1. Drake DRAKE UNIVERSITY Fin 286 Finance 286 Financial Risk Management

2. Drake Drake University Fin 286 Syllabus Textbooks Financial Institutions Management Prerequisites Rules of the Game Office Hours /Contact Information Grades WebsiteAssignments ExaminationsDisabilities Academic MisconductEvaluations

3. Drake Drake University Fin 286 Grades Individual Assignments 100 points (33.33%) Due Approximately at the middle and end of semester. Short Group Assignments (2 per group) 5 @ 20 points each, total=100 points (33.33%) Due every Monday starting July 10 Semester Long Group Project (4 per group) 100 points each

4. Drake Drake University Fin 286 Course Description Bank Vs. Financial Institutions Management Financial Services Modernization Act 1999 (Gramm-Leach Bliley Act) Breaking down the barriers between Banking, Investment Banking and Insurance.

5. Drake Drake University Fin 286 The Modern Bank Services Provided: Credit (loan) services Thrift (savings) services Payment (transaction) services Investment and financial planning services Investment Banking (security underwriting) Brokerage (trading) services Insurance Services Other

6. Drake Drake University Fin 286 Course Topics Depository Institutions and the Financial System. Introduction, financial intermediation Intro to Management UBPR, Dupont Analysis, Financial Analysis Measuring Risk in FI’s GAP analysis (Rate sensitive assets and liabilities) Market, Liquidity, Credit, Operational and other Risks Managing Risk Liability and Liquidity Risk, Capital Adequacy International Aspects Foreign Exchange and Sovereign Risk Geographic Diversification

7. Drake Drake University Fin 286 Background Financial Institutions (FI) – Channel funds from individuals and institutions with a surplus of funds to (suppliers) to those with a shortage or funds (users of capital). Banks Credit Unions Insurance Companies Mutual Funds Total assets 2000 = $14.75 trillion

8. Drake Drake University Fin 286 Categories of FI’s Depository Institutions Banks, Savings and loans, Thrifts, Credit Unions Nondepository Institutions Insurance Co’s, Investment Banks, securities firms, mutual funds and finance companies

9. Drake Drake University Fin 286 Similar Risks and Rewards All Financial Institutions: Hold Assets that are subject to default (or credit) risk Are exposed to interest rate risk based on maturity of assets and liabilities Exposed to liquidity (withdraw) risks Face operational costs and risks

10. Drake Drake University Fin 286 Without FIs Corporations (net borrowers)) Households (net savers) Cash Equity & Debt ©2003 McGraw-Hill Companies Inc. All rights reserved

11. Drake Drake University Fin 286 Problems w/o FI’s Monitoring is costly Exposes households to increased risk Lack of Liquidity Households may not be able to easily convert claims to cash Price Risks Prices fluctuate

12. Drake Drake University Fin 286 With FIs as Intermediaries Cash HouseholdsCorporations Equity & Debt FI (Brokers) FI (Asset Transformers) Deposits/Insurance Policies Cash ©2003 McGraw-Hill Companies Inc. All rights reserved

13. Drake Drake University Fin 286 Special Roles played by FI’s Economy - Wide Services Information, Liquidity, Price risk reduction, Transaction cost and Maturity intermediation services Institution Specific Services Monetary policy transmission (depository Institutions), Credit allocation (thrifts, farm banks), Intergenerational Transfers (Insurance and pensions, payments services (depository institutions) and Denomination intermediation

14. Drake Drake University Fin 286 Special Roles played by FI’s Brokerage Function Research and information provider (reduces information costs such as agency costs) Economies of Scale (decreases transaction costs and information costs) Asset – Transformation Function Purchase primary claims and issue secondary claims (reducing contracting costs) Allows for risk sharing via diversification (reduces price and liquidity risk)

15. Drake Drake University Fin 286 Special Roles played by FI’s Transmission of Monetary Policy The liquid nature of depository institutions make them the main way monetary policy is transmitted to the public Credit Allocation Primary suppliers of capital to special sectors of the economy (Residential lending for example) Intergenerational Transfer of Wealth Insurance and pension funds

16. Drake Drake University Fin 286 Other Functions Maturity Intermediation Provides households with desirable maturities Intermediaries are willing to accept longer term risks and finance them with short term deposits. Denomination Intermediation Commercial paper is issued in $250,000 units, too large for most households Payment Mechanism Facilitate the payment of claims w/o cash.

