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Special Topics In Banking &

Finance

Dr. Karim Kobeissi


Arts, Sciences and Technology University in
Lebanon

Chapter 7: Risk Management in Financial


Institutions

Keyword: Risk Management


The process of identification, analysis and
either accept or reduce the level of
uncertainty
making.

in

investment

decision-

Introduction
Managing financial institutions has never been
an easy task. But, uncertainty in the
economic environment has increased, making
the job of the financial institution manager
much harder specifically when it comes to
managing credit risk and interest-rate risk. In
this chapter, we explore the tools available to
managers to measure these risks and
strategies to reduce them.

Managing Credit Risk


A major part of the business of financial
institutions is making loans, and the
major risk with loans is that the borrow
will
not repay.
Credit risk is the risk that a borrower
will not repay a loan according to the
terms of the loan, either defaulting
(failure to pay) entirely or making late
payments
of
interest

Managing Credit Risk (con)


The concepts of moral hazard and adverse
selection will provide our framework to
understand

the

principles

financial

managers must follow to minimize credit


risk, yet make successful loans.

Asymmetric Information

In financial markets, one party often does


not know enough about the other party to
make accurate decisions. This inequality
is called asymmetric information.
For example, a borrower who takes out a
loan has better information about the
potential returns and risks associated with
investment projects than the lender does.
Lack of information creates problems in
the financial system on two fronts: before
the transaction is entered into and after.

Managing Credit Risk (con)

Moral

hazard

asymmetric

is

the

information

problem
after

the

created

by

transaction

occurs. It is the risk (hazard) that the borrower


might engage in activities that are bad (immoral)
from the lenders point of view because the
borrower might not pay back the loan.
Adverse selection is a problem in the market for
loans because those with the highest credit risk
have the biggest incentives to borrow from others.

Managing Credit Risk (con)


Solving The Moral Hazard Problem:
Financial managers have a number of tools
available to assist in reducing or eliminating
the asymmetric information problem:
1. Screening and Monitoring:
Collecting reliable information about
prospective borrowers. Screening and
monitoring also involves requiring certain
actions, or prohibiting others.

Managing Credit Risk (con)

Specialization

in

Lending

helps

in

screening. This has lead some institutions


to specialize in regions or industries,
gaining expertise in evaluating particular
firms or individuals. It allows financial
institutions to better predict problems by
having in depth knowledge.

Managing Credit Risk (con)

Monitoring

and

Enforcement

also helps.

Financial institutions

write protective clauses into loans


contracts and actively monitor them
to

ensure

that

borrowers

complying with these articles.

are

Managing Credit Risk (con)


2. Long-term Customer Relationships:
Past information contained in checking
accounts, savings accounts, and previous
loans provides valuable information to more
easily determine credit worthiness.
3. Collateral:
A guarantee of property or other assets that
must be surrendered if the terms of the
loan are not met ( the loans are called
secured loans).

Managing Credit Risk (con)

4. Compensating Balances:
Reserves that a borrower must maintain in an account that act
as collateral should the borrower default.
5. Questioning the substance of the borrowers
transaction not just the form:
Substance over formis anaccountingprincipleused "to ensure
thatfinancial statementsgive a complete, relevant, and
accurate picture of transactions and events". If an entity
practices the 'substance over form' concept, then the
financial statements will show the overall financial reality of
the entity (economic substance), rather than the legal form
of transactions (form). Substance over form is critical for
reliable financial reporting. It is particularly relevant in cases
ofrevenue recognition, sale and purchase agreements, etc.
The key point of the concept is that a transaction should not
be recorded in such a manner as to hide the true intent of
the transaction, which would mislead the readers of a
company's financial statements.

