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1.1.1.1.1Part V: Risk Management in Financial
Institutions
1.1.1.1.2
1.1.1.1.3Chapter Nineteen
Types of Risks Incurred By Financial Institutions
1.1.1.2 I. Chapter Outline
1. Why Financial Institutions Need to Manage Risk: Chapter Overview
2. Credit Risk
3. Liquidity Risk
4. Interest Rate Risk
5. Market Risk
6. Off-Balance-Sheet Risk
7. Foreign Exchange Risk
8. Country or Sovereign Risk
9. Technology and Operational Risk
10. Insolvency Risk
11. Other Risks and Interactions among Risks
II. Learning Goals
1. Describe the major risks faced by financial institutions.
2. Recognize that insolvency risk is a consequence of the other types of risk.
3. Understand how the various risks faced by financial institutions are related.
1.1.1.3 III. Chapter in Perspective
In Part V the text provides a more detailed examination of risk management at financial
institutions. Chapter 19 provides an introduction to Chapters 20-24 by discussing why risk
management is crucial to today’s institutions and by categorizing the major risks faced by
financial intermediaries. The subsequent chapters highlight a specific component of risk, or a
specific tool to manage risk and provide current applications. The chapters in Part V ask the
reader to apply their knowledge of both markets and derivatives to risk management problems at
intermediaries. Many texts include applications of risk management with the chapter on
derivatives, or with the chapter about the specific intermediary’s line of business. The text
authors have separated the introductory chapters from the risk management chapters so that the
instructor can cover some, all or none of the applications chapters. Chapters 20 through 24 are
more difficult than the prior chapters because of the applications covered, although they are still
suitable for an introductory level course. To help ensure readability, many of the mathematical
applications are relegated to appendices. Chapter 20 covers the management of credit risk that
arises from balance sheet activity. Chapter 21 illustrates the management of liquidity risk.
Chapter 22 develops tools to manage interest rate risk and institutional insolvency risk with the
repricing and duration gaps. Chapter 23 presents the use of derivatives to manage risk and
Chapter 24 covers loan sales and securitization.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Credit risk Letter of credit
Firm specific credit risk Foreign exchange risk
Systematic credit risk Country or sovereign risk
Liquidity risk Technology risk
Interest rate risk Operational risk
Market risk Insolvency risk
Off balance sheet risk Interactions among risks
Net interest margin Refinancing risk
Reinvestment risk Primary and secondary claims
Off balance sheet risk Event risk
1.1.1.5 V. Teaching Notes
1. Why Financial Institutions Need to Manage Risk: Chapter Overview
The goal of a FI is the same as any for profit corporation, namely to maximize shareholder
wealth. The major difference between a financial institution and a nonfinancial corporation is in
the nature of their assets and liabilities and the degree of regulation. A majority of financial
firms’ assets are pieces of paper. They are not readily differentiable from assets of competitors;
this leads to very low ROAs as discussed in Chapter 13. In order to offer shareholders a
competitive rate of return, FIs must therefore incur substantial risk. This risk takes the form of
using a high amount of leverage, investing in assets riskier than the liability positions funding
them and maintaining minimal liquidity positions. Consequently, small errors in judgement can
have serious negative consequences for the solvency of FIs. Because many institutions depend
upon the public’s perception of their soundness to attract business, events that erode the public’s
confidence in one or several large domestic or foreign FIs can quickly spread and lead to major
profit and solvency problems in many FIs.1 The following sections outline the major risks faced
by FIs today.
2. Credit Risk
Credit risk is the possibility that a borrower will not repay principle and interest as promised in
1The fear of contagion effects has encouraged regulators to bail out many insolvent or near
insolvent financial institutions around the world including the March 2008 bailout of Bear
Stearns engineered by the Federal Reserve. As it turned out more failures did occur due to the
severity of the financial crisis.
a timely fashion. To limit this risk, FIs engage in credit investigations of potential funds
borrowers, or in the case of investments they may rely on externally generated credit ratings. FIs
lend to many different borrowers to diversify away firm specific (borrower specific) credit
risk. Systematic credit risk will remain (credit risk due to ‘systemic’ or economy wide risks
such as inflation and recession) even in a well diversified portfolio. Many of the S&L problems
of the 1980s can be attributed to an underdiversified loan portfolio overexposed to certain types
of lending in certain regions. Chapters 20 and 24 provide methods of assessing and managing
credit risk.
Banks, thrifts, mutual funds and life insurers usually face more credit risk than certain other
intermediaries such as MMMFs and P&C insurers because the former tend to have longer
maturity loans and investments.
