20240312_125.364 Topic03

SCHOOL OF ECONOMICS & FINANCE
Topic 3
Risks of financial institutions
Financial Institutions Management (10th ed.)

Chapter 7
1
Outline
• Introduction
• Interest rate risk
• Market risk
• Credit risk
• Climate risk
• Off-balance-sheet risk
• Foreign exchange risk
• Country or sovereign risk
• Technology and operational risks
• Liquidity risk
• Insolvency risk
• Other risks and the interaction of risks
• Summary
4-2
Introduction
4-3
Interest rate risk

• Interest rate risk is the risk incurred by an FI if it
mismatches the maturities of its assets and
liabilities.
• Refinancing risk: the costs of rolling over funds or

re-borrowing funds will rise above the returns
generated on investments. When maturity of assets are longer
than that of liabilities.
• Reinvestment risk: the returns on funds to be

reinvested will fall below the cost of funds.
When maturity of liabilities are longer than that of asset.
4-4
Interest rate risk (cont)

Example:
An FI grants a five-year maturity loan at a fixed rate of 12

per cent p.a. and funds the loan with one-year maturity
fixed-rate term deposits that pay 10 per cent p.a.
Is the FI exposed to increasing or decreasing interest rates?
Would the FI still be exposed to the same risks if the loan

had a one-year maturity, while the maturity of deposits was
three years?
15-5
Interest rate risk

Solution:
The FI is exposed to increasing interest rates and refinancing
risk.
In this case, the FI would be exposed to decreasing interest rates

and reinvestment risk.
4-6
Interest Rate Risk (cont.)

• Repricing gap model: to determine how much net
interest income will vary with movements in market
interest rates. Will discuss in detail in next topic.
Financial statements checkpoint:

A bank’s net interest sensitivity position, or the fund of gap
between assets and liabilities, is approximated by comparing
the dollar amount of assets with liabilities that can be repriced
over similar time frames.
7
Example 2
A FI has the following market value B/S structure:
Assets Liabilities and equity

Cash $1,000 Certificate of deposit $10,000
Bond 10,000 Equity 1,000
Total assets $11,000 Total liabilities and equity $11,000
The bond has a 10-year maturity and a fix-rate coupon of 10%. The certificate
of deposit has a one-year maturity and a 6% fixed rate of interest. The FI
expects no additional asset growth.
1) What will be the net interest income at the end of the first year?
Net interest income = interest income – interest expense

8
Example 2 (cont.)
2) If at the end of year one market interest rates have increases 100
basis points (1%), what will be the net interest income for the
second year? Is this result caused by reinvestment risk or
refinancing risk?
Net interest income = (10000×0.1) – (10000×0.07) = $300
The decrease in net interest income is caused by the increase in

financing cost without a corresponding increase in the earning rate.
 refinancing risk.
9
Interest rate risk

• Change in interest rate cause market value risk as well.
• As interest rates increase, the market value of assets and liabilities

decreases.
• As interest rates decrease, the market value of assets and liabilities

increases.
• If the FI mismatches the maturities of its assets and liabilities, the

change in the market value of assets and liabilities will not be the same.
• As E = A – L, changing interest rates can have an adverse impact on the

FI's net worth.
4-10
Example 3
Refer to Example 2.
1) Assume that market interest rates increase 1%, the bond will have a value
of $9446 at the end of year one. What will be the market value of equity
for the FI?
Equity = assets – liabilities = (1000+9446) – 10000 = $446
2) If market interest rates had decreased 100 basis points by the end of year
one, would the market value of equity be higher or lower than $1000?
Why?
Equity will be higher than $1000 because the value of bond would be higher
and the value of CD would remain unchanged. 11
Interest rate risk

Assume the maturity of assets exceeds the
maturity of liabilities:
 a. An increase in interest rates causes a fall in the

market value of both assets and liabilities, but assets
are more severely affected.
☺
b. A decrease in interest rates causes an increase in
the market value of both assets and liabilities, and
liabilities will increase less than assets.
4-12
Interest rate risk

Assume the maturity of liabilities exceeds the
maturity of assets:
☺ a. A decrease in interest rates causes a rise in the

market value of both assets and liabilities, but
liabilities are more severely affected.

b. An increase in interest rates causes a fall in the
market value of both assets and liabilities, and assets
will decrease less than liabilities.
4-13
Interest rate risk

