1. Risks of Financial Intermediation Chapter 7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

2. McGraw-Hill/Irwin 7-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview  This chapter discusses the risks associated with financial intermediation: Interest rate risk, market risk, credit risk, off-balance-sheet risk, technology risk, operational risk, foreign exchange risk, country risk, liquidity risk, insolvency risk  Note that these risks are not unique to FIs Faced by all global firms

3. McGraw-Hill/Irwin 7-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Risks of Financial Intermediation  Interest rate risk resulting from intermediation: Mismatch in maturities of assets and liabilities.  Interest rate sensitivity difference exposes equity to changes in interest rates Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs.  Inconsistent with asset transformation role  Refinancing risk.  Reinvestment risk.

4. McGraw-Hill/Irwin 7-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Risk  Incurred in trading of assets and liabilities (and derivatives). Examples: Barings & decline in ruble. DJIA dropped 12.5 percent in two-week period July, 2002. Heavier focus on trading income over 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 and fraudulent activities involving foreign exchange positions

5. McGraw-Hill/Irwin 7-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Risk  Distinction between Investment Book and Trading Book of a commercial bank Heightened focus on Value at Risk (VAR) Heightened focus on short term risk measures such as Daily Earnings at Risk (DEAR)  Role of securitization in changing liquidity of bank assets and liabilities

6. McGraw-Hill/Irwin 7-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 1980s, most of the 1990s and early 2000s  Credit card loans (and unused balances) continue to grow

7. McGraw-Hill/Irwin 7-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Implications of Growing Credit Risk  Importance of credit screening  Importance of monitoring credit extended  Role for dynamic adjustment of credit risk premia  Diversification of credit risk

8. McGraw-Hill/Irwin 7-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Off-Balance-Sheet Risk  Striking growth of off-balance-sheet activities Letters of credit Loan commitments Derivative positions  Speculative activities using off-balance- sheet items create considerable risk

9. McGraw-Hill/Irwin 7-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Technology and Operational Risk  Risk of losses 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 (ACH) CHIPS Real time interconnection of global FIs via satellite systems

10. McGraw-Hill/Irwin 7-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Technology and Operational Risk  Risk that technology investment fails to produce anticipated cost savings.  Risk that technology may break down. CitiBank’s ATM network, debit card system and on-line banking out for two days Wells Fargo Bank of New York: Computer system failed to recognize incoming payment messages sent via Fedwire although outgoing payments succeeded

11. McGraw-Hill/Irwin 7-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Technology and Operational Risk  Operational risk not exclusively technological Employee fraud and errors Losses magnified since they affect reputation and future potential Merrill Lynch $100 million penalty  Economies of scale.  Economies of scope.

12. McGraw-Hill/Irwin 7-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Exchange Risk  FI may be net long or net short in various currencies  Returns on foreign and domestic investment are not perfectly correlated.  FX rates may not be correlated. Example: $/€ may be increasing while $/¥ decreasing  and relationship between ¥ and € time varying.  Undiversified foreign expansion creates FX risk.

13. McGraw-Hill/Irwin 7-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Foreign Exchange Risk  Note that completely hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well*. Otherwise, exposure to foreign interest rate risk is remains. *More correctly, FI must match durations, rather than maturities. See Chapter 9.

14. McGraw-Hill/Irwin 7-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Country or Sovereign Risk  Result of exposure to foreign government which may impose restrictions on repayments to foreigners.  Often lack usual recourse via court system.  Examples: Argentina Russia South Korea Indonesia Malaysia Thailand.

15. McGraw-Hill/Irwin 7-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Country or Sovereign Risk  In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs’ remaining bargaining chip is future supply of loans Weak position if currency collapsing or government failing  Role of IMF Extends aid to troubled banks Increased moral hazard problem if IMF bailout expected

16. McGraw-Hill/Irwin 7-16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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. Example: 1985, Ohio savings institutions insured by Ohio Deposit Guarantee Fund  Interaction of credit risk and liability risk Role of FDIC (see Chapter 19)

17. McGraw-Hill/Irwin 7-17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

18. McGraw-Hill/Irwin 7-18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Risks of Financial Intermediation  Other Risks and Interaction of Risks Interdependencies among risks.  Example: Interest rates and credit risk.  Interest rates and derivative counterparty risk Discrete Risks  Example: Tax Reform Act of 1986.  Other examples include effects of war or terrorist acts, market crashes, theft, malfeasance.  Changes in regulatory policy

19. McGraw-Hill/Irwin 7-19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Macroeconomic Risks  Increased inflation or increase in its volatility. Affects interest rates as well.  Increases in unemployment Affects credit risk as one example.

20. McGraw-Hill/Irwin 7-20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites Bank for International Settlements www.bis.org www.bis.org Board of Governors of the Federal Reserve www.federalreserve.gov www.federalreserve.gov Federal Deposit Insurance Corporation www.fdic.gov www.fdic.gov