1. Risks of Financial Intermediation
Chapter 7
Risks of Financial Intermediation

2. Overview
This chapter discusses the risks associated with financial intermediation:
Interest rate risk, market risk, credit risk, off-balance-sheet risk, technology and operational risk, foreign exchange risk, country risk, liquidity risk, insolvency risk

3. Risks of Financial Intermediation
Interest rate risk resulting from intermediation:
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.

4. Market Risk
Incurred in trading of assets and liabilities (and derivatives).
Examples: Barings & decline in ruble.
Trend to greater reliance on trading income rather than traditional activities increases market exposure.
Trading activities introduce other perils as was discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses on foreign exchange positions

5. 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

6. Off-Balance-Sheet Risk
Increased importance of off-balance-sheet activities
Letters of credit
Loan commitments
Derivative positions
Speculative activities using off-balance-sheet items create considerable risk

7. Technology and Operational Risk
Risk of direct or indirect loss resulting form 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

8. Technology and Operational Risk
Risk that technology investment fails to produce anticipated cost savings.
Risk that technology may break down.
Bank of New York
Well’s Fargo
Economies of scale.
Economies of scope.

9. 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.
Undiversified foreign expansion creates FX risk.

10. 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.

11. Country or Sovereign Risk
Result of exposure to foreign government which may impose restrictions on repayments to foreigners.
Lack usual recourse via court system.
Examples: South Korea, Indonesia, Thailand.
More recently, Argentina.

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

13. Insolvency Risk
Risk of insufficient capital to offset sudden decline in value of assets to liabilities.
Continental Illinois National Bank and Trust
Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.

14. 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 1986.
Other examples include effects of war, market crashes, theft, malfeasance.

15. Macroeconomic Risks Increased inflation or increase in its volatility.
Affects interest rates as well.
Increases in unemployment
Affects credit risk as one example.

16. Pertinent Websites Bank for International Settlements www.bis.org
Federal Reserve
Federal Deposit Insurance Corporation
Web Surf