Risks of Financial Intermediation

Finance 129

Common Risks

All Financial Intermediaries face similar risks.The importance of each type of risk depends upon business lines.Today – Intro to the types of risk present.The remainder of the semester is spent detailing each type of risk and discussing management techniques used by firms to limit the impact of each risk.

Interest Margin Income

Earning income from a difference in the rate paid to borrow versus the rate earned on financial assets.Difference is a result of intermediary roleBank Example

Interest Income on loans vs. Interest Expense on borrowing

Interest Rate Risk

Mismatch of Asset and Liability maturitesInterest rates on both Assets and Liabilities are tied to the length of the commitments.Interest rate risk results from a mismatch in maturities of assets and liabilities.

Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs.

Refinancing risk.Reinvestment risk.

Interest Rate RiskMismatch of Assets and Liabilities

Bank – Borrowing Short Term and Lending Long TermInsurance – Earning interest income to meet future long term liabilities.

Interest Rate Risk: Refinancing Risk

Assume you have $100 million in liabilities financed at 9% per year and the rate that you pay resets at the end of the year. Your FI also has $100 million in assets that mature in 2 years paying 10% per year.

What happens if the interest rate increases?

Interest Rate Risk:Reinvestment Rate Risk

Assume you have $100 million in liabilities financed at 9% per year that mature in 2 years. Your FI also has $100 million in assets that mature in 1 years financed at a cost of 10% per year.

What happens if the interest rate decreases?

Matching Maturities

It is difficult for the FI to match maturities and it may not eliminate interest rate risk anyway:

Not consistent with asset transformation planMatching maturities may reduce profitability (one of the functions of intermediation is accepting some of this risk. Assets are financed with both debt and equityDuration and Portfolios

Interest Rate Risk:Market Value Risk

Market value is tied to the level of interest rates and overall economic environment.As rates increase market value decreases, as rates decrease market value increases.

Broad rate changes are linked to economic environmentThe impact of rate changes is tied to maturity

Market Risk: General

The combination of interest rate, foreign exchange, and equity return risks are combined with an active trading strategy.

Greater reliance on trading income rather than traditional activities has increased market exposure for FI’s.Anytime an FI takes an unhedged speculative position it is exposed to market risk

Credit Risk

Risk that promised cash flows are not paid in full.

Firm specific credit riskSystematic credit riskHigh rate of charge-offs of credit card debt in the 80s and 90sObvious need for credit screening and monitoringDiversification of credit risk

Off-Balance-Sheet Risk

Risk associated with contingent claims that do not show up on the balance sheet. It is not on the Balance sheet since it does not involve holding a current primary claim or issuing a current secondary claim. Increased importance of off-balance-sheet activities

Letters of creditLoan commitmentsDerivative positions

Speculative activities using off-balance-sheet items create considerable risk

Technology and Operational Risk

Risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and systems or from external events.

Some include reputational and strategic risk

Technological innovation has seen rapid growth

Automated clearing housesCHIPS

Technology and Operational Risk

Technology Risk: Technology investment may fail to produce anticipated cost savings.Operational Risk: The risk that support systems (often based on new technology) may break down.

Bank of New York – failed to register incoming payments on Fedwire, but continued to process outgoing paymentsFraud and other back office issues are also operational risk

Economies of Scale and Scope

Economies of Scale: Goal of the FI is to lower its average cost per unit via new technology or operations

Economies of Scope: The generation of cost synergies by offering more services using the same inputs

Foreign Exchange Risk

Foreign Assets and Foreign Liabilities change in value with changes in exchange rates.Net Long Asset Position – Exposure to foreign denominated assets is greater than foreign liabilitiesNet Short Asset Position – Exposure to foreign denominated assets is less than exposure to foreign liabilities

Foreign Exchange Risk

Returns on foreign and domestic investment are not perfectly correlated.

FX rates may not be correlated.Example: $/DM may be increasing while $/¥ decreasing.

Foreign Exchange Risk

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.

Country or Sovereign Risk

Result of exposure to foreign government or legal systems which may impose restrictions on repayments to foreigners.Lack usual recourse via court system.Foreign credit Risk and the current European Debt Crisis – restructure risk

Liquidity Risk

Risk of being forced to borrow, or sell assets in a very short period of time due to needed cash.

Low prices result.

May generate runs.Runs may turn liquidity problem into solvency problem.Risk of systematic bank panics.

Insolvency Risk

Risk of insufficient capital to offset sudden decline in value of assets to liabilities.

Based on basic balance sheet

Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.

Risks of Financial Intermediation

Other Risks and Interaction of RisksInterdependencies among risks.

Example: Interest rates and credit risk.

Discrete RisksExample: Tax Reform Act of 1986.Other examples include effects of war, market crashes, theft, malfeasance.

Macroeconomic Risks

Increased inflation or increase in its volatility.

Affects interest rates as well.

Increases in unemployment Affects credit risk as one example.

Changes in Consumer ConfidenceChanges in home building

Risk Management Techniques

Deciding what risks to accept and how to manage themSet Asides

Financial firms often set aside funds to cover potential losses, this requires the ability to estimate the possibility and size of loss

Limits on Risky PositionsHedgingBusiness Lines vs. Total Operations

Risk Measurement Tools

Value at Risk and Earnings at RiskModels that predict the probability and magnitude of potential loss from market risk

Stress TestingWhat is the worst case Scenario

GAP, Duration GAPFinancial Statement AnalysisImpact of Regulation

*Cumming and Hirtle, The Challenges of Risk Management in Diversified Financial Companies.*Cumming and Hirtle, The Challenges of Risk Management in Diversified Financial Companies.

Consolidated Risk Management

“A coordinated process of measuring and managing risk on firm wide basis.”*Requires a system that includes identification of risks, measurement of risk, methods for controlling the level of risk accepted, checks and balances, review and oversight at all levels of management (including the board of directors)

Benefits of Consolidating Risk Management

Diversification benefits are ignored without consolidation, leading to increased risk management costsLack of coordination can increase firm wide risk in times of market problems (unwinding similar position in different business lines for example).Without consolidation contagion risks are ignored Improves the “internal capital market” of the firm.Promote more transparency and better risk analysis by creditors.

Barriers to Consolidated Risk Management

Consolidation of financial firms has produced increased product and geographic diversification which has made business wide risk management more difficult.Information Costs

The cost of integrating, recording and analyzing risk across separate business lines.

Barriers to Consolidated Risk Management

Regulatory CostsConsolidation has created a framework where firms are required to respond to multiple regulators. Capital and Liquidity requirements may prohibit the movement of funds from one business line to another.Cost associated with managing the separate regulatory requirements including opportunity costs