• How to protect against interest rate risk?
match the maturities of assets and liabilities.
• However, balance sheet hedging by matching maturities of

assets and liabilities is problematic for FIs.
– Lose the asset-transformation function. (May also reduce
profitability.)
– Hedge is done approximately rather than completely due to different
average life/maturity/duration between assets and liabilities, and the
existence of equity.
• For most FIs the maturity of assets exceeds the maturity of

liabilities.
4-14
Market risk
• This is the risk incurred when trading assets and liabilities.
• Risk is incurred due to changes in interest rates, exchange

rates or other asset prices (such as equity).
• Example of the dangers of market risk:

– Barings Bank collapsed due to a wrong bet on the movement of
the Japanese Nikkei Stock Market Index.
– A single individual caused losses that forced the bank into
insolvency.
– See www.riskglossary.com/link/barings_debacle.htm
4-15
Market risk (cont)
• FI’s trading portfolio can be differentiated from its

investment portfolio on the basis of time horizon and
secondary market liquidity.
15-16
Market Risk (cont.)

Banks often conduct value-at-risk (VaR) analyses to assess the
risk of loss with their portfolios of trading assets and hold
specific amounts of capital in support of this market risk.
(VaR analysis is beyond the scope of this paper.)
• How to protect against market risk?

Þ FIs should limit positions taken by traders, and to develop
models to measure the market risk exposure on a day-to-day
basis.
17
Credit risk
• This is the risk that promised cash flows on loans and securities held by
the FI are not repaid in full.
• Most financial claims held by FIs offer limited upside risk and a large
downside risk.
• Limited upside risk: principal and interest payment.
• Downside risk: loss of loan principal and promised interest.
• Examples:
– fixed-income coupon bonds
– bank loans
4-18
Credit risk
• Two different types of credit risk:
– firm-specific credit risk
– systematic credit risk (e.g. economic recession)
• Firm-specific credit risk affects a particular company.

• Systematic credit risk affects all borrowers.
• Firm-specific credit risk can be managed through

diversification.
4-19
Credit Risk (cont.)

1. What has been the historical loss rate on loans and
investment?
• Net losses to average total loans
• Gross losses to average total loans
• Recoveries to average total loans
• Recoveries to prior period losses
• Net losses by types of loans
20
Credit Risk (cont.)

2. What losses are expected in the future?
• Non-performing loans to total loans
• Total past due loans to total loans
• Restructured loans to total loans
• Past due loans by loan type
Past-due loans: loans for which contracted interest and principal payments
have not been made but are still accruing interest. Often separated into less
and over 90 days.
Non-performing loans: loans that are more than 90 days past due plus
nonaccrual/impaired loans.
Restructured loans: lenders have modified the required payments on
principal or interest.
21
Credit Risk (cont.)

3. How prepared is the FI to weather the losses?
• Provision for loan losses (“loan losses expenses”) to average
asset
• Loan allowance (“loan loss reserve”) to total loans
• Loan allowance to net losses
• Earning coverage of net losses
4. Other checkpoints:
• Concentration/diversification
• Loan growth rate
22
Country or sovereign risk

• The risk that repayments from foreign borrowers may be
interrupted.
– A different type of credit risk
• These interruptions may be caused, for instance, by the

interference of foreign governments.
• Note that hedging foreign exposure by matching foreign

assets and liabilities requires matching the maturities as well.
– Otherwise, exposure to foreign interest rate risk is created.
e.g. government prohibits or limits
debt repayment due to foreign
currency shortage 4-23
Country or sovereign risk

• Example: In 1982 the Mexican and Brazilian
Governments announced a debt moratorium on
Western creditors.
• This debt moratorium caused significant losses
in some of the lending banks, such as Citicorp
(now Citigroup).
• There is little recourse for lenders if a foreign
government restricts repayments in form of
rescheduling or outright prohibitions to repay.
4-24
Foreign exchange risk

• The risk that changes in exchange rates may adversely
affect the value of an FI's assets and/or liabilities.
• Returns on foreign and domestic investment are not

perfectly correlated.
• FX rates may not be correlated.

– example: A$/€ may be increasing while A$/¥ is decreasing
• Undiversified foreign expansion creates FX risk.
4-25
Foreign exchange rate risk

• FI becoming increasingly global in its outlook and to
expand abroad directly through branching or
acquisitions,
• or by developing a financial asset portfolio that includes

foreign securities as well as domestic securities.
• Foreign investment can adversely affect the value of an

FI’s assets and liabilities denominated in foreign
currencies.
15-26
Foreign Exchange Risk (cont.)

