Chapter Nineteen

Types of Risks Incurred

by Financial Institutions

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

One
Oneof
ofthe
themajor
majorobjectives
objectivesof
ofaafinancial
financialinstitutions
institutions
(FIs)
(FIs)managers
managersisisto
toincrease
increasethe
theFIs
FIsreturns
returnsfor
forits
its
owners
owners
Increased
Increasedreturns
returnsoften
oftencome
comeatatthe
thecost
costof
ofincreased
increased
risk,
risk,which
whichcomes
comesin
inmany
many forms:
forms:
credit
creditrisk
risk
liquidity
liquidityrisk
risk
interest
interestrate
raterisk
risk
market
marketrisk
risk
off-balance-sheet
off-balance-sheetrisk
risk

McGraw-Hill/Irwin

foreign
foreignexchange
exchangerisk
risk
country
countryor
orsovereign
sovereignrisk
risk
technology
technologyrisk
risk
operational
operationalrisk
risk
insolvency
insolvencyrisk
risk

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Credit
Creditrisk
riskisisthe
therisk
riskthat
thatthe
thepromised
promisedcash
cashflows
flowsfrom
from
loans
loansand
andsecurities
securitiesheld
heldby
byFIs
FIsmay
maynot
notbe
bepaid
paidin
infull
full
FIs
FIsthat
thatmake
makeloans
loansor
orbuy
buybonds
bondswith
withlong
longmaturities
maturitiesare
are
relatively
relativelymore
moreexposed
exposedtotocredit
creditrisk
risk

thus,
thus,banks,
banks,thrifts,
thrifts,and
andinsurance
insurancecompanies
companiesare
aremore
moreexposed
exposedthan
than
MMMFs
and
property-casualty
insurance
companies
MMMFs and property-casualty insurance companies

many
manyfinancial
financialclaims
claimsissued
issuedby
byindividuals
individualsor
orcorporations
corporationshave:
have:

limited
limitedupside
upsidereturn
returnwith
withaahigh
highprobability
probability
large
largedownside
downsiderisk
riskwith
withaalow
lowprobability
probability

aakey
keyrole
roleof
ofFIs
FIsinvolves
involvesscreening
screeningand
andmonitoring
monitoringloan
loan
applicants
applicantstotoensure
ensureonly
onlythe
thecreditworthy
creditworthyreceive
receiveloans
loans

FIs
FIsalso
alsocharge
chargeinterest
interestrates
ratescommensurate
commensuratewith
withthe
theriskiness
riskinessofofthe
the
borrower
borrower

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Credit
Creditrisk
risk(cont.)
(cont.)

the
theeffects
effectsof
ofcredit
creditrisk
riskare
areevidenced
evidencedby
bycharge-offs
charge-offs

the
theBankruptcy
BankruptcyReform
ReformAct
Actofof2005
2005makes
makesititmore
moredifficult
difficultfor
for
consumers
consumerstotodeclare
declarebankruptcy
bankruptcy

FIs
FIscan
candiversify
diversifyaway
awaysome
someindividual
individualfirm-specific
firm-specificcredit
creditrisk,
risk,
but
butnot
notsystematic
systematiccredit
creditrisk
risk

firm-specific
firm-specificcredit
creditrisk
riskisisthe
therisk
riskofofdefault
defaultfor
forthe
theborrowing
borrowingfirm
firm
associated
associatedwith
withthe
thespecific
specifictypes
typesofofproject
projectrisk
risktaken
takenby
bythat
thatfirm
firm
systematic
systematiccredit
creditrisk
riskisisthe
therisk
riskof
ofdefault
defaultassociated
associatedwith
withgeneral
general
economy-wide
economy-wideorormacroeconomic
macroeconomicconditions
conditionsaffecting
affectingall
allborrowers
borrowers

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19-4

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Liquidity
Liquidityrisk
riskisisthe
therisk
riskthat
thataasudden
suddenand
andunexpected
unexpected
increase
increasein
inliability
liabilitywithdrawals
withdrawalsmay
mayrequire
requirean
anFI
FIto
to
liquidate
liquidateassets
assetsin
inaavery
veryshort
shortperiod
periodof
oftime
timeand
andatatlow
low
prices
prices
day-to-day
day-to-daywithdrawals
withdrawalsby
byliability
liabilityholders
holdersare
aregenerally
generally
predictable
predictable
unusually
unusuallylarge
largewithdrawals
withdrawalsby
byliability
liabilityholders
holderscan
cancreate
create
liquidity
liquidityproblems
problems

