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Chapter 7 Risks of Financial Intermediation.docx

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Department
Finance
Course
FIN 701
Professor
Patricia Mc Graw
Semester
Fall

Description
FIN701 Financial Institutions Management CHAPTER 7 Risks of Financial Intermediation INTEREST RATE RISK  Asset transformation involves FI buying primary securities or assets and issuing secondary securities or liabilities to fund asset purchases o Primary securities FIs buy have maturity and liquidity characteristics different from those of secondary securities FIs sell  Interest rate risk – risk incurred by FI when maturities of assets and liabilities are mismatched  Refinancing risk – risk that cost of rolling over or reborrowing funds will rise above returns being earned on asset investment  Reinvestment risk – risk that returns on funds to be reinvested will fall below cost of funds  FI face market value risk where rising interest rates increase discount rate on cash flows and reduce market value of asset or liability, or falling interest increase market values of assets and liabilities  Can seek to hedge interest rate risk by matching maturity of assets and liabilities o FIs cannot be asset transformers (e.g., transforming short-term deposits into long-term loans) and direct balance sheet matches or hedgers at the same time  Matching maturities can reduce profitability because returns from acting on specialized risk-bearing asset transformers are reduced MARKET RISK  Market risk – risk incurred in trading of assets and liabilities rather than holding them for longer-term investment due to changes in interest rates, exchange rates, and other asset prices  FI’s trading portfolio can be differentiated from investment portfolio on basis of time horizon and secondary market liquidity o Concerned with fluctuations in value – value at risk (VAR) – of trading account assets and liabilities for periods as short as one day – daily earnings at risk (DEAR)  Market, or trading, risk present when FI takes open or unhedged long (buy) or short (sell) position on bonds, equities, and foreign exchange (as well as commodities and derivative products), and prices change in direction opposite to that expected CREDIT RISK  Credit risk – risk that promised cash flows from loans and securities held by FIs may not be paid in full  All FIs face this risk, but those that make loans or buy bonds with long maturities are more exposed than those with short maturities  Financial claims issued by corporations and held by FIs promise limited or fixed upside return (principal and interest payments to lender) with high probability and large downside risk with smaller probability o Probability of partial or complete default exists, FI must estimate expected default risk on these assets and demand risk premiums commensurate with perceived risk exposure  Managerial monitoring efficiency and credit risk management strategies directly affect return and risk of loan portfolio  Diversification reduces individual firm-specific credit risk – risk of default of borrowing firm associated with specific type of project risk taken by that firm – while leaving FI exposed to systematic credit risk – risk of default associated with general economy wide or macro-conditions affecting all borrowers OFF-BALANCE-SHEET RISK  Off-balance-sheet risk – risk incurred by FI due to activities related to contingent assets and liabilities o Does not appear FI’s current balance sheet since it does not involve holding current primary claim (asset) or issuance of current secondary claim (liability)  Off-balance-sheet activities affect future shape of FI’s balance sheet that involve creation of contingent assets and liabil
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