Chapter Nineteen

Types of Risks Incurred

by Financial Institutions

McGraw-Hill/Irwin 8-1 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• One
Oneofofthe
themajor
majorobjectives
objectivesof
ofaafinancial
financialinstitution’s
institution’s
(FI’s)
(FI’s)managers
managersisisto
toincrease
increasethe
theFI’s
FI’sreturns
returnsfor
forits
its
owners
owners
•• Increased
Increasedreturns
returnsoften
oftencome
comeatatthe
thecost
costof
ofincreased
increased
risk,
risk,which
whichcomes
comesin
inmany
manyforms:
forms:
–– credit
creditrisk
risk –– foreign
foreignexchange
exchangerisk
risk
–– liquidity
liquidityrisk
risk –– country
countryor
orsovereign
sovereignrisk
risk
–– interest
interestrate
raterisk
risk –– technology
technologyrisk
risk
–– market
marketrisk
risk –– operational
operationalrisk
risk
–– off-balance-sheet
off-balance-sheetrisk
risk –– insolvency
insolvencyrisk
risk

McGraw-Hill/Irwin 19-2 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions
•• Credit
Creditrisk
riskisisthe
therisk
riskthat
thatthe
thepromised
promisedcash
cashflows
flowsfrom
from
loans
loansand
andsecurities
securitiesheld
heldby
byFIs
FIsmay
maynot
notbe
bepaid
paidin
infull
full
–– FIs
FIsthat
thatmake
makeloans
loansor
orbuy
buybonds
bondswith
withlong
longmaturities
maturitiesare
are
relatively
relativelymore
moreexposed
exposedtotocredit
creditrisk
risk
•• thus,
thus,banks,
banks,thrifts,
thrifts,and
andinsurance
insurancecompanies
companiesare
aremore
moreexposed
exposedthan
than
MMMFs and property-casualty insurance companies
MMMFs and property-casualty insurance companies
–– many
manyfinancial
financialclaims
claimsissued
issuedby
byindividuals
individualsor
orcorporations
corporationshave:
have:
•• limited
limitedupside
upsidereturn
returnwith
withaahigh
highprobability
probability
•• large
largedownside
downsiderisk
riskwith
withaalow
lowprobability
probability
–– aakey
keyrole
roleof
ofFIs
FIsinvolves
involvesscreening
screeningand
andmonitoring
monitoringloan
loan
applicants
applicantstotoensure
ensureonly
onlythe
thecreditworthy
creditworthyreceive
receiveloans
loans
•• FIs
FIsalso
alsocharge
chargeinterest
interestrates
ratescommensurate
commensuratewith
withthe
theriskiness
riskinessofofthe
the
borrower
borrower

McGraw-Hill/Irwin 19-3 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• Credit
Creditrisk
risk(cont.)
(cont.)
–– the
theeffects
effectsof
ofcredit
creditrisk
riskare
areevidenced
evidencedby
bycharge-offs
charge-offs
•• the
theBankruptcy
BankruptcyReform
ReformAct
Actofof2005
2005makes
makesititmore
moredifficult
difficultfor
for
consumers
consumerstotodeclare
declarebankruptcy
bankruptcy
–– FIs
FIscan
candiversify
diversifyaway
awaysome
someindividual
individualfirm-specific
firm-specificcredit
creditrisk,
risk,
but
butnot
notsystematic
systematiccredit
creditrisk
risk
•• firm-specific
firm-specificcredit
creditrisk
riskisisthe
therisk
riskofofdefault
defaultfor
forthe
theborrowing
borrowingfirmfirm
associated
associatedwith
withthe
thespecific
specifictypes
typesofofproject
projectrisk
risktaken
takenbybythat
thatfirm
firm
•• systematic
systematiccredit
creditrisk
riskisisthe
therisk
riskofofdefault
defaultassociated
associatedwith
withgeneral
general
economy-wide
economy-wideorormacroeconomic
macroeconomicconditions
conditionsaffecting
affectingallallborrowers
borrowers

