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©2003 McGraw-Hill Companies Inc. All rights reservedSlides by Kenneth StantonMcGraw Hill / Irwin

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7Chapter

Risks of Financial

Intermediation


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Overview

A major objective of Fl management is to increase the Fl’s returns for its owners. This is often comes at the cost of increased risk.

This chapter discusses the risks associated with financial intermediation:• Interest rate risk, market risk, credit risk, off-

balance-sheet risk, technology and operational risk, foreign exchange risk, country risk, liquidity risk, insolvency risk


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Interest Rate Risk

Asset transformation is a key special function of Fls. Asset transformation involves an Fl’s buying primary

securities or assets and issuing secondary securities or liabilities to fund asset purchases.

The primary securities purchased by Fls often have maturity and liquidity characteristics different from

those of secondary securities Fls sell. In mismatching the maturities of assets and liabilities

as part of their asset- transformation function, Fls expose themselves to interest rate risk.


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Interest Rate Risk

Example 1 : Impact of an interest rate increase on an Fl’s profits when the maturity of its assets exceeds the maturity of its liabilities

Consider an Fl that issues $ 100 million of liabilities of one-year maturity to purchase of $ 100 million of assets with a tow year maturity:

Liabilities 1 year

Assets0

0

1 year2 years


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Interest Rate Risk

In this time lines the Fl can be viewed as being (short-funded): that is, the maturity of its liabilities is less than the maturity of its assets.

Suppose the cost of funds (liabilities) is 9% per year and the return on assets is 10% per year.

Over the first year the Fl can lock in a profit spread of 1% (10%-9%) times $ 100 million –by borrowing short term (one year) and lending long term (tow year).

Thus, its profit is $ 1 million (1%* $ 100 m)


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Interest Rate Risk

But, the profits for the second year are incertain. If the level of interest rate does not change:

• The Fl can refinance its liabilities at 9% and lock in 1% or 1 million profit for the second year as well.

If the level of interest rate change between years 1 and 2:• If interest rates were to rise and the Fl can borrow new-year

liabilities at 11% in the second year.

• Its profit spread in the second year would be negative 10%-11%=-1%

• The Fl’s loss is 1million


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Interest Rate Risk

The positive spread earned ine the first year by Fl from holding assets with a longer maturity than its liabilities would be offset by a negative spread in the second year.

If interest rate were to rise by more than 1% in the second year, the Fl would stand to take losses over the tow-year period as a whole.

Thus, when an Fl hold longer-term asstes relative to liabilities, it exposes itself on refinancing risk.

This is the risk that the cost of rolling over reborrowing funds could be more the the return earned of esset investement.


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Interest Rate Risk

Example 2 : Impact of an interest rate decrease on an Fl’s profits when the maturity of its liabilities exceeds the maturity of its assets• Fl borrowing 100 million for a longer term than 100 million of

assets in which it invests.

Assets 1 year

Liabilities0

0

2 years


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Interest Rate Risk

The Fl locks in one year profit spread of 1% or 1 million.

At the end of the first year, the asset matures and the funds that have been borrowing for tow year have to be reinvested.

Suppose the interest rate fall between the first year and second year to 8%

The Fl face a loss or negative spread in the second year of 1%, or the Fl loses 1 million


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Interest Rate Risk

The positive spread earned ine the first year by Fl from holding assets with a shorter maturity than its liabilities would be offset by a negative spread in the second year

Thus the Fl is exposed to reinvestment risk when an Fl hold shorter-term asstes relative to liabilities.


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Interest Rate Risk

Market value risk Market value of an asset or liability = present value of current

and future cash flow from this asset or liability. Rising interest rate increase the discount rate on those cash flow

and reduce the market value of assets ans liabilities. Falling interest rate increase the market value of assets and

liabilities Mismatching maturities by holding longer-term assets than

liabilities means that when interest rates rise, the market value of the Fl’s essets falls a greater amount than its liabilities.

This exposes the Fl ton the risk of economic loss ans risk of insolvency


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Risks of Financial Intermediation

Interest rate risk resulting from intermediation:• Mismatch in maturities of assets and liabilities.• Balance sheet hedge via matching maturities of

assets and liabilities is problematic for FIs. Refinancing risk. Reinvestment risk. Market value risk


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Hedge interest rate risk If holding assets and liabilities with mismatched maturities

exposes Fls to interest rate risk Fls seek to hedge interest rate risk by matching the maturity of their essets and liabilities.

The matching maturities is the best policy to hedge interest rate risk for Fls.

But, matching maturities is not necessarily consistent with an active asset-transforming function for Fls. • Fls cannot be asset transformers (e.g., transforming short-term deposits into

long-term loans) and direct balance sheet matchers or hedgers at the same time.

• matching maturities reduce interest rate risk but also reduce the Fl’s profitability because returns from acting as specialized risk-bearning asset transformer are reduced.


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Hedge interest rate risk

matching maturities hedges interest rate risk only in a very approximate rather than complete fashion, the reasons are:

• Technical, relating to the difference between the average life(or duration) and maturity of an asset or liability

• Whether Fl partly funds its asset with equity capital as well as liabilities.

• In the real world, Fls use a mix of liabilities and stockholders’ equity to finance asset purchases.


