McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Twenty Types of Risks Incurred by Financial Institutions

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Why FIs Need to Manage Risk Major objective of FI management is to increase the FI’s returns for its owners Risks of financial intermediation have increased as the U.S. and overseas economies have become more integrated (i.e., weak economic conditions in Asia and South America) FIs that have no foreign customers can still be exposed to foreign exchange and sovereign risk if their customers have dealings with foreign countries Major objective of FI management is to increase the FI’s returns for its owners Risks of financial intermediation have increased as the U.S. and overseas economies have become more integrated (i.e., weak economic conditions in Asia and South America) FIs that have no foreign customers can still be exposed to foreign exchange and sovereign risk if their customers have dealings with foreign countries

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Risks Faced by Financial Intermediaries Credit Risk Liquidity Risk Interest Rate Risk Market Risk Off-Balance-Sheet Risk Foreign Exchange Risk Country or Sovereign Risk Technology Risk Operational Risk Insolvency Risk Credit Risk Liquidity Risk Interest Rate Risk Market Risk Off-Balance-Sheet Risk Foreign Exchange Risk Country or Sovereign Risk Technology Risk Operational Risk Insolvency Risk

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Credit Risk Credit risk - the risk that the promised cash flows from loans and securities held by FIs may not be paid in full Firm-specific credit risk - the risk of default by the borrowing firm associated with the specific types of project risk taken by that firm Systematic credit risk - the risk of widespread defaults associated with general economy-wide or macroeconomic conditions affecting all borrowers (e.g., an economic recession) Credit risk - the risk that the promised cash flows from loans and securities held by FIs may not be paid in full Firm-specific credit risk - the risk of default by the borrowing firm associated with the specific types of project risk taken by that firm Systematic credit risk - the risk of widespread defaults associated with general economy-wide or macroeconomic conditions affecting all borrowers (e.g., an economic recession)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Liquidity Risk Liquidity risk - the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices Liquidity risk arises when an FIs liability holders demand immediate cash for their financial claim Serious liquidity problems may result in a “run” in which all liability claimholders seek to withdraw their funds and can lead to a solvency problem Liquidity risk - the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at low prices Liquidity risk arises when an FIs liability holders demand immediate cash for their financial claim Serious liquidity problems may result in a “run” in which all liability claimholders seek to withdraw their funds and can lead to a solvency problem

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Interest Rate Risk Interest rate risk - the risk incurred by an FI when the maturities of its assets and liabilities are mismatched Federal Reserve tries to have an influence on interest rate volatility through its daily open-market operations Increased globalization of financial market flows has made the measurement and management of interest rate risk a prominent concern Interest rate risk - the risk incurred by an FI when the maturities of its assets and liabilities are mismatched Federal Reserve tries to have an influence on interest rate volatility through its daily open-market operations Increased globalization of financial market flows has made the measurement and management of interest rate risk a prominent concern

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Maturity Mismatching and Interest Rate Risk Asset transformation involves an FI buying primary securities or assets and issuing secondary securities or liabilities to fund the assets, can often have differing maturities Economic or present-value uncertainty arises when interest rates change FIs can seek to hedge by matching the maturity of their assets and liabilities Asset transformation involves an FI buying primary securities or assets and issuing secondary securities or liabilities to fund the assets, can often have differing maturities Economic or present-value uncertainty arises when interest rates change FIs can seek to hedge by matching the maturity of their assets and liabilities

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Market Risk Market risk - the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices Closely related to interest rate and foreign exchange risk Decline in income from deposit taking and lending has been matched by increased reliance on income from trading FI management required to establish controls or limits on day-to-day exposure to risk Market risk - the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset prices Closely related to interest rate and foreign exchange risk Decline in income from deposit taking and lending has been matched by increased reliance on income from trading FI management required to establish controls or limits on day-to-day exposure to risk

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Off-Balance-Sheet Risk Off-balance-sheet risk - risk incurred by an FI as the result of activities related to contingent assets and liabilities Letter of credit - credit guarantee issued by an FI for a fee on which payment is contingent on some future even occurring, most notably default of the agent Loan commitments by banks, mortgage servicing contracts by thrifts, and positions in forwards, futures, swaps, options, etc., are structured to reduce an FI's exposure to credit, interest rate, or foreign exchange risk, but increase an FI’s OBS risk Off-balance-sheet risk - risk incurred by an FI as the result of activities related to contingent assets and liabilities Letter of credit - credit guarantee issued by an FI for a fee on which payment is contingent on some future even occurring, most notably default of the agent Loan commitments by banks, mortgage servicing contracts by thrifts, and positions in forwards, futures, swaps, options, etc., are structured to reduce an FI's exposure to credit, interest rate, or foreign exchange risk, but increase an FI’s OBS risk

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Foreign Exchange Risk Foreign exchange risk - the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies Returns on domestic and foreign direct investments not perfectly correlated –underlying technologies of various economies differ –exchange rate changes are not perfectly correlated across countries Foreign exchange risk - the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies Returns on domestic and foreign direct investments not perfectly correlated –underlying technologies of various economies differ –exchange rate changes are not perfectly correlated across countries

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Country or Sovereign Risk Country or Sovereign Risk - the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments When a foreign country is unwilling or unable to repay a loan, the FI has little recourse The leverage available to ensure or increase repayment probabilities is control over the future supply of loans or funds to the country concerned Country or Sovereign Risk - the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments When a foreign country is unwilling or unable to repay a loan, the FI has little recourse The leverage available to ensure or increase repayment probabilities is control over the future supply of loans or funds to the country concerned

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Technology and Operational Risk Technology risk - the risk incurred by an FI when its technological investments do not produce anticipated cost savings Operational risk - the risk that existing technology or support systems may malfunction or break down Major objective of technological expansion is to increase economies of scale and scope Technology risk - the risk incurred by an FI when its technological investments do not produce anticipated cost savings Operational risk - the risk that existing technology or support systems may malfunction or break down Major objective of technological expansion is to increase economies of scale and scope

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Insolvency Risk Insolvency risk - the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities A consequence or an outcome of one or more of these risks: interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and liquidity Occurs when the capital or equity resources of an FI’s owners are driven to, or near to, zero The lower an FI’s leverage, the better able it is to withstand losses due to risk exposures Insolvency risk - the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities A consequence or an outcome of one or more of these risks: interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and liquidity Occurs when the capital or equity resources of an FI’s owners are driven to, or near to, zero The lower an FI’s leverage, the better able it is to withstand losses due to risk exposures

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Interaction Among Risks These risks are all interdependent Various other risks, often more discrete or event- type, impact an FI’s profitability and risk exposure –sudden changes in taxation –changes in regulatory policy –sudden and unexpected changes in financial market conditions due to war, revolution, or market collapse –theft, malfeasance, and breach of fiduciary trust –increased inflation, inflation volatility, and unemployment These risks are all interdependent Various other risks, often more discrete or event- type, impact an FI’s profitability and risk exposure –sudden changes in taxation –changes in regulatory policy –sudden and unexpected changes in financial market conditions due to war, revolution, or market collapse –theft, malfeasance, and breach of fiduciary trust –increased inflation, inflation volatility, and unemployment