McGraw-Hill/Irwin 19-4 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• Liquidity
Liquidityrisk
riskisisthe
therisk
riskthat
thataasudden
suddenand
andunexpected
unexpected
increase
increasein
inliability
liabilitywithdrawals
withdrawalsmay mayrequire
requirean
anFI
FItoto
liquidate
liquidateassets
assetsininaavery
veryshort
shortperiod
periodof
oftime
timeand
andatatlow
low
prices
prices
–– day-to-day
day-to-daywithdrawals
withdrawalsby
byliability
liabilityholders
holdersare
aregenerally
generally
predictable
predictable
–– unusually
unusuallylarge
largewithdrawals
withdrawalsby byliability
liabilityholders
holderscan
cancreate
create
liquidity
liquidityproblems
problems
•• the
thecost
costof
ofpurchased
purchasedand/or
and/orborrowed
borrowedfunds
fundsrises
risesfor
forFIs
FIs
•• the
thesupply
supplyofofpurchased
purchasedor orborrowed
borrowedfunds
fundsdeclines
declines
•• FIs
FIsmay
maybebeforced
forcedtotosell
sellless
lessliquid
liquidassets
assetsatat“fire-sale”
“fire-sale”prices
prices

McGraw-Hill/Irwin 19-5 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions
•• Interest
Interestrate
raterisk
riskisisthe
therisk
riskincurred
incurredbybyan
anFI
FIwhen
whenthe
the
maturities
maturitiesofofits
itsassets
assetsand
andliabilities
liabilitiesare
aremismatched
mismatchedand
and
interest
interestrates
ratesare
arevolatile
volatile
–– asset
assettransformation
transformationinvolves
involvesan
anFI
FIissuing
issuingsecondary
secondarysecurities
securities
ororliabilities
liabilitiestotofund
fundthe
thepurchase
purchaseof
ofprimary
primarysecurities
securitiesor orassets
assets
–– ififan
anFI’s
FI’sassets
assetsare
arelonger-term
longer-termthan
thanits
itsliabilities,
liabilities,ititfaces
faces
refinancing
refinancingrisk risk
•• the
therisk
riskthat
thatthe
thecost
costof
ofrolling
rollingover
overor
orre-borrowing
re-borrowingfunds
fundswill
willrise
rise
above
abovethethereturns
returnsbeing
beingearned
earnedon
onasset
assetinvestments
investments
–– ififan
anFI’s
FI’sassets
assetsare
areshorter-term
shorter-termthan
thanits
itsliabilities,
liabilities,ititfaces
faces
reinvestment
reinvestmentriskrisk
•• the
therisk
riskthat
thatthe
thereturns
returnson
onfunds
fundstotobe
bereinvested
reinvestedwill
willfall
fallbelow
belowthe
the
cost
costofoffunds
funds

McGraw-Hill/Irwin 19-6 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• Interest
Interestrate
raterisk
risk(cont.)
(cont.)
–– all
allFIs
FIsface
faceprice
pricerisk
risk(or
(ormarket
marketvalue
valuerisk)
risk)
•• the
therisk
riskthat
thatthe
theprice
priceof
ofthe
thesecurity
securitychanges
changeswhen
wheninterest
interestrates
rates
change
change
–– FIs
FIscan
canhedge
hedgeor
orprotect
protectthemselves
themselvesagainst
againstinterest
interestrate
raterisk
riskby
by
matching
matchingthe
thematurity
maturityof
oftheir
theirassets
assetsand
andliabilities
liabilities
•• this
thisapproach
approachisisinconsistent
inconsistentwith
withtheir
theirasset
assettransformation
transformationfunction
function
•• Market
Marketriskriskisisthe
therisk
riskincurred
incurredinintrading
tradingassets
assetsand
and
liabilities
liabilitiesdue
dueto tochanges
changesin ininterest
interestrates,
rates,exchange
exchangerates,
rates,
and
andother
otherasset
assetprices
prices
–– closely
closelyrelated
relatedtotointerest
interestrate
rateand
andforeign
foreignexchange
exchangerisk
risk