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Market Risk

Arises when Fls actively trade assets and liabilities (and derivatives) rather than hold them for longer-term investment,

funding, or hedging purposes. Market risk is closely related to interest rate, equity return, and

foreign exchange risk in that as these risks increase or decrease, the overall risk of the FI is affected.

As traditional activities of the banks declines in relative proportions (deposit-taking and lending) other forms of activities have grow in importance.

Especially trading …. Actively investing in stocks, bonds, and derivative securities…as a profit-center. Market Risk is the risk that in active trading, the market value of

the banks assets declines


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Market Risk

Market risk is the incremental risk incurred by an FI when interest rate, foreign exchange, and equity return risks are combined with an active trading strategy, especially one that involves short trading horizons such as a day

Conceptually, an FI's trading portfolio can be differentiated from its investment portfolio on the basis of time horizon and secondary market liquidity.

The trading portfolio contains assets, liabilities, and derivative contracts that can be quickly bought or sold on organized financial markets.

The investment portfolio (or in the case of banks, the so-called banking book) contains assets and liabilities that are relatively illiquid and held for longer holding periods


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Market Risk

With the increasing securitization of bank loans more and more assets have become liquid and tradable

. Of course, with time, every asset and liability can be sold. While bank regulators have normally viewed tradable assets as

those being held for horizons of less than one year, private FIs take an even shorter-term view.

In particular, FIs are concerned about the fluctuation in value-or value at risk (VAR)-of their trading account assets and liabilities for periods as short as one day-so-called daily earnings at risk (DEAR)-especially if such fluctuations pose a threat to their solvency.


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Credit Risk

risk arises because of the possibility that promised cash flows on financial claims held by Fls, such as loans or bonds, will not be paid in full.

Virtually all types of Fls face this risk But in general, 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.

If the principal on all financial claims held by FIs was paid in full on maturity and interest payments were made on the promised dates, FIs would always receive back the original principal lent plus an interest return. That is, they would face no credit risk.

If a borrower defaults, however, both the principal loaned and the interest payments expected to be received are at risk, That is, they would face credit risk.


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Credit Risk

The potential loss an FI can experience from lending suggests that FIs need to monitor and collect information about borrowers whose assets are in their portfolios and to monitor those borrowers over time.

Thus, managerial monitoring efficiency and credit risk management strategies directly affect the return and risks of the loan portfolio.

Moreover, one of the advantages FIs have over individual household investors is the ability to diversify some credit risk from a single asset away by exploiting the law of large numbers in their asset investment portfolios

Diversification across assets, such as loans exposed to credit risk reduces the overall credit risk in the asset portfolio and thus increases the probability of partial or full repayment of principal and/ or interest


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Credit Risk

diversification reduces individual firm-specific credit risk, such as the risk specific holding the bonds or loans of General Motors,

while the FI still expose to systematic credit risk, such as factors that simultaneously increase the default risk of all firms in the economy (e.g., an economic recession).


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Off-Balance-Sheet Risk

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

Increased importance of off-balance-sheet activities• Letters of credit• Loan commitments• Derivative positions

some of these activities are structured to reduce an FI's exposure to credit, interest rate, or foreign exchange risks

Speculative activities using off-balance-sheet items create considerable risk

Indeed, as seen during the financial crisis of 2008-2009, significant losses in off-balance-sheet activities (e.g., credit default swaps) can cause an FI to fail, just as major losses due to balance sheet default and interest rate risks can cause an FI to fail.


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Foreign Exchange Risk

foreign investment exposes an FI to foreign exchange risk.

Foreign exchange risk is the risk that exchange rate changes can adversely affect the value of an FI's assets and liabilities denominated in foreign currencies.

Mismatches between the amount of foreign currency denominated assets and liabilities can lead to foreign exchange losses or gains depending on the relative movement of the two currencies involved


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Foreign Exchange Risk

to be approximately hedged, the FI must match its assets and liabilities in each foreign currency

FI is fully hedged only if we assume that it holds foreign assets and liabilities of exactly the same maturity .

An FI that matches both the SIZE and MATURITIES of its exposures in assets and liabilities of a given currency is hedged against foreign currency, liquidity, and interest rate risk.


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Country or Sovereign Risk

Country risk is a different type of credit risk that is faced by an FI that purchases assets such as the bonds and loans of foreign corporations

a foreign corporation may be unable to repay the principal or interest on a loan even if it would like to.

Result of exposure to foreign government which may impose restrictions on repayments to foreigners because of foreign currency shortages and adverse political reasons .

Mexico, Argentina imposing restrictions on debt repayments of domestic corporations…etc.

Greece potentially defaulting on international loan obligations


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Technology and Operational Risk

Technological innovation has seen rapid growth The major objectives of technological expansion are to

lower operating costs, increase profits, and capture new markets for the FI

the objective is to allow the FI to exploit, to the fullest extent possible, better potential economies of scale and economies of scope in selling its products.

» Economies of scale refer to an FI's ability to lower its average costs of operations by expanding its output of financial services.

» Economies of scope refer to an FI's ability to generate cost synergies by producing more than one output with the same inputs


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Technology risk occurs when technological investments do not produce the anticipated cost savings in the form of economies of either scale or scope .

