Elements of Banking and

Finance
(FINA 1001)
Semester I (2020/2021)

Bank Risks
 Banking Risks

• Banks are in the risk business, but they also

depend on confidence. Therefore there is a fine
balance between measured risk-taking and
maintaining consumer confidence.
• Assume risk in the provision of financial
services
•A major objective also of financial institution
management is to increase the returns for its
owners
• This goal is at the cost of increased risk.
 Banking Risks

• From a risk management perspective, risk can be segmented

into three groups:

• Risks that can be eliminated or avoided by simple business practices.

• Risks that can be transferred to other participants.

• Risks that must be actively managed at the firm level.

 Risk Avoidance

• Risk avoidance in banking involves actions to reduce the

chances of losses from standard banking activity.

• Common risk avoidance practices include:

▫ Standardization of process, use of contracts and procedures to
prevent inefficient or incorrect financial decisions
▫ The construction of portfolios that benefit from diversification
across borrowers and sectors and that reduce the effects of
any one loss experience is another.
▫ The implementation of incentive-compatible contracts with
the institution's management to require that employees be held
accountable.
 Key Banking risks

 Include:
Credit risk
Liquidity risk
Market risk
Interest rate risk
Off-balance sheet risk
Technology/operational risk
Foreign exchange rate risk
 Systematic risk

• Systematic/market risk is the risk related to the

uncertainty of a bank’s earnings on its trading portfolio
caused by changes in the market conditions.
• Influences a large amount of assets
• Systematic risks have market-wide effects

• By its nature, this risk can be hedged, but cannot be

diversified completely away. In fact, systematic risk can be
thought of as undiversifiable risk.
 Systematic/market risk
• A trading portfolio is affected by market conditions
such as interest rates, equity return, exchange rates,
market volatility, and market liquidity.
• Therefore market risk is actually a collection of
different risks including interest rate risk, equity
price risk, commodity price risk and foreign
exchange risk.
• These risks are associated with active trading of assets
and liabilities (and derivatives) rather than holding
them over longer horizons.
 Systematic Risk
• In recent years, trading activities of banks have risen
considerably, and the income from them has increasingly
replaced the income from traditional banking activities (loans
and deposits).
• Banks' dependence on systematic factors to generate income -
require estimation of the impact of particular systematic risks on
performance
• Attempt to hedge against risks, and thus limit the sensitivity to
variations in undiversifiable factors.
• FIs measure and manage the firm's vulnerability to market
variation, despite it being an imprecise science.
• FIs are concerned with the fluctuation in value –or value at risk
(VAR)- of their trading account. Banks measure their VAR (market
risk exposure) and then hold capital to cover it.
 Systematic risk

• All banks, especially those with large currency positions closely

monitor their foreign exchange risk .
• Manage and limit exposure.
• Where possible use of financial products

• Institutions with significant investments in commodities such as

oil, through their lending activity or geographical franchise,
concern themselves with commodity price risk.
 Credit Risk

• Credit risk is the risk that the promised cash flows from loans and
securities held by banks may not be paid in full. It is related to the
risk of default of a specific borrower, or to the risk of delay in
servicing the loan.

• This occurrence causes the present value of the bank’s assets to

decline and this undermine the solvency of the bank.

• Credit risk is the most important risk connected with the assets held
by a bank.

• Possible knock on effects - Affect the lender holding the loan

contract, as well as other lenders to the creditor.

• Financial condition of the borrower as well as the current value of

any underlying collateral is of considerable interest to the bank.
 Credit Risk

• Credit risk is diversifiable, but difficult to eliminate completely.

• Portions of the default risk may result from the systematic risk.
• The idiosyncratic nature of some portion of these losses
remains a creditor problem despite diversification
• True for banks that lend in small, local markets and ones that
take on highly illiquid assets.
• Strategy affect the shape of the loan return distribution.
 Credit Risk

• Credit risk is not easily transferred, and accurate estimates of

loss are difficult to obtain. Use of strong due diligence and
other policy guidance
• The return distribution for credit risk suggests that
intermediaries need to both monitor and collect information
about any firms whose assets are in their portfolios.
• Managerial efficiency and credit risk management
▫ Screening and monitoring
▫ Credit rationing
▫ Use of collateral and endorsement
▫ Diversification
 Liquidity Risk

• Liquidity risk can best be described as the risk of a funding crisis.

