Professional Documents
Culture Documents
McGraw-Hill/Irwin
19-1
19-2
In order to offer shareholders a competitive rate of return, FIs must therefore incur substantial risk. This risk takes the form of using a high amount of leverage, investing in assets riskier than the liability positions funding them and maintaining minimal liquidity positions. Consequently, small errors in judgement can have seriously negative consequences for the solvency of FIs. Because many institutions depend upon the publics perception of their soundness to attract business, events that erode the publics confidence in one or several large domestic or foreign FIs can quickly spread and lead to major profit and solvency problems in many FIs.
McGraw-Hill/Irwin
19-3
McGraw-Hill/Irwin
19-4
McGraw-Hill/Irwin
Credit risk
Credit risk is the possibility that a borrower will not repay principle and interest as promised in a timely fashion. To limit this risk, FIs engage in credit investigations of potential funds borrowers, or in the case of investments they may rely on externally generated credit ratings.
McGraw-Hill/Irwin
19-6
19-7
Banks, thrifts and life insurers usually face more credit risk than certain other intermediaries such as MMMFs and P&C insurers because the former tend to have longer maturity loans and investments Tip: What may appear to be relatively small loss rates can quickly bring about the threat of insolvency at depository institutions (DIs). For instance, unexpected loss rates of 5% to 6% of the total loan portfolio can easily cause a bank to fail.
McGraw-Hill/Irwin
19-8
Highest Risk
credit card loss rates are significantly higher than most other types of domestic loans. Foreign lending, particularly sovereign lending, has traditionally been the most risky throughout all of the history of banking (you would think they would learn eventually) and has led to the loss of many fortunes and caused many failures.
McGraw-Hill/Irwin
19-9
McGraw-Hill/Irwin
19-10
Liquidity Risk Liquidity risk Liquidity risk arises when an FIs liability holders demand immediate cash for their financial claim Serious liquidity problems may result in a run
McGraw-Hill/Irwin
19-11
Liquidity risk arises because there is a mismatch in the terms and maturity of a FIs assets and liabilities. In many cases liabilities either have an uncertain maturity (they are due upon demand for instance), or they have a shorter maturity than the assets. Many FIs assets are also less liquid than the FIs liabilities.
McGraw-Hill/Irwin
19-12
McGraw-Hill/Irwin
19-13
McGraw-Hill/Irwin
19-14
McGraw-Hill/Irwin
19-15
maturity intermediation
many intermediaries invest in direct claims issued by borrowers (assets) while providing separate claims to individual savers (liabilities). This process is called maturity intermediation The maturity of a FIs assets will then normally differ from the maturity of its liabilities. When this is the case, changes in interest rates can lead to changes in profitability and/or equity value
McGraw-Hill/Irwin
19-16
Banks and thrifts engage in maturity intermediation to a greater extent than other institutions such as life insurers. Consequently the former two types of FIs face more interest rate risk. In general, if an institution has longer maturity assets funded by shorter maturity liabilities, it is at risk from rising interest rates.
McGraw-Hill/Irwin
19-17
19-18
refinancing risk
The institution has refinancing risk because the liabilities must be rolled over or reborrowed before the assets mature. Refinancing risk is the risk that at rollover dates the liability cost will rise above the asset earning rate. An institution in this situation will however benefit from declining interest rates
McGraw-Hill/Irwin
19-19
Reinvestment risk
institutions with an asset maturity shorter than the liability maturity will benefit from rising interest rates, but will be hurt by falling interest rates. If the assets mature more rapidly than the liabilities then the institution faces reinvestment risk. Reinvestment risk is the risk that the returns on funds to be reinvested will fall below the cost of those funds
McGraw-Hill/Irwin
19-20
Example
A FI has $100 million of fixed earning assets that mature in 2 years. The assets earn an average of 7%. These are funded by 6 month CD liabilities paying 4%. So we are in the former case where the asset maturity is longer than the liability maturity. The banks Net Interest Margin (NIM) = [(7% 4%)*$100 million] / $100 million = 3%. If in 6 months interest rates increase 100 basis points, the 2 year assets will still be earning 7%, but the new 6 month CDs will have to pay 5%, reducing the NIM by 1/3 to 2%. This illustrates refinancing risk.
