BFW 2401 Lecture Week 2 S1 2017 Risks of Financial Institutions - Interes Rate Risk

BFW2401
Commercial Banking and

Finance
Week 2
Risks of financial institutions -
interest rate risk
Chapter 4
Risks of financial institutions
Copyright © 2013 McGraw-Hill Australia Pty Ltd

PPTs t/a Financial Institutions Management 3e by Lange, Saunders and Cornett 4-2
Slides prepared by Linda Wu
Learning objectives
4.1 Learn about the importance of interest rate risk
and its impact on FI performance.
4.2 Understand the significance of market risk for FIs.
4.3 Gain an understanding of the influence of credit
risk on FIs.
4.4 Learn about the importance of off-balance sheet
on FI management.
4.5 Discover the reasons why foreign exchange risk
management is necessary for FIs.
continued
Learning objectives
4.6 Discover why country or sovereign risk is a key
concern of FI managers.
4.7 Identify the importance of technology and
operational risks for FIs.
4.8 Understand the emphasis placed on liquidity risk
management by FIs.
4.9 Learn the importance of insolvency risk and its
relationship to other risks.
4.10 Gain an understanding of the interconnectedness
and complexity of the risks facing managers of
modern FIs.

Outline
• Introduction
• Interest rate risk
• Market risk
• Credit risk
• Off-balance-sheet risk
• Foreign exchange risk
• Country or sovereign risk
• Technology and operational risks
• Liquidity risk
• Insolvency risk
• Other risks and the interaction of risks
• Summary

Introduction

Interest rate risk
• Interest rate risk is the risk incurred by an FI if it
mismatches the maturities of its assets and liabilities.
• Refinancing risk: the costs of rolling over funds or
reborrowing funds will rise above the returns
generated on investments.
• Reinvestment risk: the returns on funds to be
reinvested will fall below the cost of funds.
Example:
An FI grants a five-year maturity loan at a fixed rate of 12 per cent
p.a. and funds the loan with one-year maturity fixed-rate term
deposits that pay 10 per cent p.a.
Is the FI exposed to increasing or decreasing interest rates?
continued
Interest rate risk
Solution:
The FI is exposed to increasing interest rates and refinancing risk.
Would the FI still be exposed to the same risks if the loan had a
one-year maturity, while the maturity of deposits was three years?
In this case, the FI would be exposed to decreasing interest rates

and reinvestment risk.
continued
Interest rate risk
• As interest rates increase the market value of assets
and liabilities decreases.
• As interest rates decrease the market value of assets
and liabilities increases.
• If the FI mismatches the maturities of its assets and
liabilities, the change in the market value of assets
and liabilities will not be the same.
• As E = A – L, changing interest rates can have an
adverse impact on the FI's net worth.
continued
Interest rate risk
Assume the maturity of assets exceeds the maturity of
liabilities:
a. An increase in interest rates causes a fall in the

market value of both assets and liabilities, but assets
are more severely affected.
b. A decrease in interest rates causes an increase in the

market value of both assets and liabilities, and liabilities
will increase less than assets.
continued
Interest rate risk
Assume the maturity of liabilities exceeds the maturity of
assets:
a. A decrease in interest rates causes a rise in the

market value of both assets and liabilities, but liabilities
are more severely affected.
b. An increase in interest rates causes a fall in the

market value of both assets and liabilities, and assets
will decrease less than liabilities.
continued
Interest rate risk
• FIs should match the maturities of assets and
liabilities.
• Balance sheet hedging by matching maturities of

assets and liabilities is problematic for FIs.
• For most FIs the maturity of assets exceeds the

maturity of liabilities.

Market risk
• This is the risk incurred when trading assets and
liabilities.
• Risk is incurred due to changes in interest rates,
exchange rates or other asset prices.
• Example of the dangers of market risk:
– Barings Bank collapsed due to a wrong bet on the
movement of the Japanese Nikkei Stock Market Index.
– A single individual caused losses that forced the bank into
insolvency.
– See www.riskglossary.com/link/barings_debacle.htm

Credit risk
• This is the risk that promised cash flows on loans and
securities held by the FI are not repaid in full.
• Most financial claims held by FIs offer limited upside
risk and a large downside risk.
• Limited upside risk: principal and interest payment.
• Downside risk: loss of loan principal and promised
interest.
• Examples:
– fixed-income coupon bonds
– bank loans
continued
Credit risk
Australian banks’ non-performing loans in domestic
FIGURE 4.1
books—per cent of loans by type, 2003 to 2011
continued
Credit risk
• Two different types of credit risk:
– firm-specific credit risk
– systematic credit risk
• Firm-specific credit risk affects a particular company.