Technological risk can result in major losses in the competitive efficiency of an FI and, ultimately, in its long-term failure.

Similarly, gains from technological investments can produce performance superior to an FI's rivals as well as allow it to develop new and innovative products, enhancing its long-term survival chances.


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Operational risk is partly related to technology risk and can arise whenever existing technology malfunctions or back-office support systems break down

For example, in February 2005 Bank of America announced that it had lost computer backup tapes containing personal information such as names and Social Security numbers

operational risk is not exclusively the result of technological failure. For example, employee fraud and errors constitute a type of operational risk that often negatively affects the reputation of an FI


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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.

liquidity risk arises when an FI's liability holders, such as depositors or insurance policyholders, demand immediate cash for the financial claims they hold with an FI

or when holders of off-balance-sheet loan commitments (or credit lines) suddenly exercise their right to borrow (draw down their loan commitments).

Risk of being forced to borrow, or sell assets in a very short period of time. • Low prices result.

May generate runs.• Runs may turn liquidity problem into solvency problem.• Risk of systematic bank panics.


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Insolvency Risk

Risk of insufficient capital to offset sudden decline in value of assets to liabilities.• Continental Illinois National Bank and Trust

Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, 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.


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Other Risks and Interaction of Risks• Interdependencies among risks.

» Example: Interest rates and credit risk.

• Discrete Risks» Example: Tax Reform Act of 1986.

» Other examples include effects of war, market crashes, theft, malfeasance.


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Macroeconomic Risks

Increased inflation or increase in its volatility.• Affects interest rates as well.

Increases in unemployment • Affects credit risk as one example.


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Pertinent Websites

Bank for International Settlements www.bis.org

Federal Reserve www.federalreserve.gov

Federal Deposit Insurance Corporation www.fdic.gov

Web Surf


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Questions and Problems

Chapter 7



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Question 7 - 1

What is the process of asset transformation performed by a financial institution? Why does this process often lead to the creation of interest rate risk? What is interest rate risk?

Asset transformation by an FI involves purchasing primary assets and issuing secondary assets as a source of funds. The primary securities purchased by the FI often have maturity and liquidity characteristics that are different from the secondary securities issued by the FI. For example, a bank buys medium- to long-term bonds and makes medium-term loans with funds raised by issuing short-term deposits.

Interest rate risk occurs because the prices and reinvestment income characteristics of long-term assets react differently to changes in market interest rates than the prices and interest expense characteristics of short-term deposits. Interest rate risk is the effect on prices (value) and interim cash flows (interest coupon payment) caused by changes in the level of interest rates during the life of the financial asset.


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Question 7 - 2

What is refinancing risk? How is refinancing risk part of interest rate risk? If an FI funds long-term fixed-rate assets with short-term liabilities, what will be the impact on earnings of an increase in the rate of interest? A decrease in the rate of interest?

Refinancing risk is the uncertainty of the cost of a new source of funds that are being used to finance a long-term fixed-rate asset.

This risk occurs when an FI is holding assets with maturities greater than the maturities of its liabilities.

For example, if a bank has a ten-year fixed-rate loan funded by a 2-year time deposit, the bank faces a risk of borrowing new deposits, or refinancing, at a higher rate in two years. Thus, interest rate increases would reduce net interest income. The bank would benefit if the rates fall as the cost of renewing the deposits would decrease, while the earning rate on the assets would not change. In this case, net interest income would increase.


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Question 7 - 3

What is reinvestment risk? How is reinvestment risk part of interest rate risk? If an FI funds short-term assets with long-term liabilities, what will be the impact on earnings of a decrease in the rate of interest? An increase in the rate of interest?

Reinvestment risk is the uncertainty of the earning rate on the redeployment of assets that have matured.

This risk occurs when an FI holds assets with maturities that are less than the maturities of its liabilities.

For example, if a bank has a two-year loan funded by a ten-year fixed-rate time deposit, the bank faces the risk that it might be forced to lend or reinvest the money at lower rates after two years, perhaps even below the deposit rates. Also, if the bank receives periodic cash flows, such as coupon payments from a bond or monthly payments on a loan, these periodic cash flows will also be reinvested at the new lower (or higher) interest rates.

Besides the effect on the income statement, this reinvestment risk may cause the realized yields on the assets to differ from the a priori expected yields.


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Question 7 - 4

The sales literature of a mutual fund claims that the fund has no risk exposure since it invests exclusively in federal government securities that are free of default risk. Is this claim true? Explain why or why not.

• Although the fund's asset portfolio is comprised of securities with no default risk, the securities remain exposed to interest rate risk.

• For example, if interest rates increase, the market value of the fund's government security portfolio will decrease.

• Further, if interest rates decrease, the realized yield on these securities will be less than the expected rate of return because of reinvestment risk.

• In either case, investors who liquidate their positions in the fund may sell at a Net Asset Value (NAV) that is lower than the purchase price.


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Question 7 - 5

How can interest rate risk adversely affect the economic or market value of an FI?

• When interest rates increase (or decrease), the value of fixed-rate assets decreases (or increases) because of the discounted present value of the cash flows. To the extent that the change in market value of the assets differs from the change in market value of the liabilities, the difference is realized in the economic or market value of the equity of the FI.