McGraw-Hill/Irwin

the
thecost
costof
ofpurchased
purchasedand/or
and/orborrowed
borrowedfunds
fundsrises
risesfor
forFIs
FIs
the
thesupply
supplyof
ofpurchased
purchasedor
orborrowed
borrowedfunds
fundsdeclines
declines
FIs
FIsmay
maybe
beforced
forcedtotosell
sellless
lessliquid
liquidassets
assetsatatfire-sale
fire-saleprices
prices

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Interest
Interestrate
raterisk
riskisisthe
therisk
riskincurred
incurredby
byan
anFI
FIwhen
whenthe
the
maturities
maturitiesof
ofits
itsassets
assetsand
andliabilities
liabilitiesare
aremismatched
mismatchedand
and
interest
interestrates
ratesare
arevolatile
volatile

asset
assettransformation
transformationinvolves
involvesan
anFI
FIissuing
issuingsecondary
secondarysecurities
securities
or
orliabilities
liabilitiestotofund
fundthe
thepurchase
purchaseof
ofprimary
primarysecurities
securitiesor
orassets
assets
ififan
anFIs
FIsassets
assetsare
arelonger-term
longer-termthan
thanits
itsliabilities,
liabilities,ititfaces
faces
refinancing
refinancingrisk
risk
the
therisk
riskthat
thatthe
thecost
costof
ofrolling
rollingover
overor
orre-borrowing
re-borrowingfunds
fundswill
willrise
rise
above
abovethe
thereturns
returnsbeing
beingearned
earnedon
onasset
assetinvestments
investments

ififan
anFIs
FIsassets
assetsare
areshorter-term
shorter-termthan
thanits
itsliabilities,
liabilities,ititfaces
faces
reinvestment
reinvestmentrisk
risk

the
therisk
riskthat
thatthe
thereturns
returnson
onfunds
fundstotobe
bereinvested
reinvestedwill
willfall
fallbelow
belowthe
the
cost
of
funds
cost of funds

McGraw-Hill/Irwin

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Interest
Interestrate
raterisk
risk(cont.)
(cont.)

all
allFIs
FIsface
faceprice
pricerisk
risk(or
(ormarket
marketvalue
valuerisk)
risk)

the
therisk
riskthat
thatthe
theprice
priceof
ofthe
thesecurity
securitychanges
changeswhen
wheninterest
interestrates
rates
change
change

FIs
FIscan
canhedge
hedgeor
orprotect
protectthemselves
themselvesagainst
againstinterest
interestrate
raterisk
riskby
by
matching
matchingthe
thematurity
maturityof
oftheir
theirassets
assetsand
andliabilities
liabilities

this
thisapproach
approachisisinconsistent
inconsistentwith
withtheir
theirasset
assettransformation
transformationfunction
function

Market
Marketrisk
riskisisthe
therisk
riskincurred
incurredin
intrading
tradingassets
assetsand
and
liabilities
liabilitiesdue
dueto
tochanges
changesin
ininterest
interestrates,
rates,exchange
exchangerates,
rates,
and
andother
otherasset
assetprices
prices
closely
closelyrelated
relatedtotointerest
interestrate
rateand
andforeign
foreignexchange
exchangerisk
risk

McGraw-Hill/Irwin

19-7

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Market
Marketrisk
risk(cont.)
(cont.)

adds
addstrading
tradingactivityi.e.,
activityi.e.,market
marketrisk
riskisisthe
theincremental
incrementalrisk
risk
incurred
incurredby
byan
anFI
FI(in
(inaddition
additiontotointerest
interestrate
rateor
orforeign
foreignexchange
exchange
risk)
risk)caused
causedby
byan
anactive
activetrading
tradingstrategy
strategy
FIs
FIstrading
tradingportfolios
portfoliosare
aredifferentiated
differentiatedfrom
fromtheir
theirinvestment
investment
portfolios
portfolioson
onthe
thebasis
basisof
oftime
timehorizon
horizonand
andliquidity
liquidity

trading
tradingassets,
assets,liabilities,
liabilities,and
andderivatives
derivativesare
arehighly
highlyliquid
liquid
investment
investmentportfolios
portfoliosare
arerelatively
relativelyilliquid
illiquidand
andare
areusually
usuallyheld
heldfor
for
longer
longerperiods
periodsof
oftime
time

declines
declinesinintraditional
traditionalbanking
bankingactivity
activityand
andincome
incomeatatlarge
large
commercial
commercialbanks
bankshave
havebeen
beenoffset
offsetby
byincreases
increasesinintrading
trading
activities
activitiesand
andincome
income
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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Market
Marketrisk
risk(cont.)
(cont.)

