Risk Management

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

INTEREST RATE RISK

Chapter 1 discussed asset transformation as a key special function of FIs. Asset trans-

Risks of Financial Intermediation

formation involves an FI’s buying primary securities or assets and issuing secondary

interest rate risk securities or liabilities to fund asset purchases. The primary securities purchased

The risk incurred by FIs often have maturity and liquidity characteristics different from those of the

Interest rate risk

by an FI when the secondary securities FIs sell. In mismatching the maturities of assets and liabilities

maturities of its assets

Asset trans- formation involves an FI’s buying primary securities or assets and issuing

as part of their asset-transformation function, FIs potentially expose themselves to

and liabilities are Final PDF to

secondary securities or liabilities to fund asset purchases. The primary securities purchased

interest rate risk.

mismatched.

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-

EXAMPLE 7–1 Consider an FI that issues $100 million of liabilities of one-year maturity to finance the pur-

transformation function, FIs potentially expose themselves to interest rate risk.

chase of $100 million of assets with a two-year maturity. We show this situation in the follow-

Impact of an ing time lines:

Interest Rate 1

Chapter 7 Risks of Financial Institutions

a) Re4inancing risk. FI can be viewed as

Increase on an

short-funded. Suppose the cost of L is 9%

FI’s Profits When 1

0 Liabilities

per year and the return on A is 10% per ($100 million)

×

the Maturity $1 million (–0.01 $100 m). The positive spread earned in the first year by the FI from holding

year. Over the Hirst year, the FI can lock in a

assets with a longer maturity than its liabilities would be offset by a negative spread in the

of Its Assets second year. Note that if interest rates were to rise by more than 1 percent in the second yea

proHit spread of 1% times 100 million by 2

1

0

Exceeds the the FI would stand to take losses over the two-year period as a whole. As a result, when an F

Assets

borrowing short term (for one year) and

refinancing risk

Maturity of Its ($100 million) refinancing risk

holds longer-term assets relative to liabilities, it potentially exposes itself to

The risk that the cost

lending long term (two years), for a proHit

This is the risk that the cost of rolling over or reborrowing funds could be more than the

Liabilities

of rolling over or

of 1 million. return earned on asset investments. As interest rates rose in the mid-2010s, good example

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

reborrowing funds will of this exposure were provided by banks that borrowed short-term deposits, that is, deposit

liabilities is less than the maturity of its assets.

However, its proHits for the second year are uncertain. If the level of interest rates does not

rise above the returns whose interest rates changed or adjusted frequently, while investing in fixed-rate loans, tha

Suppose the cost of funds (liabilities) for the FI is 9 percent per year and the return on

being earned on asset

change, the FI can reHinance its liabilities at 9% percent and lock in a 1% spread again. But

is loans whose interest rates change or adjusted infrequently.

assets is 10 percent per year. Over the first year, the FI can lock in a profit spread of 1 percent

investments.

rates can change. The reHinancing risk is the risk that the cost of rolling over or reborrowing

–

(10 percent 9 percent) times $100 million by borrowing short term (for one year) and lending

funds could be more than the return earned on asset investments. As interest rates rose in the

×

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

mid-2010s, good examples of this exposure were provided by banks that borrowed short-term

EXAMPLE 7–2 An alternative balance sheet structure would have the FI borrowing $100 million for a longe

change, the FI can refinance its liabilities at 9 percent and lock in a 1 percent, or $1 million,

deposits, that is, deposits whose interest rates changed or adjusted frequently, while investing

term than the $100 million of assets in which it invests. In the time lines below, the FI is “long

Impact of an profit for the second year as well. There is always a risk, however, that interest rates will

funded.” The maturity of its liabilities is longer than the maturity of its assets. Using a simila

in Hixed-rate loans, that is loans whose interest rates change or adjusted infrequently.

change between years 1 and 2. If interest rates were to rise and the FI can borrow new

Interest Rate example, suppose the FI borrows funds at 9 percent per year for two years and invests the

one-year liabilities only at 11 percent in the second year, its profit spread in the second year

