FINA 1001 Lecture 8 2024 Bank Risk PDF

Elements of Banking and Finance (FINA 1001) Bank Risks 1 Banking Risks Banks are in the risk business, but they also depend on confidence. Therefore, there is a fine balance between measured r...

Elements of Banking and Finance (FINA 1001) Bank Risks 1 Banking Risks Banks are in the risk business, but they also depend on confidence. Therefore, there is a fine balance between measured risk-taking and maintaining consumer confidence. Assume risk in the provision of financial services A major objective also of financial institution management is to increase the returns for its owners This goal is at the cost of increased risk. 2 1  Banking Risks From a risk management perspective, risk can be segmented into three groups: Risks that can be eliminated or avoided by simple business practices. Risks that can be transferred to other participants. Risks that must be actively managed at the firm level. 3 Risk Avoidance Risk avoidance in banking involves actions to reduce the chances of losses from standard banking activity. Common risk avoidance practices include: Standardization of process, use of contracts and procedures to prevent inefficient or incorrect financial decisions The construction of portfolios that benefit from diversification across borrowers and sectors and that reduce the effects of any one loss experience is another. The implementation of incentive-compatible contracts with the institution's management to require that employees be held accountable. 4 2  Key Banking risks Include: § Credit risk § Liquidity risk § Market risk § Interest rate risk § Off-balance sheet risk § Technology/operational risk § Foreign exchange rate risk 5 Systematic risk Systematic/market risk is the risk related to the uncertainty of a bank’s earnings on its trading portfolio caused by changes in the market conditions. Influences a large amount of assets Systematic risks have market-wide effects By its nature, this risk can be hedged, but cannot be diversified completely away. In fact, systematic risk can be thought of as undiversifiable risk. 6 3  Systematic/market risk A trading portfolio is affected by market conditions such as interest rates, equity return, exchange rates, market volatility, and market liquidity. Therefore, market risk is a collection of different risks including interest rate risk, equity price risk, commodity price risk and foreign exchange risk. These risks are associated with active trading of assets and liabilities (and derivatives) rather than holding them over longer horizons. 7 Systematic Risk In recent years, trading activities of banks have risen considerably, and the income from them has increasingly replaced the income from traditional banking activities (loans and deposits). Banks' dependence on systematic factors to generate income - require estimation of the impact of particular systematic risks on performance Attempt to hedge against risks, and thus limit the sensitivity to variations in undiversifiable factors. FIs measure and manage the firm's vulnerability to market variation, despite it being an imprecise science. FIs are concerned with the fluctuation in value –or value at risk (VAR)- of their trading account. Banks measure their VAR (market risk exposure) and then hold capital to cover it. 8 4  Systematic risk All banks, especially those with large currency positions closely monitor their foreign exchange risk. Manage and limit exposure. Where possible use of financial products Institutions with significant investments in commodities such as oil, through their lending activity or geographical franchise, concern themselves with commodity price risk. 9 Credit Risk Credit risk is the risk that the promised cash flows from loans and securities held by banks may not be paid in full. It is related to the risk of default of a specific borrower, or to the risk of delay in servicing the loan. This occurrence causes the present value of the bank’s assets to decline and this undermine the solvency of the bank. Credit risk is the most important risk connected with the assets held by a bank. Possible knock on effects - Affect the lender holding the loan contract, as well as other lenders to the creditor. Financial condition of the borrower as well as the current value of any underlying collateral is of considerable interest to the bank. 10 5  Credit Risk Credit risk is diversifiable, but difficult to eliminate completely. Portions of the default risk may result from the systematic risk. The idiosyncratic nature of some portion of these losses remains a creditor problem despite diversification True for banks that lend in small, local markets and ones that take on highly illiquid assets. Strategy affect the shape of the loan return distribution. 