• Systematic credit risk affects all borrowers.
• Firm-specific credit risk can be managed through

diversification.

Off-balance-sheet risk
• Arises if FIs enter into contingent liability or asset
contracts.
• Increased importance of off-balance-sheet activities:

– letters of credit
– loan commitments
– derivative positions
• Speculative activities using off-balance-sheet items

create considerable risk.

Foreign exchange risk
• The risk that changes in exchange rates may
adversely affect the value of an FI's assets and/or
liabilities.
• Returns on foreign and domestic investment are not
perfectly correlated.
• FX rates may not be correlated.
– example: A$/€ may be increasing while A$/¥ is decreasing
• Undiversified foreign expansion creates FX risk.

Country or sovereign risk
• The risk that repayments from foreign borrowers may
be interrupted.
• These interruptions may be caused, for instance, by

the interference of foreign governments.
• Note that hedging foreign exposure by matching

foreign assets and liabilities requires matching the
maturities as well.
– Otherwise, exposure to foreign interest rate risk is created.
continued
Country or sovereign risk
• Example: In 1982 the Mexican and Brazilian
Governments announced a debt moratorium on
Western creditors.
• This debt moratorium caused significant losses in
some of the lending banks, such as Citicorp (now
Citigroup).
• There is little recourse for lenders if a foreign
government restricts repayments in form of
rescheduling or outright prohibitions to repay.

Technology and operational risks
• According to the Bank for International Settlements
(BIS), operational risk (inclusive of technological risk)
is defined as ‘the risk of direct or indirect loss
resulting from inadequate or failed internal
processes, people and systems or from external
events’.
• Some FIs include reputational and strategic risk.
• Technological innovation has seen rapid growth:
– Automated Clearing /houses (ACH)
– CHIPS
continued
• Major objectives of technological expansion:
– to lower operating costs
– to increase profits
– to capture new markets for the FI
• Economies of scale imply an FI's ability to lower its

average costs of operations by expanding its output
to financial services.
• Economies of scope imply an FI's ability to generate
cost synergies by producing more than one output
with the same inputs.
continued
• Technology risk: technological investments may not
produce the cost savings anticipated, e.g.
diseconomies of scale.
• Operational risk: existing technology or support
systems may malfunction or break down.
• Examples of operational risk: Bank of New York
(1985), Wells Fargo Bank and First Interstate Bank
(1996), Citibank (2001), National Australia Bank
(2010), Commonwealth Bank and Westpac (2011).
• Operational risk also includes fraud and errors.

Liquidity risk
• The risk that a sudden surge in liability withdrawals
may pressure the FI into liquidating parts of its
assets.
• The liquidation of assets may have to happen in a
very short period and at very low prices.
• Problematic for illiquid assets such as loans.
• Serious liquidity problems can cause a 'run' on the FI.
• A 'run' can turn a simple liquidity problem into a
solvency problem, and might threaten the FI's
survival.
• Risk of systematic bank panics.

Insolvency risk
• The risk that an FI may not have sufficient capital to
offset a sudden decline in its asset values relative to
its liabilities.
– Continental Illinois National Bank and Trust
– In Australia: National Mutual Life Association (NMLA)
• Original cause may be excessive interest rate, or
market, credit, off-balance-sheet, technological, FX,
sovereign, and liquidity risks.
• Both FI management and regulators focus on an FI's
capital and capital adequacy as key measures to
ensure FI solvency.

Other risks and the interaction of
risks
• Most risks are correlated or interdependent:
– example: liquidity risk is related to interest rate risk and
credit risk
• Other risks, such as discrete or event-type risks, may
impact on the FI's profitability and risk exposure.
• Regulatory changes or sudden changes in the
economic or financial environment are types of
discrete risk.
– example: Stock market collapses in 1929 and 1987
continued
Other risks and the interaction of risks
• Macroeconomic risks can directly or indirectly impact

on an FI's level of interest rate, credit and liquidity risk
exposure.
• Increased inflation or an increase in its volatility.

– Affects interest rates.
• Increase in unemployment
– Affects credit risk, among other things.

Summary
• This chapter introduces the fundamental risks faced
by modern FIs.
• We identify the key features of the risks FIs face in
the modern financial world.
• We learn about the key sources of these risks.
• We gain a basic understanding of the variety and
complexity of these risks.

