Chapter 13 – Bank Risk Management & Performance Money and Banking – Michael Brandl ©2017 Cengage Learning

13-1a Credit Risk in General How do lenders evaluate credit risk? The 5C’s of credit risk Character Capacity Capital Collateral Conditions Money and Banking – Michael Brandl ©2017 Cengage Learning

13-1b Credit Risk with Consumers 3 major credit bureaus in the United States Equifax Experian TransUnion Credit report = credit history Credit score = numerical value that is a measurement of how an individual has used credit in the past FICO Scores Fair, Isaac and Company: the entity that first created these scores FICO score range: 300-800 The higher the FICO score, the lower the borrower’s credit risk Money and Banking – Michael Brandl ©2017 Cengage Learning

13-1c Credit Risk with Business Borrowers Lenders attempt to minimize credit risk using the following techniques: Specialized lending Understanding cash flows Secondary sources of repayment Collateral Compensating Balance Personal Guarantees Close monitoring Money and Banking – Michael Brandl ©2017 Cengage Learning

13-2a Managing Interest Rate Risk As interest rates change, bank assets and other investments change Interest rates do not remain constant Money and Banking – Michael Brandl ©2017 Cengage Learning

13-2b Gap Analysis Measure interest rate exposure: Compare amount of interest rate–sensitive assets a bank has with the amount of interest rate–sensitive liabilities Gap = IRSA - IRSL They want to hold more interest rate–sensitive assets than interest rate–sensitive liabilities because as interest rates increase, they will experience an increase in their income (more interest-sensitive assets) more than an increase in their interest expense. Money and Banking – Michael Brandl ©2017 Cengage Learning

13-2c Duration Analysis Duration measures the time it takes for the bondholder or debt holder to recover the price paid for the bond or amount lent from all of the discounted future cash flows from the bond or debt instrument. The discount rate for calculating the present value of the cash flow is the bond’s or debt instrument’s yield. So, if the bond price and yield changes, so does its duration. Money and Banking – Michael Brandl ©2017 Cengage Learning

13-2d Banks, Duration, & Interest Rate Risk The duration gap is the difference between the weighted (by the assets) duration of the bank’s assets and the weighted (by the liabilities) duration of the liabilities, adjusted for the bank’s asset size. If the duration gap is zero, interest rate changes affect the value of the bank’s assets and liabilities equally, leaving the value of the bank unchanged. Thus, bank management has to make a decision about the size of the duration gap it wants. By doing so, bank management is deciding how much interest rate risk they want to face. Money and Banking – Michael Brandl ©2017 Cengage Learning

13-3a Sources of Liquidity Liquidity risk is one of the oldest risks in factional reserve banking. Sources of Liquidity Primary Reserves Secondary Reserves Bank loan securities To lower liquidity risk, a bank has to accept lower returns. But those lower returns could hurt its profitability and thus its ability to continue in business. Money and Banking – Michael Brandl ©2017 Cengage Learning

13-3b Solutions to lack of Liquidity Some of the downsides to these solutions can be very costly indeed. Borrow federal funds Borrow from the FED Increase deposits Sell liquid assets Issue commercial paper Money and Banking – Michael Brandl ©2017 Cengage Learning

13-3c How Much Liquidity is Enough? Liquidity coverage ratio: compares the level of easy-to- sell liquid assets to the total cash outflows that are expected over the next 30 calendar days Basel III - This requires banks to maintain a certain level of stable funding that depends on the liquidity of their assets and the extent of off-balance exposures over the next 12 months. The goal is a ratio equal to or greater than 1. Money and Banking – Michael Brandl ©2017 Cengage Learning

13-4 Other Risks Operational risk Foreign exchange and country risk Market risk Money and Banking – Michael Brandl ©2017 Cengage Learning

13-5a Income Statement A bank’s income statement looks at explicit revenues and expenses over a specific time period, usually a year. The different parts of an income statement are: Gross interest income Gross interest expense Noninterest income Noninterest expense Money and Banking – Michael Brandl ©2017 Cengage Learning

13-5c Balance Sheet Return on assets (ROA) Return on equity (ROE) A higher ROA suggests that the bank is generating more net income A higher ROE suggests that the bank is generating more net income Money and Banking – Michael Brandl ©2017 Cengage Learning