Chapter 19 – Types of Risks Incurred By Financial Institutions 6th edition
1. Foreign Exchange Risk
Foreign exchange risk arises from current and contingent claims in foreign currencies.
Net current and contingent asset exposures are at risk from declining currency values
and net liability exposures are at risk from rising currency values (see Chapter 9).
1.1.1.1 An Example of an FI’s Exposure to Foreign Exposure Risk
An FI that makes a foreign currency loan (asset) is at risk from a declining foreign
currency. For instance, a U.S. FI lends ¥100 million when the ¥/$ exchange rate is ¥110.
The interest rate is fixed at 9% and the loan is for one year. Suppose that in a year the
exchange rate is ¥120 to the dollar,
The original dollar amount lent by the bank is:
¥100,000,000 / ¥110 = $909,090.91
In one year the borrower repays
(¥100,000,000 1.09) = ¥109,000,000
In dollar terms this is now worth:
¥109,000,000 / ¥120 = $908,333.33
thus the bank earns a negative rate of return.
Analysis: The dollar depreciated by (¥120/¥110) – 1 = 9.09% and the bank only earned
9% in interest.
The risk of a declining yen could be offset in various ways. The FI could procure yen
deposits or other yen denominated liabilities or the FI could sell the yen forward.
Suppose the FI procures a ¥100 million 6 month Euro yen liability to fund the loan. In
this case the exchange rate risk is reduced because the change in $ value of the loan asset
should be at least partially offset by a similar change in the $ value of the Euro yen
liability. Some exchange rate risk remains because the 6 month rate may change
differently than the 1 year rate. Moreover, the FI faces interest rate risk if we presume
that the FI must roll over the CD borrowings for six more months.
The potential severity of foreign exchange risk is illustrated in the 1997 Asian crisis.
Many Asian countries had short term dollar and yen denominated debts. The debts were
serviced by local currency earnings, so currency devaluations would impair the
borrower’s ability to repay the loans. These countries had engaged in currency
stabilization policies that lulled investors to believing that due to the Asian ‘economic
miracle’ currency risk was minimal. As growth slowed, currency speculators began
betting that the currency values would have to fall. Once the local currencies began to
depreciate, beginning with the Thai baht, contagion effects quickly spread to other
currencies, such as the Indonesian rupiah and eventually the Russian ruble and Brazilian
real. The crisis then fueled itself as local firms could no longer repay their dollar
denominated debts, leading to further currency devaluations. In the ensuing fallout of
loan, investment and currency losses, the earnings of many worldwide FIs were hurt
including Chase, which lost $160 million as a result, J.P. Morgan and many Japanese and
South Korean banks.
Teaching Tip: The foreign exchange markets are the largest markets in the world and
banks are major participants. They engage in currency arbitrage, taking positions in
19–1
Chapter 19 – Types of Risks Incurred By Financial Institutions 6th edition
currencies to meet customer’s needs and outright currency speculation. Participation in
the currency markets can actually reduce risk of foreign currency loans and brick and
mortar assets. It is the unhedged positions that add to risk. Moreover, currency
movements are not perfectly correlated so maintaining positions in multiple countries
may reduce overall risk given that some foreign exposure is inevitable.
2. Country or Sovereign Risk
Holding assets in a given country creates sovereign risk. Sovereign risk is the risk that a
host government will either refuse to repay its own loans or intervene and prevent some
principle from repaying its debts. Sovereign risk also incorporates the threat of
expropriation and repatriation restrictions on assets other than loans. Argentina’s three
defaults on its sovereign debt are a perfect example. Lenders to sovereign governments
usually have little recourse other than to await the outcome of often protracted
negotiations between the country and some international institution such as the IMF.