Chapter 5
Interest rate risk: the repricing

model

Learning objectives
5.1 Appreciate the influence that the RBA has on
interest rates and why this is the case.
5.2 Learn that at the heart of interest rate risk is the
tendency of many modern FIs to mismatch the
maturities of their assets and liabilities (for
example, banks normally use short-term deposits
to fund long term-loans) and that this mismatching
can give rise to significant interest rate exposure
and insolvency risk.
5.3 Learn the repricing model, repricing gaps and their
use in measuring interest rate risk.
continued
Learning objectives
5.4 Gain an understanding of rate sensitive assets and
rate sensitive liabilities.
5.5 Learn the weaknesses of the repricing model.
5.6 Gain an understanding of the problems caused by
measuring interest rate risk exposure by looking
only at the maturity mismatch.

Outline
• Introduction
• The level and movement of interest rates
• The repricing model
• Weaknesses of the repricing model
• Summary

Introduction
• Interest rate risk often arises because FIs mismatch
the maturities of their assets and liabilities.
• The mismatch of assets and liabilities can be
dangerous and threatening to an FI's solvency.
• Measuring interest rate risk by examining maturities
only can be misleading, and this and the next chapter
present techniques used by FIs to measure their
interest rate exposures.
• Reserve Bank of Australia's (RBA) monetary policy
also influences an FI's interest rate risk.

The level and movement of
interest rates
• The relative degree of interest rate volatility is directly
linked to the monetary policy of the Reserve Bank of
Australia (RBA).
• A change in approach from targeting interest rate

goals towards monetary targets of money supply
growth increased the interest rate volatility.
• No matter what, interest rate volatility exists and thus,

the appropriate measurement of management of
interest rate risk is important to every FI.
continued
The level and movement of interest
rates
FIGURE 5.1 RBA cash rate target and CPI: June 1995 to June 2011
continued
The level and movement of interest
rates
FIGURE 5.2 Yields of 3-month Treasury Notes and 10-year Treasury Bonds

The repricing model
• Repricing model is also known as the funding gap
model.
• Repricing or funding gap model based on book value.
– Focus on the changes of net interest income (NII).
• Rate sensitivity means time to repricing.
– Rate sensitivity asset (RSA)/liability (RSL): an asset/liability
whose interest rates will be priced or changed over a certain
period.
continued
The repricing model
• Repricing gap:
– the difference between the rate sensitivity of each
asset and the rate sensitivity of each liability over a
certain period: RSA – RSL
– RSA > RSL reinvestment risk
– RSA < RSL refinancing risk
continued
The repricing model
• Measuring IRR using repricing model:
– Classify the RSA & RSL based on time to repricing
(maturity bucket)
– US Federal Reserve requires US commercial banks to
report repricing gaps for assets and liabilities with
maturities of:
 1 day
 more than 1 day, up to 3 months
 more than 3 months, up to 6 months
 more than 6 months, up to 12 months
 more than 1 year, up to 5 years
 more than 5 years
continued
The repricing model
• Model can be used to estimate the change in the FI's
net interest income in a particular repricing bucket if
interest rates change.
∆NIIi = (GAPi)∆Ri = (RSAiRSLi) ∆Ri
Where:
∆NIIi = change in net interest income in the ith bucket
GAPi = the dollar size of the gap between the book

value of assets and liabilities in maturity bucket i
∆Ri = the change in the level of interest rates

impacting assets and liabilities in the ith bucket.
continued
The repricing model
Example: Consider the following repricing gaps (in $ million).
Assets Liabilities Gaps

1 day $50 $25 $25
1 day to 3 months 10 40 -30
3 to 6 months 50 80 -30
6 to 12 months 30 60 -30
1 to 5 years 70 10 +60
Over 5 years 10 5 +5
$220 $220 0
If the overnight interest rate rises by 1 per cent, then:

∆NIIi = (– $30 million) × 0.01 = –$300 000.
continued
The repricing model
The Cumulative Gap (CGAP):
Estimation of the cumulative gap over various repricing periods,
such as one year.
∆NIIi = (CGAPi)∆Ri
Reconsider the previous table.
Assets Liabilities Gaps CGAP
1 day $50 $25 $25 $25
1 day to 3 months 10 40 -30 -5
3 to 6 months 50 80 -30 -35
6 to 12 months 30 60 -30 -65
1 to 5 years 70 10 +60 -5
Over 5 years 10 5 +5 0
$220 $220 0
continued
The repricing model
• The one-year cumulative gap is –$65 million.
• Assume ∆Ri = 1 per cent is the average rate
change that affects assets and liabilities that can
be repriced within a year.
• ∆NIIi = (CGAPi)∆Ri
= (–$65 million) (0.01)
= –$650 000.1111111

