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    Risk Management in Financial Institutions

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    yebegashet
    The document discusses various types of risks faced by financial institutions including credit risk, liquidity risk, interest rate risk, market risk, and operational risk. It provides examples of how financial institutions can manage credit risk through loan diversification and the 5 C's of credit analysis. For liquidity risk, institutions can purchase liquidity through short-term borrowing or store liquidity by holding excess reserves or liquid assets. Interest rate risk is measured using repricing gaps or duration gaps to analyze how income and expenses change with interest rate movements.

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    Risk Management in Financial Institutions

    Uploaded by

    yebegashet
    78 views37 pages
    The document discusses various types of risks faced by financial institutions including credit risk, liquidity risk, interest rate risk, market risk, and operational risk. It provides examples of how financial institutions can manage credit risk through loan diversification and the 5 C's of credit analysis. For liquidity risk, institutions can purchase liquidity through short-term borrowing or store liquidity by holding excess reserves or liquid assets. Interest rate risk is measured using repricing gaps or duration gaps to analyze how income and expenses change with interest rate movements.

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    FMICh04

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    The document discusses various types of risks faced by financial institutions including credit risk, liquidity risk, interest rate risk, market risk, and operational risk. It provides examples of how financial institutions can manage credit risk through loan diversification and the 5 C's of credit analysis. For liquidity risk, institutions can purchase liquidity through short-term borrowing or store liquidity by holding excess reserves or liquid assets. Interest rate risk is measured using repricing gaps or duration gaps to analyze how income and expenses change with interest rate movements.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    78 views37 pages

    Risk Management in Financial Institutions

    Uploaded by

    yebegashet
    The document discusses various types of risks faced by financial institutions including credit risk, liquidity risk, interest rate risk, market risk, and operational risk. It provides examples of how financial institutions can manage credit risk through loan diversification and the 5 C's of credit analysis. For liquidity risk, institutions can purchase liquidity through short-term borrowing or store liquidity by holding excess reserves or liquid assets. Interest rate risk is measured using repricing gaps or duration gaps to analyze how income and expenses change with interest rate movements.

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    of 37

    Chapter 4

    Risk Management
    in Financial Institutions
    Chapter contents
     Types of risks incurred by financial
    institutions
    Managing credit risk
    Managing liquidity risk
    Managing interest rate risk

    Financial markets and Institutions


    4.1 Types of risks

    Credit Risk
     the chance that debtors default on their
    obligation
     debt securities with long-term maturity pose
    more credit risk than securities with short-
    term maturity
     banks, thrifts and life insurance companies
    have higher degree of exposure to credit risk
    3 Financial markets and Institutions
    4.1 Types of risks

    4 Financial markets and Institutions


    4.1 Types of risks

    5 Financial markets and Institutions


    4.1 Types of risks

    Credit Risk...
     managerial efficiency and credit risk
    management strategy affects credit
    risk of a loan portfolio
     Loan diversification can help
    eliminate firm specific credit risk

    6 Financial markets and Institutions


    4.1 Types of risks

    Liquidity risk
     the likelihood that a FI becomes unable to
    meet demand for withdrawal,loan, or
    indemnity
     may compel FIs to dispose illiquid assets at a
    cheap price
     may cause a ‘bank run‘
     deposit insurance

    7 Financial markets and Institutions


    4.1 Types of risks
    Interest Rate (funding)Risk
     caused by maturity mismatch of assets and liabilities
    coupled with interest rate volatility
    oRefinancing risk –assets have long-term maturity and
    liabilities of short-term maturity. Cost of refinancing
    may exceed return on assets
    oReinvestment risk –holding short-term assets relative to
    liabilities. Uncertainity about interest rate at which
    borrowed funds will be reinvested
    oPrice risk—effect of change in interest rate on value of
    an asset or liability

    8 Financial markets and Institutions


    4.1 Types of risks

    Market Risk
     risk incurred in trading assets due to
    change in interest rate, exchange rate,
    and other asset prices
     faced by FIs engaged in active trading
    of assets

    9 Financial markets and Institutions


    4.1 Types of risks

    Cases of FI failure
    1. Barings- a 200-years old british bank
    failed in 1995 due to trading losses. It
    bought a futures contract that worth
    $8bill betting that the Nikkei index
    would rise. It became insolvent after a
    loss of $1.2bill
    10 Financial markets and Institutions
    4.1 Types of risks

    2. Societe Generale- a French Bank lost


    $7.2bill as Jerome Kerviel, the bank‘s
    trading clerk, invested in future
    contracts in European stock indexes
    betting that markets would continue to
    rise.

