Week 3 Risk of Financial Institutions

Question 1

Name the risks of financial institutions

Answer 1

• Interest rate risk
• Market risk
• Credit risk
• Country/sovereign risk
• Foreign exchange risk
• Liquidity risk
• Off-balance risk
• Technology risk
• Operational risk
• Insolvency risk

Question 2

What is interest rate risk?

Answer 2

• Interest rate risk is the risk incurred by an FI if it mismatches the maturities of its assets and
liabilities.

Question 3

explain the 2 types of interest rate risk

Answer 3

– Refinancing risk:
the costs of rolling over funds or reborrowing funds will rise above the returns generated
on investments.
(maturity of assets are longer than that of liabilities)

– Reinvestment risk:
the returns on funds to be reinvested will fall below the cost of funds.
(maturity of liabilities are longer than that of assets)

Question 4

Explain the relationship interest rate movement and market value of asset and liabilities

Answer 4

-They have a opposite relationship so:
– As interest rates increase the market value of assets and
liabilities decreases.
– As interest rates decrease the market value of assets and
liabilities increases.

Question 5

Assuming the maturity of assets > the maturity of liabilities, what effect would an increase and decrease in interest rates have?

Answer 5

– An increase in interest rates causes a fall in the market value of
both assets and liabilities, but assets are more severely affected.

– A decrease in interest rates causes an increase in the market
value of both assets and liabilities, and liabilities will increase
less than assets.

Question 6

Assuming the maturity of assets < the maturity of liabilities, what effect would an increase and decrease in interest rates have?

Answer 6

– An increase in interest rates causes a fall in the market value of
both assets and liabilities, and assets will decrease less than
liabilities.

– A decrease in interest rates causes a rise in the market value of
both assets and liabilities, but liabilities will increase more than
assets

Question 7

How do you protect against interest rate risk?

Answer 7

• Match the maturities of assets and liabilities

• However, balance sheet hedging by matching
maturities of assets and liabilities is problematic for
FIs.
– Lose the asset-transformation function. (May also reduce
profitability.)
– Hedge is done approximately rather than completely due
to different average life/maturity/duration between assets
and liabilities, and the existence of equity.

• For most FIs the maturity of assets exceeds the
maturity of liabilities.

Question 8

Explain market risk

Answer 8

• Market risk is incurred due to changes in
interest rates, exchange rates or other asset
prices when trading assets and liabilities.

• It is the incremental risk incurred when
interest rate, FX and equity return risk are
combined with an active trading strategy that
involves short trading horizons.

Question 9

How do you protect against market risk?

Answer 9

• FIs should limit positions taken by traders, and to develop models to measure the market risk exposure on a day-to-day basis.

Question 10

What is credit risk?

Answer 10

• This is the risk that promised cash flows on loans and securities held by the FI are not repaid in full

– FIs that make loans or buy bonds with long
maturities are more exposed.

Question 11

What are the two types of credit risk?

Answer 11

– Firm-specific credit risk affects a particular company. It can be managed through diversification.

– Systematic credit risk affects all borrowers.

Question 12

How do you protect against credit r?isk

Answer 12

• Screening and monitoring loan applicants, efficient and effective credit management, monitoring and enforcement of restrictive covenants, diversification across assets

Question 13

What is country or sovereign risk?

Answer 13

• The risk that repayments from foreign borrowers may be interrupted because of interference of foreign governments.
• A different type of credit risk due to adverse political reasons.

Question 14

explain foreign exchange risk

Answer 14

• Foreign exchange risk is the risk that changes in exchange rates may adversely affect the value of an FI’s assets and/or liabilities.

• Arises as part of:
– Foreign exchange trading.
– Holding assets and liabilities in different currencies.
– Having foreign investment which earns profits in foreign currencies.

Question 15

How do you protect against foreign exchange risk?

Answer 15

• By matching size of foreign assets and liabilities

• Notice that hedging foreign exposure by matching foreign assets and liabilities requires matching the maturities as well. Otherwise, exposure to foreign interest rate risk is created.

Question 16

What is liquidity risk?

Answer 16

• Liquidity risk is the risk that a sudden surge in liability withdrawals may pressure the FI into liquidating parts of its assets.
• The liquidation of assets may have to happen in a very short period and at very low prices. It is problematic for illiquid assets such as loans.

Question 17

what do liquidity problems cause a bank?

Answer 17

• Serious liquidity problems can cause a “run” on
the FI. A “run” can turn a simple liquidity problem
into a solvency problem, and might threaten the
FI’s survival

Question 18

Explain off balance sheet risk

Answer 18

• Arises if FIs enter into contingent liability or asset contracts:
– Letters of credit
– Loan commitments
– Derivative positions

• Speculative activities using off-balance-sheet items create considerable risk.
• To account for off-balance-sheet risk, risk-based capital requirements oblige a bank to convert offbalance-sheet activities to “on-balance” equivalents and hold capital against these activities.

Question 19

What does the Bank for International
Settlements (BIS) define operational risk (inclusive of
technological risk)

Answer 19

• “the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events”.

Question 20

Explain technology risk

Answer 20

• the risk incurred by an FI when
technological investments do not produce the cost
savings anticipated.
– Major objectives of technological expansion are to
lower operating costs, increase profits, and/or capture
new markets.
– Economies of scale imply an FI’s ability to lower its
average costs of operations by expanding its output
of financial services.
– Economies of scope imply an FI’s ability to generate
cost synergies by producing more than one output
with the same inputs.

Question 21

Explain operational risk

Answer 21

• Operational risk: the risk that existing technology
or support systems may malfunction or break down. It also arises as the result of:
– Business interruptions: from loss or damage to
assets, facilities, systems, or people.
– Transaction processing: from failed, late, or incorrect
settlements.
– Inadequate information systems: in which the security
of data or systems is compromised.
– Breaches in internal controls: resulting in fraud, theft,
or unauthorised activities.
– Client liability: resulting in restitution payments or
reputation losses

Question 22

Explain insolvency risk

Answer 22

• The risk that an FI may not have sufficient capital
to offset a sudden decline in its asset values
relative to its liabilities.

• Original cause may be excessive interest rate, or
market, credit, off-balance-sheet, technological,
FX, sovereign, and liquidity risks. The more risk
taken, the greater the amount of capital required.

Question 23

How do you protect against insolvency risk?

Answer 23

• Both FI management and regulators focus on an FI’s capital and capital adequacy as key measures to ensure FI solvency.