PART 2 : BANKING Chapter 2 : Risk management of Banks Alain de Crombrugghe 1 May 2014 ECON M831 CORPORATE FINANCE AND FINANCIAL INTERMEDIATION What are the risks faced by banks ? How do they deal with the risks ? HULL, John C. « Risk management and financial institutions » 2 nd Ed Pearson, 3d Ed. Wiley

Outline Risk management – Type of risks, risk factors – Risk management instruments Market Risk : – Value at risk – Expected shortfall – Extreme value – Volatility – Correlations – Hedging Credit risk : – Ratings : probabilities of (partial) default – Collateral – Equity buffer Liquidity risk Model risk, operational risk 2

1. Risk management Risk factors (at bank level) : – 1. Credit risk – 2. Liquidity risk – 3. Market risk (prices, interest rate, echange rate) – 4. Operational, technical – 5. Legal - system 3

Risk management Risk management instruments – 1. Collateral (against credit risk) – 2. Hedging (against market risk) « Duration » management « Forward » and « Futures » « Swaps » Options CDS and insurance (with countreparty risk, cfr KBC’s CDO’s and MBIA’s bankruptcy in June 2009) – 3. Diversification (of borrowers, of collateral, of industry or country) … but paradoxes in Europe ! – 4. Liquidity (with interbank market and lender of last resort? ) – 5. Equity (Basle norms) – 6. Scale economies ? x 4

Risk management Swaps See annex in Word in French. Motivation – Two firms have a « comparative advantage » each in a different source of funds, – This source of funds doesn’t correspond to the income profile of the firm, – The « cheapest » source of funds thus creates an excessive « mismatch » risk on incomes,  Room for swaps. 5

Risk management Swaps The swap arrangement : – Each firm pays the financial charge of the financing contract of the other, – This adjusts the expenditure flows to the revenue flows, and reduces the mismatch risk, – Each firm keeps responsability for the « credit risk » which gave it the good financing conditions but avoids the « market risk ». Check gains : – Firm 1 : cheaper finance, lower risk, – Firm 2 : cheaper finance, lower risk, – Intermediary : margin. 6

Risk management Swaps : Currency swap Example of 2 firms : – Firm 1 is european, has US revenue from operations, can borrow in USD in US at 7% or in EUR in Europe at 6%. – Firm 2 is US, has EUR revenue from operations, can borrow in USD at 6,5% or in EUR in Europe at 6,4%. « Comparative advantage » : – Dollar interest rates are higher than in euro for both firms (exchange rate risk included), but relatively less so for US firm (6,5/6,4) than for EU firm (7/6). – So US firm borrows in USD and EU firm in EUR. – The advantage may come from a « credibility » effect, an informational advantage, which may justify a lower rate provided the « guarantee » of the initial borrower remains attached to the loan… Check gains : – Firm 1 : cheaper finance, lower risk, – Firm 2 : cheaper finance, lower risk, – Intermediary : margin. 7

Risk management : Currency swap Sales USD EU Firm Borrows at 6% in euro from EU bank Swap intermediary US Firm Sales in EUR Borrows at 6,5% in USD from US bank € 6,3%€ 6,0% $ 6,8%$ 6,5% If direct USD loan: $ 7,0% > 6,8% If direct EUR loan : 6,4%>6,3% Advantage EU firm : 0,2% par year, Advantage US firme : 0,1%, Advantage intermédiary : 0,3 + 0,3 = 0,6% per year. Currency SWAP 8

Risk management Swaps : Interest swap Variable rates vs fixed rates to be swapped. Example of 2 firms : – Firm 1 is real estate manager, has regular revenue from renting spaces, can borrow fixed at 6,5% or variable at EURIBOR + 0,75. – Firm 2 is a bank has variable revenue from loans and variable costs from demand deposits, but also more stable costs from (long term) certificates of deposit, it can borrow at 4,5% fixed (certificates of deposit) or EURIBOR +0,25 variable. « Comparative advantage » : – The interest margin of the real estate firm relative to the bank is lower on the variable market (0,75 – 0,25), than it is on the fixed rate market (6,5 – 4,5). – So the real estate firm will issue variable rate paper and the bank will issue certificates of deposit. – The real estate firm likes fixed interest against fixed rental income from tenants. It will swap its variable interest loan against a fixed interest one provided it can get a lower interest than by issuing the loan directly. It will take over the payment of the fixed interest on the certficates of deposit of the bank. – The bank has a lot of variable income from short term commercial loans. It will take over the variable interest on the loan of the real estate firm, despite the higher margin. Check gains : – Firm 1, Firm 2, Intermediary. 9

Risk management Interest swap Fixed rental income Real Estate (Firm 1) A-rated loan : euribor +0,75 Intermédiaire Financier Bank (Firm 2) AAA-rated loan: euribor +0,25 (Opportunity cost of variable rate funds) Income : Euribor + Commercial loans Certificates of deposit : fixed 4,5% e - 0,1% >0e + 0,75% fixed 5,55%Fixed 4,5% Gain Firm 1 : 6,0% - 5,55% = 0,45 % Gain bank : 0,25% + (0,1%) =0,35% Intermediary : Pays : e + 0,75 + 4,5 Earns : e – 0,1 + 5,55 Difference : - 0,65 + 1,05 = 0,40. Interest SWAP 10

Risk management Swaps : lessons Swaps and banks : – Banks can act as intermediaries in swaps between firms. – Banks can create liquidity in the swap market, by matching many firms. – Banks can use swaps to manage (hedge) their own risk. Separation opportunity : – Swaps make it possible to separate (and hedge) the market risk (exchange rate, interest rate) from the credit or solvency risk. – In case of separation of the risks from the current flows, the original issuer of the security remains liable for all payments related to this security in case of default of the counterpart of the swap. 11

Homework due Wednesday 7 May 2014 at 6 p.m. The best 2 homeworks out of 3 will be counted. Discuss the role of the « time » variable (including issues like maturity, duration, time dependence, etc.) in chapters 7 and 9 of Hull 2 nd Ed. (8th and 10th in 3d Edition). Try to be specific about risk issues and risk management instruments. OR Discuss a bank rescue, in particular KBC’s – Why could the Belgian and Flemish governments hope to earn money from the rescue of KBC (and actually did) ? – Can these gains justify the intervention or were there other motivations ? – Were European competition rules and state aid rules violated ? 12