MGMT 3076-Managing Financial

Institutions
Semester 2 2014/2015
Lecturer:
Mr. Terry Harris
terry.harris@cavehill.uwi.edu
Lectures:

Wednesdays 12:00 2:00 pm

Department of Management Studies

University of the West Indies
Cave Hill Campus
Lecture 4

Recap
Last week
We analyzed the size, and structure of securities
firms, investment banks, mutual and hedge
funds, and insurance companies; and
We discussed the activities of these firms.

Learning Objective
By the end of this weeks lecture
students will be able to critically discuss
the various risks faced by financial
institutions:
Interest rate risk, market risk, credit
risk, off-balance-sheet risk, foreign
exchange risk, country or sovereign
risk, technology risk, operational risk,
liquidity risk, and insolvency risk
Ch 7-3

Risks of Financial Intermediation

One of main objective FI management is to
increase returns for owners. However, this
often comes at the costs of some risk.

Before we get into the quantitative

assessment of these risk, we will first discuss
them in this lecture.
Ch 7-4

Risks of Financial Intermediation

Interest rate risk

Interest rate risk is the risk that results from a
mismatch in asset & liability maturities. Recall
that when playing the role of Asset
transformer FI buy primary secures and sell
secondary securities. This leads to:
Refinancing riskThe risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset
investments.
Reinvestment riskThe risk that the returns on funds to be
reinvested will fall below the cost of funds.
and other asset prices

Interest rate risk

Interest rate risk

Class activity

Credit Risk
This is the risk that promised cash flows on financial
claims (e.g. loans and bonds) are not paid in full.
Virtually all FI are exposed to this risk, but those FIs that
make loans or buy bonds with long maturities are more
exposed to it.

Credit risk results in the need to screen and monitor

loan applicants. Thus, prudent credit risk
management strategies directly affect the risk-return
characteristics of the firms loan portfolio (e.g. credit
scoring). In addition, diversification of the loan
portfolio also reduces the risk specific to the firm:

Firm specific credit risk: The risk of default of the borrowing firm
associated with the specific types of project risk taken by that firm.

Systematic credit risk: The risk of default associated with general economy
wide or macro conditions affecting all borrowers

Implications of Growing Credit Risk

Importance of credit screening &
monitoring
Diversification of credit risk
Loan sales, reschedulings
Credit derivatives

Ch 7-11

Liquidity Risk
This is the risk that a sudden surge in liability (e.g.
deposit) withdrawals (e.g. due to crisis of confidence
in the institution) of borrowings (OBS loan
commitments) force the FI to borrow additional funds
(at high prices) or sell assets (at a low price) in a very
short period of time.
When FIs face abnormal cash demands (runs) the cost
of additional funds rises and the supply of such funds
becomes restricted. This can result in the FI having to
liquidate some assets at low or fire sale prices.
The persistence of a run could in turn threaten the
profitability and solvency of the FI, thereby turning a
liquidity problem into a solvency problem.

Ch 7-12

Liquidity Risk

Class activity

Foreign Exchange Risk

Foreign exchange risk is that is the risk that exchange

rate changes can affect the value of FIs assets and
liabilities denominated in foreign currencies. Here, a
FI may be net long or net short in various currencies.

Net long FI fears FX rate depreciation

Net shortFI fears FX rate appreciation

Returns on foreign and domestic investment are not

perfectly correlated (countries are different). Thus
there is the potential for gains and an exposure to FX
risk.
Further, FI may profit as FX rates may not be perfectly
correlated.
Example: $/ may be increasing while $/ decreasing and
relationship between and time varying
Ch 7-15

Foreign Exchange Risk

To understand how foreign exchange risk arises, suppose that a
U.S. based FI makes a loan to a British company in pounds
sterling (). Should the British pound depreciate in value
relative to the U.S. dollar, the principal and interest payments
received by U.S. investors would be devalued in dollar terms.
Indeed, were the British pound to fall far enough over the
investment period, when cash flows are converted back into
dollars, the overall return could be negative.
That is, on the conversion of principal and interest payments
from pounds into dollars, foreign exchange losses can offset
the promised value of local currency interest payments at the
original exchange rate at which the investment occurred.
Ch 7-16