• Liquidity risk is the uncertainty that an FI may need to obtain large
amounts of cash to meet the withdrawals of depositors or other liability
claimants.
• Such unexpected events include a large charge off, loss of confidence, or a
crisis of national proportion such as a currency crisis.
• Need to plan for growth and unexpected expansion of credit
• Risk management centres on liquidity facilities and portfolio
structure.
• Maintenance of a sufficiently liquid capital base
• Note the trade off between liquidity management and profit and
solvency.
• Intermediaries minimize their cash assets because such holdings earn
no interest.
An opportunity cost in holding overly liquid assets.
 Systemic Impact of Liquidity
Risk

When all or many intermediaries are facing similar abnormally large cash
demands, the cost of additional funds rises as their supply becomes
restricted or unavailable.

May eventually result in a run in which all liability claimholders seek to

withdraw their funds simultaneously from intermediaries.

Liquidity problem converts into a solvency problem.

 Liquidity Management
Assets Liabilities
Reserves $9M Deposits $90M
Loans $81M Bank Capital $10M
Securities $10M

• Interbank funding
• Lender of last resort
• Reduction of loans is the most costly way of
acquiring reserves
• Calling in demand loans antagonizes sometimes long-standing customers
• Other banks may only agree to purchase loans at a substantial discount
(Solvency/profit issue)
 Interest Rate Risk

• Interest rate risk is the effect on prices and interim

cash flows caused by changes in the level of interest rates
during the life of the financial asset.
• the risk incurred by a bank when the maturities of its assets and
liabilities are mismatched and there are changes in market
interest rates.
 Interest Rate Risk- Refinancing Risk

• The change in market interest rates determines two main risks

for a financial intermediary
▫ Refinancing Risk
 the risk that the cost of reborrowing funds will be higher than the returns earned on asset
investments, inConsider a bank borrowing $100 (liability) for one year, and investing in a $100
(asset) for two years. The maturity of its asset is longer than the maturity of its liability.
Suppose that the cost of funds (liability) is 9 per cent per year, and the interest return on the
asset is fixed for the 2 years at 10 per cent per annum. The bank faces the risk that interest rates
change at the end of year 1. If interest rates increase and the bank can only borrow a new one
year liability at 11 per cent, the bank would experience a loss over the second year of the
investment (that is, 10% asset return minus 11% cost of funds).
 the presence of longer-term assets relative to liabilities
Interest Rate Risk- Reinvestment Risk


Reinvestment Risk
•
the risk that the return on funds to be reinvested will fall below the cost of funds.
• Consider a bank borrowing $100 (liability) at 9 per cent (cost of funds) for two years, and
investing $100 (asset) at 10 percent (return on assets) for one year. The maturity of its liability
is longer than the maturity of its assets. The bank is exposed to an interest rate risk: it does not
know at which rate it can reinvest in the second period. Suppose that the interest rate earned on
its assets falls to 8 per cent at the end of the first year; in this case the bank would face a loss
(that is, 8 per cent asset return minus 9 per cent cost of funds).

Liabilities
0 Assets 1
($100 M)
($100 M)
 Market Value Risk

• This risk refers to the change in the present value of the

cash flows on assets and liabilities.
• The price of an asset or liability is equal to the present value of
the relevant cash flows.

