Lesson 4: Risks of Financial Institution Pt2 Flashcards
What is credit risk?
Which types of FIs are more susceptible to this type of risk? Why?
Credit risk is the risk that promised cash flows from loans and securities held by FIs may not be paid in full. 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.
For example, life insurance companies and depository institutions are more exposed to credit risk than are money market mutual funds and property-casualty insurance companies
What is liquidity risk? What routine operating factors allow FIs to deal with this risk in times of normal economic activity?
What market reality can create severe financial difficulty for an FI in times of extreme liquidity crises?
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. In times of normal economic activity, depository institutions meet cash withdrawals by accepting new deposits and borrowing funds in the short-term money markets.
However, in times of harsh liquidity crises, the FI may need to sell assets at significant losses in order to generate cash quickly.
What is foreign exchange risk? 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?
Foreign exchange risk is the risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies.
• An FI is net long in foreign assetswhen the foreign currency-denominated assets exceed the foreign currency-denominated liabilities. In this case, 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 assetswhen the foreign currency-denominated liabilities exceed the foreign currency-denominated assets. In this case, 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.
What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency?
Country or sovereign risk is the risk that repayments to foreign lenders or investors may be interrupted because of restrictions, intervention, or interference from foreign governments.
A lender FI has very little recourse in this situation unless the FI is able to restructure the debt or demonstrate influence over the future supply of funds to the country in question. This influence likely would involve significant working relationships with the IMF and the World Bank.
What is technology risk?
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?
Technology risk occurs when investment in new technologies does not generate the cost savings expected in the production and expansion of financial services.
Economies of scale occur when the average cost of production decreases with the production of or 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. In financial service industries, the use of data from existing customer databases to assist in providing new
service products is an example of economies of scope.
Failure to produce the perceived synergies or costs savings can result in major losses in competitive efficiency of an FI and, ultimately, in an FI’s long-term failure.
Why can insolvency risk be classified as a consequence or outcome of any or all of the other types of risks?
Insolvency risk is 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. 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, credit, liquidity, sovereign, foreign exchange, market, off-balance-sheet, and technological risks.
