Risks of Financial Intermediation Finance 129

Common Risks All Financial Intermediaries face similar risks. The importance of each type of risk depends upon business lines. Today – Intro to 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.

Interest Margin Income Earning income from a difference in the rate paid to borrow versus the rate earned on financial assets. Difference is a result of intermediary role Bank Example Interest Income on loans vs. Interest Expense on borrowing

Interest Rate Risk Mismatch of Asset and Liability maturites 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.

Interest Rate Risk Mismatch of Assets and Liabilities Bank – Borrowing Short Term and Lending Long Term Insurance – Earning interest income to meet future long term liabilities.

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?

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?

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

Interest Rate Risk: Market Value Risk Market value is tied to the level of interest rates and overall economic environment. As rates increase market value decreases, as rates decrease market value increases. Broad rate changes are linked to economic environment The impact of rate changes is tied to maturity

Market Risk: General 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

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

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

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

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 Fraud and other back office issues are also operational risk

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

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

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.

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.

Country or Sovereign Risk Result of exposure to foreign government or legal systems which may impose restrictions on repayments to foreigners. Lack usual recourse via court system. Foreign credit Risk and the current European Debt Crisis – restructure risk

Liquidity Risk Risk of being forced to borrow, or sell assets in a very short period of time due to needed cash. Low prices result. May generate runs. Runs may turn liquidity problem into solvency problem. Risk of systematic bank panics.

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

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 Other examples include effects of war, market crashes, theft, malfeasance.

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

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

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

*Cumming and Hirtle, The Challenges of Risk Management in Diversified Financial Companies. 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)

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.

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.

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