9. Types of Risks Incurred by Financial Institutions PDF

Questions to Ponder on: 1. Think of a one word that comes into your mind when you hear the word “risk.” 2. Are you a risk-taking kind of person or are you averse to risks? 3. What is the biggest risk you have ever taken? 4. Does your job/current situation involve taking r...

Questions to Ponder on: 1. Think of a one word that comes into your mind when you hear the word “risk.” 2. Are you a risk-taking kind of person or are you averse to risks? 3. What is the biggest risk you have ever taken? 4. Does your job/current situation involve taking risks? 5. Have you ever considered doing a job that is full of risks? 6. Would you ever risk your life for anyone? © 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further  Types of Risks Incurred by Financial Institutions Copyright © 2022 McGraw-Hill. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill.  Risks at Financial Institutions  A major objective of FI management is to increase the FI’s returns for its owners, but increased returns typically come at the cost of increased risk:  Credit risk  Liquidity risk  Interest rate risk  Market risk  Off-balance sheet risk  Foreign exchange risk  Country or sovereign risk  Technology risk  Operational risk  Fintech risk  Insolvency risk © 2022 McGraw-Hill Education. 20-3 Risks Faced by Financial Institutions © 2022 McGraw-Hill Education. 20-4  Credit Risk  Credit risk is the risk that the promised cash flows from loans and securities held by FIs may not be paid in full.  Credit Risk Indicator:  High loan default rates  Low credit quality  The percentage of high-risk loans in the portfolio  High loan concentrations in specific sectors  7C’s Credit Appraisal Model:  Character  Capacity  Collateral  Contribution  Control  Condition  Common sense © 2022 McGraw-Hill Education. 20-5  Credit Risk (Continued)  Advantage that FIs have over individual investors is their ability to diversify credit risk exposures from a single asset by exploiting the law of large numbers in their asset investment portfolios  Diversification reduces firm-specific credit risk, the risk of default for the borrowing firm associated with the specific types of project risk taken by that firm  E.g., risk specific to holding the bonds or loans  Diversification does not reduce systemic credit risk, the risk of default associated with general economy-wide or macro- conditions affecting all borrowers  E.g., an economic recession © 2022 McGraw-Hill Education. 20-6  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 and at low prices.  On the asset side of the balance sheet, loan requests and the exercise by borrowers of their loan commitments and other credit lines causes liquidity risk  Most liquid asset of all is cash  To meet the demand for cash by liability holders, FIs must either liquidate assets or borrow additional funds  When all, or many, FIs face abnormally large cash demands, the cost of purchased of borrowed funds rises and the supply of such funds becomes restricted  FIs may have to sell some of their less liquid assets to meet the withdrawal demands, resulting in serious liquidity risk © 2022 McGraw-Hill Education. 20-7  Interest Rate Risk  Interest rate risk is the potential for investment losses that can be triggered by a move upward in the prevailing rates for new debt instruments. If interest rates rise, for instance, the value of a bond or other fixed-income investment in the secondary market will decline.  What drives interest rate risk?  It all boils down to a matter of supply and demand. When interest rates rise, the value of bonds falls because investors lose interest in owning bonds with lower yields. Thus, waning demand drives prices lower.  For example, say an investor buys a five-year, $500 bond with a 3% coupon. Then, interest rates rise to 4%. The investor will have trouble selling the bond when newer bond offerings with more attractive rates enter the market. © 2022 McGraw-Hill Education. 20-8  Market Risk  Market risk is the risk incurred in trading assets and liabilities due to changes in interest rates, exchange rates, and other asset price. The possibility of losing money on an investment. © 2022 McGraw-Hill Education. 20-9  Off-Balance-Sheet Risk  Off-balance-sheet (OBS) risk is the risk incurred by an FI as the result of activities related to contingent assets and liabilities  OBS activities involve the creation of contingent assets and liabilities that give rise to their potential placement in the future on the balance sheet  Contingent assets and liabilities are assets and liabilities off the balance sheet that potentially can produce positive or negative future cash flows for an FI  Example: loan commitments, letters of credit, and revolving underwriting facilities. © 2022 McGraw-Hill Education. 20-10  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  A net long position in a foreign currency involves an FI holding more foreign assets than liabilities  FI loses when foreign currency falls relative to the U.S. dollar  FI gains when foreign currency appreciates relative to the U.S. dollar  A net short position in a foreign currency involves an FI holding fewer foreign assets than liabilities  FI gains when foreign currency falls relative to the U.S. dollar  FI loses when foreign currency appreciates relative to the U.S. dollar © 2022 McGraw-Hill Education. 20-11  Sovereign Risk  Country, or sovereign, risk is the risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments.  Economic Factors:  High inflation  Heavy debt  A volatile currency, etc. contribute to default risk © 2022 McGraw-Hill Education. 20-12  Sovereign Risk (Continued)  Measuring sovereign risk includes an analysis of macroeconomic issues, such as the following:  Trade policy;  Fiscal stance (deficit or surplus) of the government;  Government intervention in the economy;  Its monetary policy;  Capital flows and foreign investment;  Inflation; and  Structure of its financial system © 2022 McGraw-Hill Education. 20-13  Technology and Operational Risk  Technology risk is the risk incurred by an FI when its technological investments do not produce anticipated cost savings  Major objectives of technological expansion are to lower operating costs, increase profits, and capture new markets for an FI  Example: information security incidents, cyber attacks, password theft  Operational risk is the risk that existing technology or support systems may malfunction or break down  Not exclusively the result of technological failure  Example: Employee conduct and employee error, Breach of private data resulting from cybersecurity attacks © 2022 McGraw-Hill Education. 20-14  Fintech Risk (Financial Technology)  Fintech risk is the risk that fintech firms could disrupt business of financial services firms in the form of lost customers and lost revenue  What is the biggest risk in fintech?  Data Breaches and Cyber Attacks  Example of Fintech in the Philippines: GCash, Maya  These are payments providers that have recently expanded into lending, investment, insurance, and marketplace services. © 2022 McGraw-Hill Education. 20-15 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 liquidity risk  What is insolvency in the Philippines?  Under the Philippine laws, an entity is considered insolvent if it is generally unable to pay its liabilities as they fall due in the ordinary course of business or has liabilities that are greater than its assets © 2022 McGraw-Hill Education. 20-16  Other Risks and Interactions Among Risks  All of the previously defined risks are interdependent  Each risk and its interaction with other risks ultimately affects solvency risk  Various other risks also impact FI’s profitability and risk exposure: 1. Discrete, or event-type, risks:  Sudden change in taxation  Changes in regulatory policy, including lifting the regulatory barriers to lending or to entry or on products offered  Sudden and unexpected changes in financial market conditions due to war, revolutions, or sudden market collapse  Theft, malfeasance (fraud) and breach of fiduciary trust (abused of trust) 2. Macroeconomic risks:  Increased inflation and inflation volatility  Unemployment © 2022 McGraw-Hill Education. 20-17 Sources  © 2019 McGraw-Hill Education  https://erepository.uonbi.ac.ke  https://www.investopedia.com  https://marketbusinessnews.com  https://legal.thomsonreuters.com  https://val.law/remedies-for-insolvency-in-the- philippines © 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further Question that you need to reconnect?  Why did you answer various questions prior to this lecture earlier? How do you relate them to this real-life-risk-scenario faced by FI? What is your insight. © 2019 McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further