Teaching Tip: What may appear to be relatively small loss rates can quickly bring about the
threat of insolvency at depository institutions (DIs). For instance, unexpected loss rates of 5% to
6% of the total loan portfolio can easily cause a bank to fail. Most charge off rates on specific
types of loans are much lower than this amount at well managed banks, although credit card loss
rates are significantly higher than most other types of domestic loans. Foreign lending,
particularly sovereign lending, has traditionally been the most risky throughout all of the history
of banking and has led to the loss of many fortunes and caused many failures.
Teaching Tip: Only the unexpected portion of loan losses generates solvency risk per se because
banks set aside an allowance for loan loss account against to cover expected loan losses.
Net charge offs (NCOs) vary by loan type. Text Figure 19-1 illustrates that credit card NCOs
were quite high after the financial crisis, peaking at an all-time high of 13.21% in March 2010
before falling to 3.28% in early 2014 according to the FDIC Quarterly Banking Profile. The
credit card market is quite large at $3.261 trillion in 2013, although it has declined from
pre-crisis levels. Charge offs of C&I loans and charge offs on real estate loans also rose during
the crisis (as high as 2%) but net charge offs in 2014 were 0.23% and 0.24% respectively.
The Bankruptcy Reform Act was passed in October 2005. The Act made it more difficult for
higher income individuals to seek bankruptcy protection. As the text indicates there was a large
spate of filings before the act went into effect followed by a large drop off in filings afterwards.
Filings then increased during and subsequent to the financial crisis in the late 2000s. Bankruptcy
filings have generally trended down since the recovery although there was an increase in 2012.
3. Liquidity Risk
Liquidity risk arises because there is a mismatch in the terms and maturity of a FI’s assets and
liabilities. In many cases liabilities either have an uncertain maturity (they are due upon demand
for instance), or they have a shorter maturity than the assets. Many FI’s assets are also less liquid
than the FI’s liabilities. Even if the existing assets and liabilities were perfectly maturity
matched, loan commitments and the undesirability of turning away potential loan customers
would lead to liquidity risk as borrowers increased their take downs or new loan customers
arrived unexpectedly at the FI. FIs maintain precautionary liquid assets to meet unexpected
liquidity needs and may purchase liquidity via brokered deposits, fed funds borrowed, reverse
repos or via other short term financing sources. Chapter 21 covers liquidity risk and liquidity
management at FIs. The Fed lowered interest rates, including the discount rate, during the
subprime crisis to encourage lending during the liquidity problems in the short term markets
engendered by the subprime crisis. The Fed even opened up discount window borrowing to
non-bank institutions that are not extensively regulated such as securities brokers. IndyMac
failed in 2008 in the midst of a liquidity crisis. As news spread that IndyMac was in trouble
depositors began to withdraw large sums from the bank, even those under the FDIC insurance
limit. Within a week the FDIC was forced to take over the bank. IndyMac was later acquired
by One West Bank Group.
4. Interest Rate Risk
Interest rate risk arises from intermediaries’ function as an asset transformer. Recall that many
intermediaries invest in direct claims issued by borrowers (assets) while providing separate
claims to individual savers (liabilities). This process is a form of maturity intermediation. The
maturity of a FI’s assets will normally differ from the maturity of its liabilities. When this is the
case changes in interest rates can lead to changes in profitability and/or equity value. These
changes caused by unexpected movements in interest rates give rise to interest rate risk. Banks
and thrifts engage in maturity intermediation to a greater extent than other institutions such as
life insurers. Consequently the former two types of FIs face more interest rate risk.
In general, if an institution has longer maturity assets funded by shorter maturity liabilities, it is
at risk from rising interest rates. Suppose the FI has two year fixed rate assets funded by one
year fixed rate liabilities. The FI’s liabilities will reprice sooner than its assets. If interest rates
rise, the cost of funding on the liabilities will increase in one year, but the income from the assets
will remain the same throughout the second year, reducing the net interest margin. The
institution has refinancing risk because the liabilities must be rolled over or reborrowed before
the assets mature. Refinancing risk is the risk that at rollover dates the liability cost will rise
above the asset earning rate.2
An institution in this situation will however benefit from declining interest rates.
The converse also holds. Institutions with an asset maturity shorter than the liability maturity will
benefit from rising interest rates, but will be hurt by falling interest rates. If the assets mature
more rapidly than the liabilities then the institution faces reinvestment risk. Reinvestment risk is
the risk that the returns on funds to be reinvested will fall below the cost of those funds.
Teaching Tip: These ideas are easily illustrated as follows:
A FI has $100 million of fixed earning assets that mature in 2 years. The assets earn an average
of 7%. These are funded by 6 month CD liabilities paying 4%. So in this case the asset maturity
is longer than the liability maturity. The bank’s Net Interest Margin (NIM) = [(7% – 4%)*$100
million] / $100 million = 3%. If in 6 months interest rates increase 100 basis points, the 2 year
assets will still be earning 7%, but the new 6 month CDs will have to pay 5%, reducing the NIM
by one-third to 2%. This illustrates refinancing risk.