McGraw-Hill/Irwin
19-21
McGraw-Hill/Irwin
19-22
. Economic or present-value uncertainty arises when interest rates change FIs can seek to hedge by matching the maturity of their assets and liabilities
McGraw-Hill/Irwin
19-23
Market Risk
Market risk Closely related to interest rate and foreign exchange risk Decline in income from deposit taking and lending matched by increased reliance on income from trading FI management required to establish controls or limits on day-to-day exposure to risk
McGraw-Hill/Irwin
19-24
Market risk arises when FIs take unhedged positions in securities, currencies and derivatives. Income from trading activities has increased in importance during recent years. In general, the volatility of asset prices and currency values causes market risk.
McGraw-Hill/Irwin
19-25
Bank assets and liabilities can be separated into banking book assets or liabilities and trading book assets or liabilities based on the accounts maturity and liquidity. Trading book accounts are on and off balance sheet accounts that are held for a short time period and are generally speculative in nature. They are held in hopes of generating price gains or as part of making a market in a given security or contract. Banking book accounts are those held for longer time periods and generate interest income or provide long term funding
McGraw-Hill/Irwin
19-26
Assets Liabilities Banking Book Loans Capital Other illiquid assets Deposits Trading Book Bonds (long) Bonds (short) Commodities (long) Commodities (short) FX (long) FX (short) Equities (long) Equities (short) Off BS Derivatives (long) Derivatives (short)
McGraw-Hill/Irwin
19-27
Tip: The failure of Barings bank is an extreme example of market risk (see the Off Balance Sheet section).
McGraw-Hill/Irwin
19-28
McGraw-Hill/Irwin
19-29
Tip: The VAR is a probabilistic method that estimates the likely loss that could occur at a given confidence interval (usually 95%). A simple VAR model would attempt to identify and estimate likely values for the major portfolio risk factors, such as stock price changes, currency changes, interest rate changes, etc. Based on either the factors historical variability or the use of Monte Carlo simulation the VAR model attempts to estimate the likely changes of each variable over the time interval, incorporating the correlations between the variables so that the FI can more realistically estimate the maximum loss likely to occur with 95% confidence
McGraw-Hill/Irwin
19-30
Off-Balance-Sheet Risk
Off-balance-sheet risk
Interest rate risk ,Credit risk, Currency risk abe Unique risks
Off-balance activity Letter of credit Loan commitments by banks (Unfunded loan commitments are those commitments made by a Financial institution that are contractual obligations for future funding mortgage servicing contracts by thrifts, and positions in forwards, futures, swaps, options, etc
McGraw-Hill/Irwin
19-31
The last twenty years have brought about tremendous growth in off balance sheet activities ranging from loan commitments to swaps to OTC derivatives. Off balance sheet activities are contingent claims that can affect the balance sheet in the future EX: A letter of credit issued by a FI is a contingent promise to pay off a debt if the primary claimant fails to pay.
McGraw-Hill/Irwin
19-32
the incentive
Profitability is the incentive driving the off balance sheet business. FIs are generating fee income to reduce the dependence on interest rate spreads and because of the increased competitive pressures on their traditional lines of business. Off balance sheet assets and liabilities have grown so much that ignoring them may generate a significantly misleading picture about the value of stockholders equity.
McGraw-Hill/Irwin
19-33
Many off balance sheet activities are used including: Loan commitments Mortgage servicing contracts Positions in forwards, futures, swaps and other derivatives (mostly by the largest FIs
McGraw-Hill/Irwin
19-34
McGraw-Hill/Irwin
19-35
McGraw-Hill/Irwin
McGraw-Hill/Irwin
19-37
19-38
19-39
Tip: To what extent do these problems imply we should limit derivatives usage? Are we comfortable with the caveat emptor "Let the buyer beware".[ philosophy currently employed?
McGraw-Hill/Irwin
19-40
McGraw-Hill/Irwin
19-41
The risk of a declining yen could be offset various ways. The FI could acquire yen deposits or other yen denominated liabilities or the FI could sell the yen forward. or Suppose the FI procures a 100 million 6 month Euro yen liability to fund the loan
McGraw-Hill/Irwin
19-43
In this case the exchange rate risk is reduced because the change in $ value of the loan asset should be at least partially offset by a similar change in the $ value of the Euro yen liability.
McGraw-Hill/Irwin
19-44
Some exchange rate risk remains because the 6 month rate may change differently than the 1 year rate. Moreover, the FI faces interest rate risk if we presume that the FI must roll over the CD borrowings for six more months.
