Managing Risks in Financial Institutions (1)

Managing Risks in Financial Institutions (1) • Managing Credit Risks • Managing Interest Rate Risks • Income Gap Analysis • Duration Gap Analysis

Managing Credit Risk • Solving Asymmetric Information Problems • 1. Screening • 2. Monitoring and Enforcement of Restrictive Covenants • 3. Establish Long-Term Customer Relationships • 4. Loan Commitment Arrangements • 5. Collateral and Compensating Balances • 6. Credit Rationing

Benefit of Long-Term Relationship • Reducing the cost of information collection -- check firms’ past activities • Reducing monitoring costs • Reducing borrowers’ moral hazard when they want to preserve a long-term relationship

Loan Commitments • Banks’ commitment to provide a firm with loans up to a given amount at fixed interest rate or at a rate that is tied to some market interest rates • Promote long-term relationship • Collateral requirement / Secured Loans • Collateral is a property promised to the lender as compensation if the borrow defaults • Reducing adverse selection

Compensating Balances • A firm receiving a loan must keep a required minimum amount of funds in a check account at the bank • serving as collateral • monitoring • Credit Rationing • lenders refuse to make loans even though borrows are willing to pay the stated interest rate or even a higher rate • two types: (1) no loan; (2) loan with restricted size • Deal with Adverse Selection and Moral Hazard

Managing Interest Rate Risks Income Gap Analysis Duration Gap Analysis

Managing Interest-Rate Risk • First National Bank • Assets Liabilities • --------------------------------------------------------------------------------------------------------------------- • Reserves and cash items $ 5 m | Checkable deposits $ 15 m • | • Securities | Money market deposit accounts $ 5 m • less than 1 year $ 5 m | • 1 to 2 year $ 5 m | Savings deposits $ 15 m • greater than 2 year $ 10 m | • | CDs: Variable-rate $10 m • Residential mortgages | less than 1 year $ 15 m • Variable rate $ 10 m | 1 to 2 year $ 5 m • Fixed rate (30 year) $ 10 m | greater than 2 year $ 5 m • | • Commercial Loans | Fed funds $ 5 m • less than 1 year $ 15 m | • 1 to 2 year $ 10 m | Borrowings: less than 1 year $10 m • greater than 2 year $ 25 m | 1 to 2 year $ 5 m • | greater than 2 year $ 5 m • Physical capital $ 5 m | • | Bank capital $ 5 m

Income Gap Analysis • identifying rate sensitive assets and liabilities • finding GAP = RSA – RSL • Income change = GAP * • About reinvestment risk

Income Gap Analysis • Rate-Sensitive Assets = $5m + $ 10m + $15m + 20% x $10m • RSA = $32 m • Rate-Sensitive Liabs = $5m + $25m + $5m+ $10m + 10% x $15m • + 20%x$15m • RSL = $49.5 m • i  5%  • ΔAsset Income = • ΔLiability Costs = • ΔIncome = • If RSL > RSA, i , Income • GAP = RSA - RSL • = • ΔIncome = GAP x Δi • =

Duration Gap Analysis • Examining the sensitivity of market value of financial • institutions’ net worth to changes in interest rate • %P = -DUR* i/(1+i) • if we know the duration of assets and liabilities, we could • calculate the change in net worth due to interest rate change • duration is additive – using market values as weights • DURgap = DURa - [L/A x DURl]

Example • Interest rate rise from 10% to 15% • Total asset value $100 million • Total liability value $95 million • Durations for each asset and liability as illustrated in Table 1

Duration Gap Analysis • %ΔP - DUR x Δi/(1+i) • i 5%, from 10% to 15%  • ΔAsset Value = %ΔP x Assets • ΔLiability Value = %ΔP x Liabilities • ΔNW = • DURgap = DURa - [L/A x DURl] • %ΔNW = - DURgap x Δi/(1+i) • ΔNW =

Managing Interest-Rate Risk • Problems with GAP Analysis • 1. Assumes slope of yield curve unchanged and flat • 2. Manager estimates % of fixed rate assets and liabilities that are rate sensitive

Managing Interest-Rate Risk • Strategies for Managing Interest-Rate Risk • To completely immunize net worth from interest-rate risk, set DURgap = 0

Managing Risks in Financial Institutions (1)