Although changes in profitability affect equity value, the effect of a change in interest rates can
2 Refinancing risk would also encompass increases in rates that reduced the NIM, even if it did
not become negative.
be more directly measured by examining how the present value of the existing assets and
liabilities will change as interest rates change.3 The conclusions are similar to above. A FI with
longer term (duration) assets funded by shorter term (duration) liabilities will suffer a decline in
the market value of equity if interest rates rise. This occurs because the market value of the
assets will decline more sharply than the market value of the liabilities.
Causes and measures of interest rate risk are provided in Chapter 22; using derivatives to hedge
interest rate risk is presented in Chapter 23.
5. Market Risk
Market risk arises when FIs take unhedged positions in securities, currencies and derivatives.
Income from trading activities has increased in importance during recent years. In general, the
volatility of asset prices and currency values causes market risk.
Teaching Tip: The failure of Barings bank is an extreme example of market risk (see the Off
Balance Sheet section).
Bank assets and liabilities can be separated into ‘banking book’ and ‘trading book’ assets or
liabilities based on the account’s maturity and liquidity. Trading book accounts are on and off
balance sheet accounts that are held for a short time period and are generally speculative in
nature. They are held in hopes of generating price gains or as part of making a market in a given
security or contract. Banking book accounts are those held for longer time periods and generate
interest income or provide long term funding.
Text Table 19–3 with examples of both is reproduced below:
Assets Liabilities
Banking Book Loans Capital
Other illiquid assets Deposits
Trading Book
Bonds (long) Bonds (short)
Commodities (long) Commodities (short)
FX (long) FX (short)
Equities (long) Equities (short)
Off Balance Sheet Derivatives (long) Derivatives (short)
Value at Risk (VAR) is a relatively new method of assessing overall institutional risks.4 VAR
attempts to measure the maximum dollar amount a FI is likely to lose in a given short time
period, usually a day, with some probability.
Teaching Tip: The VAR is a probabilistic method that estimates the likely loss that could occur at
a given confidence interval (usually 95%). A simple VAR model would attempt to identify and
estimate likely values for the major portfolio risk factors, such as stock price changes, currency
3The text labels this risk “present value uncertainty or price risk.” It arises from a difference
in the duration of the FI’s assets and liabilities.
4The text also uses the term Daily Earnings At Risk or DEAR.
changes, interest rate changes, etc. Based on either the factor’s historical variability or the use of
Monte Carlo simulation the VAR model attempts to estimate the likely changes of each variable
over the time interval, incorporating the correlations between the variables so that the FI can
more realistically estimate the maximum loss likely to occur with 95% confidence. VAR was
originated by J.P. Morgan and information about VAR may also be found at their website under
the title Risk Metrics.
The financial crisis provides a perfect illustration of how seriously market risk can affect an
institution’s balance sheet. When the mortgage market began to meltdown many institutions took
large losses on mortgage backed securities (MBS). The securitization market stopped
functioning and banks had to hold their securities as losses built. The securities even became
known as ‘toxic’ assets. The result was the failure of Lehman, the buyout of Merrill Lynch and
Washington Mutual. As a result of these events in 2008 the Dow fell 500 points, then the biggest
drop in seven years and global markets followed suit.
6. Off-Balance-Sheet Risk
The last twenty years have brought about tremendous growth in off balance sheet activities
ranging from loan commitments to swaps to OTC derivatives. Commercial banks alone held off
balance sheet claims of $233.853 trillion in 2013, a staggering number.5 Derivatives allow
institutions to reduce risk arising from other aspects of their business, offer risk reduction
services to their clients, and to generate income growth through fees without growing the balance
sheet. The latter is important because of regulations associated with balance sheet growth
(particularly capital regulations).
On balance sheet activities are current primary claims (assets) or current secondary claims
(liabilities). Off balance sheet activities are contingent claims that can affect the balance sheet
in the future. A letter of credit is used as an example in the text. A letter of credit issued by a FI
is a contingent promise to pay off a debt if the primary claimant fails to pay. Profitability is the
incentive driving the off balance sheet business. FIs are generating fee income to reduce the
dependence on interest rate spreads and because of the increased competitive pressures on their
traditional lines of business. Off balance sheet assets and liabilities have grown so much that
ignoring them may generate a significantly misleading picture about the value of stockholder’s
equity. Net worth (NW) is properly measured as
NW = MVAssetsOn – MVLiabilitiesOn + MVAssetsOff – MVLiabilitiesOff
where MV stands for market value of the given category.
There are many off balance sheet activities including:
Loan commitments
Mortgage servicing contracts
Positions in forwards, futures, swaps and other derivatives (mostly by the largest FIs)
5 This number significantly overstates the size of actual bank commitments because the number
includes notional principal amounts which are not actually at risk and does not represent net
payments due on these contracts.