• Assume a net long position in foreign currency (i.e. assets in
foreign currency > liabilities in the same foreign currency):
– A depreciation in the foreign currency (or, an appreciation in local

currency) will decrease the value of assets more than of liabilities.
• Assume a net short position in foreign currency (i.e. assets
in foreign currency < liabilities in the same foreign
currency):
– An appreciation in the foreign currency (or, a depreciation in local

currency) will increase the value of liabilities more than of assets.
27
Foreign Exchange Risk (cont.)

• How to protect against foreign exchange risk?
Þ By matching size of foreign assets and liabilities.
• Notice that hedging foreign exposure by matching foreign
assets and liabilities requires matching the maturities as
well. Otherwise, exposure to foreign interest rate risk is
created.
28
Liquidity risk
• The risk that a sudden surge in liability withdrawals may
pressure the FI into liquidating parts of its assets.
– Depositors at banks or insurance policy holders at Insurance
companies
• The liquidation of assets may have to happen in a very

short period and at very low prices.
“Fire sale”
• Problematic for illiquid assets such as loans.

Due to timing mismatch of CFs (i.e. maturity transformation)
• Serious liquidity problems can cause a 'run' on the FI. 4-29

Liquidity risk
• Day-to-day withdrawals by liability holders are
generally predictable, and FIs can normally expect to
borrow additional funds to meet any sudden shortfalls
of cash on the money and financial markets
• A 'run' can turn a simple liquidity problem into a

solvency problem, and might threaten the FI's
survival. Bank run: a sudden and unexpected increase in deposit
withdrawals from a depository institution.
Bank panic: a systemic or contagious run on the deposits of the
banking industry as a whole.
• Risk of systematic bank panics. 15-30

Climate-related Risk
• Physical risks: risks related to the physical
impacts of climate change e.g. instances severity
of cyclones,
hurricanes, floods, etc.
– Acute risk: extreme weather events
– Chronic risk: longer-term shifts in climate
patterns
e.g. sustained higher temperatures,
sea level rises, heat waves, etc.
31
Climate-related Risk (cont.)
• Transition risks: risks related to the
transition to a lower-carbon economy
e.g. carbon pricing and
– Policy and legal risk reporting obligation
– Technology risk e.g. unsuccessful investment
in new technologies
– Market and reputation risk
e.g. changes in market preference, including:
1) shifts supply and demand for certain commodities
2) changing customer/community perception
32
Source: TCDF (2022)
33
All registered banks with total assets of more than $1 billion are required
to start making climate-related disclosures for financial years commencing
in 2023, with disclosures being made in 2024 at the earliest.
Source: TCFD (2017)

34
FinTech Risk
• Financial technology, or FinTech, refers to the use of technology to
deliver financial solutions in a manner that competes with
traditional financial methods.
• Financial technology, or FinTech, refers to the use of technology to

deliver financial solutions in a manner that competes with
traditional financial methods.
• FinTech Risk involves the risk that FinTech firms could disrupt
business of financial services firms in the form of lost customers
and lost revenue
– broader and wider ranging than technology risk.
4-36
Off-balance-sheet risk
• Arises if FIs enter into contingent liability or asset
contracts.
• Increased importance of off-balance-sheet activities:

– letters of credit
– loan commitments
– derivative positions
• Speculative activities using off-balance-sheet items

create considerable risk.
4-37
Technology and operational risks

• According to the Bank for International Settlements
(BIS), operational risk (inclusive of technological risk) is
defined as ‘the risk of direct or indirect loss resulting from
inadequate or failed internal processes, people and
systems or from external events’.
• Some FIs include reputational and strategic risk.
• Technological innovation has seen rapid growth:

– Automated Clearing /houses (ACH)
– CHIPS (Clearing House Interbank Payment System)
4-38
• Major objectives of technological expansion:

– to lower operating costs
– to increase profits
– to capture new markets for the FI
• Economies of scale imply an FI's ability to lower its average

costs of operations by expanding its output to financial services.
• Economies of scope imply an FI's ability to generate cost

synergies by producing more than one output with the same
inputs.
4-39

• Technology risk: technological investments may
not produce the cost savings anticipated, e.g.
diseconomies of scale.
• Operational risk: existing technology or support

systems may malfunction or break down.
• Operational risk also includes fraud and errors.
4-40
Insolvency risk
• The risk that an FI may not have sufficient capital to offset
a sudden decline in its asset values relative to its
liabilities.
• Original cause may be excessive interest rate, or market,

credit, off-balance-sheet, technological, FX, sovereign,
and liquidity risks.
• Both FI management and regulators focus on an FI's

capital and capital adequacy as key measures to ensure FI
solvency.
4-41
Other risks and the interaction of risks

• Most risks are correlated or interdependent:
– example: liquidity risk is related to interest rate risk and
credit risk
• Other risks, such as discrete or event-type risks, may

impact on the FI's profitability and risk exposure.
• Regulatory changes or sudden changes in the economic

or financial environment are types of discrete risk.
– example: Stock market collapses in 1929 and 1987
4-42
Other risks and the interaction of risks

• Macroeconomic risks can directly or indirectly
impact on an FI's level of interest rate, credit and
liquidity risk exposure.
• Increased inflation or an increase in its volatility.