Decrease When funds in assets that yield 10 percent for one year. This situation is shown as follows:

– = –1

would actually be negative; that is, 10 percent 11 percent percent, or the FI’s loss is

the Maturity of

b) Reinvestment risk. The FI is now long-

an FI’s Liabilities

funded. In this case the FI is also exposed to

Exceeds the 2

1

0

1 Recall that Appendix 2B at the book’s website (www.mhhe.com/saunders9e) contains an overview of the

an interest rate risk: by holding short-term Liabilities

evaluation of FI performance and risk exposure (“Commercial Banks’ Financial Statements and Analysis”).

Maturity of Its ($100 million)

Included are several accounting ratio–based measures of risk.

assets relative to liabilities, it faces

Assets

uncertainty about the interest rate at which 1

0 Assets

it can reinvest funds in the second period. As ($100 million)

interest rates fell in the 2000s, good In this case, the FI is also exposed to an interest rate risk; by holding shorter-term asset

examples of this exposure were provided by banks that borrowed Hixed-rate deposits while

relative to liabilities, it faces uncertainty about the interest rate at which it can reinvest fund

investing in Hloating-rate loans, that is, loans whose interest rates changed or adjusted

in the second period. As before, the FI locks in a one-year profit spread of 1 percent, o

frequently. $1 million. At the end of the first year, the assets mature and the funds that have been bor

sau17771_ch07_177-198.indd 178 11/25/16 08:30 AM

rowed 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

In addition, an FI faces market value risk as well. Remember that the market (or fair) value

year assets is 8 percent. The FI would face a loss, or negative spread, in the second yea

of an asset or liability is conceptually equal to the present value of cur- rent and future cash

of 1 percent (that is, 8 percent asset return minus 9 percent cost of funds), or the FI lose

×

$1 million (–0.01 $100 m). The positive spread earned in the first year by the FI from holding

Hlows from that asset or liability. Therefore, rising interest rates increase the discount rate on

assets with a shorter maturity than its liabilities is offset by a negative spread in the second

those cash Hlows and reduce the market value of that asset or liability. Conversely, falling

reinvestment risk reinvestment risk;

year. Thus, the FI is exposed to by holding shorter-term assets relative to

The risk that the

interest rates increase the market values of assets and liabilities. Moreover, mismatching

liabilities, it faces uncertainty about the interest rate at which it can reinvest funds borrowed

return on funds to

maturities by holding longer-term assets than liabilities means that when interest rates rise,

for a longer period. As interest rates fell in the 2000s, good examples of this exposure were

be reinvested will provided by banks that borrowed fixed-rate deposits while investing in floating-rate loans

the market value of the FI’s assets falls by a greater amount than its liabilities. This exposes

fall below the cost that is, loans whose interest rates changed or adjusted frequently.

of funds.

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 int

It arises because of the possibility that promised cash Hlows on Hinancial claims held by FIs,

est rates change, an FI faces risk as well. Remember that the market (

market value

such as loans or bonds, will not be paid in full. Virtually all types of FIs face this risk. However,

fair) value of an asset or liability is conceptually equal to the present value of cu

in general, FIs that make loans or buy bonds with long maturities are more exposed than are

rent and future cash flows from that asset or liability. Therefore, rising interest rat

FIs that make loans or buy bonds with short maturities. This means, for example, that

increase the discount rate on those cash flows and reduce the market value of th

asset or liability. Conversely, falling interest rates increase the market values of asse

and liabilities. Moreover, mismatching maturities by holding longer-term assets th

liabilities means that when interest rates rise, the market value of the FI’s assets fa

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).

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

depository institutions and life insurers are more exposed to credit risk than are money

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.

market mutual funds and property–casualty insurers. FIGURE 7–1

Charge-Off Rates for Commercial Bank Lending Activities, 1984–2015

Accordingly, a key role of FIs involves screening and Source: FDIC, various issues.