• For example, for most depository FIs, an increase in interest rates will cause asset values to decrease more than liability values. The difference will cause the market value, or share price, of equity to decrease.


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Question 7 - 6

a. What will be the net interest income (NII) at the end of the first year? Note: Net interest income equals interest income minus interest expense.

Interest income $1,000 $10,000 x 0.10 Interest expense 600 $10,000 x 0.06 Net interest income (NII) $400

b. If at the end of year 1 market interest rates have increased 100 basis points (1 percent), what will be the net interest income for the second year? Is the change in NII caused by reinvestment risk or refinancing risk?

Interest income $1,000 $10,000 x 0.10 Interest expense 700 $10,000 x 0.07 Net interest income (NII) $300

The decrease in net interest income is caused by the increase in financing cost without a corresponding increase in the earnings rate. Thus, the change in NII is caused by refinancing risk. The increase in market interest rates does not affect the interest income because the bond has a fixed-rate coupon for ten years. Note: this answer makes no assumption about reinvesting the first year’s interest income at the new higher rate.


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Question 7 – 6 …

c. Assuming that market interest rates increase 1 percent, the bond will have a value of $9,446 at the end of year 1. What will be the market value of the equity for the FI? Assume that all of the NII in part (a) is used to cover operating expenses or is distributed as dividends.

Cash $1,000 Certificate of deposit$10,000Bond $9,446 Equity$ 446Total assets $10,446 Total liabilities and equity$10,446

d. If market interest rates had decreased 100 basis points by the end of year 1, would the market value of equity be higher or lower than $1,000? Why?

The market value of the equity would be higher ($1,600) because the value of the bond would be higher ($10,600) and the value of the CD would remain unchanged.


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e. What factors have caused the change in operating performance and market value for this firm?

• The operating performance has been affected by the changes in the market interest rates that have caused the corresponding changes in interest income, interest expense, and net interest income.

• These specific changes have occurred because of the unique maturities of the fixed-rate assets and fixed-rate liabilities.

• Similarly, the economic market value of the firm has changed because of the effect of the changing rates on the market value of the bond.


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Question 7 - 7

How does the policy of matching the maturities of assets and liabilities work (a) to minimize interest rate risk and (b) against the asset-transformation function for FIs?

• 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.

• The changes in income and expense may not be equal because of different cash flow characteristics of the assets and liabilities.

• The asset-transformation function of an FI involves investing short-term liabilities into long-term assets. Maturity matching clearly works against successful implementation of this process.


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Question 7 - 8

Corporate bonds usually pay interest semiannually. If a company decided to change from semiannual to annual interest payments, how would this affect the bond’s interest rate risk?

• The interest rate risk would increase as the bonds are being paid back more slowly and therefore the cash flows would be exposed to interest rate changes for a longer period of time.

• Thus any change in interest rates would cause a larger inverse change in the value of the bonds.


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Question 7 - 9

Two 10-year bonds are being considered for an investment that may have to be liquidated before the maturity of the bonds. The first bond is a 10-year premium bond with a coupon rate higher than its required rate of return, and the second bond is a zero-coupon bond that pays only a lump-sum payment after 10 years with no interest over its life. Which bond would have more interest rate risk? That is, which bond’s price would change by a larger amount for a given change in interest rates? Explain your answer.

• The zero-coupon bond would have more interest rate risk. Because the entire cash flow is not received until the bond matures, the entire cash flow is exposed to interest rate changes over the entire life of the bond.

• The cash flows of the coupon-paying bond are returned with periodic regularity, thus allowing less exposure to interest rate changes. In effect, some of the cash flows may be received before interest rates change.

• The effects of interest rate changes on these two types of assets will be explained in greater detail in the next section of the text.


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Question 7 - 10

Consider again the two bonds in problem (9). If the investment goal is to leave the assets untouched until maturity, such as for a child’s education or for one’s retirement, which of the two bonds has more interest rate risk? What is the source of this risk?

• In this case the coupon-paying bond has more interest rate risk. • The zero-coupon bond will generate exactly the expected return at the time of

purchase because no interim cash flows will be realized. Thus the zero has no reinvestment risk.

• The coupon-paying bond faces reinvestment risk each time a coupon payment is received. The results of reinvestment will be beneficial if interest rates rise, but decreases in interest rate will cause the realized return to be less than the expected return.


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Question 7 - 11

A mutual fund bought $1,000,000 of two-year government notes six months ago. During this time, the value of the securities has increased, but for tax reasons the mutual fund wants to postpone any sale for two more months. What type of risk does the mutual fund face for the next two months?

• The mutual fund faces the risk of interest rates rising and the value of the securities falling.


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Question 7 - 12

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 2Interest income $5,000,000 $5,000,000Interest expense $4,000,000 $4,500,000Net interest income $1,000,000 $500,000


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Question 7 - 13

What is market risk? How do the results of this risk surface in the operating performance of financial institutions? What actions can be taken by FI management to minimize the effects of this risk?

• Market risk is the risk of price changes that affects any firm that trades assets and liabilities.

• The risk can surface because of changes in interest rates, exchange rates, or any other changes in the prices of financial assets that are traded rather than held on the balance sheet.

