURl = average duration of liabilities

L = market value of liabilities

A = market value of assets

%NW = DURgap  i/(1 + i)

Example:
Use the following balance sheet information to answer this question.
Balance Sheet ($ thousands) and duration (in year)
Duration Amount
T-bills 0.5 $ 90
T-notes 0.9 55
T-bonds 4.393 176
Loans 7 2,724
Deposits 1 2,092
Federal funds 0.01 238
Equity 715
Example (Cont...)
1. What is the average duration of all the assets?
2. What is the average duration of all the liabilities?
3. What is the FI’s leverage-adjusted duration gap?
What is the FI’s interest rate risk exposure?
4. What is the impact on the FI’s market value of
equity, if the interest rates rise from 10 to 11
percent?
5. What is the impact on the FI’s market value of
equity, if the interest rates fall from 10 to 9
percent?