McGraw-Hill/Irwin 19-7 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• Market
Marketrisk
risk(cont.)
(cont.)
–– adds
addstrading
tradingactivity—i.e.,
activity—i.e.,market
marketriskriskisisthe
theincremental
incrementalrisk
risk
incurred
incurredbybyan
anFI
FI(in
(inaddition
additiontotointerest
interestrate
rateororforeign
foreignexchange
exchange
risk)
risk)caused
causedby
byananactive
activetrading
tradingstrategy
strategy
–– FIs’
FIs’trading
tradingportfolios
portfoliosare
aredifferentiated
differentiatedfromfromtheir
theirinvestment
investment
portfolios
portfolioson
onthe
thebasis
basisof
oftime
timehorizon
horizonand
andliquidity
liquidity
•• trading
tradingassets,
assets,liabilities,
liabilities,and
andderivatives
derivativesare
arehighly
highlyliquid
liquid
•• investment
investmentportfolios
portfoliosarearerelatively
relativelyilliquid
illiquidand
andare
areusually
usuallyheld
heldfor
for
longer
longerperiods
periodsofoftime
time
–– declines
declinesinintraditional
traditionalbanking
bankingactivity
activityand
andincome
incomeatatlarge
large
commercial
commercialbanks
bankshave
havebeen
beenoffset
offsetby
byincreases
increasesinintrading
trading
activities
activitiesand
andincome
income

McGraw-Hill/Irwin 19-8 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions
•• Market
Marketrisk
risk(cont.)
(cont.)
–– declines
declinesininunderwriting
underwritingand
andbrokerage
brokerageincome
incomeatatlarge
large
investment
investmentbanks
bankshave
havebeen
beenoffset
offsetby
byincreases
increasesinintrading
tradingactivity
activity
and
andincome
income
–– actively
activelymanaged
managedMFs
MFsare
arealso
alsoexposed
exposedtotomarket
marketriskrisk
–– FIs
FIsare
areconcerned
concernedwith
withfluctuations
fluctuationsinintrading
tradingaccount
accountassets
assetsand
and
liabilities
liabilities
•• value
valueatatrisk
risk(VAR)
(VAR)and anddaily
dailyearnings
earningsat
atrisk
risk(DEAR)
(DEAR)are
are
measures used to assess market risk exposure
measures used to assess market risk exposure
–– market
marketrisk
riskexposure
exposurehas
hascaused
causedsome
somehighly
highlypublicized
publicizedlosses
losses
•• the
thefailure
failureof
ofthe
the200-year
200-yearold
oldBritish
Britishmerchant
merchantbankbankBarings
Baringsinin1995
1995
•• $7.2
$7.2billion
billionininmarket
marketrisk
riskrelated
relatedloss
lossatatSociete
SocieteGenerale
Generaleinin2008
2008

McGraw-Hill/Irwin 19-9 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• Off-balance-sheet
Off-balance-sheet(OBS)
(OBS)riskriskisisthe
therisk
riskincurred
incurredby
byan
an
FI
FIas
asthe
theresult
resultof
ofactivities
activitiesrelated
relatedtotocontingent
contingentassets
assets
and
andliabilities
liabilities
–– OBS
OBSactivity
activitycan
canincrease
increaseFIs’
FIs’interest
interestrate
raterisk,
risk,credit
creditrisk,
risk,and
and
foreign
foreignexchange
exchangeriskrisk
–– OBS
OBSactivity
activitycan
canalso
alsobebeused
usedtotohedge
hedge(i.e.,
(i.e.,reduce)
reduce)FIs’
FIs’interest
interest
rate
raterisk,
risk,credit
creditrisk,
risk,and
andforeign
foreignexchange
exchangeriskrisk
–– large
largecommercial
commercialbanks
banks(CBs)
(CBs)ininparticular
particularengage
engageininOBS
OBS
activity
activity
•• on-balance-sheet
on-balance-sheetassets
assetsofofall
allU.S.
U.S.CBs
CBstotaled
totaled$10.8
$10.8trillion
trillioninin2007
2007
•• the
thenotional
notionalvalue
valueofofOBS
OBSitems
itemstotaled
totaled$180.6
$180.6trillion
trillioninin2007
2007

