FIN 683 Financial Institutions Management Bank Risk: An Overview
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1 FIN 683 Financial Institutions Management Bank Risk: An Overview Professor Robert B.H. Hauswald Kogod School of Business, AU Life is Risky, It mostly Ends Deadly Overview and short introduction to the various risk categories in banking core risks ancillary risks Keeping an open mind: risk is good: risk is bad: so, what is the crucial question? 1/19/2016 Bank Risks Robert B.H. Hauswald 2
2 Bank Risks Financial institutions face a plethora of risks: interest-rate, credit, off-balance-sheet risk, foreign-exchange, country or sovereign risk, technology and operational risk, liquidity and market risk, the upshot: insolvency risk Note: These risks are not unique to FIs faced by all global firms 7-3 1/19/2016 Bank Risks Robert B.H. Hauswald Risks of Financial Intermediation Interest rate risk resulting from mismatch in asset & liability maturities: Spread changes as interest rates change Since value = PV(Cash flows), equity affected Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs appears inconsistent with asset transformation role Refinancing risk Reinvestment risk 1/19/ Bank Risks Robert B.H. Hauswald
3 Credit Risk Risk that promised cash flows are not paid in full: debt-service problems essentially default risk a counterparty risk High rate of charge-offs of debt in the 1980s, most of the 1990s and 2000s Charge-offs continued to grow until late 2008 Firm-specific credit risk: Systematic credit risk: 7-5 1/19/2016 Bank Risks Robert B.H. Hauswald Charge-Off Rates for Commercial Banks 7-6 1/19/2016 Bank Risks Robert B.H. Hauswald
4 Implications of Growing Credit Risk Importance of credit screening & monitoring technological innovation: credit scoring automated monitoring of accounts Role for dynamic adjustment of credit risk premiums Diversification of credit risk Credit insurance and derivatives: trading risk 7-7 1/19/2016 Bank Risks Robert B.H. Hauswald 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 Failure of IndyMac in summer of 2008 Seizing up of interbank market: counterparty risk became liquidity risk 1/19/ Bank Risks Robert B.H. Hauswald
5 Market Risk Incurred in trading of assets and liabilities as well as derivatives: not an issue if buy&hold Short view of time horizon Value at risk (VAR), daily earnings at risk (DEAR) Market meltdown Mortgage backed securities Toxic assets Lehman Brothers, Merrill Lynch, AIG Exaggerate faith in financial innovation and 1/19/ Bank Risks Robert B.H. Hauswald Sources of Market Risk Market, or trading, risk present whenever an FI takes an open or unhedged long or short position in securities or foreign exchange Implications for regulators and management: Need for controls Need for measurement of risk exposure /19/2016 Bank Risks Robert B.H. Hauswald
6 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 Regulatory avoidance: hide risks, shift returns who benefits? who loses? /19/2016 Bank Risks Robert B.H. Hauswald Foreign Exchange Risk FI may be net long or net short in various currencies making loans in foreign denominations FX transactions 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 exposure creates FX risk /19/2016 Bank Risks Robert B.H. Hauswald
7 Managing Foreign Exchange Risk To completely hedge foreign exposure simply match foreign assets and liabilities; but requires matching the maturities as well; but to do so, you actually match duration which is a fundamental concept of interest-rate sensitivity Otherwise, exposure to foreign interest rate risk remains: the curse of FX exposure is that you always acquire two exposures! 1/19/ Bank Risks Robert B.H. Hauswald Country or Sovereign Risk Result of exposure to foreign government which may impose restrictions on repayments to foreigners Direct exposure through investment in foreign government securities: Greece big problem in the resolution of the Greek debt crisis: sovereign exposure of EU banking system Often lack of usual recourse via court system Russia Argentina 1/19/ Bank Risks Robert B.H. Hauswald
8 The Problem: Bargaining Power In the event of restrictions, reschedulings, or outright prohibition of repayments, an FI s remaining bargaining chip is future supply of loans weak position if currency collapsing or government failing EU debt crisis: everybody is weakened banks, borrowers, EU, etc. 1/19/ Bank Risks Robert B.H. Hauswald Technology and Operational Risk Risk of losses resulting from inadequate or failed internal processes, people and systems, or from external events Loss of backup files by BOA Unsecured wireless network at TJX Jerome Kerviel (Société Générale) Bernie Madoff 1/19/ Bank Risks Robert B.H. Hauswald
9 Technology Risk Technological innovation has seen rapid growth Automated clearing houses (ACH) CHIPS Real time interconnection of global FIs via satellite systems Online banking Automated credit approval processes 1/19/ Bank Risks Robert B.H. Hauswald The Importance of Technology Economies of scale Economies of scope Operational risk not exclusively technological Employee fraud and errors Losses magnified since they affect reputation and future potential Importance of IT: finance is about trading risk risk is about information: trading information 1/19/ Bank Risks Robert B.H. Hauswald
10 Insolvency Risk Risk of insufficient capital to offset sudden decline in value of assets relative to liabilities Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks Washington Mutual Too big to fail: e.g., Citigroup what about Too large to rescue Iceland, Ireland and the UK 1/19/ Bank Risks Robert B.H. Hauswald Other Risks & Interaction of Risks Interdependencies among risks Example: Interest rates and credit risk Interest rates and derivative counterparty risk Discrete Risks Examples include effects of war or terrorist acts, market crashes, theft, and malfeasance Changes in regulatory policy 1/19/ Bank Risks Robert B.H. Hauswald
11 Summary FIs face a lot of risk implication? why? Some risks are more important than others focus on those Some risks are easier to manage than others problem? Open question: operating objectives conflicts of interest between: 1/19/2016 Bank Risks Robert B.H. Hauswald 21 Pertinent Websites Bank for International Settlements Federal Reserve Federal Deposit Insurance Corporation /19/2016 Bank Risks Robert B.H. Hauswald
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