Chapter 7: Risks of Financial Institutions

Question 1

What is the process of asset transformation performed by an FI?

Answer 1

Asset transformation by an FI involves purchasing primary assets and issuing secondary assets as a source of funds. The primary securities purchased by the FI often have maturity and liquidity characteristics that are different from the secondary securities issued by the FI.

Question 2

Why does the asset transformation process often lead to the creation of interest rate risk?

Answer 2

Interest rate risk occurs because the prices and reinvestment income characteristics of long-term assets react differently to changes in market interest rates than the prices and interest expense characteristics of short-term deposits.

Question 3

What is interest rate risk?

Answer 3

Interest rate risk is the risk incurred by an FI when the maturities of its assets and liabilities are mismatched.

Question 4

What is refinancing risk? How is refinancing risk part of interest rate risk?

Answer 4

Refinancing risk is the risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments. This risk occurs when an FI is holding assets with maturities greater than the maturities of its liabilities.

Question 5

Regarding Refinancing Risk: If an FI funds long-term fixed-rate assets with short-term liabilities, what will be the impact on earnings of an increase in the rate of interest? A decrease in the rate of interest?

Answer 5

These interest rate increases would reduce net interest income. The bank would benefit if interest rates fall as the cost of renewing the deposits would decrease, while the interest rate earned on the loan would not change. In this case, net interest income would increase.

Question 6

What is reinvestment risk? How is reinvestment risk part of interest rate risk?

Answer 6

Reinvestment risk is the risk that the returns on funds to be reinvested will fall below the cost of funds. This risk occurs when an FI holds assets with maturities that are shorter than the maturities of its liabilities.

Question 7

Regarding Reinvestment Risk: If an FI funds short-term assets with long-term liabilities, what will be the impact on earnings of a decrease in the rate of interest? An increase in the rate of interest?

Answer 7

if a bank has a two-year loan funded by a ten-year fixed-rate time deposit, the bank faces the risk that it might be forced to lend or reinvest the money at lower rates after two years, perhaps even below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at the new lower (or higher) interest rates. Besides the effect on the income statement, reinvestment risk may cause realized yields on assets to differ from the expected yields.

Question 8

How can interest rate risk adversely affect the economic or market value of an FI?

Answer 8

When interest rates increase (or decrease), the value of fixed-rate assets decreases (or increases) because of the discounted present value of the cash flows. To the extent that the change in market value of the assets differs from the change in market value of the liabilities, the difference is realized in the economic or market value of the equity of the FI.

Question 9

What is credit risk?

Answer 9

Credit risk is the risk that promised cash flows from loans and securities held by FIs may not be paid in full.

Question 10

Which types of FIs are more susceptible to credit risk? Why?

Answer 10

FIs that lend money for long periods of time, whether as loans or by buying bonds, are more susceptible to this risk than those FIs that have short investment horizons.
Because they must wait longer time for returns to be realized than other types of FIs.

Question 11

What is the difference between firm-specific credit risk and systematic credit risk?

Answer 11

Firm-specific credit risk refers to the likelihood that a single asset may deteriorate in quality, while systematic credit risk involves macroeconomic factors that may increase the default risk of all firms in the economy.

Question 12

How can an FI alleviate firm-specific credit risk?

Answer 12

Portfolio theory in finance has shown that firm-specific credit risk can be diversified away if a portfolio of well-diversified stocks is held. Similarly, if an FI holds a well-diversified portfolio of assets, the FI will face only systematic credit risk that will be affected by the general condition of the economy.

Question 13

How can an FI alleviate firm-specific credit risk?

Answer 13

Portfolio theory in finance has shown that firm-specific credit risk can be diversified away if a portfolio of well-diversified stocks is held. Similarly, if an FI holds a well-diversified portfolio of assets, the FI will face only systematic credit risk that will be affected by the general condition of the economy.

Question 14

What is liquidity risk?

Answer 14

Liquidity risk is the risk that a sudden surge in liability withdrawals may require an FI to liquidate assets in a very short period of time and at less than fair market prices.

Question 15

What two factors provide potential benefits to FIs that expand their asset holdings and liability funding sources beyond their domestic borders?

Answer 15

FIs can realize operational and financial benefits from direct foreign investment and foreign portfolio investments in two ways.

1. The technologies and firms across various economies differ from each other in terms of growth rates, extent of development, etc.
2. Exchange rate changes may not be perfectly correlated across various economies.

