Risk Management and Financial Institutions, 4th Edition
Instructor Notes
Chapter 1: Introduction
This chapter is little changed from Chapter 1 of the third edition. I generally spend
about 1 to 1.5 hours on the material in this chapter. The purpose of most of the chapter is
to link concepts in the rest of the book to concepts learned in courses on corporate finance
and investments. If students have not previously been exposed to these concepts rather
more time is likely to be necessary to cover the material in the chapter.
Sections 1.1 to 1.4 review results on risk-return trade-offs and the distinction between
systematic (non-diversifiable) and non-systematic (diversifiable) risks. In most cases, stu-
dents will already have been exposed to this material in their first corporate finance class
and classroom time can be used to refresh their memories.
Section 1.5 considers why companies are concerned with more than just systematic
risk and why they hedge. The bankruptcy costs argument (which most students will have
already met in the context of capital structure decisions) is discussed. Business Snapshot
1.1 describes a typical sequence of events that leads to the value of a company being
reduced because it is forced to declare bankruptcy.
Section 1.6 introduces students to the way risks are managed by financial institutions,
distinguishing between “risk decomposition” where risks are managed one by one and risk
aggregation where risks are combined with risk diversification being taken into account.
Credit ratings are introduced at the end of this chapter.
The Further Questions can be used either for class discussion or as assignment ques-
tions. Problem 1.17 provides an introduction to capital adequacy concepts.
Chapter 2: Banks
The tables and other material in this chapter have been updated but apart from that
the chapter is little different from Chapter 2 of the third edition. The chapter is the first
of three chapters describing the activities of different types of financial institutions. The
chapters provide important background material for the discussion of risk management
and regulation later in the book.
Chapter 2 explains the activities of commercial and investment banks. As students
are likely to be aware, the year 2008 saw the disappearance of several large institutions
that were exclusively focused on investment banking. Lehman Brothers went bankrupt;
Bear Stearns was taken over by J. P. Morgan; Merrill Lynch was taken over by Bank of
America; Goldman Sachs and Morgan Stanley became bank holding companies with both
commercial and investment banking interests.
The parts of the chapter that I choose to spend most time on in class are a) Section 2.2
(the capital requirements of a small commercial bank) and b) IPOs and the Dutch auction
approach (in Section 2.4) and c) conflicts of interest in banks (Section 2.6). Section 2.2 is
an introduction to capital adequacy material that comes later in the book. I find it useful
to get students to think about what the balance sheet and income statement for a simple
bank looks like. Students enjoy the discussion of the Dutch auction approach and Google’s
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