11 Credit Risk Credit risk is not easily transferred, and accurate estimates of loss are difficult to obtain. Use of strong due diligence and other policy guidance The return distribution for credit risk suggests that intermediaries need to both monitor and collect information about any firms whose assets are in their portfolios. Managerial efficiency and credit risk management Screening and monitoring Credit rationing Use of collateral and endorsement Diversification 12 6  Liquidity Risk Liquidity risk can best be described as the risk of a funding crisis. Liquidity risk is the uncertainty that an FI may need to obtain large amounts of cash to meet the withdrawals of depositors or other liability claimants. Such unexpected events include a large charge off, loss of confidence, or a crisis of national proportion such as a currency crisis. Need to plan for growth and unexpected expansion of credit Risk management centres on liquid facilities and portfolio structure. Maintenance of a sufficiently liquid capital base Note the trade off between liquidity management and profit and solvency. Intermediaries minimize their cash assets because such holdings earn no interest. — An opportunity cost in holding overly liquid assets. 13 Systemic Impact of Liquidity Risk — When all or many intermediaries are facing similar abnormally large cash demands, the cost of additional funds rises as their supply becomes restricted or unavailable. — May eventually result in a run in which all liability claimholders seek to withdraw their funds simultaneously from intermediaries. — Liquidity problem converts into a solvency problem. 14 7  Liquidity Management Assets Liabilities Reserves $9M Deposits $90M Loans $81M Bank Capital $10M Securities $10M Interbank funding Lender of last resort Reduction of loans is the most costly way of acquiring reserves Calling in demand loans antagonizes sometimes long-standing customers Other banks may only agree to purchase loans at a substantial discount (Solvency/profit issue) 15 Interest Rate Risk Interest rate risk is the effect on prices and interim cash flows caused by changes in the level of interest rates during the life of the financial asset. the risk incurred by a bank when the maturities of its assets and liabilities are mismatched and there are changes in market interest rates. 16 8  Interest Rate Risk- Refinancing Risk The change in market interest rates determines two main risks for a financial intermediary Refinancing Risk – the risk that the cost of reborrowing funds will be higher than the returns earned on asset investments, in the presence of longer-term assets relative to liabilities – Consider a bank borrowing $100 (liability) for one year, and investing in a $100 (asset) for two years. The maturity of its asset is longer than the maturity of its liability. Suppose that the cost of funds (liability) is 9 per cent per year, and the interest return on the asset is fixed for the 2 years at 10 per cent per annum. The bank faces the risk that interest rates change at the end of year 1. If interest rates increase and the bank can only borrow a new one year liability at 11 per cent, the bank would experience a loss over the second year of the investment (that is, 10% asset return minus 11% cost of funds). 0 Liabilities 1 ($100 M) 0 1 Assets 2 ($100 M) 17 Interest Rate Risk- Reinvestment Risk q Reinvestment Risk the risk that the return on funds to be reinvested will fall below the cost of funds. Consider a bank borrowing $100 (liability) at 9 per cent (cost of funds) for two years, and investing $100 (asset) at 10 percent (return on assets) for one year. The maturity of its liability is longer than the maturity of its assets. The bank is exposed to an interest rate risk: it does not know at which rate it can reinvest in the second period. Suppose that the interest rate earned on its assets falls to 8 per cent at the end of the first year; in this case the bank would face a loss (that is, 8 per cent asset return minus 9 per cent cost of funds). 0 1 2 Liabilities ($100 M) 0 Assets 1 ($100 M) 18 9  Market Value Risk This risk refers to the change in the present value of the cash flows on assets and liabilities. The price of an asset or liability is equal to the present value of the relevant cash flows. Therefore, rising interest rates increase the discount rate on those cash flows and reduce the price of the asset or liability. Conversely, falling interest rates increase the price. 