declines
declinesininunderwriting
underwritingand
andbrokerage
brokerageincome
incomeatatlarge
large
investment
investmentbanks
bankshave
havebeen
beenoffset
offsetby
byincreases
increasesinintrading
tradingactivity
activity
and
andincome
income
actively
activelymanaged
managedMFs
MFsare
arealso
alsoexposed
exposedtotomarket
marketrisk
risk
FIs
FIsare
areconcerned
concernedwith
withfluctuations
fluctuationsinintrading
tradingaccount
accountassets
assetsand
and
liabilities
liabilities
value
valueatatrisk
risk(VAR)
(VAR)and
anddaily
dailyearnings
earningsatatrisk
risk(DEAR)
(DEAR)are
are
measures
used
to
assess
market
risk
exposure
measures used to assess market risk exposure

market
marketrisk
riskexposure
exposurehas
hascaused
causedsome
somehighly
highlypublicized
publicizedlosses
losses

McGraw-Hill/Irwin

the
thefailure
failureof
ofthe
the200-year
200-yearold
oldBritish
Britishmerchant
merchantbank
bankBarings
Baringsinin1995
1995
$7.2
$7.2billion
billionininmarket
marketrisk
riskrelated
relatedloss
lossatatSociete
SocieteGenerale
Generaleinin2008
2008

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Off-balance-sheet
Off-balance-sheet(OBS)
(OBS)risk
riskisisthe
therisk
riskincurred
incurredby
byan
an
FI
FIas
asthe
theresult
resultof
ofactivities
activitiesrelated
relatedto
tocontingent
contingentassets
assets
and
andliabilities
liabilities

OBS
OBSactivity
activitycan
canincrease
increaseFIs
FIsinterest
interestrate
raterisk,
risk,credit
creditrisk,
risk,and
and
foreign
foreignexchange
exchangerisk
risk
OBS
OBSactivity
activitycan
canalso
alsobe
beused
usedtotohedge
hedge(i.e.,
(i.e.,reduce)
reduce)FIs
FIsinterest
interest
rate
raterisk,
risk,credit
creditrisk,
risk,and
andforeign
foreignexchange
exchangerisk
risk
large
largecommercial
commercialbanks
banks(CBs)
(CBs)ininparticular
particularengage
engageininOBS
OBS
activity
activity

McGraw-Hill/Irwin

on-balance-sheet
on-balance-sheetassets
assetsofofall
allU.S.
U.S.CBs
CBstotaled
totaled$10.8
$10.8trillion
trillioninin2007
2007
the
thenotional
notionalvalue
valueofofOBS
OBSitems
itemstotaled
totaled$180.6
$180.6trillion
trillioninin2007
2007

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

OBS
OBSrisk
risk(cont.)
(cont.)

OBS
OBSactivities
activitiescan
canaffect
affectthe
thefuture
futureshape
shapeof
ofFIs
FIsbalance
balancesheets
sheets

OBS
OBSitems
itemsbecome
becomeon-balance-sheet
on-balance-sheetitems
itemsonly
onlyififsome
somefuture
futureevent
event
occurs
occurs
aaletter
letterofofcredit
credit(LOC)
(LOC)isisaacredit
creditguarantee
guaranteeissued
issuedby
byan
anFI
FIfor
foraa
fee
feeon
onwhich
whichpayment
paymentisiscontingent
contingenton
onsome
somefuture
futureevent
eventoccurring,
occurring,
most
mostnotably
notablydefault
defaultofofthe
theagent
agentthat
thatpurchases
purchasesthe
theLOC
LOC
other
otherexamples
examplesinclude:
include:
loan
loancommitments
commitmentsby
bybanks
banks
mortgage
mortgageservicing
servicingcontracts
contractsby
bysavings
savingsinstitutions
institutions
positions
positionsininforwards,
forwards,futures,
futures,swaps,
swaps,and
andother
otherderivatives
derivativesheld
held
by
byalmost
almostall
alllarge
largeFIs
FIs