• Market risk can be minimized by using appropriate hedging techniques such as futures, options, and swaps, and by implementing controls that limit the amount of exposure taken by market makers.


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Question 7 - 14

What is credit risk? Which types of FIs are more susceptible to this type of risk? Why?

• Credit risk is the possibility that promised cash flows may not occur or may only partially occur.

• FIs that lend money for long periods of time, whether as loans or by buying bonds, are more susceptible to this risk than those FIs that have short investment horizons.

• For example, life insurance companies and deposit-taking institutions generally must wait a longer time for returns to be realized than money market mutual funds and property-casualty insurance companies.


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Question 7 - 15

What is the difference between firm-specific credit risk and systematic credit risk? How can an FI alleviate firm-specific credit risk?

• Firm-specific credit risk refers to the likelihood that specific individual assets may deteriorate in quality, while systematic credit risk involves macroeconomic factors that may increase the default risk of all firms in the economy.

• Thus, if S&P lowers its rating on RIM’s stock and if an investor is holding only this particular stock, she may face significant losses as a result of this downgrading. However, portfolio theory in finance has shown that firm-specific credit risk can be diversified away if a portfolio of well-diversified stocks is held.

• Similarly, if an FI holds well-diversified assets, the FI will face only systematic credit risk that will be affected by the general condition of the economy. The risks specific to any one customer will not be a significant portion of the FIs overall credit risk.


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Question 7 - 16

Many banks and S&Ls that failed in the 1980s in the United States had made loans to oil companies in Louisiana, Texas, and Oklahoma. When oil prices fell, these companies, the regional economy, and the banks and S&Ls all experienced financial problems. What types of risk were inherent in the loans that were made by these banks and S&Ls?

• The loans in question involved credit risk. Although the geographic risk area covered a large region of the United States, the risk more closely characterized firm-specific risk than systematic risk.

• More extensive diversification by the FIs to other types of industries would have decreased the amount of financial hardship these institutions had to endure.

• Similarly, the failure of Northland Bank and Canadian Commercial Bank in the 1980s was partially a result of their lending which was concentrated in western Canadian oil and gas as well as real estate.


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Question 7 - 17

What is the nature of an off-balance-sheet activity? How does an FI benefit from such activities? Identify the various risks that these activities generate for an FI and explain how these risks can create varying degrees of financial stress for the FI at a later time.

• Off-balance-sheet activities are contingent commitments to undertake future on-balance-sheet investments.

• The usual benefit of committing to a future activity is the generation of immediate fee income without the normal recognition of the activity on the balance sheet. As such, these contingent investments may be exposed to credit risk (if there is some default risk probability), interest rate risk (if there is some price and/or interest rate sensitivity) and foreign exchange rate risk (if there is a cross currency commitment).


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Question 7 - 18

What is technology risk? What is the difference between economies of scale and economies of scope? How can these economies create benefits for an FI? How can these economies prove harmful to an FI?

• Technology risk occurs when investment in new technologies does not generate the cost savings expected in the expansion in financial services.

• Economies of scale occur when the average cost of production decreases with an expansion in the amount of financial services provided.

• Economies of scope occur when an FI is able to lower overall costs by producing new products with inputs similar to those used for other products. In financial service industries, the use of data from existing customer databases to assist in providing new service products is an example of economies of scope.


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Question 7 - 19

What is the difference between technology risk and operational risk? How does internationalizing the payments system among banks increase operational risk?

• Technology risk refers to the uncertainty surrounding the implementation of new technology in the operations of an FI.

• For example, if an FI spends millions on upgrading its computer systems but is not able to recapture its costs because its productivity has not increased commensurately or because the technology has already become obsolete, it has invested in a negative NPV investment in technology.


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Question 7 - 19

What is the difference between technology risk and operational risk? How does internationalizing the payments system among banks increase operational risk?

• Operational risk refers to the failure of the back-room support operations necessary to maintain the smooth functioning of the operation of FIs, including settlement, clearing, and other transaction-related activities.

• For example, computerized payment systems such as CHIPS, and SWIFT allow modern financial intermediaries to transfer funds, securities, and messages across the world in seconds of real time. This creates the opportunity to engage in global financial transactions over a short term in an extremely cost-efficient manner.

• However, the interdependence of such transactions also creates settlement risk. Typically, any given transaction leads to other transactions as funds and securities cross the globe. If there is either a transmittal failure or high-tech fraud affecting any one of the intermediate transactions, this could cause an unraveling of all subsequent transactions.


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Question 7 - 20

What two factors provide potential benefits to FIs that expand their asset holdings and liability funding sources beyond their domestic economies?

• FIs can realize operational and financial benefits from direct foreign investment and foreign portfolio investments in two ways.

1. First, the technologies and firms across various economies differ from each other in terms of growth rates, extent of development, etc.

2. Second, exchange rate changes may not be perfectly correlated across various economies.


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Question 7 - 21

What is foreign exchange risk? What does it mean for an FI to be net long in foreign assets? What does it mean for an FI to be net short in foreign assets? In each case, what must happen to the foreign exchange rate to cause the FI to suffer losses?

• Foreign exchange risk involves the adverse effect on the value of an FI’s assets and liabilities that are located in another country when the exchange rate changes.