17. Drake Drake University Fin 286 The Impact of FI’s on Economic Growth Traditional Economic Theories of Growth Labor Usage and Capital Accumulation Limited explanation due to decreasing marginal returns to capital, sustained growth requires productivity growth New Growth Theory Technological change increases productivity that offsets diminishing marginal returns Termed “Endogenous Growth”

18. Drake Drake University Fin 286 The Impact of FI’s on Economic Growth Financial Development’s Impact Promotes Capital Accumulation & Productivity Growth Rajan and Zingales (1998) Young firms in higher productivity sectors depend upon external financing and benefit from low cost financing associated with financial development Galindo, Schiantarelli, and Weiss (2002) Financial liberalization in developing economies improves capital allocation Both Studies stress the importance of the quality of regulation, supervision and enforcement.

19. Drake Drake University Fin 286 Regulation Given their vital role in the economy FI’s are highly regulated. The goal of this regulation is to protect against a disruption in the services they offer (provide confidence in the system). Some segments of the population could be discriminated against without regulation (race, gender etc) The difference the private benefits and private costs of regulation are the net regulatory burden.

20. Drake Drake University Fin 286 Safety and Soundness Regulation Protects borrowers and depositors against failure of the FI Diversification requirements Minimum capital to asset ratios Guaranty funds provisions Monitoring and surveillance

21. Drake Drake University Fin 286 Monetary Policy Regulation Since Financial Intermediaries serve as a conduit for monetary policy they merit special regulation. Reserve requirements, for example. Might make control of monetary policy more predictable.

22. Drake Drake University Fin 286 Credit Allocation Regulation Supports lending to portions of the economy deemed socially important (housing and farming are two examples). Requiring a % of assets in a particular sector of the economy for example. Also interest rate restrictions.

23. Drake Drake University Fin 286 Consumer Protection Regulation Home Mortgage Disclosure Act Prevents discrimination in lending based upon gender, race, age, or income. Requires standardized form on why credit is granted or denied May provide a heavy net regulatory burden without an offsetting social benefit.

24. Drake Drake University Fin 286 Investor Protection Regulation Protection of investors that use investment banks directly. Insider trading restrictions, lack of disclosure and breach of fiduciary responsibility are examples.

25. Drake Drake University Fin 286 Entry Regulation Barriers to entry can promote safety and soundness. Also impose costs on current market participants.

26. Drake Drake University Fin 286 Trends in the US

27. Drake DRAKE UNIVERSITY Fin 286 Risks of Financial Intermediation

28. Drake Drake University Fin 286 Common Risks All Financial Intermediaries face similar risks from their operations. The importance of each type of risk depends upon the intermediary and business lines We will spend today introducing the types of risk present. The remainder of the semester is spent detailing each type of risk and discussing management techniques used by firms to limit the impact of each risk.

29. Drake Drake University Fin 286 Margin Income Most financial institutions serving an intermediary role make some income from interest margins. They borrow funds at a given level of interest rates then generate a higher interest rate from their business (making loans for example). They then receive interest income due to the difference in interest rates.

30. Drake Drake University Fin 286 Interest Rate Risk The Interest rates on both Assets and Liabilities are tied to the length of the commitments. Interest rate risk results from a mismatch in maturities of assets and liabilities. Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs. Refinancing risk. Reinvestment risk.

31. Drake Drake University Fin 286 Interest Rate Risk: Refinancing Risk Assume you have $100 million in liabilities financed at 9% per year and the rate that you pay resets at the end of the year. Your FI also has $100 million in assets that mature in 2 years paying 10% per year. What happens if the interest rate increases? The cost of refinancing your liabilities increases, but your income from assets stays the same.

32. Drake Drake University Fin 286 Interest Rate Risk: Reinvestment Rate Risk Assume you have $100 million in liabilities financed at 9% per year that mature in 2 years. Your FI also has $100 million in assets that mature in 1 years financed at a cost of 10% per year. What happens if the interest rate decreases? The cost of your liabilities stays fixed but in year two your income from assets decreases.

33. Drake Drake University Fin 286 Matching Maturities It is difficult for the FI to match maturities and it may not eliminate interest rate risk anyway: Not consistent with asset transformation plan Matching maturities may reduce profitability (one of the functions of intermediation is accepting some of this risk. Assets are financed with both debt and equity Duration and Portfolios

34. Drake Drake University Fin 286 Interest Rate Risk: Market Value Risk Market value is tied to the level of interest rates. As rates increase market value decreases, as rates decrease market value increases The impact of rate changes is tied to maturity

35. Drake Drake University Fin 286 Market Risk The combination of interest rate, foreign exchange, and equity return risks are combined with an active trading strategy. Greater reliance on trading income rather than traditional activities has increased market exposure for FI’s. Anytime an FI takes an unhedged speculative position it is exposed to market risk