McGraw-Hill/Irwin

19-11

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Foreign
Foreignexchange
exchange(FX)
(FX)risk
riskisisthe
therisk
riskthat
thatexchange
exchangerate
rate
changes
changescan
canaffect
affectthe
thevalue
valueof
ofan
anFIs
FIsassets
assetsand
and
liabilities
liabilitiesdenominated
denominatedin
inforeign
foreigncurrencies
currencies
FIs
FIscan
canreduce
reducerisk
riskthrough
throughdomestic-foreign
domestic-foreignactivity/investment
activity/investment
diversification
diversification
FIs
FIsexpand
expandglobally
globallythrough
through

acquiring
acquiringforeign
foreignfirms
firmsor
oropening
openingnew
newbranches
branchesininforeign
foreigncountries
countries
investing
investingininforeign
foreignfinancial
financialassets
assets

underlying
underlyingtechnologies
technologiesofofvarious
variouseconomies
economiesdiffer
differ
exchange
exchangerate
ratechanges
changesare
arenot
notperfectly
perfectlycorrelated
correlatedacross
acrosscountries
countries

returns
returnson
ondomestic
domesticand
andforeign
foreigndirect
directand
andportfolio
portfolioinvestment
investment
are
arenot
notperfectly
perfectlycorrelated
correlated

McGraw-Hill/Irwin

19-12

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

FX
FXrisk
risk(cont.)
(cont.)

aanet
netlong
longposition
positionin
inaaforeign
foreigncurrency
currencyinvolves
involvesholding
holdingmore
more
foreign
foreignassets
assetsthan
thanforeign
foreignliabilities
liabilities

FI
FIloses
loseswhen
whenforeign
foreigncurrency
currencyfalls
fallsrelative
relativetotothe
theU.S.
U.S.dollar
dollar
FI
FIgains
gainswhen
whenforeign
foreigncurrency
currencyappreciates
appreciatesrelative
relativetotothe
theU.S.
U.S.dollar
dollar

FI
FIgains
gainswhen
whenforeign
foreigncurrency
currencyfalls
fallsrelative
relativetotothe
theU.S.
U.S.dollar
dollar
FI
FIloses
loseswhen
whenforeign
foreigncurrency
currencyappreciates
appreciatesrelative
relativetotothe
theU.S.
U.S.dollar
dollar

aanet
netshort
shortposition
positionin
inaaforeign
foreigncurrency
currencyinvolves
involvesholding
holding
fewer
fewerforeign
foreignassets
assetsthan
thanforeign
foreignliabilities
liabilities

an
anFI
FIisisfully
fullyhedged
hedgedififititholds
holdsan
anequal
equalamount
amountof
offoreign
foreign
currency
currencydenominated
denominatedassets
assetsand
andliabilities
liabilities(that
(thathave
havethe
thesame
same
maturities)
maturities)

McGraw-Hill/Irwin

19-13

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Country
Countryor
orsovereign
sovereignrisk
riskisisthe
therisk
riskthat
thatrepayments
repayments
from
fromforeign
foreignborrowers
borrowersmay
maybe
beinterrupted
interruptedbecause
becauseof
of
interference
interferencefrom
fromforeign
foreigngovernments
governments
differs
differsfrom
fromcredit
creditrisk
riskof
ofFIs
FIsdomestic
domesticassets
assets

with
withdomestic
domesticassets,
assets,FIs
FIsusually
usuallyhave
havesome
somerecourse
recoursethrough
through
bankruptcy
courtsi.e.,
FIs
can
recoup
some
of
their
losses
bankruptcy courtsi.e., FIs can recoup some of their losseswhen
when
defaulted
defaultedfirms
firmsare
areliquidated
liquidatedor
orrestructured
restructured

foreign
foreigncorporations
corporationsmay
maybe
beunable
unabletotopay
payprincipal
principaland
andinterest
interest
even
evenififthey
theywould
woulddesire
desiretotodo
doso
so
foreign
foreigngovernments
governmentsmay
maylimit
limitororprohibit
prohibitdebt
debtrepayment
repaymentdue
duetoto
foreign
foreigncurrency
currencyshortages
shortagesororadverse
adversepolitical
politicalevents
events

McGraw-Hill/Irwin

19-14

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Country
Countryor
orsovereign
sovereignrisk
risk(cont.)
(cont.)

thus,
thus,an
anFI
FIclaimholder
claimholdermay
mayhave
havelittle
littleor
orno
norecourse
recoursetotolocal
local
bankruptcy
bankruptcycourts
courtsor
ortotoan
aninternational
internationalclaims
claimscourt
court
measuring
measuringsovereign
sovereignrisk
riskincludes
includesanalyzing:
analyzing:

McGraw-Hill/Irwin

the
thetrade
tradepolicy
policyofofthe
theforeign
foreigngovernment
government
the
thefiscal
fiscalstance
stanceof
ofthe
theforeign
foreigngovernment
government
potential
potentialgovernment
governmentintervention
interventionininthe
theeconomy
economy
the
theforeign
foreigngovernments
governmentsmonetary
monetarypolicy
policy
capital
capitalflows
flowsand
andforeign
foreigninvestment
investment
the
theforeign
foreigncountrys
countryscurrent
currentand
andexpected
expectedinflation
inflationrates
rates
the
thestructure
structureof
ofthe
theforeign
foreigncountrys
countrysfinancial
financialsystem
system

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2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Technology
Technologyrisk
riskand
andoperational
operationalrisk
riskare
areclosely
closelyrelated
related

technology
technologyrisk
riskisisthe
therisk
riskincurred
incurredby
byan
anFI
FIwhen
whenits
its
technological
technologicalinvestments
investmentsdo
donot
notproduce
produceanticipated
anticipatedcost
costsavings
savings

the
themajor
majorobjectives
objectivesof
oftechnological
technologicalexpansion
expansionare
aretotoallow
allowthe
theFI
FItoto
exploit
exploitpotential
potentialeconomies
economiesofofscale
scaleand
andscope
scopeby:
by:
lowering
loweringoperating
operatingcosts
costs
increasing
increasingprofits
profits
capturing
capturingnew
newmarkets
markets

operational
operationalrisk
riskisisthe
therisk
riskthat
thatexisting
existingtechnology
technologyor
orsupport
support
systems
systemsmay
maymalfunction
malfunctionor
orbreak
breakdown
down

the
theBIS
BISdefines
definesoperational
operationalrisk
riskas
asthe
therisk
riskofofloss
lossresulting
resultingfrom
from
inadequate
inadequateor
orfailed
failedinternal
internalprocesses,
processes,people,
people,and
andsystems
systemsor
orfrom
from
external
externalevents
events

McGraw-Hill/Irwin

19-16

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Insolvency
Insolvencyrisk
riskisisthe
therisk
riskthat
thatan
anFI
FImay
maynot
nothave
have
enough
enoughcapital
capitalto
tooffset
offsetaasudden
suddendecline
declinein
inthe
thevalue
valueof
of
its
itsassets
assetsrelative
relativeto
toits
itsliabilities
liabilities

insolvency
insolvencyrisk
riskisisaaconsequence
consequenceor
oran
anoutcome
outcomeof
ofone
oneor
ormore
moreof
of
the
therisks
riskspreviously
previouslydescribed:
described:
interest
interestrate,
rate,market,
market,credit,
credit,OBS,
OBS,technological,
technological,foreign
foreignexchange,
exchange,
sovereign,
sovereign,and/or
and/orliquidity
liquidityrisk
risk

generally,
generally,the
themore
moreequity
equitycapital
capitaltotoborrowed
borrowedfunds
fundsan
anFI
FIhas
hasthe
the
less
lessinsolvency
insolvencyrisk
riskititisisexposed
exposedtoto
both
bothregulators
regulatorsand
andmanagers
managersfocus
focuson
oncapital
capitaladequacy
adequacyas
asaa
measure
measureof
ofaaFIs
FIsability
abilitytotoremain
remainsolvent
solvent

McGraw-Hill/Irwin

19-17

2009, The McGraw-Hill Companies, All Rights

Risks at Financial Institutions

Other
Otherrisks
risksand
andinteractions
interactionsamong
amongrisks
risks

ininreality,
reality,all
allof
ofthe
thepreviously
previouslydefined
definedrisks
risksare
areinterdependent
interdependent

e.g.,
e.g.,liquidity
liquidityrisk
riskcan
canbe
beaafunction
functionofofinterest
interestrate
rateand
andcredit
creditrisk
risk

when
whenmanagers
managerstake
takeactions
actionstotomitigate
mitigateone
onetype
typeof
ofrisk,
risk,they
they
must
consider
such
actions
on
other
risks
must consider such actions on other risks
changes
changesininregulatory
regulatorypolicy
policyconstitute
constituteanother
anothertype
typeof
ofdiscrete
discreteor
or
event-specific
event-specificrisk
risk
other
otherdiscrete
discreteor
orevent
eventspecific
specificrisks
risksinclude
include
war,
war,revolutions,
revolutions,sudden
suddenmarket
marketcollapses,
collapses,theft,
theft,malfeasance,
malfeasance,and
and
breach
of
fiduciary
trust
breach of fiduciary trust

macroeconomic
macroeconomicrisks
risksinclude
includeincreased
increasedinflation,
inflation,inflation
inflation
volatility
volatilityand
andunemployment
unemployment

McGraw-Hill/Irwin

19-18

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