• Therefore, rising interest rates increase the discount rate

on those cash flows and reduce the price of the asset or
liability. Conversely, falling interest rates increase the
price.
 Interest Rate Risk
Banks protect themselves against interest rate risk by matching the maturity of
their assets and liabilities.
•Matching maturities work against an active asset-transformation function for
intermediaries .
• A policy of maturity matching will allow changes in market interest rates to have
approximately the same effect on both interest income and interest expense. An
increase in rates will tend to increase both income and expense, and a decrease in
rates will tend to decrease both income and expense.
• Though reducing exposure, matching maturities may also reduce the profitability

• Matching maturities only hedges interest rate risk in a very approximate rather than
complete fashion.
• The changes in income and expense may not be equal because of different cash flow
characteristics of the assets and liabilities.
 Interest Rate Risk
First UWI Bank

Assets Liabilities
Rate-sensitive assets $20M Rate-sensitive liabilities $50M
Variable-rate and short-term loans Variable-rate CDs
Short-term securities Money market deposit accounts
Fixed-rate assets $80M Fixed-rate liabilities $50M
Reserves Checkable deposits
Long-term loans Savings deposits
Long-term securities Long-term CDs
Equity capital

If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce
bank profits and a decline in interest rates will raise bank profits
Interest Rate Risk Management

• Asset-liability management (ALM) (broadly defined as

the coordinated management of banks’ balance sheet
activities driven by interest rate risk) is one of the most
important risk management functions in banking.
• The two main ALM techniques used to manage interest
rate risk are:
• income gap analysis
• duration gap analysis
• A market value-based model of measuring and managing interest
rate risk
 Gap Analysis
Banks report the gap in each maturity bucket, calculated as the difference
between rate-sensitive assets (RSA) and rate-sensitive liability (RSL) on their
balance sheets, shown as :

GAP = RSA – RSL

A positive GAP implies interest sensitive assets > interest sensitive liabilities. A
rise in interest rates will cause a bank to have interest revenues rising faster than
interest costs; thus the net interest margin and income will increase.
A decline in interest rates will increase liabilities costs faster than assets returns;
as a consequence the net interest margin and income will decrease.

Bank managers can calculate the income exposure to changes in interest

rates in different maturity buckets, by multiplying GAP times the change in
the interest rate:
ΔI = GAP * Δi
where:
ΔI = change in the banks’ income;
Δi = change in interest rate.
 Operational Risk

• Associated with the processing, settling, and taking or making

delivery on trades in exchange for cash. (Largely internal
processes)
• Also arises in record keeping, processing system failures and
compliance with various regulations.
• Usually small probability events
• Despite being a low probability risk, occurrence can cause
major dislocations in the intermediary’s operation and
potentially disrupt the financial system in general. (Low
risk/high losses)
 Operational Risk – Technology Risk

• Technology risk is a subset of operational risk.

• Occurs when technological investments do not produce the
anticipated cost savings in economies of scale or scope.
 Operational Risk: Technology
Improvements

• Past 20 years financial intermediaries emphasis on operational

efficiency: major investments
• There was an expanded technological infrastructure.
• Micro level: A more networked and integrated infrastructure.
• Macro system: Automated clearing house (ACH) and wire transfer
payment networks, such as the clearinghouse inter-bank payments
system.
 Off-balance Sheet Risk
Off-balance-sheet activities affect the future shape of an intermediaries balance sheet in that
they involve the creation of contingent assets and liabilities.
Letters of credit
Loan commitments
Derivative contract
As banks’ ability to attract high-quality loan applicants and depositors diminishes, off-balance
sheet activities have become important in terms of the income that they can generate:
The ability to earn fee income while not loading up or expanding the balance sheet - An
important motivation in intermediaries pursuing off-balance-sheet business. Off-balance
sheet assets/liabilities move onto the balance sheet when a contingent event occurs.
Complements declining margins on banks’ traditional lending activities
Allows banks to avoid regulatory costs that are not levied on off-balance sheet activities.
Some activities structured to reduce exposure to credit, interest rate, or foreign exchange risks.
Activity is not risk free. Mismanagement or inappropriate use of these instruments can result in
major losses to intermediaries. Significant losses can lead to firm failure.
CFO of Enron created off-balance-sheet vehicles that were highly complex to hide its debt.
 Off-balance Sheet Activities
Major types of off-balance sheet activities include:
Guarantees (letters of credit)
Letters of credit are used in both domestic and international trade.
The financial institution’s function is to provide a formal guaranty
that payment for goods shipped or sold will be forthcoming
regardless of whether the buyer of the goods (the FI’s
customer)defaults on payment.

