Overview

2. Overview • This chapter discusses the risks associated with financial intermediation: • Interest rate risk, market risk, credit risk, off-balance-sheet risk, foreign exchange risk, country or sovereign risk, technology risk, operational risk, liquidity risk, insolvency risk • Note that these risks are not unique to FIs • Faced by all global firms

3. 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.

4. Market Risk • Incurred in trading of assets and liabilities (and derivatives). • Example: Barings Bank’s Nick Leeson & decline in Nikkei Stock Market Index. • 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

5. 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

6. 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

7. Charge Off Rates for Commercial Banks

8. 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

9. 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

10. 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.

11. 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 remains. *More correctly, FI must match durations, rather than maturities. See Chapter 9.

12. 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.

13. 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

14. Technology and Operational Risk • Economies of scale. • Economies of scope. • Operational risk not exclusively technological • Employee fraud and errors • Losses magnified since they affect reputation and future potential

15. 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

16. 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 • Prudential Financial fined $600 million due to allegations of improper mutual fund trades • Bank of America breakdown in security of tapes • Bank of New York: Computer system failed to recognize incoming payment messages sent via Fedwire although outgoing payments succeeded

17. 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)

18. 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.

19. 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 • Examples include effects of war or terrorist acts, market crashes, theft, malfeasance. • Changes in regulatory policy

20. Macroeconomic Risks • Increased inflation or increase in its volatility. • Affects interest rates as well. • Increases in unemployment • Affects credit risk as one example.

21. 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