Risk Management

Interest rate risk

time to understanding and managing the various risks to which their FIs are exposed.

Chapter 1 discussed asset transformation as a key special function of FIs. Asset transformation involves an FI’s buying primary securities or assets and issuing secondary securities or liabilities to fund asset purchases. The primary securities purchased by FIs often have maturity and liquidity characteristics different from those of the secondary securities FIs sell. In mismatching the maturities of assets and liabilities as part of their asset-transformation function, FIs potentially expose themselves to interest rate risk.

Risks of Financial Intermediation.

Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched. Asset transformation involves an FI’s buying primary securities or assets and issuing secondary securities or liabilities to fund asset purchases. The primary securities purchased by FIs often have maturity and liquidity characteristics different from those of the secondary securities FIs sell. In mismatching the maturities of assets and liabilities as part of their asset-transformation function, FIs potentially expose themselves to interest rate risk.

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Example 7–1: impact of an interest rate increase

Consider an FI that issues $100 million of liabilities of one-year maturity to finance the purchase of $100 million of assets with a two-year maturity. We show this situation in the following time lines:

Impact of an interest rate increase on an FI’s profits when the maturity of its assets exceeds the maturity of its liabilities.

Chapter 7 Risks of Financial Institutions.

a) Refinancing risk. FI can be viewed as short-funded. Suppose the cost of L is 9% per year and the return on A is 10% per year. Over the first year, the FI can lock in a profit spread of 1% times 100 million by borrowing short term, for one year, and lending long term, two years, for a profit of 1 million.

10 Liabilities ($100 million) × $1 million (–0.01 $100 m). The positive spread earned in the first year by the FI from holding assets with a longer maturity than its liabilities would be offset by a negative spread in the second year. Note that if interest rates were to rise by more than 1 percent in the second year, the FI would stand to take losses over the two-year period as a whole. As a result, when an FI holds longer-term assets relative to liabilities, it potentially exposes itself to refinancing risk.

210 Assets ($100 million).

Refinancing risk is the risk that the cost of rolling over or reborrowing funds could be more than the return earned on asset investments.

In these time lines, the FI can be viewed as being “short-funded.” That is, the maturity of its liabilities is less than the maturity of its assets.

However, its profits for the second year are uncertain. If the level of interest rates does not rise above the returns being earned on asset investments, change, the FI can refinance its liabilities at 9% percent and lock in a 1% spread again. But rates can change. The refinancing risk is the risk that the cost of rolling over or reborrowing funds could be more than the return earned on asset investments. As interest rates rose in the mid-2010s, good examples of this exposure were provided by banks that borrowed short-term deposits, that is, deposits whose interest rates changed or adjusted frequently, while investing in fixed-rate loans, that is loans whose interest rates change or adjusted infrequently.

Suppose the cost of funds, liabilities, for the FI is 9 percent per year and the return on assets is 10 percent per year. Over the first year, the FI can lock in a profit spread of 1 percent, –(10 percent 9 percent), times $100 million by borrowing short term, for one year, and lending long term, for two years. Thus, its profit is $1 million (0.01 × $100 m).

However, its profits for the second year are uncertain. If the level of interest rates does not change, the FI can refinance its liabilities at 9 percent and lock in a 1 percent, or $1 million, profit for the second year as well. There is always a risk, however, that interest rates will change between years 1 and 2. If interest rates were to rise and the FI can borrow new one-year liabilities only at 11 percent in the second year, its profit spread in the second year would actually be negative; that is, 10 percent – 11 percent = –1 percent, or the FI’s loss is $1 million (–0.01 × $100 m). The positive spread earned in the first year by the FI from holding assets with a longer maturity than its liabilities would be offset by a negative spread in the second year.

Note that if interest rates were to rise by more than 1 percent in the second year the FI would stand to take losses over the two-year period as a whole. As a result, when an FI holds longer-term assets relative to liabilities, it potentially exposes itself to refinancing risk. This is the risk that the cost of rolling over or reborrowing funds could be more than the return earned on asset investments. As interest rates rose in the mid-2010s, good examples of this exposure were provided by banks that borrowed short-term deposits, that is, deposits whose interest rates changed or adjusted frequently, while investing in fixed-rate loans, that is, loans whose interest rates change or adjusted infrequently.

Example 7–2: impact of an interest rate decrease

An alternative balance sheet structure would have the FI borrowing $100 million for a longer term than the $100 million of assets in which it invests. In the time lines below, the FI is “long-funded.” The maturity of its liabilities is longer than the maturity of its assets. Using a similar example, suppose the FI borrows funds at 9 percent per year for two years and invests the funds in assets that yield 10 percent for one year. This situation is shown as follows:

Impact of an interest rate decrease when the maturity of an FI’s liabilities exceeds the maturity of its assets.

b) Reinvestment risk. The FI is now long-funded. In this case the FI is also exposed to an interest rate risk: by holding short-term assets relative to liabilities, it faces uncertainty about the interest rate at which it can reinvest funds in the second period.

