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Chapter Nineteen

Types of Risks Incurred


by Financial Institutions

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Why Financial Institutions Need to


Manage Risk
The goal of a FI is the same as any for profit
corporation, namely to maximize shareholder
wealth.
The major difference between a financial
institution and a nonfinancial corporation is in
the nature of their assets and liabilities and the
degree of regulation.
A majority of financial firms assets are pieces
of paper. They are not readily differentiable
from assets of competitors; this leads to very
low ROAs.
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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.
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Why FIs Need to Manage Risk


why foreign FIs
Risks of financial intermediation have
increased as the U.S. and overseas economies
have become more integrated
FIs that have no foreign customers can still be
exposed to foreign exchange and sovereign
risk if their customers have dealings with
foreign countries

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Risks Faced by Financial Intermediaries

Credit Risk
Liquidity Risk
Interest Rate Risk
Market Risk
Off-Balance-Sheet Risk
Foreign Exchange Risk
Country or Sovereign Risk
Technology Risk
Operational Risk
Insolvency Risk

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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.

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Diversify away Credit Risk


FIs lend to many different borrowers to
diversify away firm specific (borrower specific)
credit risk.
But the Systematic credit risk will remain
(credit risk due to systemic or economy wide
risks such as inflation and recession) even in a
well diversified portfolio.
Many of the S&L problems of the 1980s can be
attributed to an underdiversified loan portfolio
overexposed to certain types of lending in
certain regions.
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Banks, thrifts and life insurers usually face


more credit risk than certain other
intermediaries
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.

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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.
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Why our Bank hesitate to lend


Tip: Only the unexpected portion of loan
losses generates solvency risk per se.
Banks set aside an allowance for loan
loss account against to cover expected
loan losses.

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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

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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.
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Not to turn away customers


Even if the existing assets and liabilities
were perfectly maturity matched, loan
commitments and the undesirability of
turning away potential loan customers
would lead to liquidity risk as borrowers
increased their take downs or new loan
customers arrived unexpectedly at the FI

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So what is the solution


FIs maintain precautionary liquid assets
to meet unexpected liquidity needs and
may purchase liquidity via brokered
deposits, fed funds borrowed, reverse
repos or via other short term financing
sources.

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Interest Rate Risk


Interest rate risk (These changes caused by
unexpected movements in interest rates give rise)
Federal Reserves influence on interest rate
volatility through daily open-market operations
Effect of increased globalization of financial market
Refinancing risk
Reinvestment risk

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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
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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.
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net interest margin


Suppose the FI has two year fixed rate
assets funded by one year fixed rate
liabilities. The FIs liabilities will reprice
sooner than its assets.
If interest rates rise, the cost of funding
on the liabilities will increase in one year,
but the income from the assets will
remain the same throughout the second
year, reducing the net interest margin.
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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
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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
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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.
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present value uncertainty


The effect of a change in interest rates can be more
directly measured by examining how the present value
of the existing assets and liabilities will change as
interest rates change.
A FI with longer term (duration) assets funded by
shorter term (duration) liabilities will suffer a decline in
the market value of equity if interest rates rise.
This occurs because the market value of the assets
will decline more sharply than the market value of the
liabilities.
present value uncertainty arises from a difference in
the duration of the FIs assets and liabilities.

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Maturity Mismatching and Interest Rate


Risk
Asset transformation can involve differing
maturities

One type of asset transformation is the creation of a mutual fund - a portfolio of securities
that are "transformed" into fund shares. These shares are available for purchase by
persons who generally do not have the means to purchase a range of securities for

.
Economic or present-value uncertainty arises
when interest rates change
FIs can seek to hedge by matching the
maturity of their assets and liabilities
diversification purposes

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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
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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.

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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
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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)
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Tip: The failure of Barings bank is an


extreme example of market risk (see the
Off Balance Sheet section).

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Daily Earnings At Risk or DEAR


Value at Risk (VAR) is a relatively new
method of assessing overall institutional
risks.
VAR attempts to measure the maximum
dollar amount a FI is likely to lose in a
given short time period, usually a day,
with some probability

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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
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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
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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.
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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.
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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

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Why derivatives lead to risk


Two aspects of certain types of derivatives lead to
additional risks involved with their usage.
First, calculating derivative values and payouts is
complicated. This is particularly true for many OTC
derivatives that banks sell. The selling banks typically
understand the risks better than the clients.
Second, derivatives typically involve large amounts of
leverage. These two attributes imply that misuse of
derivatives is likely to occur, and can result in extreme
losses (or extreme gains, but rarely are the winners
upset about those).

