Risks of Financial Intermediation Chapter 7

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Risks of Financial IntermediationChapter 7

• Financial Institutions Management, 3/e
• By Anthony Saunders

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Risks of Financial Intermediation

• Interest rate risk
• Mismatch in maturities of assets and liabilities.
• Balance sheet hedge via matching maturities of
  assets and liabilities is problematic for FIs.
• Refinancing risk.
• Reinvestment risk.

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Risks of Financial Intermediation

• Market risk
• Incurred in trading of assets and liabilities
  (and derivatives).
• Examples Barings decline in ruble.
• Trend to greater reliance on trading income
  rather than traditional activities increases
  market exposure.

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Risks of Financial Intermediation

• Credit Risk
• Risk that promised cash flows are not paid in
  full.
• Firm specific credit risk
• Systematic credit risk
• Off-balance-sheet risk
• Letters of credit, loan commitments, derivative
  positions, etc.

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Risks of Financial Intermediation

• Technology and operational risk
• Risk that technology investment fails to produce
  anticipated cost savings.
• Risk that technology may break down.
• Economies of scale.
• Economies of scope.

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Risks of Financial Intermediation

• 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.
• Undiversified foreign expansion creates FX risk.

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Risks of Financial Intermediation

• Country or Sovereign Risk
• Result of exposure to foreign government which
  may impose restrictions on repayments to
  foreigners.
• Lack usual recourse via court system.
• Examples Korea, Indonesia, Thailand 1998.

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Risks of Financial Intermediation

• 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.

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Risks of Financial Intermediation

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

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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.
• Other examples include effects of war, market
  crashes, theft, malfeasance.

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Risks of Financial Intermediation

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