1. Risks of FinancialRisks of Financial
IntermediationIntermediation
Chapter 7
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.McGraw-Hill/Irwin

2. 7-2
Overview
 This chapter discusses the risks associated
with financial intermediation:

Interest rate risk, market risk, credit risk,
off-balance-sheet risk, foreign exchange
risk, country or sovereign risk, technology
risk, operational risk, liquidity risk,
insolvency risk
 Note that these risks are not unique to FIs

Faced by all global firms

3. 7-3
Risks of Financial Intermediation
 Interest rate risk resulting from
intermediation:

Mismatch in maturities of assets and liabilities.
 Interest rate sensitivity difference exposes equity to
changes in interest rates

Balance sheet hedge via matching maturities of
assets and liabilities is problematic for FIs.
 Inconsistent with asset transformation role

Refinancing risk.

Reinvestment risk.

4. 7-4
Market Risk
 Incurred in trading of assets and liabilities
(and derivatives).

Example: Barings Bank’s Nick Leeson & decline
in Nikkei Stock Market Index.

Heavier focus on trading income over traditional
activities increases market exposure.
 Trading activities introduce other perils as was
discovered by Allied Irish Bank’s U.S. subsidiary,
AllFirst Bank when a rogue trader successfully
masked large trading losses and fraudulent activities
involving foreign exchange positions

5. 7-5
Market Risk
 Distinction between Investment Book and
Trading Book of a commercial bank

Heightened focus on Value at Risk (VAR)

Heightened focus on short term risk measures
such as Daily Earnings at Risk (DEAR)
 Role of securitization in changing liquidity of
bank assets and liabilities

6. 7-6
Credit Risk
 Risk that promised cash flows are not paid
in full.

Firm specific credit risk

Systematic credit risk
 High rate of charge-offs of credit card debt
in the 1980s, most of the 1990s and early
2000s
 Credit card loans (and unused balances)
continue to grow

7. 7-7
Charge Off Rates for Commercial Banks

8. 7-8
Implications of Growing Credit Risk
 Importance of credit screening
 Importance of monitoring credit extended
 Role for dynamic adjustment of credit risk
premia
 Diversification of credit risk

9. 7-9
Off-Balance-Sheet Risk
 Striking growth of off-balance-sheet
activities

Letters of credit

Loan commitments

Derivative positions
 Speculative activities using off-balance-
sheet items create considerable risk

10. 7-10
Foreign Exchange Risk
 FI may be net long or net short in various
currencies
 Returns on foreign and domestic investment
are not perfectly correlated.
 FX rates may not be correlated.

Example: $/€ may be increasing while $/¥
decreasing
 and relationship between ¥ and € time varying.
 Undiversified foreign expansion creates FX
risk.

11. 7-11
Foreign Exchange Risk
 Note that completely hedging foreign
exposure by matching foreign assets and
liabilities requires matching the maturities as
well*.

Otherwise, exposure to foreign interest rate risk
remains.
*More correctly, FI must match durations, rather
than maturities. See Chapter 9.

12. 7-12
Country or Sovereign Risk
 Result of exposure to foreign government
which may impose restrictions on
repayments to foreigners.
 Often lack usual recourse via court system.
 Examples:

Argentina

Russia

South Korea
• Indonesia
• Malaysia
• Thailand.

13. 7-13
Country or Sovereign Risk
 In the event of restrictions, reschedulings, or
outright prohibition of repayments, FIs’
remaining bargaining chip is future supply of
loans

Weak position if currency collapsing or
government failing
 Role of IMF

Extends aid to troubled banks

Increased moral hazard problem if IMF bailout
expected

14. 7-14
Technology and Operational Risk
 Economies of scale.
 Economies of scope.
 Operational risk not exclusively
technological

Employee fraud and errors

Losses magnified since they affect reputation
and future potential

15. 7-15
Technology and Operational Risk
 Risk of losses resulting from inadequate or
failed internal processes, people, and
systems or from external events.

Some include reputational and strategic risk
 Technological innovation has seen rapid
growth

Automated clearing houses (ACH)

CHIPS

Real time interconnection of global FIs via
satellite systems

16. 7-16
Technology and Operational Risk
 Risk that technology investment fails to
produce anticipated cost savings.
 Risk that technology may break down.

CitiBank’s ATM network, debit card system and
on-line banking out for two days

Prudential Financial fined $600 million due to
allegations of improper mutual fund trades

Bank of America breakdown in security of tapes

Bank of New York: Computer system failed to
recognize incoming payment messages sent via
Fedwire although outgoing payments
succeeded

17. 7-17
Liquidity Risk
 Risk of being forced to borrow, or sell
assets in a very short period of time.

Low prices result.
 May generate runs.

Runs may turn liquidity problem into solvency
problem.

Risk of systematic bank panics.

Example: 1985, Ohio savings institutions
insured by Ohio Deposit Guarantee Fund
 Interaction of credit risk and liability risk

Role of FDIC (see Chapter 19)

18. 7-18
Insolvency Risk
 Risk of insufficient capital to offset sudden
decline in value of assets to liabilities.

Continental Illinois National Bank and Trust
 Original cause may be excessive interest
rate, market, credit, off-balance-sheet,
technological, FX, sovereign, and liquidity
risks.

19. 7-19
Risks of Financial Intermediation
 Other Risks and Interaction of Risks

Interdependencies among risks.
 Example: Interest rates and credit risk.
 Interest rates and derivative counterparty risk

Discrete Risks
 Examples include effects of war or terrorist acts,
market crashes, theft, malfeasance.
 Changes in regulatory policy

20. 7-20
Macroeconomic Risks
 Increased inflation or increase in its
volatility.

Affects interest rates as well.
 Increases in unemployment

Affects credit risk as one example.

21. 7-21
Pertinent Websites
Bank for International Settlements
www.bis.org
Board of Governors of the Federal Reserve
www.federalreserve.gov
Federal Deposit Insurance Corporation
www.fdic.gov