19 Interest Rate Risk Banks protect themselves against interest rate risk by matching the maturity of their assets and liabilities. Matching maturities work against an active asset-transformation function for intermediaries. A policy of maturity matching will allow changes in market interest rates to have approximately the same effect on both interest income and interest expense. An increase in rates will tend to increase both income and expense, and a decrease in rates will tend to decrease both income and expense. Though reducing exposure, matching maturities may also reduce the profitability Matching maturities only hedges interest rate risk in a very approximate rather than complete fashion. The changes in income and expense may not be equal because of different cash flow characteristics of the assets and liabilities. 20 10  Interest Rate Risk First UWI Bank Assets Liabilities Rate-sensitive assets $20M Rate-sensitive liabilities $50M Variable-rate and short-term loans Variable-rate CDs Short-term securities Money market deposit accounts Fixed-rate assets $80M Fixed-rate liabilities $50M Reserves Checkable deposits Long-term loans Savings deposits Long-term securities Long-term CDs Equity capital If a bank has more rate-sensitive liabilities than assets, a rise in interest rates will reduce bank profits and a decline in interest rates will raise bank profits 21 Interest Rate Risk Management Asset-liability management (ALM) (broadly defined as the coordinated management of banks’ balance sheet activities driven by interest rate risk) is one of the most important risk management functions in banking. The two main ALM techniques used to manage interest rate risk are: income gap analysis duration gap analysis A market value-based model of measuring and managing interest rate risk 22 11  Gap Analysis — Banks report the gap in each maturity bucket, calculated as the difference between rate-sensitive assets (RSA) and rate-sensitive liability (RSL) on their balance sheets, shown as : — GAP = RSA – RSL — A positive GAP implies interest sensitive assets > interest sensitive liabilities. A rise in interest rates will cause a bank to have interest revenues rising faster than interest costs; thus the net interest margin and income will increase. — A decline in interest rates will increase liabilities costs faster than assets returns; as a consequence the net interest margin and income will decrease. — Bank managers can calculate the income exposure to changes in interest rates in different maturity buckets, by multiplying GAP times the change in the interest rate: — ΔI = GAP * Δi — where: — ΔI = change in the banks’ income; — Δi = change in interest rate. 23 Operational Risk Associated with the processing, settling, and taking or making delivery on trades in exchange for cash. (Largely internal processes) Also arises in record keeping, processing system failures and compliance with various regulations. Usually small probability events Despite being a low probability risk, occurrence can cause major dislocations in the intermediary ’ s operation and potentially disrupt the financial system in general. (Low risk/high losses) 24 12  Operational Risk – Technology Risk Technology risk is a subset of operational risk. Occurs when technological investments do not produce the anticipated cost savings in economies of scale or scope. 25 Operational Risk: Technology Improvements Past 20 years financial intermediaries emphasis on operational efficiency: major investments There was an expanded technological infrastructure. Micro level: A more networked and integrated infrastructure. Macro system: Automated clearing house (ACH) and wire transfer payment networks, such as the clearinghouse inter-bank payments system. 26 13  Off-balance Sheet Risk Off-balance-sheet activities affect the future shape of an intermediaries balance sheet in that they involve the creation of contingent assets and liabilities. § Letters of credit § Loan commitments § Derivative contract As banks’ ability to attract high-quality loan applicants and depositors diminishes, off- balance sheet activities have become important in terms of the income that they can generate: § The ability to earn fee income while not loading up or expanding the balance sheet - An important motivation in intermediaries pursuing off-balance-sheet business. Off-balance sheet assets/liabilities move onto the balance sheet when a contingent event occurs. § Complements declining margins on banks’ traditional lending activities § Allows banks to avoid regulatory costs that are not levied on off-balance sheet activities. Some activities structured to reduce exposure to credit, interest rate, or foreign exchange risks. Activity is not risk free. Mismanagement or inappropriate use of these instruments can result in major losses to intermediaries. Significant losses can lead to firm failure. § CFO of Enron created off-balance-sheet vehicles that were highly complex to hide its debt. https://www.investopedia.com/updates/enron-scandal-summary/ 27 Off-balance Sheet Activities — Major types of off-balance sheet activities include: — Guarantees (letters of credit) — Letters of credit are used in both domestic and international trade. The financial institution’s function is to provide a formal guaranty that payment for goods shipped or sold will be forthcoming regardless of whether the buyer of the goods (the FI’s customer)defaults on payment. — Future commitments to lend (loan commitments) — A loan commitment is a contractual commitment by an FI to lend to a firm a certain maximum amount at a given interest rate. The FI may charge an up-front fee and a possible back end fee (commitment fee) on any unused balances in the arrangement but must also be ready to supply the stipulated amount at any time over the commitment period. 