Chapter Seven:

1

• Chapter Seven
• Risks of Financial Intermediation

2
Overview

• This chapter discusses the risks associated with
  financial intermediation
• Interest rate risk, market risk, credit risk,
  off-balance-sheet risk, technology risk,
  operational risk, foreign exchange risk, country
  risk, liquidity risk, insolvency risk
• Note that these risks are not unique to FIs
• Faced by all global firms

3
Risks of Financial Intermediation

• Interest rate risk resulting from intermediation
• Mismatch in maturities of assets and liabilities.
• Interest rate sensitivity difference exposes
  equity to changes in interest rates
• Balance sheet hedge via matching maturities of
  assets and liabilities is problematic for FIs.
• Inconsistent with asset transformation role
• Refinancing risk.
• Reinvestment risk.

4
Market Risk

• Incurred in trading of assets and liabilities
  (and derivatives).
• Examples Barings decline in ruble.
• DJIA dropped 12.5 percent in two-week period
  July, 2002.
• Heavier focus on trading income over traditional
  activities increases market exposure.
• Trading activities introduce other perils as was
  discovered by Allied Irish Banks U.S.
  subsidiary, AllFirst Bank when a rogue trader
  successfully masked large trading losses and
  fraudulent activities involving foreign exchange
  positions

5
Market Risk

• Distinction between Investment Book and Trading
  Book of a commercial bank
• Heightened focus on Value at Risk (VAR)
• Heightened focus on short term risk measures such
  as Daily Earnings at Risk (DEAR)
• Role of securitization in changing liquidity of
  bank assets and liabilities

6
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 1980s, most of the 1990s and early 2000s
• Credit card loans (and unused balances) continue
  to grow

7
Implications of Growing Credit Risk

• Importance of credit screening
• Importance of monitoring credit extended
• Role for dynamic adjustment of credit risk premia
• Diversification of credit risk

8
Off-Balance-Sheet Risk

• Striking growth of off-balance-sheet activities
• Letters of credit
• Loan commitments
• Derivative positions
• Speculative activities using off-balance-sheet
  items create considerable risk

9
Technology and Operational Risk

• Risk of losses 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 (ACH)
• CHIPS
• Real time interconnection of global FIs via
  satellite systems

10
Technology and Operational Risk

• Risk that technology investment fails to produce
  anticipated cost savings.
• Risk that technology may break down.
• CitiBanks ATM network, debit card system and
  on-line banking out for two days
• Wells Fargo
• Bank of New York Computer system failed to
  recognize incoming payment messages sent via
  Fedwire although outgoing payments succeeded

11
Technology and Operational Risk

• Operational risk not exclusively technological
• Employee fraud and errors
• Losses magnified since they affect reputation and
  future potential
• Merrill Lynch 100 million penalty
• Economies of scale.
• Economies of scope.

12
Foreign Exchange Risk

• FI may be net long or net short in various
  currencies
• Returns on foreign and domestic investment are
  not perfectly correlated.
• FX rates may not be correlated.
• Example / may be increasing while /
  decreasing
• and relationship between and time varying.
• Undiversified foreign expansion creates FX risk.

13
Foreign Exchange Risk

• Note that completely hedging foreign exposure by
  matching foreign assets and liabilities requires
  matching the maturities as well.
• Otherwise, exposure to foreign interest rate risk
  is remains.
• More correctly, FI must match durations, rather
  than maturities. See Chapter 9.

14
Country or Sovereign Risk

• Result of exposure to foreign government which
  may impose restrictions on repayments to
  foreigners.
• Often lack usual recourse via court system.
• Examples
• Argentina
• Russia
• South Korea

• Indonesia
• Malaysia
• Thailand.

15
Country or Sovereign Risk

• In the event of restrictions, reschedulings, or
  outright prohibition of repayments, FIs
  remaining bargaining chip is future supply of
  loans
• Weak position if currency collapsing or
  government failing
• Role of IMF
• Extends aid to troubled banks
• Increased moral hazard problem if IMF bailout
  expected

16
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.
• Example 1985, Ohio savings institutions insured
  by Ohio Deposit Guarantee Fund
• Interaction of credit risk and liability risk
• Role of FDIC (see Chapter 19)

17
Insolvency Risk

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

18
Risks of Financial Intermediation

• Other Risks and Interaction of Risks
• Interdependencies among risks.
• Example Interest rates and credit risk.
• Interest rates and derivative counterparty risk
• Discrete Risks
• Example Tax Reform Act of 1986.
• Other examples include effects of war or
  terrorist acts, market crashes, theft,
  malfeasance.
• Changes in regulatory policy

19
Macroeconomic Risks

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

20
Pertinent Websites

• Bank for International Settlements www.bis.org
• Board of Governors of the Federal Reserve
  www.federalreserve.gov
• Federal Deposit Insurance Corporation
  www.fdic.gov

21
Team Names for Paper Presentation?

• Names are due tonight.
• The Finished Paper is due February 28th,
• at the Start of Class.
• Your Presentations will be done March 4th 6th

22

• Final Report and In-Class Presentation
• Groups of five students (names of those in your
  group due to me Tuesday, January 15th ) are
  required to hand in a professionally written
  (end-noted 10 page max) report about the
  banking system on any country of their choosing
  by the beginning of class on Thursday, February
  28th. The report should give a broad overview of
  the country, and a more in-depth discussion of
  the banking system (e.g. size, types and number
  of financial institutions) of the respective
  countries. The regulation of commercial banks,
  the evolution and performance of the financial
  system, and the presence of foreign banks in the
  country should be addressed in the report.
  Possibly a comparison and contrast to the U.S.
  Bank system as well?
• In addition to the written assignment, each group
  will give a 15 to 20-minute speech with power
  point presentation of their report during the
  last week of class (March 4th and March 6th) and
  using the whole group.