risks of financial intermediation chapter 7 © 2006 the mcgraw-hill companies, inc., all rights...
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Risks of Financial Risks of Financial IntermediationIntermediation
Chapter 7
© 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
K. R. Stanton
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Overview
This chapter discusses the risks associated with financial intermediation: Interest rate risk, market risk, credit risk,
off-balance-sheet risk, technology risk, operational risk, foreign exchange risk, country risk, liquidity risk, insolvency risk
Note that these risks are not unique to FIs Faced by all global firms
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Risks of Financial Intermediation
Interest rate risk resulting from intermediation: Mismatch in maturities of assets and liabilities.
Interest rate sensitivity difference exposes equity to changes in interest rates
Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs.
Inconsistent with asset transformation role
Refinancing risk. Reinvestment risk.
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Market Risk
Incurred in trading of assets and liabilities (and derivatives). Examples: Barings & decline in ruble. DJIA dropped 12.5 percent in two-week period
July, 2002. Heavier focus on trading income over traditional
activities increases market exposure. Trading activities introduce other perils as was
discovered by Allied Irish Bank’s U.S. subsidiary, AllFirst Bank when a rogue trader successfully masked large trading losses and fraudulent activities involving foreign exchange positions
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Market Risk
Distinction between Investment Book and Trading Book of a commercial bank Heightened focus on Value at Risk (VAR) Heightened focus on short term risk measures
such as Daily Earnings at Risk (DEAR) Role of securitization in changing liquidity of
bank assets and liabilities
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Credit Risk
Risk that promised cash flows are not paid in full. Firm specific credit risk Systematic credit risk
High rate of charge-offs of credit card debt in the 1980s, most of the 1990s and early 2000s
Credit card loans (and unused balances) continue to grow
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Implications of Growing Credit Risk
Importance of credit screening Importance of monitoring credit extended Role for dynamic adjustment of credit risk
premia Diversification of credit risk
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Off-Balance-Sheet Risk
Striking growth of off-balance-sheet activities Letters of credit Loan commitments Derivative positions
Speculative activities using off-balance-sheet items create considerable risk
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Technology and Operational Risk
Risk of losses 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 houses (ACH) CHIPS Real time interconnection of global FIs via
satellite systems
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Technology and Operational Risk
Risk that technology investment fails to produce anticipated cost savings.
Risk that technology may break down. CitiBank’s ATM network, debit card system and
on-line banking out for two days Wells Fargo Bank of New York: Computer system failed to
recognize incoming payment messages sent via Fedwire although outgoing payments succeeded
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Technology and Operational Risk
Operational risk not exclusively technological Employee fraud and errors Losses magnified since they affect reputation
and future potential Merrill Lynch $100 million penalty
Economies of scale. Economies of scope.
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Foreign Exchange Risk
FI may be net long or net short in various currencies
Returns on foreign and domestic investment are not perfectly correlated.
FX rates may not be correlated. Example: $/€ may be increasing while $/¥
decreasing and relationship between ¥ and € time varying.
Undiversified foreign expansion creates FX risk.
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Foreign Exchange Risk
Note that completely hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well*. Otherwise, exposure to foreign interest rate risk
is remains.
*More correctly, FI must match durations, rather than maturities. See Chapter 9.
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Country or Sovereign Risk
Result of exposure to foreign government which may impose restrictions on repayments to foreigners.
Often lack usual recourse via court system. Examples:
Argentina Russia South Korea
• Indonesia• Malaysia• Thailand.
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Country or Sovereign Risk
In the event of restrictions, reschedulings, or outright prohibition of repayments, FIs’ remaining bargaining chip is future supply of loans Weak position if currency collapsing or
government failing Role of IMF
Extends aid to troubled banks Increased moral hazard problem if IMF bailout
expected
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Liquidity Risk
Risk of being forced to borrow, or sell assets in a very short period of time. Low prices result.
May generate runs. Runs may turn liquidity problem into solvency
problem. Risk of systematic bank panics. Example: 1985, Ohio savings institutions
insured by Ohio Deposit Guarantee Fund Interaction of credit risk and liability risk
Role of FDIC (see Chapter 19)
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Insolvency Risk
Risk of insufficient capital to offset sudden decline in value of assets to liabilities. Continental Illinois National Bank and Trust
Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.
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Risks of Financial Intermediation
Other Risks and Interaction of Risks Interdependencies among risks.
Example: Interest rates and credit risk. Interest rates and derivative counterparty risk
Discrete Risks Example: Tax Reform Act of 1986. Other examples include effects of war or terrorist
acts, market crashes, theft, malfeasance. Changes in regulatory policy
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Macroeconomic Risks
Increased inflation or increase in its volatility. Affects interest rates as well.
Increases in unemployment Affects credit risk as one example.
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Pertinent Websites
Bank for International Settlements www.bis.org
Board of Governors of the Federal Reserve www.federalreserve.gov
Federal Deposit Insurance Corporation www.fdic.gov