28 14  Off-balance Sheet Risk (cont’d) Derivative contract Agreement between two parties to exchange a standard quantity of an asset at a predetermined price at a specified date in the future. 29 Credit Risk: OBS exposure Credit rating of the borrower may deteriorate over life of the loan commitment. A counterparty may default on the contractual obligation, for example in a forward contact (counterparty credit risk). 30 15  What is Risk Management? The practice of: Defining Risk Defining the risk level a firm desires. Measuring Risk: Identifying the risk level a firm currently has. Hedging Risk: Using procedures, derivatives or other financial instruments to adjust the actual level of risk to the desired level of risk. 31 Why Manage Risks? According to standard economic theory, managers of value- maximizing firms should maximize expected profit without regard to the variability around its expected value. There is a number of distinct rationales proposed for active risk management. The key ones are: managerial self-interest, the costs of financial distress the existence of capital market imperfections. 32 16  Why Manage Risks? The explosion in information technology makes the complex calculation of derivative prices quickly and at low cost that allow financial firms to track the positions taken The favorable regulatory environment that encourages new product innovation for risk management. The needs of commercial banks to generate fee incomes through offering off-balance-sheet activities. 33 Why manage risks? Concerns over the increasing volatility of interest rates, exchange rates, commodity prices, and stock prices. Interest rates had become more volatile From the early 1970s, interest rates and bond prices became increasingly volatile due to increases in inflation and the advent of floating exchange rates. Sharp increase in volatility from the early 1980s - the use of money supply as a major monetary policy tool. In the late 1990’s volatility was reduced, BUT speed of technology improvements, information and funds flow can induce volatility. When important information spreads to the market at a faster pace, triggering collective investor behaviour, rapid price fluctuations can occur. 34 17  Why Manage Risks? Commodity prices have become more volatile Commodity prices fluctuated significantly in the 1970s and early 1980s due to the oil embargo in 1974. It is estimated that the 1974 oil price increase contributed to inflation in industrialized countries by 2% to 3%. Current situation seems more drastic Crude oil prices reached a 30-year high in the aftermath of the pandemic In level terms, in January 2020–January 2023, the average spot price of crude oil (Brent) fluctuated between $23.3 per barrel (April 2020) and $120.1 per barrel (June 2022). The war in Ukraine in February 2022 The average monthly price of wheat (United States hard red winter No. 2) fluctuated between $198.4 per ton (June 2020) and $522.3 per ton (May 2022). 35 Why Manage Risks? Foreign exchange rates have become more volatile Since the dismantling of the Bretton Woods Agreement in 1973: The movements in exchange rates have been abrupt and large. The volatility of movements in the foreign exchange value of the currencies has been large. As volatility surfaced in traded foreign currencies, the financial market began to offer currency traders special tools for insuring against these risks. 36 18  Why Manage Risks? Regulators’ push for implementing risk management systems The Bank for International Settlements (BIS) was charged with the job of setting common standards and procedures for international banks on capital requirements. Basel III Accord: Regulators are placing greater emphasis on common equity to protect banks during times of financial stress (the level of common equity has gone up from 2% under Basel II to 7% under Basel III) 37 References Saunders, A. and Cornett, M. Financial Institutions Management: A Risk Management Approach. McGraw-Hill Education, 2014. UNCTAD. Managing commodity price volatility in commodity dependent developing countries. UNCTAD Secretariat, 2023. 38 19