Managing Credit Risk (con)


Solving
The
Problem:

Adverse

Selection

This problem can be solved by avoiding high risk

customers (Credit Rationing). More risk


sometimes means more interest revenue
but most of the time it will lead to default
on payments. Consequently, lenders will:
(1)Refuse to lend to some borrowers,
regardless of how much interest they are
willing to pay, or
(2)Only finance part of a project, requiring
that the remaining part come from equity

Managing Interest-Rate Risk


Interest-rate risk refers to the risk that a securitys
valuewillchangeduetoachangeininterest
rates.
For example, Let's assume the bank purchased a bond
from Company XYZ. Because bond prices typically fall
when interest rates rise, an unexpected increase in
interest rates means that the investment (bond) could
suddenly lose value. If the bank expect to sell the bond
before it matures, this could mean that the bank will end
up selling the bond for less than paid for it (a capital
loss).

Managing Interest-Rate Risk


Financial institutions, banks in particular,
specialize in earning a higher rate of
return on their assets relative to the
interest paid on their liabilities.
As interest rate volatility increased in the
last 20 years, interest-rate risk exposure

Managing Interest-Rate Risk


To see how financial institutions can measure
and manage interest-rate risk exposure, we
will examine the balance sheet for The First
National Bank (next slide).
We will develop two tools, (1) Income Gap
Analysis (for short term analysis) and (2)
Duration Gap Analysis (for long term analysis),
to assist the financial manager in this effort.

Managing Interest-Rate Risk

Income Gap Analysis


Income Gap Analysis: measures the sensitivity of a banks
current year net income to changes in interest rate.
For the financial institution manager, the first step in
assessing interest-rate risk is to decide which assets and
liabilities are rate-sensitive, that is, which have interest
rates that will be reset (reprised) within the year. Let us
note that rate-sensitive assets or liabilities can have
interest rates reprised within the year either because the
debt instrument matures within the year or because the
reprising is done automatically, as with variable-rate
mortgages.

For

many

assets

and

liabilities,

whether they are rate-sensitive is straight forward.

deciding

Income Gap Analysis (con)


In our example, the obviously rate sensitive assets are securities
with maturities of less than one year ($5 million), variable-rate
mortgages ($10 million), and commercial loans with maturities
less than one year ($15 million), for a total of $30 million.
However, some assets that look like fixed-rate assets whose interest
rates are not reprised within the year actually have a component
that is rate-sensitive. Thus these assets are partially, but not fully
rate-sensitive. For example, although fixed-rate residential
mortgages may have a maturity of 30 years, homeowners can
repay their mortgages early by selling their homes or repaying
the mortgage in some other way. This means that within the year,
a certain percentage of these fixed-rate mortgages will be paid
off, and interest rates on this amount will be reprised. From past
experience the bank manager knows that 20% of the fixed-rate
residential mortgages are repaid within a year, which means that
$2 million of these mortgages (20% of $10 million) must be
considered rate-sensitive. The bank manager adds this $2 million
to the $30 million of rate-sensitive assets already calculated, for a
total of $32 million in rate-sensitive assets.

Income Gap Analysis (con)


Using a similar procedure, the bank manager could determine the
total amount of rate-sensitive liabilities. The obviously rate-sensitive
liabilities are money market deposit accounts ($5 million), variablerate CD and CDs with less than one year to maturity ($25 million),
federal funds ($5 million), and borrowings with maturities of less
than one year ($10 million), for a total of $45 million. Checkable
deposits and savings deposits often have interest rates that can be
changed at any time by the bank, although banks often like to keep
their rates fixed for substantial periods. Thus these liabilities are
partially, but not fully rate-sensitive. Suppose that the bank
manager estimates that 10% of checkable deposits ($1.5 million)
and 20% of saving deposits ($3 million) should be considered ratesensitive. Adding the $1.5 million and $3 million to the $45 million
figure yields a total for rate-sensitive liabilities of $49.5 million.