Class activity

Country or Sovereign Risk

This is the risk that repayment from foreign borrowers
may be interrupted because of interference from
foreign governments. These governments may
impose restrictions (rescheduling or outright
prohibition) on repayments to foreigners.
Foreign currency shortages
Adverse political reasons

Here the FI often lacks the usual recourse via court

system; however, they can increase the probability
of repayment by influencing the future supply (and
costs) of funds to the countries concerned.
Examples:
Argentina and more recently Greece

Ch 7-18

Country or Sovereign Risk

As previously mentioned, in the event
of restrictions, rescheduling, or outright
prohibition of repayments, a FIs
remaining bargaining chip is future
supply of loans
However, you should not that this is a
weak position if countrys currency is
collapsing or if the government is failing
Ch 7-19

Market Risk
The risk incurred in actively trading
(rather than holding for the long term)
assets and liabilities (and derivatives)
due to interest rates, exchange rates,
and other asset price movements.
When facing market risk, FIs are concerned about the
fluctuation in valueor value at risk (VAR)of their trading
account assets and liabilities for periods as short as one day
so-called daily earnings at risk (DEAR)especially if such
fluctuations pose a threat to their solvency.
Ch 7-20

Market Risk
To be clear, a FIs trading portfolio can be
differentiated from its investment portfolio on the
basis of time horizon and secondary market
liquidity. The trading portfolio contains assets,
liabilities, and derivative contracts that can be
quickly bought or sold on organized financial
markets.
The investment portfolio (or in the case of banks,
the so-called banking book) contains assets and
liabilities that are relatively illiquid and held for
longer holding periods.

Market Risk

Off-Balance-Sheet Risk
This is the risk incurred by FIs due to the
activities related to contingent assets and
liabilities E.g.,:
Letters of credit
Loan commitments
Derivative positions

FIs engage in OBS activities for a number of reasons.

One reason is the opportunity to earn revenue while
not expanding the BS (could have regulator
implication). However, it should be noted that OBS
activity is not risk free.
Ch 7-23

Off-Balance-Sheet Risk

Off-Balance-Sheet Risk

Technology and Operational Risk

Risk of losses resulting from inadequate or failed
internal processes, people and systems, or from
external events

Loss of backup files

Unsecured wireless networks
Technology risk: The risk incurred by an FI when
technological investments do not produce the cost savings
anticipated
Operational risk: The risk that existing technology or support
systems may malfunction or break down. Operational risk are
not exclusively technological but includes risk of:
Employee fraud and errors
reputation risk and strategic risk (e.g. failed merger)

Technology and Operational Risk

The objective of technological advancement is to lower
operating costs, increase profits, and capture/create new
markets for the FI, thereby allowing the FI to exploit
economies of scale and economies of scope in selling its
products.
Economies of scale. The degree to which an FIs
average unit costs of producing financial services fall
as its outputs of services increase.
Economies of scope. The degree to which an FI can
generate cost synergies by producing multiple
financial service products.
Ch 7-27

Insolvency Risk
The risk that a FI may not have enough
capital to offset a sudden decline in
the value of its assets relative to its
liabilities. Put another way, the FI has
insufficient capital (equity) to offset a
sudden decline in value of assets
relative to liabilities:
Original cause may be excessive interest rate, market,
credit, off-balance-sheet, technological, FX, sovereign,
and liquidity risks
Ch 7-28

Other Risks & Interaction of Risks

Interdependencies among risks
Example: Interest rates and credit risk
Interest rates and derivative counterparty risk

Discrete or Event Risks

Events external to the FI e.g. the effects of war
or terrorist acts, regulatory policy changes
market crashes, theft, and malfeasance
These risk may cause FI to fail or be severely
harmed

Ch 7-29