TOPIC 4: TYPES OF RISKS FACED BY FINANCIAL INSTITUTIONS

(i) Credit risk

Credit risk arises because the possibility that promised cash flows on financial
claims held by FIs, such as loans or bonds, will not be paid in full. Virtually all
types of FIs face this risk. FIs that make loans or buy bonds with long
maturities are relatively more exposed to credit risk. This means, banks,
thrifts, and insurance companies are more exposed than Money market mutual
funds (MMFs) and property-casualty insurance companies.

If a borrower defaults, however, both the principal loaned and the interest
payments expected to be received are at risk. As a result, many financial claims
issued by individuals or corporations and held by FIs promise a limited or fixed
upside return(principal and interest payments to the lender) with a high
probability and a large downside risk(loss of loan principal and promised interest)
with a much smaller probability.
In the event of default, however, the FI earns zero interest on the asset and
may lose all or part of the principal lent, depending on the its ability to lay
claim on to some of the borrower’s assets through legal bankruptcy and
insolvency proceedings.

A key role of FIs involves screening and monitoring loan applicants to ensure
only the creditworthy receive loans. FIs also charge interest rates commensurate
with the riskiness of the borrower

Diversification across assets, such as loan exposed to credit risk, reduces the
overall credit risk in the asset portfolio and thus increases the probability of
partial or full payment of principal and or interest.

In effect diversification reduces individual firm-specific credit risk, such as risk

specific to holding the bonds, but not systematic credit risk

Firm-specific credit risk is the risk of default for the borrowing firm associated
with the specific types of project risk taken by that firm

Systematic credit risk is the risk of default associated with general economy-
wide or macroeconomic conditions affecting all borrowers (e.g.an economic
recession)

(ii) Liquidity risk

 Liquidity risk is the risk that a sudden and unexpected increase in liability
withdrawals may require an FI to liquidate assets in a very short period of
time and at low prices.
Or
Liquidity risk arises when an FIs liability holders, such as depositors or
insurance policyholders, demand immediate claims they hold with an FI or when
holders off-balance – sheet loan commitments ( or credit lines) suddenly exercise
their right to borrow(draw down their loan commitments).
Day-to-day withdrawals by liability holders are generally predictable –
unusually large withdrawals by liability holders can create liquidity problems and
FIs can normally expect to borrow additional funds to meet any sudden shortfalls
of cash on the money and financial markets.

When many FIs face abnormally cash demands, the cost of additional purchased
or borrowed fund rises and the supply of such funds become restricted. As a
consequence, FIs may have to sell some of their less liquid assets to meet the
withdrawal demands of liability holders. This results in more serious liquidity
risk, especially as some assets with thin markets generate lower prices when the
asset sale is immediate than when the FI has more time to negotiate the sale of an
asset. As a result the liquidation of some assets at low or fire – sale prices
( the price of an FI receives if an asset must be liquidated immediately at less
than its fair market value) could threaten an FI’s profitability and solvency.

(iii) Interest rate risk

Interest rate risk is the risk incurred by an FI when the maturities of its assets and
liabilities are mismatched and interest rates are volatile – asset transformation
involves an FI issuing secondary securities or liabilities to fund the purchase of primary
securities or assets – if an FI’s assets are longer-term than its liabilities, it faces
refinancing risk.
The refinancing risk is the risk that the cost of rolling over or re-borrowing funds will
rise above the returns being earned on asset investments.
If an FI’s assets are shorter-term than its liabilities, it faces reinvestment risk - the risk
that the returns on funds to be reinvested will fall below the cost of funds

FI faces market value risk as well. Remember that the market (or fair) value of an asset or
liability is conceptually equal to the present value of current and future cash flows from
that asset or liability. Mismatching maturities by holding longer – term assets than
liabilities means that when interest rates rise, the market value of the FI’s assets
falls by a greater amount than its liabilities. This exposes the FI to the risk of
economic loss and potentially, the risk of insolvency.
FIs can seek to hedge or protect against, interest rate risk by matching the maturity of
their assets and liabilities. This has resulted in the general philosophy that matching
maturities is somehow the best policy to hedge interest rate risk for FIs that are averse to
risk.