Income Gap Analysis (con)

In this moment the bank manager can analyze what will happen if interest
rates rise by 5 percentage points, say, on average from 10% to 15%. The
income on the assets rises by $1.6 million ( = 5% x $32 million of ratesensitive assets), while the payments on the liabilities rise by $2.475 million
(= 5% x $49.5 million of rate sensitive liabilities). The First National
Banks current year net income will now decrease by $0.875 million (= $1.6
million - $2.475 million).

Conversely, if interest rates fall by 5%, similar

reasoning tells us that The First National Banks


current year net income will now increase by $0.875
million (= -$1.6 million +2.475 million).
Income Gap Analysis is essentially a short term focus.

A longer-term focus uses duration gap analysis.

Income Gap Analysis (con)

This example illustrates the following point:


If a financial institution has more ratesensitive liabilities than assets, a rise in
interest rates will reduce the net income
and a decline in interest rates will raise
the net income.

Duration Gap Analysis


Banks owners and managers not only
care about the impact of interest rate
exposure on current year net income,
but

they are also interested in the

impact of interest rate changes on


the market value of balance sheet
items and the impact on the bank

Duration Gap Analysis (con)


Duration

Gap

Analysis:

measures

the

sensitivity of the market value of the banks


net worth to changes in interest rates.
Requires determining the duration for assets
and liabilities, items whose market value will
change as interest rates change.

Lets see

how this looks for The First National Bank.

Duration GAP Analysis (con)


It is important to understand the concept of duration
prior to learning about duration gap analysis.
Duration is the average time it takes to receive an
Investment 's Net present value. A zero-Bond with a
maturity of 7-years would have a duration of 7-years
because it only makes one payment consisting of
interest and the principle at the maturity date.
However, a coupon-Bond with a maturity of 7-years
makes coupon payments throughout the maturityterm, therefore it actually returns portions of the
investments net present value sooner than 7 years
which shortens its duration.
Duration is a complicated concept but is very useful for
companies, especially banks when attempting to
immunize their portfolios against interest rate risk.

Duration GAP Analysis (con)


Duration is additive; that is, the duration
of a portfolio of securities is the weighted
average of the durations of the individual
securities, with the weights reflecting the
proportion of the portfolio invested in each.
What this means is that the bank manager
can figure out the effect that interest-rate
changes will have on the market value of
net worth by calculating the average
duration for assets and for liabilities and
then using those figures to estimate the
effects of interest-rate changes.

Duration Gap Analysis


The basic equation for determining
the change in market value for assets
or liabilities is:
% Change in Value = DUR x [i / (1 + io)]

or
Change in Value = DUR x [i / (1 + io)] x
Original Value

Duration Gap Analysis


Consider a change in rates from 10% to 15% i =
5% = 0.05
Using the value from Table 1, we see:
Assets:
Asset Value = DUR x [i / (1 + io)] x Original
Value
= 2.7 [0.05/(1 + 0.1)] $100m
= $12.3m

Duration Gap Analysis


Liabilities:
Liability Value = DUR x [i / (1 + io)] x Original
Value = 1.03 [0.05/(1 + 0.1)] $95m
= $4.5m
Net Worth:
NW

= Assets Liabilities

NW = $12.3m ($4.5m) = $7.8m

Duration Gap Analysis (con)


For a rate change from 10% to 15%,
the net worth of The First National
Bank will fall, changing by $7.8m.
Recall from the balance sheet that
The First National Bank has Bank
capital totaling $5m. Following such
a dramatic change in rate, the
capital would fall to $2.8m.

Managing Interest-Rate Risk


Problems with GAP Analysis
Assumes slope of yield curve unchanged
and flat
Manager estimates % of fixed rate
assets and liabilities that are rate
sensitive

Managing Interest-Rate Risk


Strategies for Managing Interest-Rate Risk
In

general,

bereducedby

the

interest

diversifying

rateriskcan
thedurationsof

thefixed-incomeinvestmentsthat areheldat a
given time.
In the example above, shorten duration of bank
assets or lengthen duration of bank liabilities

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