• An FI is net long in foreign assets when the foreign currency-denominated assets exceed the foreign currency denominated liabilities. In this case, an FI will suffer potential losses if the domestic currency strengthens relative to the foreign currency when repayment of the assets will occur in the foreign currency.

• An FI is net short in foreign assets when the foreign currency-denominated liabilities exceed the foreign currency denominated assets. In this case, an FI will suffer potential losses if the domestic currency weakens relative to the foreign currency when repayment of the liabilities will occur in the domestic currency.


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Question 7 - 22

If the Euro is expected to depreciate in the near future, would a Canadian FI based in Paris prefer to be net long or net short in its asset positions? Discuss.

• The Canadian FI would prefer to be net short (liabilities greater than assets) in its asset position.

• The depreciation of the Euro relative to the dollar means that the Canadian FI would pay back the net liability position with fewer dollars.

• In other words, the decrease in the foreign assets in dollar value after conversion will be less than the decrease in the value of the foreign liabilities in dollar value after conversion.


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Question 7 - 23

If international capital markets are well integrated and operate efficiently, will banks be exposed to foreign exchange risk? What are the sources of foreign exchange risk for FIs?

• If there are no real or financial barriers to international capital and

goods flows, FIs can eliminate all foreign exchange rate risk exposure.

• Sources of foreign exchange risk exposure include international differentials in real prices, cross-country differences in the real rate of interest (perhaps, as a result of differential rates of time preference), regulatory and government intervention and restrictions on capital movements, trade barriers, and tariffs.


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Question 7 - 24

If an FI has the same amount of foreign assets and foreign liabilities in the same currency, has that FI necessarily reduced to zero the risk involved in these international transactions? Explain.

• Matching the size of the foreign currency book will not eliminate the risk of the international transactions if the maturities of the assets and liabilities are mismatched.

• To the extent that the asset and liabilities are mismatched in terms of maturities, or more importantly durations, the FI will be exposed to foreign interest rate risk.


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Question 7 - 25

An insurance company invests $1,000,000 in a private placement of British bonds. Each bond pays £300 in interest per year for 20 years. If the current exchange rate is £1.7612/$, what is the nature of the insurance company’s exchange rate risk? Specifically, what type of exchange rate movement concerns this insurance company?

• In this case, the insurance company is worried about the value of the £ falling. If this happens, the insurance company would be able to buy fewer dollars with the £ received.

• This would happen if the exchange rate rose to say £1.88/$ since now it would take more £ to buy one dollar, but the bond contract is paying a fixed amount of interest and principal.


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Question 7 - 26

Assume that a bank has assets located in London worth £150 million on which it earns an average of 8 percent per year. The bank has £100 million in liabilities on which it pays an average of 6 percent per year. The current spot rate is £1.50/$.

a. If the exchange rate at the end of the year is £2.00/$, will the dollar have appreciated or devalued against the mark?

The dollar will have appreciated, or conversely, the £ will have depreciated.


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b. Given the change in the exchange rate, what is the effect in dollars on the net interest income from the foreign assets and liabilities? Note: The net interest income is interest income minus interest expense.Measurement in £Interest received = £12 millionInterest paid = £6 millionNet interest income = £6 millionMeasurement in $ before £ devaluationInterest received in dollars = $8 millionInterest paid in dollars = $4 millionNet interest income = $4 millionMeasurement in $ after £ devaluationInterest received in dollars = $6 millionInterest paid in dollars = $3 millionNet interest income = $3 million


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c. What is the effect of the exchange rate change on the value of assets and liabilities in dollars?

The assets were worth $100 million (£150m/1.50) before depreciation, but after devaluation they are worth only $75 million. The liabilities were worth $66.67 million before depreciation, but they are worth only $50 million after devaluation. Since assets declined by $25 million and liabilities by $16.67 million, net worth declined by $8.33 million using spot rates at the end of the year. c.What is the effect of the exchange rate change on the value of assets and liabilities in dollars?

The assets were worth $100 million (£150m/1.50) before depreciation, but after devaluation they are worth only $75 million. The liabilities were worth $66.67 million before depreciation, but they are worth only $50 million after devaluation. Since assets declined by $25 million and liabilities by $16.67 million, net worth declined by $8.33 million using spot rates at the end of the year.


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Question 7 - 27

Six months ago, Qualitybank, LTD., issued a US$100 million, one-year maturity CD denominated in Euros. On the same date, US$60 million was invested in a €-denominated loan and US$40 million was invested in a U.S. Treasury bill. The exchange rate six months ago was €1.7382/US$. Assume no repayment of principal, and an exchange rate today of €1.3905/US$.

a. What is the current value of the Euro CD principal (in US dollars and €)?Today's principal value on the Euro CD is €173.82 and US$125m (173.82/1.3905).

b. What is the current value of the Euro-denominated loan principal (in US dollars and €)?Today's principal value on the loan is DM104.292 and US$75 (104.292/1.3905).

c. What is the current value of the U.S. Treasury bill (in US dollars and €)?Today's principal value on the U.S. Treasury bill is US$40m and €55.62 (40 x 1.3905),

although for a U.S. bank this does not change in value.

d. What is Qualitybank’s profit/loss from this transaction (in US dollars and €)?Qualitybank's loss is US$10m or €13.908.


