5. Risk management

Question 1

Source of Business Risk

Answer 1

• Mismatches between a firm’s “assets” and “liabilities” imply risks

Question 2

Major Mismatches and Risks for Banks

Answer 2

• Greater credit risk with assets than liabilities - default or credit risk
• Assets usually of longer maturity than liabilities - interest rate risk
• Liabilities more liquid than assets - liquidity risk

Question 3

• Two sources of default risk:

Answer 3

• Physical hazard, i.e., cash flow variations beyond the borrower’s control
• Moral hazard, i.e., borrower’s incentive to take actions that increase the bank’s risk exposure

Question 4

• Banks’ control over default risk:

Answer 4

• Screening borrowers, assessing the risk of physical hazard (but not bear it), which involves an analysis of borrowers’ financial and operating information Banks screen borrowers in order to assess lending risk ex ante .
• Bank monitoring of borrower compliance with covenants that are included in loan contracts to restrict the activities of borrowers
• Diversification through holding many loans in their asset portfolios

Question 5

Interest Rate Risk

Answer 5

• If the firm’s assets and liabilities are traded, they are subject to being revalued by the market. Any such revaluation, due to changes in either the level or structure of interest rates, is described as interest rate risk.

Question 6

Liquidity Risk

Answer 6

• Risk that an asset owner will not be able to realize the full value of that asset at the time a sale is desired

Question 7

Source of liquidity problems: informational frictions

Answer 7

• An informational asymmetry about asset quality creates liquidity risk.
• Even if the bank has a duration-matched balance sheet, default risk can lead to liquidity risk because of asymmetric information.
• Deposit interest rate ceilings transform interest rate risk into withdrawal risk; due to an informational asymmetry, the bank may only be able to sell its loans for less than their worth to meet unanticipated deposit withdrawals.

Question 8

Operational Risk

Answer 8

• The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal but excludes strategic and reputational risk.

Question 9

7 events categories

Answer 9

1. Internal fraud
2. External fraud
3. Employee practices and workplace safety
4. Natural disasters and public safety
5. Technology and infrastructure failure
6. Execution, delivery and process management
   * Often have subcategories…