    11 Financial markets and Institutions


    4.1 Types of risks

    Off-balance sheet risk


     arises in relation with contingent
    assets and liabilities
    Eg. Credit guarantees, LCs

    12 Financial markets and Institutions


    4.1 Types of risks

    Foreign exchange risk


     risk that exchange rate changes affect
    the value of assets and liabilities of a
    FIs

    13 Financial markets and Institutions


    4.1 Types of risks

    Country (sovereign) Risk


     the risk that repayment from foreign
    borrowers may be interrupted because of
    interference from foreign governments
     governments may control foreign
    currency outflows to mitigate currency
    shortages
    14 Financial markets and Institutions
    4.1 Types of risks

    Technology and operational risk


     technology risk arises when FIs
    technological investment fails to fetch
    the anticipated benefit
     economies of scale and economies of
    scope

    15 Financial markets and Institutions


    4.1 Types of risks

    Technology and operational risk...


     operational risk arises when the
    existing technology or support system
    mulfunctions or breaks down
     may also arise due to employee fraud,
    misrepresentations, and account errors

    16 Financial markets and Institutions


    4.1 Types of risks

    Insolvency risk
     the risk that an FI may not have
    enough capital to offset a sudden
    decline in the value of its assets
    relative to its liabilities

    17 Financial markets and Institutions


    4.2 Managing credit risk on the BS

    Causes
     the problem of information asymmetry
    adverse selection and moral hazard
    Credit Analysis
     the 5 C‘s (Capacity, Conditions,
    Character, Capital, and Collateral)

    18 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS

    Sources of liquidity risk


    a) When debt holders(depositors or insurance policy
    holders) want to withdraw their financial claim
    b) Off balance sheet commitments(loan
    commitments) made by FIs are exercised
     to meet demands of short term debt holders , FIs
    may at times be compelled to liquidate assets at
    fire-sale prices

    19 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS

    Liability side liquidity risk of DIs


     arises due to holding short-term financial obligations
     a DI has core deposit that remains unwithdrawn over a
    long period of time
     withdrawals may be offset by attracting new deposits,
    and here only the net deposit drain becomes a concern
     a drain on deposit can be managed through
    (1) purchased liquidity and (2) stored liquidity mgt

    20 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS

    (1) Purchased liquidity


     raising short-term funds from the money
    market (Repos or interbank loan)
     helps to keep the asset side of the
    balance sheet undisturbed
     expensive when cost of the funds is less
    than return on asset
    21 Financial markets and Institutions
    4.3 Managing liquidity risk on the BS

    (2) Stored liquidity mgt


     keeping excess reserves or by
    liquidating near-cash items

    22 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS

    Example: Impact of purchased liquidity


    versus stored liquidity on NI
    Suppose Addis Bank has the following
    balance sheet:
    Assets(‘000) Liabilities and Equity(‘000)
    Cash Br 400 Deposits Br6,500
    Non-liquid assets 9,600 Borrowed funds 2,000
    Equity 1,500
    Total assets Br 10,000 Total Liab & Equity Br 10,000

    23 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS

    Example...
    Addis Bank pays, on average, 5% on core deposit
    and generates average return of 8% on loans.
    Increases in market interest rate are expected to
    cause a net drain of Br 2mill. Two options are
    available to manage the expected net drain:
    (1) Raise short-term debt at a cost of 7%
    (purchase liquidity)
    (2) Sell loans for cash (store liquidity)