Future commitments to lend (loan commitments)

A loan commitment is a contractual commitment by an FI to lend to
a firm a certain maximum amount at a given interest rate. The FI
may charge an up-front fee and a possible back end fee
(commitment fee) on any unused balances in the arrangement but
must also be ready to supply the stipulated amount at any time over
the commitment period.
Off-balance Sheet Risk (cont’d)

• Derivative contract
• Agreement between two parties to exchange a standard quantity of an
asset at a predetermined price at a specified date in the future.
 What is Risk Management?

• The practice of:

• Defining Risk
• Defining the risk level a firm desires.

• Measuring Risk: Identifying the risk level a firm currently has.

• Hedging Risk: Using procedures, derivatives or other financial

instruments to adjust the actual level of risk to the desired level of risk.
 Why manage risks?
• According to standard economic theory, managers of value-
maximizing firms should maximize expected profit without
regard to the variability around its expected value.
• There is a number of distinct rationales proposed for active
risk management. The key ones are:
• managerial self-interest,
• the costs of financial distress
• the existence of capital market imperfections.
 Why manage risks?

• The explosion in information technology makes the

complex calculation of derivative prices quickly and at
low cost that allow financial firms to track the positions
taken
• The favorable regulatory environment that encourages
new product innovation for risk management.
• The needs of commercial banks to generate fee incomes
through offering off-balance-sheet activities.
 Why manage risks?
• Concerns over the increasing volatility of interest rates, exchange rates,
commodity prices, and stock prices.
• Interest rates had become more volatile
• From the early 1970s, interest rates and bond prices became increasingly
volatile due to increases in inflation and the advent of floating exchange
rates.

• Sharp increase in volatility from the early 1980s - the use of money supply
as a major monetary policy tool.

• In the late 1990’s volatility was reduced, BUT speed of technology

improvements, information and funds flow can induce volatility.

• New options on Treasury bills, Treasury notes, and long-term government

bonds, as well as futures on synthetic government bonds, were offered by
the exchanges; a multitude of OTC interest-sensitive instruments were
marketed by banks and other financial intermediaries.
 Why manage risks?

• Commodity prices have become more volatile

• Commodity prices fluctuated significantly in the 1970s and early 1980s
due to the oil embargo in 1974.

• It is estimated that the 1974 oil price increase contributed to inflation in

industrialized countries by 2% to 3%.

• Current situation seems more drastic

 Why manage risks?

• Foreign exchange rates have become more volatile

• Since the dismantling of the Bretton Woods Agreement in 1973:
• The movements in exchange rates have been abrupt and large.
• The volatility of movements in the foreign exchange value of the
currencies has been large.

• As volatility surfaced in traded foreign currencies, the financial market

began to offer currency traders special tools for insuring against these
risks.
 Why manage risks?

Regulators’ push for implementing risk management systems

In the mid-1980s, the Federal Reserve in the US and the Bank of
England became concerned about the growing exposure of banks to off
balance sheet (OBS) claims, coupled with problem loans to developing
economies.

The results: Strengthening of the equity base of banks by requiring

more capital against risky assets and to assess capital requirements on
OBS claims.
 Why Manage Risks?

• Regulators’ push for implementing risk management systems

• The Bank for International Settlements (BIS) was charged with the job
of setting common standards and procedures for international banks on
capital requirements.

• Basel III Accord: Regulators are placing greater emphasis on common

equity to protect banks during times of financial stress (the level of
common equity has gone up from 2% under Basel II to 7% under Basel
III)
 References

• Saunders, A. and Cornett, M. (2014), Financial Institutions

Management: A Risk Management Approach, McGraw-Hill
Education, New York.