Financial Markets

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Risk Management In Financial Institutions

Module 010 Risk Management In Financial Institutions

At the end of this module, you will be able to:

1. Identify the different risk faced by financial institutions
2. Understand the impact of each risk to the financial
institutions
3. Learn and discuss the concept of risk management for
financial institutions.

INTRODUCTION
The primary objective of the financial institution\ management is to increase the rims returns
for its shareholders. This mostly happens, however, at the exchange of increased risk.
Regulators’ assessment of a depository institution's overall safety and reliability (DI) is
summarized in the CAMELS rating assigned to the DI. This module overviews the various risks
facing financial institutions: credit risk, liquidity risk, interest rate risk, market risk, off-
balance-sheet risk, foreign exchange risk, country or sovereign risk, technology risk,
operational risk, and insolvency risk.
The effective management of these risks is vital to a FI’s performance. Certainly, it can be
reasoned that the main business of FIs is to manage these risks. In general, FI managers must
dedicate significant time to understanding and dealing with the various risks to which their
FIs are exposed. By the end of this module, you will have a basic understanding of the variety
and complications of the risks facing managers of present FIs.
Because of some financial institutions' huge size, overexposure to risk can lead financial
institutions to failure and affect millions of people. By understanding the risks posed to banks,
governments can impose better regulations to promote prudent management and decision-
making. The ability of a bank to handle risk also affects investors’ decisions. Even if a bank can
generate huge revenues, poor risk management can lower profits due to losses on loans. Value
investors are most likely to invest in a bank that has the capability to provide profits and is
not at an excessive risk of losing money.

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Risks Faced by Financial Institutions

• Credit Risk—the risk that promised cash flows from loans and securities held by FIs may
not be paid in full.
• Liquidity Risk—the risk that a sudden and unexpected increase in liability withdrawals
may require an FI to liquidate assets in a very short period of time and at low prices.
• Interest Rate Risk—the risk incurred by an FI when the maturities of its assets and
liabilities are mismatched, and interest rates are volatile.
• Market Risk—the risk incurred in trading assets and liabilities due to changes in interest
rates, exchange rates, and other asset prices.
• Off-Balance-Sheet risk—the risk incurred by an FI as the result of its activities related to
contingent assets and liabilities.
• Foreign Exchange Risk—the risk that exchange rate changes can affect the value of an FI’s
assets and liabilities denominated in foreign currencies.
• Country or Sovereign Risk—the risk that repayments by foreign borrowers may be
interrupted because of interference from foreign governments or other political entities.
• Technology Risk—the risk incurred by an FI when its technological investments do not
produce anticipated cost savings.
• Operational risk—the risk that existing technology or support systems may malfunction,
that fraud impacts the FI's activities may occur, and/or that external shocks such as
hurricanes and floods may occur.
• Insolvency Risk—the risk that an FI may not have enough capital to offset a sudden decline
in the value of its assets relative to its liabilities.

CREDIT RISK

Credit risk occurs because of the possibility that assured cash flows on financial claims held
by businesses, such as loans and bonds, will not be paid in full. Almost all types of financial
institutions face this risk. Nevertheless, in general, financial institutions that avail loans or buy
bonds with long maturities are more exposed than are financial institutions that make loans
or buy bonds with short maturities. For example, depository institutions and life insurers are
more exposed to credit risk than money market mutual funds and property like casualty
insurers since depository institutions and life insurers tend to hold longer maturity assets in
their portfolios than mutual funds property-casualty insurers. For example, commercial and
investment banks incurred billions of dollars of losses in the mid- and late 2000s as a result of
credit risk on subprime mortgages and mortgage-backed securities. If the principal on all
financial claims held by FIs were settled in full on maturity and interest payments were made
on their guaranteed payment dates, FIs would always receive back the original principal lent
plus an interest return; that is, they would face minimal to nothing credit risk. Should a

