Risks of Financial Intermediation

1
Risks of Financial Intermediation

• Finance 129

2
Common Risks

• All Financial Intermediaries face similar risks
  from their operations.
• The importance of each type of risk depends upon
  the intermediary and business lines
• We will spend today introducing the types of risk
  present. The remainder of the semester is spent
  detailing each type of risk and discussing
  management techniques used by firms to limit the
  impact of each risk.

3
Margin Income

• Most financial institutions serving an
  intermediary role make some income from interest
  margins.

4
Interest Rate Risk

• The Interest rates on both Assets and Liabilities
  are tied to the length of the commitments.
• Interest rate risk results from a mismatch in
  maturities of assets and liabilities.
• Refinancing risk.
• Reinvestment risk.

5
Interest Rate Risk Refinancing Risk

• Assume you have 100 million in liabilities
  financed at 9 per year and the rate that you pay
  resets at the end of the year. Your FI also has
  100 million in assets that mature in 2 years
  paying 10 per year.
• What happens if the interest rate increases?

6
Interest Rate RiskReinvestment Rate Risk

• Assume you have 100 million in liabilities
  financed at 9 per year that mature in 2 years.
  Your FI also has 100 million in assets that
  mature in 1 years financed at a cost of 10 per
  year.
• What happens if the interest rate decreases?

7
Matching Maturities

• It is difficult for the FI to match maturities
  and it may not eliminate interest rate risk
  anyway

8
Interest Rate RiskMarket Value Risk

• Market value is tied to the level of interest
  rates.
• As rates increase market value decreases, as
  rates decrease market value increases
• The impact of rate changes is tied to maturity

9
Market Risk

• The combination of interest rate, foreign
  exchange, and equity return risks are combined
  with an active trading strategy.

10
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 80s and 90s
• Obvious need for credit screening and monitoring
• Diversification of credit risk

11
Off-Balance-Sheet Risk

• Risk associated with contingent claims that do
  not show up on the balance sheet. It is not on
  the Balance sheet since it does not involve
  holding a current primary claim or issuing a
  current secondary claim.

12
Technology and Operational Risk

• Risk of direct or indirect loss 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
• CHIPS

13
Technology and Operational Risk

• Technology Risk Technology investment may fail
  to produce anticipated cost savings.
• Operational Risk The risk that support systems
  (often based on new technology) may break down.
• Bank of New York failed to register incoming
  payments on Fedwire, but continued to process
  outgoing payments
• Wells Fargo Failure to correctly post deposits
  to acquired firms account holders cost 180
  Million

14
Economies of Scale and Scope

• Economies of Scale
• Economies of Scope

15
Foreign Exchange Risk

• Foreign Assets and Foreign Liabilities change in
  value with changes in exchange rates.
• Net Long Asset Position
• Net Short Asset Position

16
Foreign Exchange Risk

• Returns on foreign and domestic investment are
  not perfectly correlated.
• FX rates may not be correlated.
• Example /DM may be increasing while /
  decreasing.

17
Foreign Exchange Risk

• Note that hedging foreign exposure by matching
  foreign assets and liabilities requires matching
  the maturities as well.
• Otherwise, exposure to foreign interest rate risk
  is created.

18
Country or Sovereign Risk

• Result of exposure to foreign government which
  may impose restrictions on repayments to
  foreigners.
• Lack usual recourse via court system.

19
Liquidity Risk

• Risk of being forced to borrow, or sell assets in
  a very short period of time.
• Low prices result.
• May generate runs.

20
Insolvency Risk

• Risk of insufficient capital to offset sudden
  decline in value of assets or liabilities.
• Original cause may be excessive interest rate,
  market, credit, off-balance-sheet, technological,
  FX, sovereign, and liquidity risks.

21
Risks of Financial Intermediation

• Other Risks and Interaction of Risks
• Interdependencies among risks.
• Example Interest rates and credit risk.
• Discrete Risks
• Example Tax Reform Act of 1986.

22
Macroeconomic Risks

• Increased inflation or increase in its
  volatility.
• Affects interest rates as well.
• Increases in unemployment
• Affects credit risk as one example.
• Changes in Consumer Confidence
• Changes in home building

23
Risk Management Techniques

• Deciding what risks to accept and how to manage
  them
• Set Asides
• Limits on Risky Positions
• Hedging
• Business Lines vs. Total Operations

24
Risk Measurement Tools

• Value at Risk and Earnings at Risk
• Models that predict the probability and magnitude
  of potential loss from market risk
• Stress Testing
• What is the worst case Scenario?
• GAP, Duration GAP
• Financial Statement Analysis
• Impact of Regulation

25
Consolidated Risk Management

• A coordinated process of measuring and managing
  risk on firmwide basis.

26
Benefits of Consolidating Risk Management

• Diversification benefits are ignored without
  consolidation, leading to increased risk
  management costs
• Lack of coordination can increase firm wide risk
  in times of market problems (unwinding similar
  position in different business lines for
  example).

27
Barriers to Consolidated Risk Management

• Consolidation of financial firms has produced
  increased product and geographic diversification
  which has made business wide risk management more
  difficult.
• Information Costs
• The cost of integrating, recording and analyzing
  risk across separate business lines.

28
Barriers to Consolidated Risk Management

• Regulatory Costs
• Consolidation has created a framework where firms
  are required to respond to multiple regulators.
• Capital and Liquidity requirements may prohibit
  the movement of funds from one business line to
  another.
• Cost associated with managing the separate
  regulatory requirements including opportunity
  costs