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Question 7 - 29

What is country or sovereign risk? What remedy does an FI realistically have in the event of a collapsing country or currency?

• Country risk involves the interference of a foreign government in the transmission of funds transfer to repay a debt by a foreign borrower.

• A lender FI has very little recourse in this situation unless the FI is able to restructure the debt or demonstrate influence over the future supply of funds to the country in question.

• This influence likely would involve significant working relationships with the IMF and the World Bank.


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Question 7 - 31

Consider these four types of risks: credit, foreign exchange, market, and sovereign. These risks can be separated into two pairs of risk types in which each pair consists of two related risk types, with one being a subset of the other. How would you pair off the risk types, and which risk type may be considered a subset of another?

• Credit risk and sovereign risk comprise one pair, while FX and market risk make up the other.

• Sovereign risk is a type of credit risk in that one reason why a loan may default is because of political upheaval in the country in which the borrower resides.

• FX risk is a type of market risk in that one reason why the market value of an outstanding loan or security may change is due to a change in exchange rates.


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Question 7 - 32

What is liquidity risk? What routine operating factors allow FIs to deal with this risk in times of normal economic activity? What market reality can create severe financial difficulty for an FI in times of extreme liquidity crises?

• 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.

• In times of normal economic activity, depository FIs meet cash withdrawals by accepting new deposits and borrowing funds in the short-term money markets.

• However, in times of harsh liquidity crises, the FI may need to sell assets at significant losses in order to generate cash quickly.


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Question 7 - 33

Why can insolvency risk be classified as a consequence or outcome of any or all of the other types of risks?

• Insolvency risk involves the shortfall of capital in times when the operating performance of the institution generates accounting losses.

• These losses may be the result of one or more of interest rate, market, credit, liquidity, sovereign, foreign exchange, technological, and off-balance-sheet risks.


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Question 7 - 34

Discuss the interrelationships among the different sources of bank risk exposure. Why would the construction of a bank risk-management model to measure and manage only one type of risk be incomplete?

Measuring each source of bank risk exposure individually creates the false impression that they are independent of each other. For example, the interest rate risk exposure of a bank could be reduced by requiring bank customers to take on more interest rate risk exposure through the use of floating rate products. However, this reduction in bank risk may be obtained only at the possible expense of increased credit risk. That is, customers experiencing losses resulting from unanticipated interest rate changes may be forced into insolvency, thereby increasing bank default risk. Similarly, off-balance sheet risk encompasses several risks since off-balance sheet contingent contracts typically have credit risk and interest rate risk as well as currency risk. Moreover, the failure of collection and payment systems may lead corporate customers into bankruptcy. Thus, technology risk may influence the credit risk of FIs.

As a result of these interdependencies, FIs have focused on developing sophisticated models that attempt to measure all of the risks faced by the FI at any point in time.


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4

Sample Question 1

The sales literature of a mutual fund claims that the fund has no risk exposure because it invests exclusively in default risk-free federal government securities. Is this claim true? Why or Why not?

Although the fund’s asset portfolio is comprised of default risk free securities, the fund may still be exposed to risk if there is significant interest rate risk exposure

for example, if interest rates increase significantly, the market value of the fund’s Treasury security portfolio may decrease. Moreover, although it is virtually impossible for the federal government to go bankrupt (at least in terms of local currency where it can always print more money to meet its obligations), in times of political or economic turmoil the government may refuse to meet its debt obligations.


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5

Sample Question 2

This is a summary of the descriptive contents of the chapter…be sure to review.A. bank finances a $20 million 5-year fixed-rate commercial loan by

selling 1-year certificates of deposit. Liquidity, interest rate and credit risks exist.

B. An insurance company invests its policy premiums in a long-term municipal bond portfolio. Liquidity, credit and actuarial risks exist. Interest rate risk may also exist if the investment duration differs from the actuarial duration.

C. A German bank sells two-year fixed-rate notes to finance a two-year fixed-rate loan to a Polish entrepreneur. Credit and sovereign risks exist. If the note and the loan are in different currencies, foreign exchange risk also exists.


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5

Sample Question 2 ...

D. A British bank acquires an Australian bank so as to facilitate

clearing operations. The whole portfolio of the Australian bank has a peculiar set of risks that may include all of I to vii. The equity investment from the point of view of the British bank has foreign exchange risk.

E. A mutual fund completely hedges its interest rate risk exposure

using forward contingent contracts. Credit risk exists with respect to the forward counterparty.

F. A bond dealer uses his own equity to buy Brazilian sovereign bonds.

Interest rate, market and credit risks exist. Assuming that the debt is in US dollars and the bond dealers’ home currency is Canadian dollars, foreign exchange risk also exists.


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5

Sample Question 2 ...

G. The bond dealer sold the Brazilian debt in question f.

Assuming that the sale is complete, no new risk is incurred. Note, however, that the funds must be reinvested (or paid out to equity holders). This could be considered a realization of liquidity risk.

H. A bank sells a package of its mortgage loans as mortgage-backed

securities. Liquidity and interest rate risks exist to the extent that the bank must reinvest its cash, funded by deposits of a given maturity and interest rate.