FIs face price risk (or market value risk). The risk that the price of the security changes
when interest rates change – FIs can hedge or protect themselves against interest rate
risk by matching the maturity of their assets and liabilities. This approach is
inconsistent with their asset transformation function.

(iv) Market risk

Market risk is the risk incurred in trading assets and liabilities due to changes in
interest rates, exchange rates, and other asset prices.
Market risk arises when FIs actively trade assets and liabilities (and derivatives)
rather than hold them for longer –term investment funding ,or hedging purposes.
Market risk is closely related to interest rate, equity return and foreign exchange risk in
that as these risks increase or decrease, the overall risk of the firm is affected.

Market risk is the incremental risk incurred by an FI (in addition to interest rate or
foreign exchange risk) caused by an active trading strategy – FIs’ trading portfolios are
differentiated from their investment portfolios on the basis of time horizon and liquidity.

Trading assets, liabilities, and derivatives are highly liquid. Investment portfolios are
relatively illiquid and are usually held for longer periods of time – declines in traditional
banking activity and income at large commercial banks have been offset by increases in
trading activities and income

Declines in underwriting and brokerage income at large investment banks have

been offset by increases in trading activity and income – actively managed MFs are
also exposed to market risk – FIs are concerned with fluctuations in trading account
assets and liabilities. Value at risk (VAR) and daily earnings at risk (DEAR) are
measures used to assess market risk exposure – market risk exposure has caused
some highly publicized losses • the failure of the 200-year old British merchant bank
Barings in 1995 • $7.2 billion in market risk related loss at Societe Generale in 2008

(v) Off balance sheet risk

Off-balance-sheet (OBS) risk - the risk incurred by an FI as the result of activities related
to contingent assets and liabilities.

Off- balance sheet activities affect the future shape of an FI’s balance sheet in that they
involve the creation of contingent assets and liabilities that give rise to their potential
(future) placement on the balance sheet. Thus, accountants place them ‘’below the bottom
line’’ of an FI’s asset and liability balance sheet.
Example:

Off – balance – sheet activity is the issuance of standby letter of credit guarantees by
insurance companies and banks to back the issuance of municipal bonds. The letter of
credit guarantees payment should a municipal government face problems in paying the
promised interest payments and or the principal bonds it issues. If municipal
government’s cash flow is sufficiently strong so as to pay off the principal and interest on
its debt it issues, the letter of credit guarantee issued by the FI expires unused. Nothing
appears on the FI’s balance sheet today or in the future. However, the fee earned for
issuing the letter of credit guarantee appears on the FI’s income statement.

As a result, the ability to earn fee income while not loading up or expanding the balance
sheet has become an important motivation for FIs to pursue off- balance sheet business.
Unfortunately, this activity is not risk free. Suppose the municipal government defaults
on its bond interest and principal payments. The contingent liability or guaranty the FI
issued becomes an actual liability that appears on the FI’s balance sheet. That is the
FI has to use its own equity to compensate investors in municipal bonds.

Indeed, significant losses in off- balance sheet activities can cause an FI to fail, just as
major losses due to balance sheet default and interest rate risks can cause an FI to
fail.

Other examples include: – loan commitments by banks – mortgage servicing contracts by

savings institutions – positions in forwards, futures, swaps, and other derivatives held by
almost all large FIs

(vi) Foreign exchange risk

Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value
of an FI’s assets and liabilities denominated in foreign currencies.

To illustrate how a foreign exchange risk arises, suppose that a US FI makes a loan to a
British company in pounds sterling. Should the British pound depreciate in value relative
to the U.S. dollar, the principal and interests payments received by U.S. investors would
be devalued in dollar-terms.

Indeed, were the British pound to fall far enough over the investment period, when cash
flows are converted back into dollars, the overall returns could be negative. That is, on
the conversion of principal and interest payments from pounds into dollars, foreign
exchange losses can offset the promised value of local currency interest payments at the
original exchange rate at which the investment occurred.

