Week 13 Chapter 23

Financial
Markets and
Institutions
Chapter 23 Risk
Management in Financial
Institutions
Outlines
• Financial institution’s risks overviews

• The credit risks
– Definition
– How do the risks happen?
– How to manage
• The interest rate risks
– Definition
– The tools to measure risk
– How to manage
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Financial institution risks overview
• What is risk? the chance an outcome or investment's actual
return will differ from the expected outcome or return.
• Risk includes the possibility of losing some or all of the
original investment.
• Different versions of risk are usually measured by calculating
the standard deviation of the historical returns or average
returns of a specific investment.
• Risk management process
Risk Risk Risk

Risk control
identification measurement monitoring
Determine Effective Set risk limit through

Continuous their impact on standard, policies,
management
process to the bank’s procedures, define
information
Recognize and profitability responsibility,
system to review
Understand risk and capital authority
risk position
Types of Financial institutions’ risks
Outlines

– Definition
– Why do they happen?
– How to manage
– Definition
– How to manage
Managing Credit Risk
Overviews
• Credit risk (default risk) is the potential that a bank borrower
or counterparty will fail to meet its obligations in accordance with
agreed terms. Regarding a loan, risk that a borrower will not
repay a loan according to the terms of the loan, either defaulting
entirely or making late payments of interest or principal.
• Can happen in any bank’s transactions (loans, acceptances,
interbank transactions, trade financing, forex transactions,
derivatives, bonds, equities, commitments and guarantees, …
• Why might the risk happen?
– Adverse selection: Those with the highest credit risk have
the biggest incentives to borrow from others.
– Moral hazard: Once a borrower has a loan, she has an
incentive to engage in risky projects to produce the highest
payoffs.
– Both of these may lead to the credit risks
Credit Risk Management Process
Monitor long term Screening Macroeconomic or
customers, loan
industry risks
commiments
forecast the
Follow rights loss in case
and of default,
obligations, analyze data
monitor the from
enforcement borrower to
get credit
scores
Set up loan Structure the payment

agreement, check cashflow suitable to
restrictive Set the interest rate, borrower’s capacity.
covenants, default rate Collaterals required
• Screening - KYC
– What is it: Collecting reliable information about prospective
borrowers.
– The way to collect information: interview borrower and
related people (relatives, boss, friends,…), fill in form, check
appearance, check big data, visit the company=> calculate
credit scores
– What information to collect:
 personal finance (salary, credit card, electricity bill
payment, rental, years of working,…)
 company’s profits and losses (income); its assets and
liabilities; likely future success of the business; company’s
future plans, the purpose of the loan, and the competition in
the industry
– Specialization in Lending: helps in screening. It is easier
to collect data on local firms and firms in specific industries.
It allows them to better predict problems by having better
industry and location knowledge.
 On one hand, not diversifying its portfolio of loans and thus
is exposing itself to more risk
 On the other hand, concentrating its lending on firms in
specific industries, the financial institution becomes more
knowledgeable about these industries and is therefore
better in assessing the risk of particular company in the
industry
Managing Risk
• Structural the deal
 Collateral: a pledge of property or other assets that must
be surrendered if the terms of the loan are not met (the
loans are called secured loans).
 Compensating Balances: reserves that a borrower must
maintain in an account that act as collateral should the
borrower default.
 Credit Rationing: (1) lenders will refuse to lend to some
borrowers, regardless of how much interest they are
willing to pay, or (2) lenders will only finance part of a
project, requiring that the remaining part come from
equity financing.
 Negotiation: think about duration strategy in relation to
the forecast of interest rate/exchange rate movements
Managing Risk
• Present and close the deal
─ Monitoring and Enforcement. Financial institutions write
protective covenants into loans contracts and actively
manage them to ensure that borrowers are not taking risks
at their expense.
• Monitoring relationship
 Long-term customer relationships:
 reduce the costs of information collection and make it easier
to screen out bad credit risks
 costs of monitoring long-term customers are lower than
those for new customers.
 borrower then has the incentive to avoid risky activities that
would upset the financial institution
 Loan Commitments: arrangements where the bank agrees to
provide a loan up to a fixed amount, whenever the firm requests
the loan (applicable only with long-term customers)
Outlines

– Definition
– Why do they happen?
– How to manage
– Why does it matter?
– Definition, how it affects bank’s balance sheet
– How to manage
Managing Interest-Rate Risk
• Why does it matter?

