Risks of Financial Intermediation Finance 129 Drake Fin

Risks of Financial Intermediation Finance 129 Drake Fin 129 DRAKE UNIVERSITY

Common Risks Drake University Fin 129 All Financial Intermediaries face similar risks from their operations. The importance of each type of risk depends upon the intermediary and business lines We will spend today introducing the types of risk present. The remainder of the semester is spent detailing each type of risk and discussing management techniques used by firms to limit the impact of each risk.

Margin Income Drake University Fin 129 Most financial institutions serving an intermediary role make some income from interest margins.

Interest Rate Risk Drake University Fin 129 The Interest rates on both Assets and Liabilities are tied to the length of the commitments. Interest rate risk results from a mismatch in maturities of assets and liabilities. Refinancing risk. Reinvestment risk.

Interest Rate Risk: Refinancing Risk Drake University Fin 129 Assume you have $100 million in liabilities financed at 9% per year and the rate that you pay resets at the end of the year. Your FI also has $100 million in assets that mature in 2 years paying 10% per year. What happens if the interest rate increases?

Interest Rate Risk: Reinvestment Rate Risk Drake University Fin 129 Assume you have $100 million in liabilities financed at 9% per year that mature in 2 years. Your FI also has $100 million in assets that mature in 1 years financed at a cost of 10% per year. What happens if the interest rate decreases?

Matching Maturities Drake University Fin 129 It is difficult for the FI to match maturities and it may not eliminate interest rate risk anyway:

Interest Rate Risk: Market Value Risk Drake University Fin 129 Market value is tied to the level of interest rates. As rates increase market value decreases, as rates decrease market value increases The impact of rate changes is tied to maturity

Market Risk Drake University Fin 129 The combination of interest rate, foreign exchange, and equity return risks are combined with an active trading strategy.

Credit Risk Drake University Fin 129 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 Drake University Fin 129 Risk associated with contingent claims that do not show up on the balance sheet. It is not on the Balance sheet since it does not involve holding a current primary claim or issuing a current secondary claim.

Technology and Operational Risk Drake University Fin 129 Risk of direct or indirect loss 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 CHIPS

Technology and Operational Risk Drake University Fin 129 Technology Risk: Technology investment may fail to produce anticipated cost savings. Operational Risk: The risk that support systems (often based on new technology) may break down. Bank of New York – failed to register incoming payments on Fedwire, but continued to process outgoing payments Well’s Fargo – Failure to correctly post deposits to acquired firms account holders – cost $180 Million

Economies of Scale and Scope Economies of Scale: Economies of Scope: Drake University Fin 129

Foreign Exchange Risk Drake University Fin 129 Foreign Assets and Foreign Liabilities change in value with changes in exchange rates. Net Long Asset Position – Net Short Asset Position –

Foreign Exchange Risk Drake University Fin 129 Returns on foreign and domestic investment are not perfectly correlated. FX rates may not be correlated. Example: $/DM may be increasing while $/¥ decreasing.

Foreign Exchange Risk Drake University Fin 129 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 Drake University Fin 129 Result of exposure to foreign government which may impose restrictions on repayments to foreigners. Lack usual recourse via court system.

Liquidity Risk Drake University Fin 129 Risk of being forced to borrow, or sell assets in a very short period of time. Low prices result. May generate runs.

Insolvency Risk Drake University Fin 129 Risk of insufficient capital to offset sudden decline in value of assets or liabilities. Original cause may be excessive interest rate, market, credit, off-balance-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. Drake University Fin 129

Macroeconomic Risks Drake University Fin 129 Increased inflation or increase in its volatility. Affects interest rates as well. Increases in unemployment Affects credit risk as one example. Changes in Consumer Confidence Changes in home building

Risk Management Techniques Drake Deciding what risks to accept and how to manage them Set Asides Limits on Risky Positions Hedging Business Lines vs. Total Operations Drake University Fin 129

Risk Measurement Tools Drake University Fin 129 Value at Risk and Earnings at Risk Models that predict the probability and magnitude of potential loss from market risk Stress Testing What is the worst case Scenario? GAP, Duration GAP Financial Statement Analysis Impact of Regulation

Consolidated Risk Management “A coordinated process of measuring and managing risk on firmwide basis. ”* *Cumming and Hirtle, The Challenges of Risk Management in DIversified Financial Compaies. Drake University Fin 129

Benefits of Consolidating Risk Management Drake University Fin 129 Diversification benefits are ignored without consolidation, leading to increased risk management costs Lack of coordination can increase firm wide risk in times of market problems (unwinding similar position in different business lines for example).

Barriers to Consolidated Risk Management Drake University Fin 129 Consolidation of financial firms has produced increased product and geographic diversification which has made business wide risk management more difficult. Information Costs The cost of integrating, recording and analyzing risk across separate business lines.

Barriers to Consolidated Risk Management Drake University Fin 129 Regulatory Costs Consolidation has created a framework where firms are required to respond to multiple regulators. Capital and Liquidity requirements may prohibit the movement of funds from one business line to another. Cost associated with managing the separate regulatory requirements including opportunity costs