36. Drake Drake University Fin 286 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 80s and 90s Obvious need for credit screening and monitoring Diversification of credit risk

37. Drake Drake University Fin 286 Off-Balance-Sheet Risk Risk associated with contingent claims that do not show up on the balance sheet. It is not on the Balance sheet since it does not involve holding a current primary claim or issuing a current secondary claim. Increased importance of off-balance-sheet activities Letters of credit Loan commitments Derivative positions Speculative activities using off-balance-sheet items create considerable risk

38. Drake Drake University Fin 286 Technology and Operational Risk Risk of direct or indirect loss 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 CHIPS

39. Drake Drake University Fin 286 Technology and Operational Risk Technology Risk: Technology investment may fail to produce anticipated cost savings. Operational Risk: The risk that support systems (often based on new technology) may break down. Bank of New York – failed to register incoming payments on Fedwire, but continued to process outgoing payments Well’s Fargo – Failure to correctly post deposits to acquired firms account holders – cost $180 Million

40. Drake Drake University Fin 286 Economies of Scale and Scope Economies of Scale: Goal of the FI is to lower its average cost per unit via new technology or operations Economies of Scope: The generation of cost synergies by offering more services using the same inputs

41. Drake Drake University Fin 286 Foreign Exchange Risk Foreign Assets and Foreign Liabilities change in value with changes in exchange rates. Net Long Asset Position – Exposure to foreign denominated assets is greater than foreign liabilities Net Short Asset Position – Exposure to foreign denominated assets is less than exposure to foreign liabilities

42. Drake Drake University Fin 286 Foreign Exchange Risk Returns on foreign and domestic investment are not perfectly correlated. FX rates may not be correlated. Example: $/DM may be increasing while $/¥ decreasing.

43. Drake Drake University Fin 286 Foreign Exchange Risk 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.

44. Drake Drake University Fin 286 Country or Sovereign Risk Result of exposure to foreign government which may impose restrictions on repayments to foreigners. Lack usual recourse via court system.

45. Drake Drake University Fin 286 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.

46. Drake Drake University Fin 286 Insolvency Risk Risk of insufficient capital to offset sudden decline in value of assets to liabilities. Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.

47. Drake Drake University Fin 286 Risks of Financial Intermediation Other Risks and Interaction of Risks Interdependencies among risks. Example: Interest rates and credit risk. Discrete Risks Example: Tax Reform Act of 1986. Other examples include effects of war, market crashes, theft, malfeasance.

48. Drake Drake University Fin 286 Macroeconomic Risks Increased inflation or increase in its volatility. Affects interest rates as well. Increases in unemployment Affects credit risk as one example. Changes in Consumer Confidence Changes in home building

49. Drake Drake University Fin 286 Risk Management Techniques Deciding what risks to accept and how to manage them Set Asides Financial firms often set aside funds to cover potential losses, this requires the ability to estimate the possibility and size of loss Limits on Risky Positions Hedging Business Lines vs. Total Operations

50. Drake Drake University Fin 286 Risk Measurement Tools Value at Risk and Earnings at Risk Models that predict the probability and magnitude of potential loss from market risk Stress Testing What is the worst case Scenario GAP, Duration GAP Financial Statement Analysis Impact of Regulation

51. Drake Drake University Fin 286 *Cumming and Hirtle, The Challenges of Risk Management in DIversified Financial Compaies. Consolidated Risk Management “A coordinated process of measuring and managing risk on firm wide basis.”* Requires a system that includes identification of risks, measurement of risk, methods for controlling the level of risk accepted, checks and balances, review and oversight at all levels of management (including the board of directors)

52. Drake Drake University Fin 286 Benefits of Consolidating Risk Management Diversification benefits are ignored without consolidation, leading to increased risk management costs Lack of coordination can increase firm wide risk in times of market problems (unwinding similar position in different business lines for example). Without consolidation contagion risks are ignored Improves the “internal capital market” of the firm. Promote more transparency and better risk analysis by creditors.

53. Drake Drake University Fin 286 Barriers to Consolidated Risk Management Consolidation of financial firms has produced increased product and geographic diversification which has made business wide risk management more difficult. Information Costs The cost of integrating, recording and analyzing risk across separate business lines.

54. Drake Drake University Fin 286 Barriers to Consolidated Risk Management Regulatory Costs Consolidation has created a framework where firms are required to respond to multiple regulators. Capital and Liquidity requirements may prohibit the movement of funds from one business line to another. Cost associated with managing the separate regulatory requirements including opportunity costs