Losses in the 1980s and 1990s due to sovereign risk were quite large and would have
been even larger except for huge amounts of emergency funding provided by the IMF to
countries experiencing a crisis. In 2001 Argentina defaulted on $130 billion of
government issued debt and in September 2003 it defaulted on a $3 billion loan from the
IMF. In 2005 Argentina unilaterally announced it would pay only $0.30 per dollar on
loans and bonds outstanding from its 2001 debt restructuring. Apparently happy to get
anything, many of the bondholders accepted the offer. Many other countries have had
similar difficulties, for instance, Mexico had two major crises in the last decades, Russia
suddenly and with no explanation defaulted on its foreign loans in 1998. In the past
Indonesia has declared a moratorium on repayments of foreign debt, Malaysia instituted
capital controls after the Asian currency crisis, and Brazil has had difficulty repaying
debts several times, etc. More recently, in 2012, investors in Greek government debt lost
53.5% of the total $265 billion held due to the Greek crisis. Unknown amounts were lost
by foreign investors, predominantly Russian, in the Cypriot banking crisis in 2013 when
the government liquidated the second largest bank, Laiki Bank and seized 60% of
deposits over 100 thousand euros to recapitalize the largest bank, Bank of Cyprus.1
Banks may attempt to assess sovereign risk by examining a country’s trade policy, debt to
GDP ratio, foreign debt to GDP, foreign currency reserves, government control of the
economy, extent of property rights, independence of the monetary authority, history of
exchange rate movements, amount of foreign capital inflows, inflation and structure of
the financial system.
3. Technology and Operational Risk
Changing technology is affecting the entire FI industry. At the retail level many banks
now offer telephone deposit and lending services and similar online services. At the
wholesale level electronic funds transfers (EFT) through the Automated Clearing
Houses (ACH) and wire transfer payment systems such as the Clearing House
Interbank Payments Systems (CHIPS) are standard methods of funds transfers. The
1 Russians Return to Cyprus, a Favorite Tax Haven, by Liz Alderman, The New York
Times, February 17, 2014.
19–2
Chapter 19 – Types of Risks Incurred By Financial Institutions 6th edition
goals of technological improvements are to generate scale and scope economies and to
generate additional revenue sources. Technology risk arises from the possibility that
new technology investments do not result in profit improvements. Excess capacity and
customer reluctance to use online services are two examples of this type of risk. Online
banking is currently facing these problems.
Teaching Tip: Security seems to me be the largest concern with online banking. We
certainly already have the technology so that one could be able to conduct all of their
banking through their computer, or better yet, on their television without ever having to
stand in line or deal with ‘banker’s hours.’ Privacy and security concerns are the major
impediments to implementing this type technology. Nevertheless, this may be the last
generation that has the corner bank as the main provider of banking services. The cost
savings from online services will be too great to ignore.
Operational risk arises when technology (or technology users) and other systems fail to
perform properly. Major examples of operational risk include settlement risk, clearing
risk, risks associated with custodial services and outright computer breakdowns. In
Wells Fargo’s merger with First Interstate (FI), FI’s customer account numbers were not
properly credited with incoming deposits. Wells Fargo incurred a $180 million operating
loss as a result. In 2002 Citibank’s ATMs went down for several days along with its
online banking. In September 2004 about one third of Wachovia Securities brokers’
assistants could not access customer records or even log onto their computers. In
February 2005, Bank of America announced it had lost computer backup tapes containing
personal information (including social security numbers) of about 1.2 million federal
government employees’ charge cards transactions. In May 2007 authorities discovered
that as many as 200 million credit card numbers were stolen over a two year period from
TJX Company (owner of TJ Maxx and Marshalls among others). TJX apparently had
very poor security for its wireless network.
Note: The text broadens the definition of operational risk by including employee fraud,
misrepresentation and account errors in operational risks.
Teaching Tip: Clearing is verifying the details of the many trades made each day. This
activity is critical in ensuring smooth flow of trading and risk management. Settlement
occurs when money and or security title changes hands. Because banks enter into many
transactions with each other throughout the day it is much more cost effective to calculate
and pay only the net amount owed as a result of the day’s transactions. Computer
technology runs these systems and ensure that banks know the net amount to pay and to
whom. Technology can also be used to make the payments and transfer title to securities
electronically. Clearing and settlement risk, sometimes called ‘Herstatt risk,’ is the risk
that these systems fail.