– Financial institutions, banks in particular, specialize in
earning a higher rate of return on their assets relative to
the interest paid on their liabilities.
– As interest rate volatility increased in the last 20 years,
interest-rate risk exposure has become a concern for
financial institutions.
– Financial institutions have to develop tools to measure
and manage interest-rate risk exposure including
(1) Income Gap Analysis and
(2) Duration Gap Analysis
Income Gap Analysis
• Income Gap Analysis: measures the sensitivity of a
bank’s current year net income to changes in interest rate.
• Steps:
– determining which assets and liabilities will have their
interest rate change as market interest rates change
(rate-sensitive assets or liabilities): including short term or
variable-rate Debt instruments. Other longer term A&L
may get some portion based on past experience judgment
– Calculate Rate-Sensitive Assets (RSA) and Rate-Sensitive
Liabilities (RSL) => GAP = RSA- RSL
– Suppose interest rate change level => calculate Assets
income and liability cost =>
– Income gap due to interest rate change=
Assets income - liability cost
Assets Liabilities
Reserves and cash items $5 million Checkable deposits $15 million

Securities Money market
Less than 1 year $5 million deposit accounts $5 million
1 to 2 years $5 million Savings deposits $15 million
Greater than 2 years $10 million CDs
Residential mortgages Variable rate $10 million
Variable rate $10 million Less than 1 year $15 million
Fixed rate (30-year) $10 million 1 to 2 years $5 million
Greater than 2 years $5 million
Commercial loans Fed funds $5 million
Less than 1 year $15 million
1 to 2 years $10 million Borrowings
Greater than 2 years $25 million Less than 1 year $10 million
Physical capital $5 million 1 to 2 years $5 million
Bank capital $5 million
Total $100 million Total $100 million
Income Gap Analysis: Determining Rate
Sensitive Items for First National Bank (1 of 2)
Assets Liabilities
– assets with maturity less – money market deposits
than one year – variable-rate CDs
– variable-rate mortgages – short-term CDs
– short-term commercial – federal funds
loans
– short-term borrowings
– portion of fixed-rate
– portion of checkable
mortgages (say 20%)
deposits (10%)
– portion of savings (20%)
Assets Liabilities
Reserves and cash items $5 million Checkable deposits $15 million

Securities Money market
Less than 1 year $5 million deposit accounts $5 million
1 to 2 years $5 million Savings deposits $15 million
Greater than 2 years $10 million CDs
Residential mortgages Variable rate $10 million
Variable rate $10 million Less than 1 year $15 million
Fixed rate (30-year) $10 million 1 to 2 years $5 million
Commercial loans Fed funds $5 million
Less than 1 year $15 million
1 to 2 years $10 million Borrowings
Greater than 2 years $25 million Less than 1 year $10 million
Physical capital $5 million 1 to 2 years $5 million
Bank capital $5 million
Total $100 million Total $100 million
Income Gap Analysis:
Determining Rate Sensitive Assets
Rate-Sensitive Assets =
Short-term securities ($5 m)
+ variable-rate mortgages ($10 m)
+ and short term commercial loans ($15 m)
+ a portion of fixed rate 30 yrs mortgage (20%  $20m)
(borrowers can repay early if they decide to sell the real
estate before the mortgage is due)
= $5m + $ 10m + $15m + 20%  $20m
RSA = $32m
Income Gap Analysis:
Determining Rate Sensitive Liabilities
Rate-Sensitive Liabilities =
money market deposit ($5 m)
+ variable-rate CDs and short term CDs ($25 m)
+ federal funds ($5 m),
+ short term borrowings ($10 m)
+ 10% of checkable deposits ($1.5 m)
+ 20% of savings deposits ($3 m)
= $5m+$25m+$5m+$10m+10%$15m+20%$15m
RSL = $49.5m
Income Gap Analysis
if i  1%  Asset Income = +1%  $32.0m = +$ 0.32m
Liability Costs = +1%  $49.5m = +$ 0.495m
Change in Income = $0.32m − $ 0.495m = −$ 0.175m
Another way to show what happens to the bank:

GAP = RSA − RSL = $32.0m −$49.5m = −$17.5m
∆ Income = GAP  ∆ i = −$17.5m  1% = −$0.175m
If RSL > RSA (GAP<0), i  results in Income 

NIM=(interest income - interest expense)/bank assets
Net interest margin: 1% rise in interest rates has resulted in a
decline of the NIM by 0.175% (=-$0.175m/$100m)
This is essentially a short-term focus on interest-rate risk
exposure. Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
• Strategies for Managing Interest-Rate Risk using