McGraw-Hill/Irwin 19-10 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• OBS
OBSrisk
risk(cont.)
(cont.)
–– OBS
OBSactivities
activitiescan
canaffect
affectthe
thefuture
futureshape
shapeof
ofFIs’
FIs’balance
balancesheets
sheets
•• OBS
OBSitems
itemsbecome
becomeon-balance-sheet
on-balance-sheetitems
itemsonly
onlyififsome
somefuture
futureevent
event
occurs
occurs
•• aaletter
letterofofcredit
credit(LOC)
(LOC)isisaacredit
creditguarantee
guaranteeissued
issuedbybyan
anFI
FIfor
foraa
fee
feeon
onwhich
whichpayment
paymentisiscontingent
contingenton onsome
somefuture
futureevent
eventoccurring,
occurring,
most
mostnotably
notablydefault
defaultof ofthe
theagent
agentthat
thatpurchases
purchasesthetheLOC
LOC
•• other
otherexamples
examplesinclude:
include:
–– loan
loancommitments
commitmentsby bybanks
banks
–– mortgage
mortgageservicing
servicingcontracts
contractsbybysavings
savingsinstitutions
institutions
–– positions
positionsininforwards,
forwards,futures,
futures,swaps,
swaps,and
andother
otherderivatives
derivativesheld
held
by
byalmost
almostall
alllarge
largeFIs
FIs

McGraw-Hill/Irwin 19-11 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions
•• Foreign
Foreignexchange
exchange(FX)
(FX)risk
riskisisthe
therisk
riskthat
thatexchange
exchangerate
rate
changes
changescancanaffect
affectthe
thevalue
valueofofananFI’s
FI’sassets
assetsand
and
liabilities
liabilitiesdenominated
denominatedininforeign
foreigncurrencies
currencies
–– FIs
FIscan
canreduce
reducerisk
riskthrough
throughdomestic-foreign
domestic-foreignactivity/investment
activity/investment
diversification
diversification
–– FIs
FIsexpand
expandglobally
globallythrough
through
•• acquiring
acquiringforeign
foreignfirms
firmsororopening
openingnew
newbranches
branchesininforeign
foreigncountries
countries
•• investing
investingininforeign
foreignfinancial
financialassets
assets
–– returns
returnson
ondomestic
domesticand
andforeign
foreigndirect
directand
andportfolio
portfolioinvestment
investment
are not perfectly correlated
are not perfectly correlated
•• underlying
underlyingtechnologies
technologiesofofvarious
variouseconomies
economiesdiffer
differ
•• exchange
exchangerate
ratechanges
changesare
arenot
notperfectly
perfectlycorrelated
correlatedacross
acrosscountries
countries