Two aspects of certain types of derivatives lead to additional risks involved with their usage.
First, calculating derivative values and payouts is complicated. This is particularly true for
many OTC derivatives that banks sell. The selling banks typically understand the risks better
than the clients. Second, derivatives typically involve large amounts of leverage. These two
attributes imply that misuse of derivatives is likely to occur, and can result in extreme losses (or
extreme gains, but rarely are the winners upset about those). There have been many cases in
recent years where derivatives usage has led to problems:
1. In 2012, Bruno Iksil, a trader for J.P. Morgan Chase, made large bets (the so called
London Whale) by trading credit default swaps on an index of corporate bonds that
eventually cost the bank about $6 billion.
2. In February 2008, Societe Generale, a large French bank, indicated that a rogue trader,
Jerome Kerviel had generated $7.2 billion in losses on futures trades. 6 This was the
largest market risk related loss ever. Kerviel used his knowledge of the “back office”
order processing systems to hide trades.
3. In 1995 Barings Bank failed when a so called ‘rogue trader,’ Nick Leeson, bankrupted
Barings after the bank allowed him to run up extremely large losses in futures and option
trading on Tokyo and Singapore derivatives exchanges. Interestingly, Barings did not
complain when he supposedly generated large gains for the bank and allowed Leeson to
run back office order processing as well as trading activity, a clear violation of sound
internal control procedures.
4. In 1995, a trader at Sumitomo incurred losses of $2.6 billion from commodity futures
trading. Losses of this size just shouldn’t happen if the bank’s internal controls are
functioning properly.
5. Bankers Trust sold several complicated OTC swaps to customers. In one of the swap
deals the customer (Gibson Greeting Cards) had to make variable rate payments based on
Libor2. In the second swap deal with Procter and Gamble, P&G would have to make
high variable rate payments if either short term or long rates rose, and extremely high
variable rate payments if both rose, which is what happened. Both customers sued
Bankers Trust claiming they did not understand the risks they were facing. The fallout
helped lead to the Deutsche Bank takeover of BT.
6. Orange County investment advisor Bob Citron, a portfolio manager with very little
formal finance or investment training, purchased structured notes from Credit Suisse First
Boston. The notes were a type of inverse floater that would drop in value if rates
increased, which of course they did. Citron had used an extreme amount of leverage in
an attempt to earn higher returns (which he did for several years). When rates rose,
losses mounted quickly and he could not repay the borrowings and the municipality went
bankrupt, losing $1.5 billion. Twenty banks were sued; CSFB paid $52 million to settle
charges.
After the fact, the problems in the financial crisis indicate that banks hid risks in their derivatives
activities and did not have sufficient capital to back these commitments. Losses on MBS and
collateralized mortgage obligations (CMOs) were very high. Recovery rates on CMOs ranged
from only $0.05 to $0.32 per dollar of par value. Investors purchased claims in very complex
instruments that turned out to be very risky. One reason they did so was because of high ratings
6 Apparently a ‘rogue’ trader is one who gets into trouble.
from the credit ratings agencies. In some cases the securities were so complicated that ratings
agencies and regulators had to rely on the bankers’ assessment of the riskiness of the securities.
This is obviously a flawed operating procedure. Part of the problem has been an overreliance on
mathematical risk modeling. Actually, I don’t believe the pricing models were seriously flawed.
Rather the inputs were developed by statisticians who relied excessively on historical data, rather
than examining whether future economic conditions supported such conclusions.
Credit line draw-downs rose dramatically in 2008. Firms like GM maxed out their credit line
borrowing as other short term money sources dried up. Unused commitments on lines fell
sharply and about 45% of banks announced commercial loans increases associated with
previously arranged credit lines. The draw-downs increased liquidity problems at some FIs, and
in response the Fed created the Commercial Paper Funding Facility (CPFF), to assist in funding
for short term markets. The Fed began purchasing commercial paper to assist funding of
institutions and corporate issuers of paper.
Teaching Tip: To what extent do these problems imply we should limit derivatives usage? Are
we comfortable with the caveat emptor philosophy currently employed? Even after
Dodd-Frank, the regulators have trouble keeping track of this market. In 2014 the CFTC
admitted to misstating the size of the credit default swap market by an estimated $250-$300
billion and in 2013 the Depository Trust & Clearing Corporation (DTCC) underestimated swap
notional principals by about $55 trillion.7
7 Acknowledging Mistake, U.S. Regulators Still Struggle to Oversee Derivatives Market: CFTC
Says It Published Inaccurate Data on Swaps Similar to 'London Whale' Going Back to
November, by Andrew Ackerman and Katy Burne, The Wall Street Journal Online, May 1, 2014.
