Risk Assessment and Management Chapter 21 © 2003 South-Western/Thomson Learning

Slide 2 Learning Objectives  How financial managers use the “Five Cs” of credit to assess default risk  Strategies for managing default risk  How GAP analysis is used to measure the threat of interest-rate risk to bank earnings  Balance sheet strategies for managing interest-rate risk  How to assess and manage liquidity risk

Slide 3 Managing Balance Sheet Risk and Return  Central problem is that strategies designed to achieve the highest rates of return are characterized by highest risk  Management must pursue profitability  That maintains institution’s solvency  By avoiding excessive exposure to credit, interest rate, liquidity and foreign exchange-rate risk  Most banks utilize an asset-liability committee The goal of financial management is to enhance an institution’s earnings and market value.

Slide 4 Managing Balance Sheet Risk and Return  Positive Spread  Rate of return on assets is greater than cost of funds on liabilities  Occurs when loan rates are above deposit rates  Negative Spread  Rate of return on assets is less than cost of funds on liabilities  Occurs when loan rates are below deposit rates  Insolvent  Value of bank’s liabilities are greater than the value of its assets

Slide 5 Five Cs of Credit  Capacity  Borrower’s ability to repay a loan  Character  Competency and willingness of business firm’s management or individual borrower to repay debts  Capital  Amount of equity or wealth a borrower has at stake in proposed project  Collateral  Amount and liquidity of assets a borrower uses to secure a loan  Conditions  Forecasts of economic conditions, revenues, market share, degree of competition, and other variables that may affect ability to repay loan

Slide 6 Five Cs of Credit  Capacity  Debt-to-Income Ratio  Financial ratio to assess a loan applicant’s capacity for repaying a loan  Based on share of one’s total monthly debt payments relative to gross monthly income  Ratio over 36% may make one ineligible for traditional mortgage  Housing-to-Income Ratio  Financial ratio used to assess a mortgage loan applicant’s capacity to repay a loan  Based on share of total housing expenses relative to gross monthly income

Slide 7 Five Cs of Credit  Capital  Loan-to-Value Ratio  Financial ratio to assess degree of equity or capital a loan applicant has at stake in investment project  Computed by dividing the total loan amount financed by total market value of property  125s  Specialized and increasingly popular type of home equity loan  Borrower is allowed to borrow up to 125 percent of home’s value

Slide 8 Five Cs of Credit  Collateral  Value of borrower’s property given as security to lender as promise of loan repayment  Includes capital  Compensating Balances  Form of collateral  Specifies portion of loan proceeds to be maintained on deposit at bank making the loan

Slide 9 Default Risk Assessment and Management Techniques  To counter problems of asymmetric information, adverse selection and moral hazard, managers must  Engage in accurate discernment and pricing  Carry out careful observation  Encourage long-term banking relationships  Manage asset portfolios actively

Slide 10 Default Risk Assessment and Management Techniques  Engage in accurate discernment and pricing  Credit Reporting Agencies (such as Experian, Equifax and TransUnion)  Gather credit and legal information on individuals  Compile information into credit report  Account or file of individual’s legal and credit history  Includes information about previous legal judgments, types and amounts of one’s outstanding debts, and record of one’s payment history  Provide credit report to prospective creditors, insurers, and employers for a fee

Slide 11 Default Risk Assessment and Management Techniques  Engage in accurate discernment and pricing  Credit Score  Three digit number  Predicts loan applicant’s likelihood of default  Risk-Based Pricing  Charging different interest rates to borrowers  Based on assessment of applicant’s default risk  Highly rated applicants are charged the lowest rates  Credit Rationing  Charging lower interest rate than some borrowers are willing to pay  Apportioning loans and loan amounts only to those with sufficient credit

Slide 12 Default Risk Assessment and Management Techniques  Carry Out Careful Observation  Borrower’s financial actions must be observed to  Ensure moral hazard is avoided  Ensure that borrower continues to meet conditions of the Five Cs  Encourage Long-Term Banking Relationships  Develop professional relationships with clients  Loan Commitments  Promises made by banks to firm to lend a given amount of funds at particular rate for specified period of time

Slide 13 Default Risk Assessment and Management Techniques  Manage Asset Portfolios Actively  Loan portfolios must be managed prudently  Loan Participations  Loan agreement  Allows originating bank to give partial interest in a loan to one or more additional banks  Securitization  Pooling and repackaging of similar loans into marketable securities

Slide 14 Assessing Interest-Rate Risk Income Gap Analysis  Income GAP  Difference between bank’s interest-rate- sensitive assets and its interest-rate- sensitive liabilities (21-1) GAP = ISAs – ISLs where ISAs = interest-rate-sensitive assets ISLs = interest-rate-sensitive liabilities

