CHAPTER 4

Risk Management
in Financial Institutions
 Chapter contents
 Types of risks incurred by financial
institutions
Managing credit risk
Managing liquidity risk
Managing interest rate risk

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4.1 Types of risks
Credit Risk
 the chance that debtors default on their
obligation
 debt securities with long-term maturity pose
more credit risk than securities with short-
term maturity
 banks, thrifts and life insurance companies
have higher degree of exposure to credit risk

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4.1 Types of risks
Credit Risk...
 managerial efficiency and credit risk
management strategy affects credit risk of
a loan portfolio
 Loan diversification can help eliminate
firm specific credit risk

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 4.1 Types of risks
Liquidity risk
 the likelihood that a FI becomes unable to
meet demand for withdrawal,loan, or
indemnity
 may compel FIs to dispose illiquid assets
at a cheap price
 may cause a ‘bank run‘
 deposit insurance
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 4.1 Types of risks
Interest Rate (funding)Risk
caused by maturity mismatch of assets and liabilities
coupled with interest rate volatility
oRefinancing risk –assets have long-term maturity and
liabilities of short-term maturity. Cost of refinancing
may exceed return on assets
oReinvestment risk –holding short-term assets relative
to liabilities. Uncertainity about interest rate at which
borrowed funds will be reinvested
oPrice risk—effect of change in interest rate on value
of an asset or liability
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 4.1 Types of risks
Market Risk
 risk incurred in trading assets due to
change in interest rate, exchange rate, and
other asset prices
 faced by FIs engaged in active trading of
assets

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4.1 Types of risks
Cases of FI failure
1. Barings- a 200-years old british bank
failed in 1995 due to trading losses. It
bought a futures contract that worth
$8bill betting that the Nikkei index
would rise. It became insolvent after a
loss of $1.2bill
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4.1 Types of risks
2. Societe Generale- a French Bank lost
$7.2bill as Jerome Kerviel, the bank‘s
trading clerk, invested in future
contracts in European stock indexes
betting that markets would continue to
rise.

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4.1 Types of risks
Off-balance sheet risk
 arises in relation with contingent assets
and liabilities
Eg. Credit guarantees, LCs
Foreign exchange risk
 risk that exchange rate changes affect the
value of assets and liabilities of a FIs

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 4.1 Types of risks
Country (sovereign) Risk
 the risk that repayment from foreign
borrowers may be interrupted because of
interference from foreign governments
 governments may control foreign
currency outflows to mitigate currency
shortages

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4.1 Types of risks
Technology and operational risk
 technology risk arises when FIs
technological investment fails to fetch the
anticipated benefit
 economies of scale and economies of
scope

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4.1 Types of risks
Technology and operational risk...
 operational risk arises when the existing
technology or support system
mulfunctions or breaks down
 may also arise due to employee fraud,
misrepresentations, and account errors

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4.1 Types of risks
Insolvency risk
 the risk that FI may not have enough
capital to offset a sudden decline in the
value of its assets relative to its liabilities

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 4.2 Managing credit risk
Causes
 the problem of information asymmetry
adverse selection and moral hazard
Credit Analysis
 the 5 C‘s (Capacity, Conditions,
Character, Capital, and Collateral)

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4.2 Managing credit risk
Real estate lending
 Capacity can be assessed by taking into
account
 applicant‘s income in light of monthly
mortgage obligations
 monthly financial obligations

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4.2 Managing credit risk
Real estate lending...
 Credit scoring- a technique in which points are
assigned for selected characteristics of applicants
 Characters may include the ff:
 annual gross income  age
 TDS (total debt
service)  residence
 relation with FI  length of residence
 major credit cards  job stability
 credit history

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4.2 Managing credit risk
Medium size commercial & Industrial
lending
 Cash flow analysis
 Ratio analysis
 Common size analysis

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4.2 Managing credit risk
Large commercial & Industrial
lending
 Less risky
 Good financial health and hence can
directly issue securities to raise
capital

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4.2 Managing credit risk
Large commercial & Industrial loans
 Credit scoring
 Altman‘s Z-score-measure of overall
default risk classification
Z= 1.2X1+1.4X2+3.3X3+0.6X4+1.0X5

Where X1= WC/TA X2 = RE/TA

X3=EBIT/TA X4= MV of SHE/BV of LTD

X5= Sales/TA

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 4.2 Managing credit risk
Large commercial & Industrial
lending
 Altman‘s Z-score
Z-score Degree of default risk
< 1.81 High
1.81-2.99 Intermediate
> 2.99 low
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4.2 Managing credit risk
Return on Loans
Return depends on:
 interest rate on the loan
 fees related to the loan (f)
 credit risk premium (m)
 collateral backing the loan
 non-price terms such as compensating
balance and reserve requirements
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4.2 Managing credit risk
Return on Loans (ROL)
Loan rate= Basic lending rate(BR) + Risk
Premium(m)

BR represents cost of capital of a bank

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 4.2 Managing credit risk
Return on Loans (ROL)
ROA per birr lent equals:

-
where b=compensating bal
R= reserve requirement

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4.2 Managing credit risk
Return on Loans(Example)
Suppose Addis bank sets a loan rate of 11%
(where BR=9% and m=2%), charges loan
origination fee of 1%, imposes 10%
compensating balance(b) and sets aside 15%
reserve (R).
What is ROA per birr lent?