4. Insolvency Risk
Insolvency (bankruptcy) occurs when an institution’s assets are less than its liabilities.
Insolvency risk arises from each of the aforementioned risks. The major safeguards
against insolvency are equity capital and prudent management practices.
19–3
Chapter 19 – Types of Risks Incurred By Financial Institutions 6th edition
Teaching Tip: A DI’s insolvency usually occurs as a result of problems in the loan
portfolio. The problems may show up elsewhere, as in the case of Continental Illinois
(liquidity risk), but the root of the problem is typically poor lending policies. Washington
Mutual (WaMu) was taken over by the FDIC and sold to J.P. Morgan in 2008 as its
capital fell from $43 billion to $3.5 billion due to mortgage related losses in both on and
off balance sheet activities. In March 2009 Citigroup stock fell to below $1 per share
before receiving government guarantees worth up to $306 billion and $20 billion in cash
due to lending and investment losses.
5. Other Risks And Interaction Among Risks
The risks described above are interdependent. For example, a bank with problems in its
loan portfolio may face higher funding costs and/or reduced funding availability due to
the increased credit risk.2 Liquidity risk can result in emergency discount window loans
and even insolvency. This is roughly what happened to Continental Illinois in 1984.
Credit risk will often rise as interest rates rise, and credit problems can certainly lead to
liquidity problems if the FI was counting on the receipt of loan repayments in its liquidity
planning.
Events can also lead to multiple risk exposures. The most obvious forms of event risk
for FIs are regulatory changes that can affect multiple areas of performance. Terrorist
attacks could fit in this category as well. FI losses due to the September 11, 2001 attacks
were quite large. Large stock market moves can also result in increased credit, liquidity
risk, interest rate risk and even foreign exchange risk. The financial crisis is an extreme
example of this type risk. With a struggling economy and high unemployment consumers
have a difficult time repaying their credit card debts, small businesses struggle to repay
their loans and appear too risky to qualify for more loans. With reduced consumer and
small business spending the economy struggles with generating sufficient growth.
Clearly interactions exist that affect all FIs.
1.1.1.2 VI. Web Links
http://www.federalreserve.gov/ Website of the Board of Governors of the Federal
Reserve
http://www.fdic.gov/ The Federal Deposit Insurance Corporation website
has net charge off rates for banks and thrifts.
http://www.americanbanker.com/ ABA website.
http://bnymellon.com/ The text uses the Bank of New York Mellon to
illustrate technological risk.
2 Many wholesale sources of funds are well over the insurance limit so these lenders to
the bank will either require a higher rate of return to offset the riskiness of the institution
or refuse to provide funds entirely.
19–4
Chapter 19 – Types of Risks Incurred By Financial Institutions 6th edition
http://www.mybank.com/ This website has a list of banks available on the
web.
http://www.wsj.com/ Website of the Wall Street Journal Interactive
edition. The web version of the well known
financial newspaper can be personalized to meet
your own needs. Instructors can also receive via
e-mail current events cases keyed to financial
market news complete with discussion questions.
http://www.nyt.com/ The New York Times occasionally provides
information pertaining to FI risks.
1.1.1.2.1.1 VII. Student Learning Activities
1. Go to the FDIC’s website and find the latest Quarterly Banking Profile. What
are the ratios of noncurrent loans and leases to total loans and leases for all
commercial banks and for all banks in your state? What is the ratio of nonperforming
assets to total assets? What do these numbers tell you? Is your state having more or
less credit risk problems than the national average? How do you explain any
differences?
2. Download the file found at
http://www3.ambest.com/ambv/ratingmethodology/OpenPDF.aspx?rc=197697 and
investigate what factors AM Best uses to assess country risk. What are the main
differences between Tier I, Tier II and Tier III countries? What factors does AM Best
use to assess country risk?
3. Go to http://www.ebusinessforum.com/ and ascertain the level of risk of an
investment in the foreign country of your choice.
19–5