210 Liabilities ($100 million).

10 Assets ($100 million).

Recall that Appendix 2B at the book’s website (www.mhhe.com/saunders9e) contains an overview of the evaluation of FI performance and risk exposure (“Commercial Banks’ Financial Statements and Analysis”). Included are several accounting ratio–based measures of risk.

As interest rates fell in the 2000s, good examples of this exposure were provided by banks that borrowed fixed-rate deposits while investing in floating-rate loans, that is, loans whose interest rates changed or adjusted frequently.

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In this case, the FI is also exposed to an interest rate risk; by holding shorter-term assets relative to liabilities, it faces uncertainty about the interest rate at which it can reinvest funds in the second period. As before, the FI locks in a one-year profit spread of 1 percent, or $1 million. At the end of the first year, the assets mature and the funds that have been borrowed for two years have to be reinvested. Suppose interest rates fall between the first and second years so that in the second year the return on $100 million invested in new one-year assets is 8 percent. The FI would face a loss, or negative spread, in the second year of 1 percent, that is, 8 percent asset return minus 9 percent cost of funds, or the FI loses $1 million (–0.01 × $100 m). The positive spread earned in the first year by the FI from holding assets with a shorter maturity than its liabilities is offset by a negative spread in the second year.

Thus, the FI is exposed to reinvestment risk; by holding shorter-term assets relative to liabilities, it faces uncertainty about the interest rate at which it can reinvest funds borrowed for a longer period. Reinvestment risk is the risk that the return on funds to be reinvested will fall below the cost of funds.

As interest rates fell in the 2000s, good examples of this exposure were provided by banks that borrowed fixed-rate deposits while investing in floating-rate loans, that is, loans whose interest rates changed or adjusted frequently.

Market value risk

In addition, an FI faces market value risk as well. Remember that the market or fair value of an asset or liability is conceptually equal to the present value of current and future cash flows from that asset or liability. Therefore, rising interest rates increase the discount rate on those cash flows and reduce the market value of that asset or liability. Conversely, falling interest rates increase the market values of assets and liabilities. Moreover, mismatching maturities by holding longer-term assets than liabilities means that when interest rates rise, the market value of the FI’s assets falls by a greater amount than its liabilities. This exposes the FI to the risk of economic loss and, potentially, the risk of insolvency.

Credit risk

In addition to a potential refinancing or reinvestment risk that occurs when interest rates change, an FI faces risk as well. Remember that the market, market value or fair value, of an asset or liability is conceptually equal to the present value of current and future cash flows from that asset or liability. Therefore, rising interest rates increase the discount rate on those cash flows and reduce the market value of that asset or liability. Conversely, falling interest rates increase the market values of assets and liabilities. Moreover, mismatching maturities by holding longer-term assets than liabilities means that when interest rates rise, the market value of the FI’s assets falls.

It arises because of the possibility that promised cash flows on financial claims held by FIs, such as loans or bonds, will not be paid in full. Virtually all types of FIs face this risk. However, in general, FIs that make loans or buy bonds with long maturities are more exposed than are FIs that make loans or buy bonds with short maturities. This means, for example, that depository institutions and life insurers are more exposed to credit risk than are money market mutual funds and property–casualty insurers.

Return-risk trade-offs are fixed-income coupon bonds issued by corporations and bank loans. In both cases, an FI holding these claims as assets earns the coupon on the bond or the interest promised on the loan if no borrower default occurs. In the event of default, however, the FI earns zero interest on the asset and may lose all or part of the principal lent, depending on its ability to lay claim to some of the borrower’s assets through legal bankruptcy and insolvency proceedings. Accordingly, a key role of FIs involves screening and monitoring loan applicants to ensure that FIs fund the most creditworthy loans, see Chapter 10.

Accordingly, a key role of FIs involves screening and monitoring loan applicants to ensure that FIs fund the most creditworthy loans.

Charge-off rates for commercial bank lending activities

The effects of credit risk are evident in Figure 7–1, which shows commercial bank charge-off, or write-off, rates for various types of loans between 1984 and 2015. Notice, in particular, the high rate of charge-offs experienced on credit card loans throughout this period. Indeed, credit card charge-offs by commercial banks increased persistently from the mid-1980s until 1993 and again from 1995 through early 1998. By 1998, charge-offs leveled off, and they even declined after 1998.

The effects of credit risk are evident in Figure, which shows commercial bank charge-off, or write-off, rates for various types of loans between 1984 and 2015. Notice, in particular, the high rate of charge-offs experienced on credit card loans throughout this period.

Figure 7–1: Charge-off rates for commercial bank lending activities, 1984–2015.

Source: FDIC, various issues. Quarterly Banking Profile, www.fdic.gov.

Net charge-off rate (%): 14.0, 13.0, 12.0, 11.0, 10.0, 9.0, 8.0, 7.0, 6.0, 5.0, 4.0, 3.0, 2.0, 1.0, 0.0.

C&I loans. Real estate loans. Credit card loans.

84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15.