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borrower default but, both the principal loaned and the interest payments expected to be
received are at risk.
A lot of financial claims issued by individuals or businesses and held by FIs promise a limited
or fixed upside return (principal and interest payments to the lender) with a high possibility,
but they also may result in a huge downside risk (loss of loan principal and promised interest)
with a quite lesser probability. Some examples of financial claims issued with these return-
risk trade-offs are fixed-coupon bonds issued by corporations and bank loans. In both cases,
an FI holding these claims as assets earns the coupon on the bond or the interest promised on
the loan if no borrower default occurs. In the event of default, however, the FI earns zero
interest on the asset and may well lose all or part of the principal lent, a subject on its ability
to lay claim to some of the borrower’s assets through legal bankruptcy and insolvency
proceedings.
Credit risk is the largest and common risk for banks. It appears when borrowers or
counterparties fail to meet contractual obligations. An example is when borrowers fail or
default on a principal or interest payment of a loan. Defaults can occur on mortgages, credit
cards, and fixed-income securities. Failure to meet obligational contracts can also happen in
areas such as derivatives and guarantees provided.
While banks and other financial institutions may not be fully protected from credit risk due to
their business model's nature, they can minimize their exposure in several ways. Since the
decline in an industry or issuer is frequently unpredictable, banks lower their exposure via
diversification.
By doing so, during a credit recession, banks are less likely to be overexposed to a category
with huge losses. To lessen their risk exposure, they can loan money to people with good
credit records, transact with high-quality counterparties, or own collateral to back up the
loans.

Example: Impact of Credit Risk on an FI’s Value of Equity

Consider Financial Institutions with the following balance sheet:

Suppose that the managers of the FI recognize that $5 million of its $80 million in loans is doubtful
to be repaid due to an increase in credit repayment difficulties of its borrowers. Eventually, the FI’s
managers must answer by charging off or writing down these loans' value on the FI's balance sheet.
This means that the value of loans falls from $80 million to $75 million, an economic loss that must
be charged off against the stockholder's equity capital or net worth (i.e., equity capital falls from $10
million to $5 million). Thus, both sides of the balance sheet shrink by the amount of the loss:

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Despite losses due to credit risk increase, financial institutions continue to give loans readily.
This is because the FI charges a rate of interest on a loan that pays off for the loan risk. Thus, a
significant component in the credit risk management process is its pricing. The potential loss
a financial institution can experience from lending suggests that FIs need to gather
information about borrowers whose assets are in their portfolios and monitor those
borrowers over time. Consequently, managerial (monitoring) efficiency and credit risk
management strategies directly influence the loan portfolio's returns and risks.

Firm-specific credit risk - The risk of default for 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.

LIQUIDITY RISK
Liquidity risk occurs when a financial institutions liability holders, such as depositors or
insurance policyholders, demand instant cash for the financial claims they hold with the
financial institutions or when holders of off-balance-sheet loan commitments (or credit lines)
quickly exercise their right to borrow (draw down their loan commitments). For example,
when liability holders demand cash instantly—that is, “put” their financial claim back to the
FI, the FI must either liquidate assets or borrow supplementary funds to meet the demand for
the withdrawal of funds. The most liquid asset of all is cash, which financial institutions can
use directly to meet liability holders’ demands to withdraw cash. Even though FIs limit their
cash asset holdings because cash earns no interest, low cash holdings are mostly not a
problem.
Daily withdrawals by liability holders are mostly predictable, and large banks can normally
expect to borrow additional funds to meet any unexpected shortfalls of cash in the money and
financial markets.
Liquidity risk also means the ability of a financial institution to access cash to meet funding
obligations. Obligations include enabling clients to take out their deposits. The failure to
provide cash in a timely manner to clients can result in a domino effect. If bank delays
providing cash for a few of their customer for a day, other depositors may haste to take out

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their deposits as they lose confidence in the bank. This further lowers the bank’s ability to
deliver funds and leads to a bank run.
Reasons that banks face liquidity problems include dependence on short-term sources of
funds ever, having a balance sheet concentrated in fixed assets, and loss of confidence in the
bank on the part of customers. Mishandling of asset-liability duration can also cause funding
difficulties. This happens when a bank has many short-term liabilities and not enough short-
term assets.
Short-term liabilities are customer deposits or short-term guaranteed investment contracts
(GICs) that the bank is obligated to pay out to customers. If all or majority of a bank’s assets
are tied up in long-term loans or investments, the bank may suffer from a discrepancy in
asset-liability duration. Regulations exist to reduce liquidity problems. They include a
requirement for banks to possess enough liquid assets to survive for a period of time even
without outside funds' inflow.

