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Managing Financial Institutions I. Performance and Risk in Financial Institutions

Managing Financial Institutions I. Performance and Risk in Financial Institutions Financial institutions attempt to obtain adequate returns on equity capital. This requires managing both return and risk. Return Spread Default Rates

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Managing Financial Institutions I. Performance and Risk in Financial Institutions

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  1. Managing Financial Institutions • I. Performance and Risk in Financial Institutions • Financial institutions attempt to obtain adequate returns on equity capital. This requires managing both return and risk. • Return • Spread • Default Rates • Cost of Operations => Return on Assets (ROA) • Return on Equity (ROE) • Risk • Credit Risk • Interest Rate Risk • Foreign Exchange Risk • Liquidity Risk • Operating Risk

  2. II. Managing Credit Risk • The two types of credit risk are default and price risk. • The key tools of risk reduction are quality standards and diversification. • Market prices of bonds may decrease because of changes in: investor perceptions, supply and demand factors, regulatory policy, etc. • Insert 25.1, 25.2, & 25.3 • These are referred to as systematic credit risk. The risk associated with a specific offering is known as specific credit risk. • Systematic credit risk can be lessened by broad diversification across sectors as well as across firms and ratings. • An institution may reduce credit risk through strong reserves and sufficient equity capital. • Another method is to restrict investment to primarily high grade assets only.

  3. Alternatively, a firm may seek to transfer risk to the liability side, where the investor bears the risk. • III. Managing Interest Rate Risk • Asset/liability management (ALM) deals with managing interest rate risk. • A change in interest rates may cause the value of liabilities to change at a different rate than the value of assets. • By matching the dollar duration of the assets and liabilities we can immunize equity against changing interest rates. • The change in the value of equity due to changes in interest rates is calculated:

  4. Small asset/liability duration mismatches can result in large rate sensitivity of the equity, because equity is small relative to assets. • The sensitivity of equity to interest rate movement is given by: • Effective immunization takes into account the convexities of assets and liabilities. Ideally, the convexity of assets should be greater than that of liabilities. • Insert 25.4 & 25.5 • The passage of time will result in changes in dollar durations and convexities. Periodic rebalancing of portfolios must occur.

  5. IV. Managing Liquidity Risk • Liquidity risk is the sudden need for funds that will put a strain on the institution’s ability to finance itself. • The first type of risk is associated with the need for cash in normal daily operations. • The second type of risk relates to the real or perceived integrity of the asset portfolio. Rumors of declining quality of assets can lead to rapid withdrawals by creditors. • Asset portfolios can be constructed with a portion invested in lower yielding, higher liquidity assets. • These may be divided into primary and secondary reserves which are distinguished by the degree of liquidity.

  6. V. Managing Foreign Exchange Rate Risk • Risk arises when an institution has assets and revenues in one currency(ies) and liabilities and costs in another currency(ies). • A change in the value of one currency will cause a value change. • This risk can be eliminated by denominating all categories in the same currency. • Alternatively, the firm can undertake actions (i.e. currency swaps and/or forward rate agreements) that reduce exposure to foreign exchange rate risk. • Insert 25.6 • Sometimes, exposures in many different currencies can lead to a reduction in risk. This is due to the covariance which we have discussed earlier.

  7. VI. Measuring Potential Loss • How much could the firm lose as a result of risk exposure? • The concept of value-at-risk (VaR) • Insert 25.7 • VII. Passing the Risks Through to Investors • Risk transfer mechanisms come in two forms. • Some assets, created by an institution, are packaged and sold to investors willing to take the risk. Mortgage-backed securities are an example of this type. • Another method is to manage the correlation of returns. An example of this is a mutual fund.

  8. VIII. Differences Between Financial Institutions Some institutions are more prone to certain risks than others. • A. Open-End and Closed-End Mutual Funds • Open-end mutual funds pass all risks through to the investor. • The fund retains some of its funds in short- term, highly liquid securities to meet cash needs associated with withdrawals. • A closed-end fund does not have as great a need for liquidity. Investors merely trade shares which does not entail any liquidation of the portfolio. • B. Pension Plans • A defined benefit plan must take into account the long duration of its liabilities. • Because of the long-term nature of its liabilities, pension plans face little convexity risk and very little liquidity risk. • Defined contribution plans pass most duration risk, convexity risk, and default risk onto the customer.

  9. C. Insurance Companies • Life insurance policies often grant the holder numerous options, such as loan privileges. These options impart a positive convexity to the liabilities. • At the same time, firms invest in assets that have options embedded. The assets therefore have negative convexity. • This combination of assets and liabilities creates a short straddle. If interest rates remain unchanged the firm reaps high profits. If interest rates move, then the surplus is depleted. • Insert 25.8 & 25.9 • Insurance companies generally have low credit risk because they invest in high grade securities. • The lack of federal insolvency guarantees leads investors to worry about the quality of investment portfolios. The possibility of a run compels insurers to hold some liquidity in their portfolios.

  10. D. Commercial Banks • Loan origination and collection have traditionally been sources of credit risk. • The possibility of runs has prompted use of primary and secondary reserves, supplemented by deposit insurance and the discount window. • The interest rate structure of assets and liabilities is reported in the GAP report. The dollar amount of the mismatch is called the GAP. • The banking industry has tended to use GAP analysis instead of duration analysis in the past, but the trend is toward duration analysis. • As the focus on market values increases, duration analysis will become more widespread, and derivatives used. • Insert 25.10 & 25.11 • Commercial banks also have foreign exchange risk. • They manage this through net currency exposure reports and position limits.

  11. E. Thrifts, Credit Unions, and Finance Companies • Other depository institutions’ product lines are becoming similar to commercial banks’. They are therefore subject to the same risks with some exceptions. • Finance companies have substantial exposure to credit risk. • Savings banks and S&Ls often have severe duration mismatches and liquidity risks. The latter are somewhat alleviated by FDIC insurance. • The risks of credit unions tend to be minor. Regulatory oversight is attempting to improve the skills of management staff.

  12. IX. Summary • We have focused on four major types of financial risk and the management techniques employed to deal with these risks. • Increased competition has meant that financial risks must be better managed in order to survive. Survival is, in fact, dependent upon improved risk management.

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