In general, an FI can hold assets denominated in a foreign currency and or issue foreign
liabilities. Consider a U.S. FI that holds £100 million in pound loans as assets and funds
£80 million of them with pound certificates of deposit. The difference between the
£100million in pound loans and £80 million in pounds CDS is funded by dollar CDs ( i.e.
£20 million worth of dollar CDs).

In this case the U.S. FI is net long £20 million in pounds assets, that is ,it holds more
foreign assets than liabilities. The U.S FI suffers losses if the exchange rate for pounds
falls or depreciates against the dollar over this period.

In dollar terms, the value of the pound loan assets falls or decreases in value by more than
the pound CD liabilities do. That, is the FI is exposed to the risk that its net foreign assets
may have to be liquidated at an exchange rate lower than the that existed when the FI
entered into the foreign exchange asset – liability position.

Instead, the FI could have £20 million more pound liabilities than assets, in this case, it
would be holding a net short position in pounds ,as shown in figure. Under this
circumstance, the FI is exposed to foreign exchange risk if the pound appreciates
against the dollar over the investment period. This occurs because the value of its
pound liabilities in dollar terms rose faster than the return on its pound assets and
liabilities. Consequently to be appropriately hedged, the FI must match its assets and
liabilities in each foreign currency.

(vii) Country or sovereign risk

Country or sovereign risk is the risk that repayments from foreign borrowers may be
interrupted because of interference from foreign governments – differs from credit
risk of FIs’ domestic assets. With domestic assets, FIs usually have some recourse
through bankruptcy courts—i.e., FIs can recoup some of their losses when defaulted
firms are liquidated or restructured – foreign corporations may be unable to pay
principal and interest even if they would desire to do so, Foreign governments may
limit or prohibit debt repayment due to foreign currency shortages or adverse
political events

Thus, an FI claimholder may have little or no recourse to local bankruptcy courts or to an

international claims court.

Measuring sovereign risk includes analyzing:

(a) The trade policy of the foreign government,

(b) The fiscal stance of the foreign government,
(c) Potential government intervention in the economy,
(d) The foreign government’s monetary policy,
(e) Capital flows and foreign investment,
(f) The foreign country’s current and expected inflation rates and
(g) The structure of the foreign country’s financial system
 (viii) Technology and operation risk

Technology risk and operational risk are closely related.

Technology risk is the risk incurred by an FI when its technological investments do not
produce anticipated cost savings. The major objectives of technological expansion are to allow
the FI to exploit potential economies of scale and scope by: lowering operating costs, increasing
profits, capturing new markets.

Operational risk is the risk that existing technology or support systems may malfunction or
break down.

The Bank for international settlements (BIS) the principal organization of central banks in the
major economies of the world, defines operational risk(inclusive of technological risk), as
―the risk of loss resulting from inadequate or failed internal processes, people, and
systems or from external events

Technological risk occurs when technological investments do not produce the anticipated cost
savings in the form of economies of scale of either scale or scope .

Economies of scale – the degree to which an FI’s average unit costs of producing financial
services fall as its output of services increase.

Economies of scope – the degree to which FI can generate cost synergies by producing multiple
financial services products.

Operational risk – is partly related to technological risk and can arise whenever existing
technology malfunctions or back – office support systems break down. E.g. ATM crashing
for an extended period of time.

Operational risk is not exclusively the result of technological failure. For example, employee
fraud and errors constitute a type of operational risk that often negatively affects the reputation
of an FI.

(ix) Insolvency risk

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.

Insolvency risk is a consequence or an outcome of one or more of the risks previously described:
interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and/or liquidity
risk.

Technically, insolvency occurs when the capital or equity capital of an FI’s owners are driven to
or near to, zero because of losses incurred as a result of one or more of the risks described above.
In general, the more equity capital to borrowed funds an FI has, i.e., the lower its leverage,
the better able it is to withstand losses, whether due to adverse interest changes, unexpected
credit losses, or other reasons. Thus both management and regulators of FI’S capital (and
adequacy) as a key measure of its ability to remain solvent and grow in the face of a multiple of
risk exposures.