Risks Of Financial Intermediation PDF

RISKS OF FINANCIAL INTERMEDIATION Financial Intermediation (FI) Management MAIN OBJECTIVE: § TO INCREASE THE FI’S RETURNS FOR ITS OWNERS HOWEVER, § AT THE COST OF INCREASED RISK Risks Faced by Financial Intermediaries u INTEREST RATE RISK u MARKET RISK u CREDIT RISK u OFF-BALANCE SHEET RISK u FOREIG...

RISKS OF FINANCIAL INTERMEDIATION Financial Intermediation (FI) Management MAIN OBJECTIVE: § TO INCREASE THE FI’S RETURNS FOR ITS OWNERS HOWEVER, § AT THE COST OF INCREASED RISK Risks Faced by Financial Intermediaries u INTEREST RATE RISK u MARKET RISK u CREDIT RISK u OFF-BALANCE SHEET RISK u FOREIGN EXCHANGE RISK u COUNTRY OR SOVEREIGN RISK u TECHNOLOGY RISK u OPERATIONAL RISK u LIQUIDITY RISK u INSOLVENCY RISK INTEREST RATE RISK u The risk incurred by an FI when the maturities of the assets and liabilities are mismatched. u Example: An FI issues PHP 50 Million of liabilities of one-year maturity to finance the purchase of PHP 50 Million of assets with two-year maturity. The FI is viewed as short funded because the maturity of its liability is less than the maturity of its assets. MARKET RISK u The risk incurred in the trading of assets and liabilities due to the changes in interest rates, exchange rates and other asset prices. u Market risk arises when FIs actively trade assets and liabilities rather than hold them for longer term investment, funding or hedging purposes. CREDIT RISK u The risk that promised cash flows from loans and securities held by FIs may not be paid in full. u FIs that make loans or buy bonds with long maturities are more exposed than are FIs that make loans or buy bonds with short maturities. u Example: banks are more exposed to credit risk than are money market mutual funds and property–casualty insurance companies OFF-BALANCE-SHEET RISK u The risk incurred by an FI due to activities related to contingent assets and liabilities. u An off-balance-sheet activity, does not appear on an FI’s current balance sheet since it does not involve holding a current primary claim (asset) or the issuance of a current secondary claim (liability). u The 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. u Accountants place them “below the bottom line” of an FI’s asset and liability balance sheet. u Example of an 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. FOREIGN EXCHANGE RISK u The risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies. u Example: PHP to USD; USD to British Pound COUNTRY OR SOVEREIGN RISK u u The risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments. Examples: U.S., European, and Japanese banks had enhanced sovereign risk exposures to countries such as Argentina, Russia, Thailand, South Korea, Malaysia, and Indonesia. Financial support given to these countries by the International Monetary Fund (IMF), the World Bank, and the U.S., Japanese, and European governments enabled the banks to avoid the full extent of the losses that were possible. Nevertheless, Indonesia had to declare a moratorium on some of its debt repayments, while Russia defaulted on payments on its short-term government bonds. In 1999, some banks agreed to settle their claims with the Russian government, receiving less than five cents for every dollar owed them. In 2001, the government of Argentina, which had pegged its peso to the dollar on a one-to-one basis since the early 1990s, had to default on its government debt largely because of an overvalued peso and the adverse effect this had on its exports and foreign currency earnings. In December 2001, Argentina ended up defaulting on $130 billion in government-issued debt and, in 2002, passed legislation that led to defaults on $30 billion of corporate debt owed to foreign creditors. Argentina’s economic problems continued into 2003; in September 2003 it defaulted on a $3 billion loan repayment to the IMF. TECHNOLOGY RISK The risk incurred by an FI when technological investments do not produce the cost savings anticipated. u Economies of scale refer to an FI’s ability to lower its average costs of operations by expanding its output of financial services. u Economies of scope refer to an FI’s ability to generate cost synergies by producing more than one output with the same inputs. u Example: an FI could use the same information on the quality of customers stored in its computers to expand the sale of both loan products and insurance products. That is, the same information (e.g., age, job, size of family, income) can identify both potential loan and life insurance customers. Indeed, the attempt to better exploit such economies of scope lies behind megamergers such as that of Citicorp with Travelers to create Citigroup, an FI that services over 100 million customers in areas such as banking, securities, and insurance. u OPERATIONAL RISK u The risk that existing technology or support systems may malfunction or break down. u Examples: A. Failure of a back-office system occurred in September 2001 when Citibank’s (a subsidiary of Citigroup) ATM system crashed for an extended period of time. Citibank’s 2,000 nationwide ATMs, its debit card system, and its online banking functions went down for almost two business days. B. In February 2005 Bank of America announced that it had lost computer backup tapes containing personal information such as names and Social Security numbers on about 1.2 million federal government employee charge cards as the tapes were being transported to a data-storage facility for safe keeping. Bank of America could not rule out the possibility of unauthorized purchases using lost data, but it said the account numbers, addresses, and other tape contents were not easily accessible without highly sophisticated equipment and technological expertise. Even though such computer breakdowns are rare, their occurrence can cause major dislocations in the FIs involved and potentially disrupt the financial system in general. C. Several highly publicized securities violations by employees of major investment banks resulted in criminal cases brought against securities law violators by state and federal prosecutors. LIQUIDITY RISK u 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. INSOLVENCY RISK u 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. u Insolvency risk is a consequence or outcome of one or more of the risks described above: interest rate, market, credit, off-balance-sheet, technology, foreign exchange, sovereign, and liquidity risks. Technically, insolvency occurs when the capital or equity resources of an FI’s owners are driven to, or near to, zero because of losses incurred as the result of one or more of the risks described above. THANK YOU! u FROM THE TEXT BOOK: FINANCIAL INSTITUTIONS MANAGEMENT - A RISK MANAGEMENT APPROACH BY ANTHONY SAUNDERS AND MARCIA MILLON CORNETT