GAP income analysis
─ To completely immunize income from interest-rate risk, set

GAP = 0 or RSA = RSL
─ To improve income when interest-rate change
• Strategies to completely immunize income from interest-
rate risk
In case of the First National Bank: RSA = $32m, RSL =$49.5m
Then manager should:
 increase RSA to 49.5 by
 increase short term or variable-rate assets (offer more short term
loans, offer more floating mortgages)
 Calculate and point out the exact numbers
 reduce RSL to 32 by
 decrease short term or variable-rate liabilities (buy back short term
debt instruments issued by the bank, pay back floating rate
borrowing).
 Calculate and point out the exact numbers
– Pls note that: find suitable rate-sensitive assets and liabilities,
then decide to buy/sell/borrow/lend the required amount
to make RSA=RSL
• Strategies To improve income when interest-rate is going to change
GAP = RSA − RSL ∆ Income = GAP  ∆i

∆i GAP Improve income (make ∆ Income >0) by altering
Rate-sensitive Assets Rate-sensitive Liabilities
>0 Increase RSA by Lower RSL by paying/buying
>0 or offering/issuing more back short-term or floating rate
Interest <0 short term or floating rate borrowings/debt instruments
rate is loans/debt instruments issued by the bank
going to
rise
Lower RSA by increase RSL by
<0 >0 offering/issuing less short borrowing/issuing more short-
Interest or term or floating rate term or floating rate
rate is <0 loans/debt instruments borrowings/debt instruments
going to
fall
Duration Gap Analysis
Duration review
• Duration measures how long it takes, in years, for an investor
to be repaid the bond’s price by the bond’s total cash flows.
• Estimate the sensitivity of the price of a bond or other debt
instrument to a change in interest rates.
• Duration vs Maturity: both in years, buts
 Maturity: unchanged
 Duration: depends on cash flows
More cash flows before maturity
Quicker the bondholder get their
money back
Less risk on interest changes
Shorter duration
Duration = maturity with Zero coupon bond
Duration and Interest-Rate Risk
•DUR

+ (positively) - (negatively)
Duration can be used to show that the approximate
change in price is related to duration, as follows:
• %∆Price = − DUR × (∆i /(1 + i))
• i  10% to 11%: ∆i = 1%
Maturity Coupon Duration Price change
10 years 10% 6.76 -6.15% (1)
10 years 20% 5.98 -5.44% (2)
(1) %∆Price = −6.76 × (0.01 / 1.10) = −6.15%

(2) %∆Price = −5.98 × (0.01 / 1.20) = −5.44%
Duration and Interest-Rate Risk (2 of 3)
• The greater the duration of a security, the greater the percentage
change in the market value of the security (price) for a given
change in interest rates => the greater its interest-rate risk
• The duration of a portfolio of securities is the weighted-
average of the durations of the individual securities, with the
weights equaling the proportion of the portfolio invested in each
security
• A manager of a financial institution X is holding 25% of a portfolio
in a bond with a five-year duration and 75% in a bond with a 10-
year duration. What is the duration of the portfolio?
• The duration of the portfolio is (0.25*5) + (0.75*10) = 1.25+7.5
= 8.75 years
• Duration Gap Analysis: measures the sensitivity of a
bank’s current year net worth to changes in interest rate. This is
a long-term focus on interest-rate risk exposure.
• Steps:
– Determine the duration for assets and liabilities.
– Calculate duration gap:
– Calculate change in the
market value of net worth
as a percentage of assets
• change in net worth as % of assets
Amount Duration Weighted
($ millions) (years) Duration (years)
Assets
Reserves and cash items 5 0.0 0.00
Securities
Less than 1 year 5 0.4 0.02
1 to 2 years 5 1.6 0.08
Greater than 2 years 10 7.0 0.70
Residential mortgages
Variable rate 10 0.5 0.05
Fixed rate (30-year) 10 6.0 0.60
Commercial loans
1 to 2 years 10 1.4 0.14
Physical capital 5 0.0 0.00
Average duration 100 2.70
Amount Duration Weighted
($ millions) (years) Duration (years)
Liabilities
Checkable deposits 15 2.0 0.32
Money market deposit
accounts 5 0.1 0.01
Savings deposits 15 1.0 0.16
CDs
Variable rate 10 0.5 0.05
1 to 2 years 5 1.2 0.06
Fed funds 5 0.0 0.00
Borrowings
1 to 2 years 5 1.3 0.07
Average duration 95 1.03
• For First National Bank, with a rate change from 10% to
11%, these equations are:
DURgap = DURa − (L/A × DURl)
= 2.7 − (95/100 × 1.03) = 1.72 years
Change in Net Worth as % of asset = −DURgap × Δi / (1+i)
= −1.72 × 0.01 / 1.10 = −1.56% of assets