Quarterly Banking Profile, www.fdic.gov

monitoring loan applicants to ensure that FIs fund the Net charge-off rate (%)

14.0

13.0

most creditworthy loans. 12.0

11.0

The effects of credit risk are evident in Figure, which C&I loans

10.0 Real estate loans

9.0 Credit card loans

shows commercial bank charge-off (or write-off) rates 8.0

7.0

for various types of loans between 1984 and 2015. 6.0

5.0

Notice, in particular, the high rate of charge-offs 4.0

3.0

experienced on credit card loans throughout this period. 2.0

1.0

0.0 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

sau17771_ch07_177-198.indd 181 11/25/16 08:30 AM

their asset investment portfolios.

The effect of risk diversiHication is to truncate or limit the probabilities of the bad outcomes in

the portfolio. In effect, diversiHication reduces individual 4irm-speci4ic credit risk, such as the

risk speciHic 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

Hirms 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 Hinancial 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

Hinancial markets.

However, there are times when an FI can face a liquidity crisis. Because of a lack of conHidence

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 Hire-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 proHitability

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 mort- gage 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

4

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

Example (in millions)

Adjusting

Suppose a very simple FI balance

to a Deposit Before the Withdrawal After the Withdrawal

Withdrawal Using

sheet. The FI has initially 10 in cash Assets Liabilities/Equity Assets Liabilities/Equity

Asset Sales

assets and 90 in non-cash assets Cash assets $ 10 Deposit $ 90 Cash assets $ 0 Deposits $ 75

Nonliquid assets 90 Equity 10 Nonliquid assets 80 Equity 5

(such as small business loans). These $100 $100 $80 $ 80

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

Concept 1. Why might an FI face a sudden liquidity crisis?

Questions 2. What circumstances might lead an FI to liquidate assets at fire-sale prices?

about the proHits of the FI) and FI receives no new deposits to replace them. To meet these Final PDF to

deposit withdrawals, the FI Hirst 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

FOREIGN EXCHANGE RISK

assets to obtain the 5 needed: it would incur in a loss of 5 from the face value of the assets. The 18

Chapter 7 Risks of Financial Institutions

FI must then write off any such losses against its equity funds. The FI is then left with only 5 in

Increasingly, FIs have recognized that both direct foreign investment and foreign portfo-

interest payments from pounds into dollars, foreign exchange losses can offset th

lio investments can extend the operational and financial benefits available from purely

equity. promised value of local currency interest payments at the original exchange rate

domestic investments. Thus, U.S. pension funds that held approximately 5 percent of

which the investment occurred.

their assets in foreign securities in the early 1990s now hold over 13 percent of their

In general, an FI can hold assets denominated in a foreign currency and/or issu

assets in foreign securities. At the same time, many large U.S. banks, investment banks,

Foreign Exchange Risk foreign liabilities. Consider a U.S. FI that holds £100 million in pound loans as asse

and mutual funds have become more global in their orientation. To the extent that

and funds £80 million of them with pound certificates of deposit. The differen

Foreign exchange risk is the risk that exchange rate changes can adversely affect the value of

the returns on domestic and foreign investments are imperfectly correlated, there are

between the £100 million in pound loans and £80 million in pound CDs is funde

potential gains for an FI that expands its asset holdings and liability funding beyond the

an FI’s assets and liabilities denominated in foreign currencies.

by dollar CDs (i.e., £20 million worth of dollar CDs). See Figure 7–2. In this cas

domestic borders. the U.S. FI is £20 million in pound assets; that is, it holds more foreig

net long

The returns on domestic and foreign direct investing and portfolio investments are not

The returns on domestic and foreign direct investing and portfolio investments

assets than liabilities. The U.S. FI suffers losses if the exchange rate for pounds fa

are not perfectly correlated for two reasons. The first is that the underlying technol-

or depreciates against the dollar over this period. In dollar terms, the value of th

perfectly correlated for two reasons. The Hirst is that the underlying technologies of various

ogies of various economies differ, as do the firms in those economies. For example,<