McGraw-Hill/Irwin 19-12 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions
•• FX
FXrisk
risk(cont.)
(cont.)
–– aanet
netlong
longposition
positionininaaforeign
foreigncurrency
currencyinvolves
involvesholding
holdingmore
more
foreign
foreignassets
assetsthan
thanforeign
foreignliabilities
liabilities
•• FI
FIloses
loseswhen
whenforeign
foreigncurrency
currencyfalls
fallsrelative
relativetotothe
theU.S.
U.S.dollar
dollar
•• FI
FIgains
gainswhen
whenforeign
foreigncurrency
currencyappreciates
appreciatesrelative
relativetotothe
theU.S.
U.S.dollar
dollar
–– aanet
netshort
shortposition
positionininaaforeign
foreigncurrency
currencyinvolves
involvesholding
holding
fewer
fewerforeign
foreignassets
assetsthan
thanforeign
foreignliabilities
liabilities
•• FI
FIgains
gainswhen
whenforeign
foreigncurrency
currencyfalls
fallsrelative
relativetotothe
theU.S.
U.S.dollar
dollar
•• FI
FIloses
loseswhen
whenforeign
foreigncurrency
currencyappreciates
appreciatesrelative
relativetotothe
theU.S.
U.S.dollar
dollar
–– an
anFI
FIisisfully
fullyhedged
hedgedififititholds
holdsan
anequal
equalamount
amountof offoreign
foreign
currency
currencydenominated
denominatedassets
assetsandandliabilities
liabilities(that
(thathave
havethe
thesame
same
maturities)
maturities)

McGraw-Hill/Irwin 19-13 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• Country
Countryor orsovereign
sovereignrisk
riskisisthe
therisk
riskthat
thatrepayments
repayments
from
fromforeign
foreignborrowers
borrowersmay
maybe beinterrupted
interruptedbecause
becauseof
of
interference
interferencefrom
fromforeign
foreigngovernments
governments
–– differs
differsfrom
fromcredit
creditrisk
riskof
ofFIs’
FIs’domestic
domesticassets
assets
•• with
withdomestic
domesticassets,
assets,FIs
FIsusually
usuallyhave
havesome
somerecourse
recoursethrough
through
bankruptcy
bankruptcycourts—i.e.,
courts—i.e.,FIs
FIscan
canrecoup
recoupsome
someof
oftheir
theirlosses
losseswhen
when
defaulted
defaultedfirms
firmsare
areliquidated
liquidatedor
orrestructured
restructured
–– foreign
foreigncorporations
corporationsmay
maybe beunable
unabletotopay
payprincipal
principaland
andinterest
interest
even
evenififthey
theywould
woulddesire
desiretotodo
doso
so
•• foreign
foreigngovernments
governmentsmay
maylimit
limitororprohibit
prohibitdebt
debtrepayment
repaymentdue
duetoto
foreign
foreigncurrency
currencyshortages
shortagesororadverse
adversepolitical
politicalevents
events

McGraw-Hill/Irwin 19-14 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• Country
Countryor
orsovereign
sovereignrisk
risk(cont.)
(cont.)
–– thus,
thus,an
anFI
FIclaimholder
claimholdermay mayhave
havelittle
littleor
orno
norecourse
recoursetotolocal
local
bankruptcy
bankruptcycourts
courtsor
ortotoan
aninternational
internationalclaims
claimscourt
court
–– measuring
measuringsovereign
sovereignriskriskincludes
includesanalyzing:
analyzing:
•• the
thetrade
tradepolicy
policyofofthe
theforeign
foreigngovernment
government
•• the
thefiscal
fiscalstance
stanceof
ofthe
theforeign
foreigngovernment
government
•• potential
potentialgovernment
governmentintervention
interventionininthe
theeconomy
economy
•• the
theforeign
foreigngovernment’s
government’smonetary
monetarypolicy
policy
•• capital
capitalflows
flowsand
andforeign
foreigninvestment
investment
•• the
theforeign
foreigncountry’s
country’scurrent
currentand
andexpected
expectedinflation
inflationrates
rates
•• the
thestructure
structureof
ofthe
theforeign
foreigncountry’s
country’sfinancial
financialsystem
system

