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CHAPTER SEVEN: RISK OF FINANCIAL INSTITUTIONS

SAUNDERS

CORNETT

MC GRAW

5TH CANADIAN EDITION

Chapter Seven: Risks of Financial Institutions Learning Objectives

LO2 Define and identify interest rate risk, market risk, credit risk, OBS risk, foreign exchange risk, country or sovereign risk, technology and operational risk, liquidity risk, and insolvency risk for an FI.

LO2 Discuss the interaction of risks for an FI.

Risks Faced by Financial Institutions (Table 7-1)

Interest Rate Risk

interest rate risk

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

Refinancing Risk

refinancing risk

The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments.

Reinvestment Risk

reinvestment risk

The risk that the returns on funds to be reinvested will fall below the cost of funds.

Credit Risk

credit risk

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

Credit Risk

firm-specific credit risk

The risk of default of the borrowing firm associated with the specific types of project risk taken by that firm.

systematic credit risk

The risk of default associated with general economy-wide or macroconditions affecting all borrowers.

Liquidity Risk

liquidity risk

The risk that a sudden surge in liability withdrawals may leave an FI in a position of having to liquidate assets in a very short period of time and at low prices.

Foreign Exchange Risk

foreign exchange risk

The risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies.

Foreign Asset and Liability Position: Net Long Asset in ₤ (Figure 7-1)

Foreign Asset and Liability Position: Net Short Asset in ₤ (Figure 7-2)

Sovereign Risk

country or sovereign risk The risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments.

Market Risk

market risk

The risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.

Off-Balance-Sheet Risk

off-balance-sheet (OBS) risk

The risk incurred by an FI due to activities related to contingent assets and liabilities.

Off-Balance-Sheet Risk

standby letter of credit (LC or L/C) An irrevocable credit guarantee that the issuing FI will pay a third party should its customer default on its obligation.

commercial letter of credit A written undertaking that the issuing FI will pay a third party on the presentation of specified documents evidencing the shipment of goods.

Technology and Operational Risk

Technology and operational risks are closely related and in recent years have caused great concern to FI managers and regulators alike. The Bank for International Settlements (BIS), the principal organization of central banks of 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.”

Technology and Operational Risk

economies of scale

The degree to which an FI’s average unit costs of producing financial services fall as its outputs of services increase.

economies of scope

The degree to which an FI can generate cost synergies by producing multiple financial service products.

Technology and Operational Risk

technology risk

The risk incurred by an FI when technological investments do not produce the cost savings anticipated.

operational risk

The risk that existing technology or support systems may malfunction or break down.

Insolvency Risk

insolvency risk

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.

Other Risks & the Interaction of Risks

Various other risks, often of a more discrete or event type, also impact an FI’s profitability and risk exposure, although, as noted earlier, many view discrete or event risks as part of operational risks. Discrete risks might include events external to the FI, such as a sudden change in taxation. Such changes can affect the attractiveness of some types of assets over others, as well as the liquidity of an FI’s balance sheet.

Chapter Summary

This chapter provided an introductory view of ten major risks faced by modern FIs. They face interest rate risk when the maturities of their assets and liabilities are mismatched. They face credit risk or default risk if their clients default on their loans and other obligations. They encounter liquidity risk as a result of excessive withdrawals or problems in refinancing liabilities. If FIs conduct foreign business, they are subject to additional risks, namely foreign exchange and sovereign risks. They incur market risk on their trading assets and liabilities if adverse movements in interest rates, exchange rates, or other asset prices occur. Modern-day FIs also engage in significant off-balance-sheet activities that expose them to off-balance-sheet risks: contingent asset and liability risks.

Chapter Summary (cont’d)

The advent of sophisticated technology and automation exposes FIs to both technological and operational risks. FI’s face insolvency risk when their capital is insufficient to withstand the losses that they incur as a result of such risks. The interaction of the various risks means that FI managers face making trade-offs among them. As they take actions in an attempt to affect one type of risk, FI managers must consider the possible impact on other risks. The effective management of these risks determines a modern FI’s success or failure. The chapters that follow analyze each of these risks in greater detail.