• Firth National Bank asset is $100m. For a rate change from 10%
to 11%, the net worth of First National Bank will fall, changing
by −$1.56m (=$100m x (-1.56%)).
• Recall from the balance sheet that First National Bank has “Bank
capital” totaling $5m. Following such a dramatic change in rate,
the capital would fall to $3.44m.
• Problems with GAP Analysis
─ Assumes slope of yield curve unchanged and flat (the
level of interest rates changes, interest rates on all
maturities change by exactly the same amount)
─ Manager estimates % of fixed rate assets and liabilities
that are rate sensitive based on experience and statistic
data
• Managing interest rate risk
─ To completely immunize net worth from interest-rate
risk, set DURgap = 0 or DURa - L/A × DURl = 0
─ To improve the Networth market value when interest
rate changes
•• Strategies for Managing Interest-Rate Risk
– To completely immunize net worth from interest-rate risk,
set DURgap = 0 = DURa - L/A × DURl
In case of the First National Bank: DURa = 2.7
L/A × DURl = 0.95 * 1.03=0.98, the manager should:
 shorten duration of bank assets:
 Increase assets with short duration instead of long duration
 Choose the asset with higher coupon and high frequency of
coupon payment
 lengthen duration of bank liabilities:
 Increase liabilities with long duration instead of short duration
 Choose the liabilities with longer time to maturity, less coupon
and less frequency of coupon payment, …)
DUR
+ (positively) - (negatively)
• Strategies for improving net worth market value when
interest rate is forecasted to changes
DURgap = DURa - L/A × DURl
∆i Dur Improve net worth (make ∆ NW more positive or less negative)

GAP by altering
Asset duration DURa Liability duration DURl
>0 Decrease DURa by Increase DURl by More long
Interest >0 More short duration assets duration liabilities instead of short
rate is or instead of long duration: duration: borrow long rather than
going to <0 lending more shorter term loans borrow short term
rise rather than long term loans
<0 Increase DURa Decrease DURl
Interest >0 More long duration assets More short duration liabilities
rate is or instead of short duration: invest instead of long duration: issue
going to <0 in zero coupon bond instead of more bond with annual coupon
fall annual coupon bonds with the payment rather than zero coupon
same maturity bonds with the same maturity
Excel file has been uploaded in MSTeam/Files: Simulation of risk analysis C23.xlsx
Decrease in absolute Increase in absolute

value = Less negative value = More negative
When changing data in cells, pls check condition
DUR gap<0 => ABS(DUR gap)= L/A x DUR L – DUR A

Chapter Summary
• Managing Credit Risk:
– adverse selection and moral hazard explain the origin of
many credit risk management principles.
– Managing credit risk is a continuous process from KYC to
credit rationing
• Managing Interest-Rate Risk: the essential

techniques of measuring interest-rate risk for both income
(Income gap) and (capital duration gap) affects were
presented.
– RSA < RSL => a rise in interest rates will reduce income
and a fall in interest rates will raise it and vice verse to
the case of RSA > RSL
– To reduce the interest rate risk, managers try to balance
RSA and RSL, as well as bring Duration Gap close to 0.
choose the right assets and liabilities

Week 13 Chapter 23

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Week 13 Chapter 23

Uploaded by

Copyright:

Available Formats

Financial

• Financial institution’s risks overviews

Risk Risk Risk

Determine Effective Set risk limit through

• Financial institution’s risks overviews

Set up loan Structure the payment

• Financial institution’s risks overviews

• Why does it matter?

Reserves and cash items $5 million Checkable deposits $15 million

Reserves and cash items $5 million Checkable deposits $15 million

Another way to show what happens to the bank:

If RSL > RSA (GAP<0), i  results in Income 

• Strategies for Managing Interest-Rate Risk using

─ To completely immunize income from interest-rate risk, set

─ To improve income when interest-rate change

GAP = RSA − RSL ∆ Income = GAP  ∆i

(1) %∆Price = −6.76 × (0.01 / 1.10) = −6.15%

• change in net worth as % of assets

DURgap = DURa − (L/A × DURl)

= 2.7 − (95/100 × 1.03) = 1.72 years

Change in Net Worth as % of asset = −DURgap × Δi / (1+i)

= −1.72 × 0.01 / 1.10 = −1.56% of assets

∆i Dur Improve net worth (make ∆ NW more positive or less negative)

Decrease in absolute Increase in absolute

When changing data in cells, pls check condition

DUR gap<0 => ABS(DUR gap)= L/A x DUR L – DUR A

• Managing Interest-Rate Risk: the essential

You might also like