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cases in recent years 1

In 1995 Barings Bank failed when a so called


rogue trader, Nick Leeson, bankrupted
Barings after the bank allowed him to run up
extremely large losses in futures and option
trading on Tokyo and Singapore derivatives
exchanges.
Interestingly, Barings did not complain when
he supposedly generated large gains for the
bank and allowed Leeson to run back office
order processing as well as trading activity, a
clear violation of sound internal control
procedures.

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cases in recent years 2


In 1995, a trader at Sumitomo incurred
losses of $2.6 billion from commodity
futures trading.
Losses of this size just shouldnt
happen if the banks internal controls
are functioning properly.

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cases in recent years 3


Bankers Trust sold several complicated OTC swaps to
customers.
In one of the swap deals the customer (Gibson Greeting
Cards) had to make variable rate payments based on
Libor2.
In the second swap deal with Procter and Gamble, P&G
would have to make high variable rate payments if
either short term or long rates rose, and extremely
high variable rate payments if both rose, which is
what happened.
Both customers sued Bankers Trust claiming they did
not understand the risks they were facing. The
fallout helped lead to the Deutsche Bank takeover of
BT.
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cases in recent years 4


Orange County investment advisor Bob Citron, a
portfolio manager with very little formal finance or
investment training, purchased structured notes from
Credit Suisse First Boston.
The notes were a type of inverse floater that would
drop in value if rates increased, which of course they
did.
Citron had used an extreme amount of leverage in an
attempt to earn higher returns (which he did for several
years).
When rates rose, losses mounted quickly and he
could not repay the borrowings and the municipality
went bankrupt, losing $1.5 billion.
Twenty banks were sued; CSFB paid $52 million to
settle charges
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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?

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Foreign Exchange Risk


Foreign exchange risk
Net current and contingent asset (asset
depend on future) exposures are at risk
from declining currency values and net
liability exposures are at risk from rising
currency values

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An Example of an FIs Exposure to


Foreign Exposure Risk
An FI that makes a foreign currency loan (asset) is at
risk from a declining foreign currency. For instance, a
U.S. FI lends 100 million when the /$ exchange rate
is 110. The interest rate is fixed at 9% and the loan is
for one year. Suppose that in a year the exchange rate
is 120 to the dollar,
The original dollar amount lent by the bank is:
100,000,000 / 110 = $909,090.91
In one year the borrower repays
(100,000,000 1.09) = 109,000,000
In dollar terms this is now worth:
109,000,000 / 120 = $908,333.33
thus the bank earns a negative rate of return.
Analysis: The dollar depreciated
(120/110)
= Reserved
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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

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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.

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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.

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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
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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.
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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.
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Country or Sovereign Risk


Holding assets in a given country creates
sovereign risk.
When a foreign country is unwilling or unable
to repay a loan, the FI has little recourse
FIs usually have little recourse other than to
await the outcome of often protracted
negotiations between the country and some
international institution such as the IMF.
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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.
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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.

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Technology and Operational Risk


Technology risk arises from the possibility
that new technology investments do not result
in profit improvements. Excess capacity and
customer reluctance to use online services are
two examples of this type of risk. Online
banking is currently facing these problems.
Major objective of technological expansion is
to increase economies of scale and scope

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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.
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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.
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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
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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.

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A consequence or an outcome of one or


more of these risks:

interest rate
Market
credit
OBS
Technological
foreign exchange
Sovereign
liquidity

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Interaction Among Risks


These risks are all interdependent
For example, a bank with problems in its loan portfolio
may face higher funding costs and/or reduced funding
availability due to the increased credit risk.
Liquidity risk can result in emergency discount window
loans and even insolvency. This is roughly what
happened to Continental Illinois in 1984.
Credit risk will often rise as interest rates rise, and
credit problems can certainly lead to liquidity problems
if the FI was counting on the receipt of loan repayments
in its liquidity planning.

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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.
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Various other risks


sudden changes in taxation
changes in regulatory policy
sudden and unexpected changes in financial market
conditions due to war, revolution, or market collapse
theft, malfeasance, and breach of fiduciary trust
increased inflation, inflation volatility, and
unemployment

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