I. A bank funds its asset portfolio consisting of commercial loans by

issuing demand deposits. Liquidity and credit risks exist. If the commercial loans are fixed rate, interest rate also exists.


7-75Sample Question 3

Discuss how off-balance-sheet risk can encompass several of the other eight sources of risk exposure.

Off-balance-sheet commitments are contingent claims and obligations that either increase or are used to mitigate other risks.

An LC brings the credit risk of the account party. Risk of exercise of a guarantee by the beneficiary is a liquidity

risk. Interest rate and foreign exchange derivatives may be used to

hedge on balance sheet interest rate and foreign exchange exposure or, if there is no offsetting balance sheet position, increase those exposures.

Various derivatives are marketable securities traded in deep and liquid markets and constitute an important part of market risk of the FI.


7-76Sample Question 3 ….

Off-balance-sheet positions where the counterparty is in another country contain a sovereign dimension in their credit risks.

Derivatives are contingent claims. The value of some can be calculated according to actuarial pricing; hence, open positions in such derivatives have actuarial risk.

Settlement of off-balance sheet obligations involves the payment system and various inter- and intra- bank technological risks.



Discuss how the availability of international computerized payments systems creates both risk and opportunity.

Computerized payments systems such as Fedwire, Chips, and SWIFT allow modern financial intermediaries to transfer funds, securities and messages across the world in seconds of real time. This creates the opportunity to engage in global financial transactions over the short term in an extremely cost efficient manner.

However, the interdependence of such transactions also creates settlement risk. Typically, any given transaction leads to other transactions as funds and securities cross the globe. If there is either a transmittal failure or high-tech fraud affecting any one of the intermediate transactions, this could cause unravelling of all subsequent transactions in the pyramid.



What are the sources of foreign exchange risk for FIs? If international capital markets are well-integrated and operate efficiently, will banks be exposed to foreign exchange risk?

An FI is exposed to foreign exchange risk when its funds (liabilities) and its investments (assets) are denominated in different currencies and no offsetting off-balance-sheet position is taken.

FIs that are currently able to completely hedge their foreign exchange exposure often choose not to in order to perform an active trading (ie. Position taking) role.

International capital markets in most of the currencies in which this activity is currently performed are well integrated, yet FIs still can make profits from position taking.

If all markets operated efficiently, then expected profits to open positions taking would disappear, and all FIs would choose to be hedged on their investments (relative to their funding) all of the time.



Discuss the interrelationships among the different sources of bank risk exposure.

Measuring each source of bank risk exposure individually creates the false impression that they are each independent.• For example, the bank’s interest rate risk exposure could be

reduced by allowing bank customers to take on more interest rate risk exposure through the use of floating rate products. However, this reduction in bank risk may be obtained only at the possible expense of increased credit risk exposure. That is, customers experiencing losses resulting from unanticipated interest rate changes may be forced into insolvency, thereby increasing bank default risk exposure.

• Off-balance-sheet risk encompasses other sources of risk since off-balance-sheet contingencies typically entail credit risk, interest rate risk as well as currency risk.



If it were feasible, would it be optimal for banks to be totally free of risk exposure?

No, such policy would prevent the bank from performing its intermediation functions of risk pooling, asset transformation, and delegating monitoring.

In financial markets, there are higher returns to be had for assuming higher risks.

Due to diversification opportunities and economies of scale and scope available to large agents like an F.I., it can realize better returns for a given level of risk in comparison to a small agent.



“Banks have greater exposure to liquidity risk than do mutual funds.” Is this statement true? If so, why? If not, why not?

Banks issue demand deposits which can be withdrawn at full face value at any time by the depositor.

Mutual funds must redeem shares upon demand by the investor. However, the mutual fund does not guarantee payment at some “face value.”

Instead, the mutual fund redeems shares on the basis of net asset value, which is simply the market value of the funds portfolio divided by the number of shares outstanding.

Thus, if liquidity pressure forces the mutual fund to sell assets, any reduction in the value of those assets will be borne by the mutual fund investor.

Instead, if liquidity pressure forces the bank to sell assets, any reduction in the face value of those assets will be borne by the bank’s shareholders, not the depositor.


7-82Problem 7 - 1

There would be no impact on net interest income during the first year. However, net interest income would decrease in the second year.

Yr. 1 Interest Income = $50m .10 = $5.0 m

Yr. 1 Interest Expense = $50m .08 = $4.0m

Yr. 1 Net Interest Income = $5.0m - $4.0m = $1.0m

Yr. 2 Interest Income = $50m .10 = $5.0m

Yr. 2 Interest Expense = $50m .09 = $4.5m

Yr. 2 Net Interest Income = $5.0m - $4.5m = $0.5m


7-83Problem 7 - 2

Megabank Ltd., as US bank, issued a euro CD (i.e., a CD denominated in euros) in the amount of 100 million. On the date of the issuance of the CD, the exchange rate was 1.00 = U.S. $1.10. It used the funds to invest 60 million in a euro-denominated loan and 40 million in a US dollar treasury bill. Principal of the CD, the loan and the T-bill are still amortized when the euro plunges to par (1.00 = U.S. $1.00).

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