Figure 1: Adjusting to a Deposit Withdrawal Using Asset Sales

Example: Impact of Liquidity Risk on an FI’s Equity Value

Impact of Liquidity Risk on an FI's Equity Value Consider the simple FI balance sheet in Table 19–2 .
Before deposit withdrawals, the FI has $10 million in cash assets and $90 million in non-liquid
assets (such as small business loans). These assets were funded with $90 million in deposits and
$10 million in owner's equity. Suppose that depositors unexpectedly withdraw $15 million in
deposits (perhaps due to the release of negative news about the profits of the FI), and the FI receives
no new deposits to replace them. To meet these deposit withdrawals, the FI first uses the $10
million it has in cash assets and then seeks to sell some of its non-liquid assets to raise an additional
$5 million in cash.
Assume that the FI cannot borrow any more funds in the short-term money markets, and because it
cannot wait to get better prices for its assets in the future (as it needs the cash now to meet
immediate depositor withdrawals), the FI has to sell any non-liquid assets at 50 cents on the dollar.
Thus, to cover the remaining $5 million in deposit withdrawals, the FI must sell $10 million in non-
liquid assets, incurring a loss of $5 million from those assets' face value. The FI must then write off
any such losses against its capital or equity funds. Since its capital was only $10 million before the
deposit withdrawal, the loss on the fire-sale of assets of $5 million leaves the FI with $5 million.

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INTEREST RATE RISK

The main securities that FIs acquire often have maturity characteristics unique from the
secondary securities that FIs sell. In mismatching the maturities of its assets and liabilities as
part of its asset transformation function, an FI potentially exposes itself to interest rate risk.

Interest rate risk - The risk incurred by an FI when the maturities of its assets and liabilities are
mismatched, and interest rates are volatile.

Example: Impact of an Interest Rate Increase on an FI’s Profit When the Maturity of Assets
Exceeds the Maturity of Liabilities

Consider an FI that issues $100 million of liabilities with one year to maturity to finance the
purchase of $100 million of assets with a two-year maturity. We show this in the following
timelines:

Suppose that the cost of funds (liabilities) for the FI is 9 percent in year 1 and the interest return on
the assets is 10 percent per year. Over the first year, the FI can lock in a profit spread of 1 percent
(10 percent - 9 percent) times $100 million by borrowing short term (for one year) and lending long
term (for two years). Thus, its profit is $1 million (.01 x 100m). Its profit for the second year,
however, is uncertain. If the level of interest rates does not change, the FI can refinance its liabilities
at 9 percent and lock in a 1 percent or $1 million profit for the second year as well. The risk always
exists, however, that interest rates will change between years 1 and 2. If interest rates rise and the
FI can borrow new one-year liabilities at only 11 percent in the second year, its profit spread in the
second year is actually negative; that is, 10 percent - 11 percent = - 1 percent, or the FI loses $1
million (-.01 x 100m). The positive spread earned in the first year by the FI from holding assets with
a longer maturity than its liabilities is offset by a negative spread in the second year. Note that if
interest rates were to rise by more than 2 percent in the second year, the FI would stand to make
losses over the two-year period as a whole. As a result, when an FI holds longer-term assets relative
to liabilities, it potentially exposes itself to refinancing risk.

Refinancing risk is a type of interest rate risk in that the cost of refinancing can be more than the
return earned on asset investments.

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Example: Impact of an Interest Rate Decrease on an FI’s Profit When the Maturity of
Liabilities Exceeds the Maturity of Assets
An alternative balance sheet structure would have the FI borrowing $100 million for a longer-term
than the $100 million of assets in which it invests. This is shown as follows:

In this case, the FI is also exposed to an interest rate risk; by holding shorter-term assets relative to
liabilities, it faces uncertainty about the interest rate at which it can reinvest funds in the second
year. As before, suppose that the cost of funds for the FI is 9 percent per year over the two years and
the interest rate on assets is 10 percent in the first year. Over the first year, the FI can lock in a profit
spread of 1 percent, or $1 million. If the second-year interest rates on $100 million invested in new
one-year assets decrease to 8 percent, the FI's profit spread is negative 1 percent (8 percent – 9
percent), or the FI loses $1 million (-.01 x $100m). The positive spread earned in the first year by
the FI from holding assets with a shorter maturity than its liabilities is offset by a negative spread in
the second year. Thus, the FI is exposed to reinvestment risk; by holding shorter-term assets
relative to liabilities, it faces uncertainty about the interest rate at which it can reinvest funds
borrowed over a longer period. In recent years, good examples of this exposure are banks operating
in the Euromarkets that have borrowed fixed-rate deposits while investing in floating-rate loans—
loans whose interest rates are changed or adjusted frequently.