– Affects interest rates.
• Increase in unemployment
– Affects credit risk, among other things.
4-43
Example 6
Characterise the risk exposure(s) of the following FI
transactions by choosing one or more of the risk types
listed below:
(a) interest rate risk
(b) credit risk
(c) off-balance-sheet risk
(d) technology risk
(e) foreign exchange rate risk
(f) country or sovereign risk
44
interest rate, credit 1) A bank finances a $10 million, 6-year fixed-rate

commercial loan by selling one-year certificate of
deposit.
interest rate, credit
2) An insurance company invests its policy premiums
in a long-term municipal bond portfolio.
credit, FX, country 3) A French bank sells 2-year fixed-rate notes to

finance a 2-year fixed-rate loan to a British
entrepreneur.
credit, off-B/S
4) A mutual fund completely hedges its interest rate
risk exposure using forward contingent contracts.
interest rate, credit, 5) A NZ bond dealer uses his own equity to buy
FX, country Mexican debt on the less-developed country bond
market.
45
Summary
• This chapter introduces the fundamental risks faced by
modern FIs.
• We identify the key features of the risks FIs face in the

modern financial world.
• We learn about the key sources of these risks.
• We gain a basic understanding of the variety and

complexity of these risks.
4-46

20240312_125.364 Topic03

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

20240312_125.364 Topic03

Uploaded by

Copyright:

Available Formats

SCHOOL OF ECONOMICS & FINANCE

Financial Institutions Management (10th ed.)

Interest rate risk

• Refinancing risk: the costs of rolling over funds or

• Reinvestment risk: the returns on funds to be

Interest rate risk (cont)

An FI grants a five-year maturity loan at a fixed rate of 12

Is the FI exposed to increasing or decreasing interest rates?

Would the FI still be exposed to the same risks if the loan

Interest rate risk

In this case, the FI would be exposed to decreasing interest rates

Interest Rate Risk (cont.)

Financial statements checkpoint:

Assets Liabilities and equity

Net interest income = interest income – interest expense

Net interest income = (10000×0.1) – (10000×0.07) = $300

The decrease in net interest income is caused by the increase in

Interest rate risk

• As interest rates increase, the market value of assets and liabilities

• As interest rates decrease, the market value of assets and liabilities

• If the FI mismatches the maturities of its assets and liabilities, the

• As E = A – L, changing interest rates can have an adverse impact on the

Equity = assets – liabilities = (1000+9446) – 10000 = $446

Interest rate risk

 a. An increase in interest rates causes a fall in the

Interest rate risk

☺ a. A decrease in interest rates causes a rise in the

Interest rate risk

• However, balance sheet hedging by matching maturities of

• For most FIs the maturity of assets exceeds the maturity of

• Risk is incurred due to changes in interest rates, exchange

• Example of the dangers of market risk:

Market risk (cont)

• FI’s trading portfolio can be differentiated from its

Market Risk (cont.)

Financial statements checkpoint:

• How to protect against market risk?

• Limited upside risk: principal and interest payment.

• Downside risk: loss of loan principal and promised interest.

• Firm-specific credit risk affects a particular company.

• Firm-specific credit risk can be managed through

Credit Risk (cont.)

Credit Risk (cont.)

Credit Risk (cont.)

Country or sovereign risk

• These interruptions may be caused, for instance, by the

• Note that hedging foreign exposure by matching foreign

Country or sovereign risk

Foreign exchange risk

• Returns on foreign and domestic investment are not

• FX rates may not be correlated.

• Undiversified foreign expansion creates FX risk.

Foreign exchange rate risk

• or by developing a financial asset portfolio that includes

• Foreign investment can adversely affect the value of an

Foreign Exchange Risk (cont.)

Foreign Exchange Risk (cont.)

• The liquidation of assets may have to happen in a very

• Problematic for illiquid assets such as loans.

• Serious liquidity problems can cause a 'run' on the FI. 4-29

• A 'run' can turn a simple liquidity problem into a

• Risk of systematic bank panics. 15-30

Source: TCFD (2017)

• Financial technology, or FinTech, refers to the use of technology to