Rate-sensitive assets
Examples:
• Short-term loans
• T-Notes (of various maturities)
• Floating-rate long-term loans
The question to ask is:

Will or can this asset have its interest rate changed
within a specified time?
• Yes? Rate-sensitive
• No? Not rate-sensitive

Rate-sensitive liabilities
Examples:
• Term deposits (of various maturities)
• Bankers' acceptances
• Negotiable certificates of deposits (NCDs)
The question to ask is:

Will or can this liability have its interest rate changed
within a specified time?
• Yes? Rate-sensitive
• No? Not rate-sensitive
continued
Rate-sensitive liabilities
Are cheque accounts or transaction accounts
rate-sensitive liabilities?
• Against inclusion:
– Rates paid on these accounts are 'sticky'
– Many deposits act as core deposits
– Implicit cost of accounts is close to zero
• For inclusion:
– Runoffs in case of interest rate rises resulting in high
opportunity cost for the FI

The CGAP as a percentage of
assets
• The CGAP can be expressed as a percentage of
assets.
• CGAP / A provides the following information:
– the direction of the interest rate exposure (positive versus
negative CGAP)
– the scale of that exposure.
Example:
Assume a bank's total assets are $500 million.
The one-year cumulative gap is $20 million.
CGAP / A = $20 m / $500 m = 0.04 = 4 per cent

The CGAP as a percentage of assets

The repricing model
Advantages:
• Information value
• Simplicity
Weaknesses:
• Market value effects
• Over-aggregation
• Runoffs
• Ignore off-balance-sheet effects

Weaknesses of the repricing
model
• Market value effects:

– Interest rate changes can adversely affect the market value
of assets and liabilities, and thus the net worth of an FI.
– As such, the repricing model is only a partial measure of
interest rate risk.
continued
Weaknesses of the repricing model
• Over-aggregation:
– Rate-sensitive assets and rate-sensitive liabilities might not
be evenly distributed within a maturity bucket.
FIGURE 5.5 The over-aggregation problem: the three- to six-month bucket
continued
• Runoffs:
– Periodic cash flow of interest and principal amortisation
payments on long-term assets that can be reinvested at
market rates.
– This runoff component is rate-sensitive.
continued
• Off-balance-sheet effect:
– The repricing model generally include only the assets and
liabilities listed on the balance sheet
– Changes in interest rates will also affect cash flows on many
off-balance-sheet instruments.
– Such cash flows from off-balance-sheet activities are ignored
by the simple repricing model.

Summary
• This chapter explains how to measure an FI's
exposure to interest rates using the repricing model.
• We examine the particular strengths of the model.
• We discuss the particular weaknesses of the model.
• As such, the model does not provide an accurate
picture of an FI's interest rate risk exposure.
– More complete measures of interest rate risk are provided by
duration and the duration gap model which are explained in
Chapter 6.


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BFW2401

Commercial Banking and

Risks of financial institutions

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

In this case, the FI would be exposed to decreasing interest rates

a. An increase in interest rates causes a fall in the

b. A decrease in interest rates causes an increase in the

a. A decrease in interest rates causes a rise in the

b. An increase in interest rates causes a fall in the

• Balance sheet hedging by matching maturities of

• For most FIs the maturity of assets exceeds the

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

• Firm-specific credit risk affects a particular company.

• Firm-specific credit risk can be managed through

Copyright © 2013 McGraw-Hill Australia Pty Ltd

• Increased importance of off-balance-sheet activities:

• Speculative activities using off-balance-sheet items

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

• These interruptions may be caused, for instance, by

• Note that hedging foreign exposure by matching

Copyright © 2013 McGraw-Hill Australia Pty Ltd

• Economies of scale imply an FI's ability to lower its

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

• Macroeconomic risks can directly or indirectly impact

• Increased inflation or an increase in its volatility.

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Interest rate risk: the repricing

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

• A change in approach from targeting interest rate

• No matter what, interest rate volatility exists and thus,

Copyright © 2013 McGraw-Hill Australia Pty Ltd

GAPi = the dollar size of the gap between the book

∆Ri = the change in the level of interest rates

Assets Liabilities Gaps

If the overnight interest rate rises by 1 per cent, then:

Copyright © 2013 McGraw-Hill Australia Pty Ltd

The question to ask is:

Copyright © 2013 McGraw-Hill Australia Pty Ltd

The question to ask is:

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

Copyright © 2013 McGraw-Hill Australia Pty Ltd

• Market value effects:

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Copyright © 2013 McGraw-Hill Australia Pty Ltd

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