Risks of Financial Risks of Financial IntermediationIntermediation

Chapter 7

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

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Overview

This chapter discusses the risks associated with financial intermediation: Interest rate risk, market risk, credit risk,

off-balance-sheet risk, foreign exchange risk, country or sovereign risk, technology risk, operational risk, liquidity risk, insolvency risk

Note that these risks are not unique to FIs Faced by all global firms

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Risks of Financial Intermediation

Interest rate risk resulting from intermediation: Mismatch in maturities of assets and liabilities.

Interest rate sensitivity difference exposes equity to changes in interest rates

Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs.

Inconsistent with asset transformation role Refinancing risk. Reinvestment risk.

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Market Risk

Incurred in trading of assets and liabilities (and derivatives). Example: Barings Bank’s Nick Leeson & decline

in Nikkei Stock Market Index. Heavier focus on trading income over traditional

activities increases market exposure. Trading activities introduce other perils as was

discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses and fraudulent activities involving foreign exchange positions

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Market Risk

Distinction between Investment Book and Trading Book of a commercial bank Heightened focus on Value at Risk (VAR) Heightened focus on short term risk measures

such as Daily Earnings at Risk (DEAR) Role of securitization in changing liquidity of

bank assets and liabilities

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Credit Risk

Risk that promised cash flows are not paid in full. Firm specific credit risk Systematic credit risk

High rate of charge-offs of credit card debt in the 1980s, most of the 1990s and early 2000s

Credit card loans (and unused balances) continue to grow

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Charge Off Rates for Commercial Banks

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Implications of Growing Credit Risk

Importance of credit screening Importance of monitoring credit extended Role for dynamic adjustment of credit risk

premia Diversification of credit risk

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Off-Balance-Sheet Risk

Striking growth of off-balance-sheet activities Letters of credit Loan commitments Derivative positions

Speculative activities using off-balance-sheet items create considerable risk

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Foreign Exchange Risk

FI may be net long or net short in various currencies

Returns on foreign and domestic investment are not perfectly correlated.

FX rates may not be correlated. Example: $/€ may be increasing while $/¥

decreasing and relationship between ¥ and € time varying.

Undiversified foreign expansion creates FX risk.

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Foreign Exchange Risk

Note that completely hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well*. Otherwise, exposure to foreign interest rate risk

remains.

*More correctly, FI must match durations, rather than maturities. See Chapter 9.

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Country or Sovereign Risk

Result of exposure to foreign government which may impose restrictions on repayments to foreigners.

Often lack usual recourse via court system. Examples:

Argentina Russia South Korea

• Indonesia• Malaysia• Thailand.

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Country or Sovereign Risk

In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs’ remaining bargaining chip is future supply of loans Weak position if currency collapsing or

government failing Role of IMF

Extends aid to troubled banks Increased moral hazard problem if IMF bailout

expected

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Technology and Operational Risk

Economies of scale. Economies of scope. Operational risk not exclusively

technological Employee fraud and errors Losses magnified since they affect reputation

and future potential

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Technology and Operational Risk

Risk of losses resulting from inadequate or failed internal processes, people, and systems or from external events. Some include reputational and strategic risk

Technological innovation has seen rapid growth Automated clearing houses (ACH) CHIPS Real time interconnection of global FIs via

satellite systems

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Technology and Operational Risk

Risk that technology investment fails to produce anticipated cost savings.

Risk that technology may break down. CitiBank’s ATM network, debit card system and

on-line banking out for two days Prudential Financial fined $600 million due to

allegations of improper mutual fund trades Bank of America breakdown in security of tapes Bank of New York: Computer system failed to

recognize incoming payment messages sent via Fedwire although outgoing payments succeeded

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Liquidity Risk

Risk of being forced to borrow, or sell assets in a very short period of time. Low prices result.

May generate runs. Runs may turn liquidity problem into solvency

problem. Risk of systematic bank panics. Example: 1985, Ohio savings institutions

insured by Ohio Deposit Guarantee Fund Interaction of credit risk and liability risk

Role of FDIC (see Chapter 19)

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Insolvency Risk

Risk of insufficient capital to offset sudden decline in value of assets to liabilities. Continental Illinois National Bank and Trust

Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.

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Risks of Financial Intermediation

Other Risks and Interaction of Risks Interdependencies among risks.

Example: Interest rates and credit risk. Interest rates and derivative counterparty risk

Discrete Risks Examples include effects of war or terrorist acts,

market crashes, theft, malfeasance. Changes in regulatory policy

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Macroeconomic Risks

Increased inflation or increase in its volatility. Affects interest rates as well.

Increases in unemployment Affects credit risk as one example.

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Pertinent Websites

Bank for International Settlements www.bis.org

Board of Governors of the Federal Reserve www.federalreserve.gov

Federal Deposit Insurance Corporation www.fdic.gov