© 2008 Pearson Education Canada12.1 Chapter 12 Risk Management in Financial Institutions

© 2008 Pearson Education Canada12.2 Managing Credit Risk A major component of many financial institutions business is making loans To make profits, these firms must make successful loans that are paid back in full The concepts of moral hazard and adverse selection are useful in explaining the risks faced when making loans

© 2008 Pearson Education Canada12.3 Managing Credit Risk (Cont’d) Adverse selection is a problem in loan markets because bad credit risks (those likely to default) are the one which usually line up for loans Those who are most likely to produce an adverse outcome are the most likely to be selected

© 2008 Pearson Education Canada12.4 Managing Credit Risk (Cont’d) Moral hazard is a problem in loan markets because borrowers may have incentives to engage in activities that are undesirable from the lenders point of view

© 2008 Pearson Education Canada12.5 Once a borrower has obtained a loan, they are more likely invest in high-risk investment projects that might bring high rates of return if successful The high risk, however, makes it less likely the loan will be repaid.

© 2008 Pearson Education Canada12.6 Managing Credit Risk (Cont’d) To be profitable, lending firms must overcome adverse selection and moral hazard problems Attempts by the lending institutions to solve the problems explains a number of principles for managing risk

© 2008 Pearson Education Canada12.7 Principles for Managing Credit Risk Screening and Monitoring Long-term Customer relationships Loan Commitments Collateral Compensating Balances Credit Rationing

© 2008 Pearson Education Canada12.8 Interest Rate Risk Interest Rate Risk If a financial institution has more interest rate sensitive liabilities than interest rate sensitive assets, a rise in interest rates will reduce the net interest margin and income

© 2008 Pearson Education Canada12.9 If a financial institution has more interest rate sensitive assets than interest rate sensitive liabilities, a rise in interest rates will raise the net interest margin and income

© 2008 Pearson Education Canada12.10 Duration Gap Analysis

© 2008 Pearson Education Canada12.11 Income Gap Analysis The Gap is the difference between interest rate sensitive liabilities and interest rate sensitive assets

© 2008 Pearson Education Canada12.12 Owners and managers care not only about the change in interest rates on income but also on net worth of the institution Duration Gap Analysis examines the sensitivity of the market value of the financial institution’s net worth to changes in interest rates Duration Gap Analysis

© 2008 Pearson Education Canada12.13 Some Problems with Income and Duration Gap Analysis The interest rate on all maturities may not be the same The duration gap (text equation 3) is an approximation and only works well for small changes in interest rates

© 2008 Pearson Education Canada12.14 The value of interest rate sensitive assets and liabilities is an estimate as many of the cash payments/receipts (occurring from prepayment of loans or shifting of deposits) are uncertain

© 2008 Pearson Education Canada12.15 Strategies to Manage Interest-rate Risk 1.Rearrange balance-sheet 2.Interest-rate swaps 3.Hedge with financial futures/options