Transcript Saunders Cornett Chapter 7

Chapter 7
Risks of Financial
Intermediation
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Overview
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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
Risks of Financial Intermediation

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Interest rate risk resulting from
intermediation:

Mismatch in maturities of assets and liabilities.


Balance sheet hedge via matching maturities of
assets and liabilities is problematic for FIs.



Interest rate sensitivity difference exposes equity to
changes in interest rates
Inconsistent with asset transformation role
Refinancing risk.
Reinvestment risk.
Market Risk

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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
Market Risk

Distinction between Investment Book and
Trading Book of a commercial bank



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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
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-balancesheet items create considerable risk
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Foreign Exchange Risk
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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.
Foreign Exchange Risk

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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.
Country or Sovereign Risk
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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.
Country or Sovereign Risk

In the event of restrictions, reschedulings, or
outright prohibition of repayments, FIs’
remaining bargaining chip is future supply of
loans


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Weak position if currency collapsing or
government failing
Role of IMF


Extends aid to troubled banks
Increased moral hazard problem if IMF bailout
expected
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.


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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
Technology and Operational Risk
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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
Liquidity Risk

Risk of being forced to borrow, or sell assets
in a very short period of time.


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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)
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
Macroeconomic Risks

Increased inflation or increase in its volatility.


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Affects interest rates as well.
Increases in unemployment

Affects credit risk as one example.
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
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