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4.3 Managing liquidity risk
Sources of liquidity risk
a)When debt holders(depositors or insurance
policy holders) want to withdraw their financial
claim
b)Off balance sheet commitments(loan
commitments) made by FIs are exercised
 to meet demands of short term debt holders ,
FIs may at times be compelled to liquidate
assets at fire-sale prices
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 4.3 Managing liquidity risk

Liability side liquidity risk of DIs

 arises due to holding short-term financial obligations
 a DI has core deposit that remains unwithdrawn over
a long period of time
 withdrawals may be offset by attracting new deposits,
and here only the net deposit drain becomes a concern
 a drain on deposit can be managed through
(1) purchased liquidity and (2) stored liquidity mgt

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4.3 Managing liquidity risk
(1) Purchased liquidity
 raising short-term funds from the money
market (Repos or interbank loan)
 helps to keep the asset side of the balance
sheet undisturbed
 expensive when cost of the funds is less
than return on asset

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4.3 Managing liquidity risk

(2) Stored liquidity mgt

 keeping excess reserves or by liquidating
near-cash items such as marketable
securities, Loans etc

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4.3 Managing liquidity risk
Impact of purchased liquidity versus
stored liquidity on NI(Example)
Suppose Addis Bank has the following
condensed balance sheet:
Assets(‘000) Liabilities and Equity(‘000)

Cash Br 400 Deposits Br6,500

Non-liquid assets 9,600 Borrowed funds 2,000
Equity 1,500
Total assets Br 10,000 Total Liab & Equity Br 10,000

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4.3 Managing liquidity risk
Example...
Addis Bank pays, on average, 5% on core deposit
and generates average return of 8% on loans.
Increases in market interest rate are expected to
cause a net drain of Br 2mill. Two options are
available to manage the expected net drain:
(1) Raise short-term debt at a cost of 7%
(purchase liquidity)
(2) Sell loans for cash (store liquidity)
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4.3 Managing liquidity risk
Example...
(1) Raise short-term debt at a cost of 7%
(purchase liquidity)
Decrease in interest exp-
core deposit Br 2mill x 5% = Br 100,000
Increase in interest exp-
short-term debt Br 2mill x 7%= 140,000
Change in Net Income -Br 40,000
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4.3 Managing liquidity risk

Example...
(2) Sell loans for cash (store liquidity)
Decrease in interest exp-
core deposit Br 2mill x 5% = Br 100,000
Decrease in interest income-
loans Br 2mill x 8%= 160,000
Change in Net Income -Br 60,000

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4.3 Managing liquidity risk
Asset side liquidity risk
 arises when borrowers want to exercise
loan commitments made by a bank
 such commitments obligate the bank to
satisfy loan demand by borrowers
 demand for loan can be satisfied through
either purchased liquidity or stored
liquidity
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4.3 Managing liquidity risk
Measuring a Bank‘s liquidity exposure
(a) The net liquidity statement
 Shows the sources and uses of liquidity
 Sources of liquidity include selling near
cash items, borrowing in the money
market, or using excess reserves
 Uses of liquidity include repayment of
debts.
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4.3 Managing liquidity risk
Measuring a Bank‘s liquidity exposure
(Example)
The following information has been extracted
from records of a bank.
Near cash items Br 100,000
Interbank loan(Debt) 250,000
Max borrowed funds lim 850,000
Funds borrowed 550,000
Excess reserve at NBE 150,000

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4.3 Managing liquidity risk
Measuring a Bank‘s liquidity exposure
The net liquidity statement
A bank can have the ff sources and uses of liquidity
Sources of Liquidity:
-Near cash items Br 100,000
-max borrowed funds lim 850,000
-excess reserve 150,000
Total Br 1,100,000
Uses
- Funds borrowed Br 550,000
- Interbank loan 250,000
Total Br 800,000
Excess liquidity Br 300,000
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4.3 Managing liquidity risk
(b) Peer group ratio comparison
 Comparison of the following ratios may
help
 loan to deposit
 borrowed fund to total asset
 commitments to lend to total asset
ratio

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 4.3 Managing liquidity risk
(c) Liquidity index
 measures the pottential loss from disposal
of assets at fire sale prices compared with
market value under normal conditions

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 4.3 Managing liquidity risk
(c) Liquidity index...

