Chapter 7 Risks of Financial Intermediation K R

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

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

Risks of Financial Intermediation 7 -3 u Interest rate risk resulting from intermediation: l Mismatch in maturities of assets and liabilities. § l 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 u Refinancing risk. u Reinvestment risk. Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Market Risk 7 -4 u Incurred in trading of assets and liabilities (and derivatives). l l l 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, All. First Bank when a rogue trader successfully masked large trading losses and fraudulent activities involving foreign exchange positions Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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

Credit Risk 7 -6 u Risk that promised cash flows are not paid in full. l l Firm specific credit risk Systematic credit risk u High rate of charge-offs of credit card debt in the 1980 s, most of the 1990 s and early 2000 s u Credit card loans (and unused balances) continue to grow Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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

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

Technology and Operational Risk 7 -9 u Risk of losses resulting from inadequate or failed internal processes, people, and systems or from external events. l Some include reputational and strategic risk u Technological innovation has seen rapid growth l l l Automated clearing houses (ACH) CHIPS Real time interconnection of global FIs via satellite systems Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Technology and Operational Risk 7 -10 u Risk that technology investment fails to produce anticipated cost savings. u Risk that technology may break down. l l l Citi. Bank’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 Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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

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

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

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

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

Liquidity Risk 7 -16 u Risk of being forced to borrow, or sell assets in a very short period of time. l Low prices result. u May l l l Runs may turn liquidity problem into solvency problem. Risk of systematic bank panics. Example: 1985, Ohio savings institutions insured by Ohio Deposit Guarantee Fund § l generate runs. Interaction of credit risk and liability risk Role of FDIC (see Chapter 19) Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

Insolvency Risk 7 -17 u Risk of insufficient capital to offset sudden decline in value of assets to liabilities. l Continental Illinois National Bank and Trust u Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks. Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

7 -18 Risks of Financial Intermediation u Other l Interdependencies among risks. § § l Risks and Interaction of 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 Mc. Graw-Hill/Irwin © 2006 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.

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

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