In addition to a possible refinancing or reinvestment outcome, financial institutions

experience price risk or market value uncertainty when interest rates fluctuate. Recall that an
asset or liability's economic or fair market value is theoretically equal to the present value of
the current and future cash flows on that asset or liability. Therefore, increasing interest rates
increases the discount rate on future asset (liability) cash flows and lessens the market price
or present value of that asset or liability.
On the other hand, falling interest rates improve the cash flows' present value from assets and
liabilities. Likewise, mismatching maturities by holding longer term assets than liabilities
states that when interest rates rise, the FI's assets' economic or present value falls by a
longer-term than do its liabilities. This exposes the FI to the risk of economic loss and
possibly to the risk of insolvency.

MARKET RISK

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Market risk arises when FIs actively transact assets and liabilities (and derivatives) instead of
holding them for a longer-term investment, funding, or hedging purposes. Market risk is
directly related to interest rate and foreign exchange risk in that as these risks fluctuate, the
overall risk of the FI is affected. However, market risk adds another dimension of risk, which
is the trading activity. Market risk is the additional risk incurred by an FI when the interest
rate and foreign exchange risks are combined with an active trading strategy, particularly one
that involves short trading periods such as a day.
Theoretically, a financial institution's trading portfolio can be distinguished from its
investment portfolio on the basis of time horizon and liquidity. The trading portfolio
comprises assets, liabilities, and derivative contracts that can be quickly acquired or sold on
structured financial markets. The investment portfolio (for banks, the "banking book")
contains assets and liabilities that are fairly illiquid and held for longer periods.
The financial market crisis demonstrates trading or market risk, the risk that when an FI takes
an open or unhedged long (buy) or short (sell) position in bonds, equities, commodities, and
derivatives, prices may change in a direction opposite to that expected. As a result, as the
volatility of asset prices rises, financial institutions' market risks that adopt open trading
positions increase. This needs FI management (and regulators) to establish controls or limits
on positions taken by traders and develop models to determine the market risk exposure of
an FI daily.

OFF-BALANCE-SHEET RISK
One of the most remarkable trends involving present financial institutions has been the
growth in their off-balance sheet (OBS) activities and, thus, their off-balance-sheet risks. The
off-balance-sheet risk is the risk incurred by an FI as the result of activities associated with
contingent assets and liabilities.
While all FIs, to some level, involve in off-balance-sheet activities, most attention has been
drawn to the activities of banks, particularly large banks that invest largely in off-balance-
sheet assets and liabilities, mainly derivative securities. Off-balance-sheet activities have not
been much of a concern to smaller depository institutions and many insurers. An off-balance-
sheet activity, by definition, does not appear on an FI’s current balance sheet since it does not
involve holding a current primary claim (asset) or the issuance of a current secondary claim
(liability). Instead, off-balance-sheet activities influence an FI's balance sheet's future shape
since they engage in the creation of contingent assets and liabilities that give sense to their
potential placement in the future on the balance sheet. As such, accountants place them
“below the bottom line” on an FI’s balance sheet.
Another example of an off-balance-sheet activity is the issuance of standby letters of credit
guarantees by insurance companies and banks to back the issuance of municipal bonds.

Letter of credit - A credit guarantee issued by an FI for a fee on which payment is contingent on
some future event occurring, most notably the default of the agent that purchases the letter of

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credit.