Slide 15 Assessing Interest-Rate Risk Income Gap Analysis Positive Gap Interest-Rate- Sensitive Assets Are Greater Than Interest-Rate- Sensitive Liabilities (ISAs > ISLs) Negative Gap Interest-Rate- Sensitive Assets Are Less Than Interest-Rate- Sensitive Liabilities (ISAs < ISLs) Zero Gap Interest-Rate- Sensitive Assets Are Equal To Interest-Rate- Sensitive Liabilities (ISAs = ISLs) Bank income rises Bank income falls Bank income is unchanged Interest rates increase Interest rates decrease Bank income falls Bank income rises Bank income is unchanged

Slide 16 Effects of Gap & Interest Rate Changes on Bank Income (21-2)  BI = GAP x  i where  BI = change in bank income GAP = ISAs – ISLs  i = change in interest rates

Slide 17 Assessing Interest-Rate Risk  Managing Interest-Rate Risk in Response to Income Gap Analysis  If bank expects interest rates to rise over upcoming year, it should move bank’s balance sheet toward a positive GAP  If committee expects interest rates to fall, bank’s balance sheet should be moved toward a negative GAP

Slide 18 Assessing Liquidity Risk  Liquidity Ratio  Commonly used measure of liquidity and interest-rate risk  Computed by taking difference between bank’s short-term investments and liabilities and dividing them by the bank’s assets (21-3) where ISAs = interest-rate-sensitive assets ISLs = interest-rate-sensitive liabilities

Slide 19 Managing Liquidity Risk  Causes of illiquidity come from both sides of balance sheet  Asset side – run short of funds because  Make more commercial or mortgage loans than expected  Receive fewer loan and interest payments than expected  Hold securities that are less marketable than anticipated at their purchase  Liability side – run short of funds when  Bank customers withdraw more checkable, savings, and/or money market deposits than expected  One cause of illiquidity involves off-balance sheet use of unused credit lines and letters of credit

Slide 20 Appendix: Risk Assessment with Duration and Duration Gap Analysis  Duration Analysis  Price Risk  Threat that an increase in interest rates will reduce market value of security holdings  Reinvestment Risk  Threat that falling interest rates will reduce future rates of return on current and future cash flows

Slide 21 Appendix: Risk Assessment with Duration and Duration Gap Analysis  Liquidity Ratio  Commonly used measure of liquidity and interest- rate risk  Computed by taking difference between bank’s short-term investments and liabilities and dividing them by the bank’s assets (21-5) where CP t = the future stream of cash payments (principal and/or interest) made at time t i = interest rate n = number years until loan or security matures

Slide 22 Appendix: Risk Assessment with Duration and Duration Gap Analysis  Duration Analysis  Measure of interest-rate risk  Seeks to measure how responsive the value of bank’s assets, liabilities, and net worth are to changes in interest rates  Duration is reported in chronological terms

Slide 23 Appendix: Risk Assessment with Duration and Duration Gap Analysis where CP t = the future stream of cash payments (principal and/or interest) made at time t (t) multiplies the present value in each period by the number of each year i = interest rate n = number years until loan or security matures

Slide 24 Appendix: Risk Assessment with Duration and Duration Gap Analysis  Applying Duration to Portfolios and Capital Management  Duration Gap Analysis  Type of duration analysis  Involves subtracting the duration of bank’s interest- rate-sensitive assets from its interest-rate-sensitive liabilities  For most banks, duration gap is positive, indicating that increased interest rates will adversely affect their net worth

Slide 25 Exhibit 21A–2 The Effects of Duration GAP and Interest-Rate on Bank Capital

Slide 26 Appendix: Risk Assessment with Duration and Duration Gap Analysis  Applying Duration to Portfolios and Capital Management (21-7) duration gap = DURAs - DURLs where DURAs = the average duration of assets DURLS = the average duration of liabilities

Slide 27 Appendix: Risk Assessment with Duration and Duration Gap Analysis  Applying Duration to Portfolios and Capital Management where %  NW = the percent change in bank’s net worth i = interest rate

Slide 28 Appendix: Risk Assessment with Duration and Duration Gap Analysis Positive Duration Gap DURAs > DURLs Negative Duration Gap DURAs < DURLs Zero Duration Gap DURAs = DURLs Interest rates increase Bank capital falls Bank capital rises Bank capital is unchanged Interest rate decrease Bank capital rises Bank capital falls Bank capital is unchanged  Effects of Duration Gap and Interest- Rate Changes on Bank Capital