Where
Wi = percentage of each asset in the portfolio
Pi = price of asset if sold today(fire-sale price)
Pj =price of asset if liquidated at the end of the
month

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4.3 Managing liquidity risk
(c) Liquidity index(Example)
Suppose a bank has two assets: 40% in government
treasury bill and 60% in real estate loans. It can liquidate
the treasury bill today at a price of Br 95 per Br 100 face
value, instead of Br 100 after a month. If it has to liquidate
real estate loans it will receive only Br 80 per Br 100 face
value, instead of Br 90 per Br 100 face value after one
month.
I = 0.40 x (95/100) + 0.60 x (80/90)
= 0.913

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 4.3 Managing liquidity risk
(d) Financing Gap and the financing
requirement
 financing Gap is the difference between average
deposit and average loans
Financing Gap = Average – Average
Loans Deposits
If FG is negative then a bank must find liquidity through
either purchasing or storing liquidity. Therefore,
FG = Borrowed funds - Liquid assets
Financing reqrt(Borrowed funds) = FG+Liquid A
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4.3 Managing liquidity risk on the BS
(e) Maturity ladder/senario analysis
 Developed by Bank for International
Settlements (BIS)
 Involves comparison of cash inflows and
outflows on a daily, monthly, and semi-
annual basis

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4.4 Managing interest rate risk
Measuring interest rate risk
 central banks often manipulate interest
rate as part of the government‘s monetary
policy measure
 two techniques
(1) Repricing (funding gap) model
(2) Duration gap model

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4.4 Managing interest rate risk
(1) Repricing (funding gap) model
 analysis of the interest income earned on assets
and interest expense paid on liabilities over a
certain period
 Repricing gaps can be computed for Rate
sensitive assets(RSAs) and Rate sensitive
Liabilities (RSLs) over different maturity
periods(maturity bucket)

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4.4 Managing interest rate risk
 A negative Gap (RSA<RSL) means a Bank‘s
net interest income will fall
 NIIi = (GAPi)  Ri= (RSAi-RSLi)  Ri
Where
 NIIi = Change in Net Interest Income in maturity bucket i
GAPi = Size of the Gap (Book Value of RSA- RSL)
in maturity bucket i
 Ri = Change in interest rate affecting assets and liabilities
in
the ith maturity bucket

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4.4 Managing interest rate risk
Example: Consider the following list of RSAs and
RSLs of Addis Bank (in millions)
Assets Liabilities Gaps
1. 1 Day Br 15 Br 20 Br – 5
2. More than 1 day -3 months 25 35 - 10
3. More than 3 months-6months 65 80 - 15
4. More than 6 months- 90 70 20
12months
5. More than 1 year-5 years 40 35 5
6. More than 5 years 15 10 5
Br 250 Br 250 0

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4.4 Managing interest rate risk
Example...
Suppose short-term interest rate increases by 1%
affecting assets and liabilities in the first bucket.
 NII= - Br 5mill x 1%
= - Br 50,000
What would be the change in NII if the change
in short-term interest rate affects RSAs and
RSLs that can be reprised within 6months to a
year?
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4.4 Managing interest rate risk
(2) Duration model
 duration measures interest sensitivity of
an asset or liability‘s value to small
changes in interest rates
D = - %  security market value/
( R/1+R)

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4.4 Managing interest rate risk
(2) Duration model
Duration of portfolio of assets or liabilities is a
weighted average of the duration of components of
the portfolio
DA= X1A D1A + X2AD2A+......+XnADnA
DL= X1L D1L + X2LD2L+......+XnLDnL

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4.4 Managing interest rate risk
(2) Duration model...
 E = -(DA- kDL) x A x ( R/(1+R))
where
k= L/A –measure of financial leverage
Effect of interest rate on a firm‘s equity has three
components
(i) Leverage adjusted duration gap (DA- kDL). The larger
the gap the more exposed the FI is to interest rate risk
(ii) Size of the FI-measured by its total assets(A)
(iii) Size of interest rate shock =  R/(1+R)
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4.4 Managing interest rate risk
(2) Duration model(Example)
Suppose Financial manager of Addis Bank finds
that duration of assets (DA) is 5 years and duration
of liabilities(DL) is 3 years, and estimates that
interest rate will increase to 11% from its present
level of 10%. The Bank has total assets of Br
100mill and liabilities of Br 85mill.
What would be loss of value of equity due to
rise in interest rate?

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4.4 Managing interest rate risk
(2) Duration model...
Example...
 E = -(5-(0.85)(3))x Br 100million x (0.01/1.1)
= -Br 2.22 million
-to eliminate loss in value of equity set
DA = kDL

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End of Chapter 4