Moreover, one of the advantages FIs have over individual household investors is the ability to diversify some credit risk from a single asset away by exploiting the law of large numbers in their asset investment portfolios.

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The effect of risk diversification is to truncate or limit the probabilities of the bad outcomes in the portfolio. In effect, diversification reduces individual firm-specific credit risk, such as the risk specific to holding the bonds or loans of General Motors, while leaving the FI still exposed to systematic credit risk, such as factors that simultaneously increase the default risk of all firms in the economy, e.g., an economic recession.

Liquidity risk

It arises when an FI’s liability holders, such as depositors or insurance policyholders, demand immediate cash for the financial claims they hold with an FI or when holders of off-balance-sheet loan commitments, or credit lines, suddenly exercise their right to borrow, draw down their loan commitments.

Day-to-day withdrawals by liability holders are generally predictable, and FIs can normally expect to borrow additional funds to meet any sudden shortfalls of cash on the money and financial markets.

However, there are times when an FI can face a liquidity crisis. Because of a lack of confidence by liability holders in the FI or some unexpected need for cash, liability holders may demand larger withdrawals than normal. When all, or many, FIs face abnormally large cash demands, the cost of additional purchased or borrowed funds rises and the supply of such funds becomes restricted. As a consequence, FIs may have to sell some of their less liquid assets to meet the withdrawal demands of liability holders.

This results in a more serious liquidity risk, especially as some assets with “thin” markets generate lower prices when the asset sale is immediate than when the FI has more time to negotiate the sale of an asset. As a result, the liquidation of some assets at low or fire-sale prices, the price an FI receives if an asset must be liquidated immediately at less than its fair market value, could threaten an FI’s profitability and solvency.

For example, in the summer of 2008, IndyMac bank failed, in part due to a bank run that continued for several days, even after being taken over by the FDIC. The bank had announced on July 7 that, due to its deteriorating capital position, its mortgage operations would stop and it would operate only as a retail bank. News reports over the weekend highlighted the possibility that IndyMac would become the largest bank failure in over 20 years. Worried that they would not have access to their money, bank depositors rushed to withdraw money from IndyMac even though their deposits were insured up to $100,000 by the FDIC. The run was so large that within a week of the original announcement, the FDIC had to step in and take over the bank.

184 Part One Introduction.

Table 7–2: adjusting to a deposit withdrawal using asset sales

Example, in millions.

Suppose a very simple FI balance sheet. The FI has initially 10 in cash assets and 90 in non-cash assets, such as small business loans. These assets were funded with 90 in deposits and 10 in owner’s equity.

Suppose that depositors unexpectedly withdrew 15 in deposits, perhaps due to negative news about the profits of the FI, and FI receives no new deposits to replace them. To meet these deposit withdrawals, the FI first uses 10 it has in cash assets and then seeks to sell some of its non-cash assets to raise an additional 5 in cash. Suppose it is obliged to sell 10 in non-cash assets to obtain the 5 needed: it would incur in a loss of 5 from the face value of the assets. The FI must then write off any such losses against its equity funds. The FI is then left with only 5 in equity.

Concept questions.

• 1. Why might an FI face a sudden liquidity crisis?
• 2. What circumstances might lead an FI to liquidate assets at fire-sale prices?

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Foreign exchange risk

Chapter 7 Risks of Financial Institutions.

Increasingly, FIs have recognized that both direct foreign investment and foreign portfolio investments can extend the operational and financial benefits available from purely domestic investments. Thus, U.S. pension funds that held approximately 5 percent of their assets in foreign securities in the early 1990s now hold over 13 percent of their assets in foreign securities. At the same time, many large U.S. banks, investment banks, and mutual funds have become more global in their orientation. To the extent that the returns on domestic and foreign investments are imperfectly correlated, there are potential gains for an FI that expands its asset holdings and liability funding beyond the domestic borders.

Foreign exchange risk is the risk that exchange rate changes can adversely affect the value of an FI’s assets and liabilities denominated in foreign currencies.

The returns on domestic and foreign direct investing and portfolio investments are not perfectly correlated for two reasons. The first is that the underlying technologies of various economies differ, as do the firms in those economies.

Interest payments from pounds into dollars, foreign exchange losses can offset the promised value of local currency interest payments at the original exchange rate at which the investment occurred.

In general, an FI can hold assets denominated in a foreign currency and/or issue foreign liabilities. Consider a U.S. FI that holds £100 million in pound loans as assets and funds £80 million of them with pound certificates of deposit. The difference between the £100 million in pound loans and £80 million in pound CDs is funded by dollar CDs, i.e., £20 million worth of dollar CDs. See Figure 7–2. In this case, the U.S. FI is net long £20 million in pound assets; that is, it holds more foreign assets than liabilities. The U.S. FI suffers losses if the exchange rate for pounds falls or depreciates against the dollar over this period. In dollar terms, the value of the

The returns on domestic and foreign direct investing and portfolio investments are not perfectly correlated for two reasons. The first is that the underlying technologies of various economies differ, as do the firms in those economies. For example,