FOREIGN EXCHANGE RISK

FIs have progressively recognized that both direct foreign investment and foreign portfolio
investment can extend the operational and financial benefits presented from purely domestic
investments. To the extent that the gains on domestic and foreign investments are imperfectly
correlated, FIs can lessen the risk through domestic-foreign activity/ investment
diversification.
Foreign exchange risk is the risk that arises, and a fall in the exchange rate can directly
influence the value of an FI’s assets and liabilities denominated in foreign currencies.
Foreign exchange risk occurs when a company involves in financial transactions denominated
in a currency other than the currency where that company is located. Any movement of the
base currency or the depreciation/appreciation of the denominated currency will have an
impact on the cash flows emanating from that transaction. Investors are also affected by the
foreign exchange risk, trade in international markets, and companies engaged in
import/exporting products or services to various countries.
A closed trade earnings, whether it is a profit or loss, will be denominated in the foreign
currency and must be converted back to the investor's base currency. Movement in the
exchange rate could badly affect this conversion resulting in a lower than expected amount.
TECHNOLOGY AND OPERATIONAL RISK
Technology and operational risks are closely related and, in recent years, have led to great
concern to the managers of financial institutions and regulators alike. The Bank for
International Settlements (BIS), the principal organization of central banks in the major
economies of the world, describes operational risk (inclusive of technological risk) as “the risk
of loss resulting from inadequate or failed internal processes, people, and systems or from
external events.” Several FIs add reputational risk and strategic risk (e.g., due to a failed
merger) as part of a wider definition of operational risk.
Technology risk rises when technological investments do not produce the anticipated cost
savings in the form of either economy of scale or economies of scope. Diseconomies of scale,
for example, occur because of excess capacity, redundant technology, and/or organizational
and bureaucratic inefficiencies that become worse as an FI grows in size. Diseconomies of
scope arise when an FI fails to generate perceived synergies or cost savings through major
new technological investments. Technological risk can result in major losses in an FI’s
competitive efficiency and eventually result in its long-term failure. Likewise, gains from
technological investments can provide performance superior to an FI’s rivals as well as
enables it to develop new and innovative products enhancing its long-term survival chances.

Technology risk - The risk incurred by an FI when its technological investments do not produce
anticipated cost savings.

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Operational risk is partly related to technology risk and can arise when existing technology
malfunctions or "back-office" support systems break down. For example, in February 2005,
Bank of America announced that it had lost computer backup tapes containing personal
information such as names and Social Security numbers on about 1.2 million federal
government employee charge cards as the tapes were being transported to a data storage
facility for safekeeping. Bank of America could not rule out the possibility of unauthorized
purchases using the lost data, but it said the account numbers, names, addresses, and other
tape contents were not easily accessible without highly sophisticated equipment and
technological expertise. The biggest known theft of credit card numbers was exposed in May
2007, when, over a two-year period, as many as 200 million card numbers were stolen from
TJX Company—parent company to such retail stores as Marshalls and TJ Maxx. The retailer’s
wireless network reportedly had less security than most home networks. Even though such
computer and data problems are uncommon, the incidence can cause major dislocations for
the FIs involved and potentially disrupt the financial system in general.

Operational risk - The risk that existing technology or support systems may malfunction or break
down.

INSOLVENCY RISK
Insolvency risk is a consequence or an outcome of one or more of the risks described above:
interest rate, market, credit, off-balance-sheet, technological, foreign exchange, sovereign, and
liquidity. Technically, insolvency occurs when the capital or equity resources of an FI’s
owners are driven to, or near to, zero due to losses incurred as the result of one or more of the
risks described above.

Insolvency risk - The risk that an FI may not have enough capital to counter a sudden decline in the
value of its assets relative to its liabilities.

In general, the more equity capital to borrowed funds an FI has, the lower its leverage—the
better able it is to endure losses due to risk exposures such as adverse liquidity changes,
unexpected credit losses, and so on. Thus, both the management and regulators of FIs focus on
an FI’s capital (and its “adequacy”) as a key measure of its ability to continue solvent and grow
in the face of a multitude of risk exposures.

Books and Journals

Saunders, A. and Cornett, M. (2016). Financial Markets and Institutions, The McGraw-
Hill Inc. New York
Hubbard, G. and O’brien, A. (2017). Money, Banking, and the Financial System, Prentice
Hall, Prentice Hall, One Lake Street, Upper Saddle River, NJ 07458

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Boumediene, N. and Coelho da Rocha, L. (2016) INTERNATIONAL CORPORATE

FINANCE, Leaders League SAS, Paris : B422 584 532
Krugman, P. and Obstfeld,M. (2018) International Finance: THEORY & POLICY (11th
Ed.), Pearson Education Limited, United Kingdom, ISBN 10: 1-292-23873-9

Online sources
https://www.cfainstitute.org/en/research/
https://corporatefinanceinstitute.com
https://www.investopedia.com
https://www.nber.org/
https://hbr.org/2012/06/managing-risks-a-new-framework
http://jhfinance.web.unc.edu/

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