    24 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS
    Example...
    (1) Raise short-term debt at a cost of 7%
    (purchase liquidity)
    Decrease in interest exp-
    core deposit Br 2mill x 5% = Br 100,000
    Increase in interest exp-
    short-term debt Br 2mill x 7%= 140,000
    Change in Net Income -Br 40,000
    25 Financial markets and Institutions
    4.3 Managing liquidity risk on the BS

    Example...
    (2) Sell loans for cash (store liquidity)
    Decrease in interest exp-
    core deposit Br 2mill x 5% = Br 100,000
    Decrease in interest income-
    loans Br 2mill x 8%= 160,000
    Change in Net Income -Br 60,000

    26 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS

    Asset side liquidity risk


     arises when borrowers want to exercise
    loan commitments made by a bank
     such commitments obligate the bank to
    satisfy loan demand by borrowers
     demand for loan can be satisfied through
    either purchased liquidity or stored liquidity

    27 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS

    Measuring a Bank‘s liquidity exposure


    (a) The net liquidity statement
     Shows the sources and uses of liquidity
     Sources of liquidity include selling near
    cash items, borrowing in the money
    market, or using excess reserves

    28 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS
    Measuring a Bank‘s liquidity exposure
    The net liquidity statement
    A bank can have the ff sources and uses of liquidity
    Sources of Liquidity:
    -Near cash items Br 100,000
    -max borrowed funds lim 850,000
    -excess reserve 150,000
    Total Br 1,100,000
    Uses
    - Funds borrowed Br 550,000
    - Interbank loan 250,000
    Total Br 800,000
    Excess liquidity Br 300,000

    29 Financial markets and Institutions


    4.3 Managing liquidity risk on the BS

    (b) Peer group ratio comparison


     comparison of the following ratios may
    help
     loan to deposit
     borrowed fund to total asset
     commitments to lend to total asset
    ratio

    30 Financial markets and Institutions


    4.4 Managing interest rate risk

    Measuring interest rate risk


     central banks often manipulate interest rate
    as part of the government‘s monetary policy
    measure
     two techniques
    (1) Repricing (funding gap) model
    (2) Duration gap model

    31 Financial markets and Institutions


    4.4 Managing interest rate risk

    (1) Repricing (funding gap) model


     analysis of the interest income earned on assets
    and interest expense paid on liabilities over a
    certain period
     Repricing gaps can be computed for Rate
    sensitive assets(RSAs) and Rate sensitive
    Liabilities (RSLs) over different maturity
    periods(maturity bucket)

    32 Financial markets and Institutions


    4.4 Managing interest rate risk

     A negative Gap (RSA<RSL) means a Bank‘s net


    interest income will fall
     NIIi = (GAPi)  Ri= (RSAi-RSLi)  Ri
    Where
     NIIi = Change in Net Interest Income in maturity bucket i
    GAPi = Size of the Gap (Book Value of RSA- RSL)
    in maturity bucket i
     Ri = Change in interest rate affecting assets and liabilities in
    the ith maturity bucket

    33 Financial markets and Institutions


    4.4 Managing interest rate risk

    Example: Consider the following list of RSAs and


    RSLs of Addis Bank (in millions)
    Assets Liabilities Gaps
    1. 1 Day Br 15 Br 20 Br – 5
    2. More than 1 day -3 months 25 35 - 10
    3. More than 3 months-6months 65 80 - 15
    4. More than 6 months-12months 90 70 20
    5. More than 1 year-5 years 40 35 5
    6. More than 5 years 15 10 5
    Br 250 Br 250 0

    34 Financial markets and Institutions


    4.4 Managing interest rate risk and solvency risk

    Example...
    Suppose short-term interest rate increases by 1%
    affecting assets and liabilities in the first bucket.
     NII= - Br 5mill x 1%
    = - Br 50,000
    What would be the change in NII if the change
    in short-term interest rate affects RSAs and
    RSLs that can be reprised within 6months to a
    year?
    35 Financial markets and Institutions
    4.4 Managing interest rate risk

    (2) Duration model


     duration measures interest sensitivity of an
    asset or liability‘s value to small changes in
    interest rates
    D = - %  security market value/
    ( R/1+R)

    36 Financial markets and Institutions


    End of Chapter 4

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