McGraw-Hill/Irwin 19-15 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions
•• Technology
Technologyrisk
riskand
andoperational
operationalrisk
riskare
areclosely
closelyrelated
related
–– technology
technologyrisk
riskisisthe
therisk
riskincurred
incurredby
byan
anFI
FIwhen
whenits
its
technological
technologicalinvestments
investmentsdo donot
notproduce
produceanticipated
anticipatedcost
costsavings
savings
•• the
themajor
majorobjectives
objectivesofoftechnological
technologicalexpansion
expansionare
aretotoallow
allowthe
theFI
FItoto
exploit
exploitpotential
potentialeconomies
economiesof ofscale
scaleand
andscope
scopeby:
by:
–– lowering
loweringoperating
operatingcosts
costs
–– increasing
increasingprofits
profits
–– capturing
capturingnew
newmarkets
markets
–– operational
operationalrisk
riskisisthe
therisk
riskthat
thatexisting
existingtechnology
technologyor
orsupport
support
systems
systemsmay
maymalfunction
malfunctionor orbreak
breakdown
down
•• the
theBIS
BISdefines
definesoperational
operationalrisk
riskas
as“the
“therisk
riskof
ofloss
lossresulting
resultingfrom
from
inadequate
inadequateor
orfailed
failedinternal
internalprocesses,
processes,people,
people,and
andsystems
systemsororfrom
from
external events”
external events”

McGraw-Hill/Irwin 19-16 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions

•• Insolvency
Insolvencyriskriskisisthe
therisk
riskthat
thatananFI
FImay
maynotnothave
have
enough
enoughcapital
capitaltotooffset
offsetaasudden
suddendecline
declinein
inthe
thevalue
valueof
of
its
itsassets
assetsrelative
relativetotoits
itsliabilities
liabilities
–– insolvency
insolvencyrisk
riskisisaaconsequence
consequenceor
oran
anoutcome
outcomeof
ofone
oneor
ormore
moreof
of
the
therisks
riskspreviously
previouslydescribed:
described:
•• interest
interestrate,
rate,market,
market,credit,
credit,OBS,
OBS,technological,
technological,foreign
foreignexchange,
exchange,
sovereign,
sovereign,and/or
and/orliquidity
liquidityrisk
risk
–– generally,
generally,the
themore
moreequity
equitycapital
capitaltotoborrowed
borrowedfunds
fundsan
anFI
FIhas
hasthe
the
less
lessinsolvency
insolvencyrisk
riskititisisexposed
exposedtoto
–– both
bothregulators
regulatorsand
andmanagers
managersfocusfocuson oncapital
capitaladequacy
adequacyas
asaa
measure
measureof ofaaFI’s
FI’sability
abilitytotoremain
remainsolvent
solvent

McGraw-Hill/Irwin 19-17 ©2009, The McGraw-Hill Companies, All Rights Reserved

 Risks at Financial Institutions
•• Other
Otherrisks
risksand
andinteractions
interactionsamong
amongrisks
risks
–– ininreality,
reality,all
allof
ofthe
thepreviously
previouslydefined
definedrisks
risksare
areinterdependent
interdependent
•• e.g.,
e.g.,liquidity
liquidityrisk
riskcan
canbe
beaafunction
functionofofinterest
interestrate
rateand
andcredit
creditrisk
risk
–– when
whenmanagers
managerstake
takeactions
actionstotomitigate
mitigateone
onetype
typeof
ofrisk,
risk,they
they
must consider such actions on other risks
must consider such actions on other risks
–– changes
changesininregulatory
regulatorypolicy
policyconstitute
constituteanother
anothertype
typeofofdiscrete
discreteor
or
event-specific
event-specificrisk
risk
–– other
otherdiscrete
discreteor
orevent
eventspecific
specificrisks
risksinclude
include
•• war,
war,revolutions,
revolutions,sudden
suddenmarket
marketcollapses,
collapses,theft,
theft,malfeasance,
malfeasance,and
and
breach of fiduciary trust
breach of fiduciary trust
–– macroeconomic
macroeconomicrisksrisksinclude
includeincreased
increasedinflation,
inflation,inflation
inflation
volatility
volatilityand
andunemployment
unemployment

McGraw-Hill/Irwin 19-18 ©2009, The McGraw-Hill Companies, All Rights Reserved