McGraw-Hill/Irwin
19-45
The potential severity of foreign exchange risk is illustrated in the 1997 Asian crisis. Many Asian countries had short term dollar and yen denominated debts. The debts were serviced by local currency earnings, so currency devaluations would impair the borrowers ability to repay the loans. These countries had engaged in currency stabilization policies that lulled investors to believing that due to the Asian economic miracle currency risk was minimal
McGraw-Hill/Irwin
19-46
As growth slowed, currency speculators began betting that the currency values would have to fall. Once the local currencies began to depreciate, beginning with the Thai baht, contagion effects quickly spread to other currencies, such as the Indonesian rupiah and eventually the Russian ruble and Brazilian real. The crisis then fueled itself as local firms could no longer repay their dollar denominated debts, leading to further currency devaluations. In the ensuing fallout of loan, investment and currency losses, the earnings of many worldwide FIs were hurt including Chase, which lost $160 million as a result, J.P. Morgan and many Japanese and South Korean banks.
McGraw-Hill/Irwin
19-47
The foreign exchange markets are the largest markets in the world and banks are major participants. They engage in currency arbitrage, taking positions in currencies to meet customers needs and outright currency speculation. Participation in the currency markets can actually reduce risk of foreign currency loans. It is the unhedged positions that add to risk. Moreover, currency movements are not perfectly correlated so maintaining positions in multiple countries may reduce overall risk given that some foreign exposure is inevitable.
McGraw-Hill/Irwin
19-48
19-49
Losses in the 1980s and 1990s due to sovereign risk were quite large and would have been even larger except for huge amounts of emergency funding provided by the IMF to countries experiencing a crisis. In 2001 Argentina defaulted on $130 billion of government issued debt and in September 2003 it defaulted on a $3 billion loan from the IMF.
McGraw-Hill/Irwin
19-50
In 2005 Argentina unilaterally announced it would pay only $0.30 per dollar on loans and bonds outstanding from its 2001 debt restructuring. Apparently happy to get anything, about three fourths of the bondholders were expected to accept the offer. Many other countries have had similar difficulties, for instance, Mexico had two major crises in the last decades, Russia suddenly and with no explanation defaulted on its foreign loans in 1998, in the past Indonesia declared a debt moratorium, Malaysia instituted capital controls after the Asian currency crisis, Brazil has had difficulty repaying debts several times, etc.
McGraw-Hill/Irwin
19-51
McGraw-Hill/Irwin
19-52
Operational risk arises when technology (or technology users) and other systems fail to perform properly. Major examples of operational risk include settlement risk, clearing risk, risks associated with custodial services and outright computer breakdowns. In Wells Fargos merger with First Interstate (FI), FIs customer account numbers were not properly credited with incoming deposits. Wells Fargo incurred a $180 million operating loss as a result.
McGraw-Hill/Irwin
19-53
the definition of operational risk may including employee fraud, misrepresentation and account errors in operational risks In Wells Fargos merger with First Interstate (FI), FIs customer account numbers were not properly credited with incoming deposits. Wells Fargo incurred a $180 million operating loss as a result.
McGraw-Hill/Irwin
19-54
Citibanks 2002 ATMs went down for several days, along with its online banking. In September 2004 about one third of Wachovia Securities brokers assistants could not access customer records or even log onto their computers. In February 2005, Bank of America announced it had lost computer backup tapes containing personal information (including social security numbers) of about 1.2 million federal government employees charge cards transactions
McGraw-Hill/Irwin
19-55
Insolvency Risk
Insolvency risk (bankruptcy) occurs when an institutions assets are less than its liabilities. Insolvency risk arises from each of the aforementioned risks. The major safeguards against insolvency are equity capital and prudent management practices.
McGraw-Hill/Irwin
19-56
McGraw-Hill/Irwin
McGraw-Hill/Irwin
19-58
Events can also lead to multiple risk exposures. The most obvious forms of event risk for FIs are regulatory changes that can affect multiple areas of performance. Terrorist attacks could fit in this category as well. FI losses due to the September 11, 2001 attacks were quite large. Large stock market moves can also result in increased credit, liquidity risk, interest rate risk and even foreign exchange risk.
McGraw-Hill/Irwin
19-59
McGraw-Hill/Irwin
19-60