Lecture 10 Risks of Financial Intermediation Overview

Lecture 10 Risks of Financial Intermediation

Overview • This chapter discusses the risks associated with financial intermediation: • Interest rate risk, market risk, credit risk, off-balance-sheet risk, technology and operational risk, foreign exchange risk, country risk, liquidity risk, insolvency risk

Risks of Financial Intermediation • Interest rate risk resulting from intermediation: • 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.

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. • Trading activities introduce other perils as was discovered by Allied Irish Bank’s U. S. subsidiary, All. First Bank when a rogue trader successfully masked large trading losses on foreign exchange positions

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 80 s and 90 s • Obvious need for credit screening and monitoring • Diversification of credit risk

Off-Balance-Sheet Risk • Increased importance of off-balance-sheet activities • Letters of credit • Loan commitments • Derivative positions • Speculative activities using off-balance-sheet items create considerable risk

Technology and Operational Risk • Risk of direct or indirect loss resulting form 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 • CHIPS

Technology and Operational Risk • Risk that technology investment fails to produce anticipated cost savings. • Risk that technology may break down. • Bank of New York • Well’s Fargo • Economies of scale. • Economies of scope.

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.

Foreign Exchange Risk • Note that hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well*. • Otherwise, exposure to foreign interest rate risk is created.

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: South Korea, Indonesia, Thailand. • More recently, Argentina.

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.

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, offbalance-sheet, technological, FX, sovereign, and liquidity risks.

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.

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