Question 16

What is foreign exchange risk?

Answer 16

Foreign exchange risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in non-domestic currencies.

Question 17

What does it mean for an FI to be net long in foreign assets? What does it mean for an FI to be net short in foreign assets? In each case, what must happen to the foreign exchange rate to cause the FI to suffer losses?

Answer 17

An FI is net long in foreign assets when the foreign currency-denominated assets exceed the foreign currency denominated liabilities (an FI will suffer potential losses if the domestic currency strengthens relative to the foreign currency when repayment of the assets will occur in the foreign currency).
An FI is net short in foreign assets when the foreign currency-denominated liabilities exceed the foreign currency denominated assets (an FI will suffer potential losses if the domestic currency weakens relative to the foreign currency when repayment of the liabilities will occur in the domestic currency)

Question 18

What does it mean for an FI to be net long in foreign assets? What does it mean for an FI to be net short in foreign assets? In each case, what must happen to the foreign exchange rate to cause the FI to suffer losses?

Answer 18

An FI is net long in foreign assets when the foreign currency-denominated assets exceed the foreign currency denominated liabilities (an FI will suffer potential losses if the domestic currency strengthens relative to the foreign currency when repayment of the assets will occur in the foreign currency).
An FI is net short in foreign assets when the foreign currency-denominated liabilities exceed the foreign currency denominated assets (an FI will suffer potential losses if the domestic currency weakens relative to the foreign currency when repayment of the liabilities will occur in the domestic currency)

Question 19

What is country or sovereign risk?

Answer 19

Country risk is the risk that repayments to foreign lenders or investors may be interrupted because of restrictions, intervention, or interference from foreign governments.

Question 20

What is market risk?

Answer 20

Market risk is the risk incurred from assets and liabilities in an FI’s trading book due to changes in interest rates, exchange rates, and other prices.

Question 21

How does market risk affect the operating performance of financial institutions?

Answer 21

Market risk affects any firm that trades assets and liabilities. The risk can surface because of changes in interest rates, exchange rates, or any other prices of financial assets that are traded rather than held on the balance sheet.

Question 22

What actions can be taken by FI management to minimize the effects of market risk?

Answer 22

Market risk can be minimized by using appropriate hedging techniques such as futures, options, and swaps, and by implementing controls that limit the amount of exposure taken by market makers.

Question 23

What is the nature of an off-balance-sheet activity?

Answer 23

Off-balance-sheet activities are contingent commitments to undertake future on-balance-sheet investments.

Question 24

How does an FI benefit from OBS activities? Identify the various risks that these activities generate for an FI and explain how these risks can create varying degrees of financial stress for the FI at a later time.

Answer 24

The usual benefit of committing to a future activity is the generation of immediate fee income without the normal recognition of the activity on the balance sheet. As such, these contingent investments may be exposed to credit risk (if there is some default risk probability), interest rate risk (if there is some price and/or interest rate sensitivity) and foreign exchange rate risk (if there is a cross currency commitment).

Question 25

What is technology risk?

Answer 25

Technology risk occurs when investment in new technologies does not generate the cost savings expected in the expansion in financial services.

Question 26

What is the difference between economies of scale and economies of scope? How can these economies create benefits for an FI? How can these economies prove harmful to an FI?

Answer 26

Economies of scale occur when the average cost of production decreases with an expansion in the amount of financial services provided.
Economies of scope occur when an FI is able to lower overall costs by producing new products with inputs similar to those used for other products.

Question 27

What is the difference between technology risk and operational risk?

Answer 27

Technology risk is the risk incurred by an FI when its technological investments do not produce anticipated cost savings.
Operational risk refers to the risk that existing technology, auditing, monitoring, and other support systems may malfunction or break down. This includes the failure of the back-room support operations necessary to maintain the smooth functioning of the operation of FIs, including settlement, clearing, and other transaction-related activities.

Question 28

Why can insolvency risk be classified as a consequence or outcome of any or all of the other types of risks?

Answer 28

Insolvency risk is the risk that an FI may not have enough capital to offset a sudden decline in the value of its assets. This risk involves the shortfall of capital in times when the operating performance of the institution generates accounting losses. These losses may be the result of one or more of interest rate, market, credit, liquidity, sovereign, foreign exchange, technological, and off-balance-sheet risks.