Risks of Financial Intermediation

Chapter 7
Financial Institutions Management, 3/e
By Anthony Saunders

Irwin/McGraw-Hill

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.

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