Overview-CollegeofBusiness.docVIP

Overview of the Risks Faced by Financial Institutions Types of Risks Interest rate risk Credit risk Market risk, Technology and operational risk Off-balance-sheet risk Foreign exchange risk Country risk Liquidity risk Insolvency risk Interest Rate Risk Interest rate risk resulting from intermediation: Mismatch in maturities of assets and liabilities Refinancing risk: when the maturity of a bank’s assets is greater then the maturity of it’s liabilities Reinvestment risk: when the maturity of a bank’s assets is less than the maturity of it’s liabilities Example A bank invested $50 million in a two-year asset paying 10 percent interest per annum and simultaneously issued a $50 million, one-year liability paying 8 percent interest per annum. What will be the bank’s net interest income each year if at the end of the first year all interest rates have increased by 1 percent (100 basis points)? Net interest income is not affected in the first year, but NII will decrease in the second year. Year 1 Year 2 Interest income $5,000,000 $5,000,000 Interest expense $4,000,000 $4,500,000 Net interest income $1,000,000 $500,000 Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs Market Risk Market risk arises in trading of assets and liabilities (and derivatives) Trend to greater reliance on trading income rather than traditional activities increases market exposure Examples: stock market, bond market and foreign exchange market 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 80s, 90s, 2008-2010 Credit screening and monitoring Diversification of credit risk Off-Balance-Sheet Risk Increased importance of off-balance-sheet activities Letters of credit Loan commitments Derivative positions Speculative activities using off-balance-sheet items create considerable risk Technology and Ope