6. Risk Management in Banks Flashcards
What do Banks do?
- Typical financial intermediary.
- Expertise in reducing transaction costs and asymmetric information.
- Maturity transformation.
- Liquidity transformation.
- Risk transformation.
What are assets in a balance sheet for a commercial bank?
- Use of funds
- Loans
- Reserves
- Cash
- Deposits at other financial institutions.
- Advances
What are liabilities in a commercial bank balance sheet?
- Source of Funds
- Checkable Deposits
- Equities
- Non-transaction deposits.
- Borrowing from other financial institutions.
What is Bank Capital?
- Assets-Liabilities: Buffer to prevent bank failure
What the general principles of Bank Management?
- Asset management: to ensure low risk and high return of asset acquisition.
- Liability Management: To acquire fund at low cost.
- Capital adequacy management: To balance between failure buffer and profitability.(ICARA used to be ICAAP)
- Liquidity Management: To keep enough cash for obligation.
What are the main risks in bank management?
- Credit risk: borrowers may default.
- Liquidity risks: unable to meet cash commitments to lenders.
- Interest rate risks: falling in net margins or asset values due to changes in interest rates.
- Other market risks: losses due to changes in exchange rates, commodity prices etc.
- Macro risks: losses due to institutional or policy risks.
- Operational risks: losses caused by errors or damages by people, systems, data etc.
What are the associate risks of interest rate risks in a bank?
- If a financial institution has more rate-sensitive liabilities than assets, a rise in interest rates will reduce the net interest margin and net worth of the institution, while a decline in interest rates will raise the margin and net worth.
What is income gap analysis?
- Estimates the sensitivity of a bank’s current year net interest income (interest - cost) to changes in interest rate.
What is Duration Gap Analysis?
- Estimates the sensitivity of the net worth of market values of a bank.
What does triangle I stand for in income gap analysis?
- Change in net interest income
What does triangle I^A stand for in income gap analysis?
- Change in interest income.
What does triangle I^L stand for in income gap analysis?
Change in interest payment.
What does RSA stand for in income gap analysis?
Rate sensitive assets.
What does RSL stand for in income gap analysis?
Rate sensitive liabilities.
What does change in i stand for in income gap analysis?
- Change in net interest rate.
What does GAP stand for in income gap analysis?
= Rate-Sensitive Assets - Rate Sensitive Liabilities.
Income Gap Analysis Formula
Change in Net Interest Income = (Rate-Sensitive Assets - Rate-Sensitive Liabilities) * Change in net interest rate
What is the Macauley Duration?
- Interest rate changes can affect longer-term net interest income and hence the net worth of a financial institution.
- Duration (Frederick Macaulay) - the average lifetime of a debt security’s stream of payments.
- A coupon bond pays back earlier than the same-valued zero-coupon bond with the same time to maturity.
- Consider a series of zero-coupon bonds resembling the payment flow of a coupon bond.
- Thus effective maturity of a coupon bond: presented-value weighted average of the time to maturity of those zero-coupon bonds.
What are the properties of Duration?
- All else being equal
- Longer the term to maturity of a bond is, the longer the duration.
- When interest rates rise, duration of a coupon bond falls.
- Higher the coupon rate on the bond is, shorter is the duration of the bond.
- Duration is additive: duration of a portfolio is the weighted-value average of the durations of the individual securities.
- Greater the duration is, greater the interest rate risk.
Evaluating Income and Duration Gap Analyses
- To be completely immunised, manage DurationA and Duration L to let gaps - 0
- Gaps analyses have problems - interest rates differ with time to maturity
- Some judgmental rate-sensitive exposures.
Alts Evaluation
- Risk assessment: scenario analysis, value at risk or its improved measures.
- Hedging: IR swaps and other financial derivatives to mitigate risks.
Banks Assets
- A banks asset can be a use of its funds.
Types of Bank Capital Definition
- Raised by selling new equity.
- A cushion against a drop in the value of its assets.
- Comes from retained earnings.
When does a bank fail?
- A bank fails when the value of its assets falls below the value of liabilities, causing the bank to become insolvent.
When is adverse selection present in banks?
- Banks face the problem of adverse selection in loan markets because bad credit risks are the ones most likely to seek banks loans.
When do banks face the moral hazard problem?
- Because borrowers, once they have a loan, are more likely to invest in high-risk investment projects, banks face the moral hazard problem.
Diversification and Adverse Selection in Banks
- From the standpoint of diversification, specialisation in lending is surprising but makes perfect sense when one considers the adverse selection problem.
Rationing Credit in Banks
- When a bank offers borrowers smaller loans than they have requested.
What happens if a bank has more rate-sensitive liabilities than rate-sensitive assets?
- An increase in interest rates will reduce bank profits.
What is duration gap analysis to basic gap analysis?
- A complement to basic gap analysis that accounts for the effect of interest rate changes on market value.
Negative Duration Gap
- A rise in interest rate causes the market value of a bank’s net worth to rise.
