Introduction to Financial System and Types of Risk

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
FOFA: Financer Part
Topic: Introduction to Financial System

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 1
Why study Financial Markets and Institutions?.
Prudent investment and financing requires a thorough
understanding of
✓the structure of domestic and international markets
✓the flow of funds through domestic and international markets
✓the strategies used to manage risks faced by investors and savers

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Components of Indian Financial System

Financial Institutions Financial Markets Financial Instruments Financial Services

Banking Non-Banking Money Capital Term Type Fund based Fee based
Call money Primary Short Primary Leasing Merchant
Treasury Secondary Medium Secondary Hire purchase Credit Rating

Commercial Cooperative Commercial bills Derivatives Long Innovative Factoring M&A

Public
PVT Leasing is a contract by which one party conveys land, property, services etc., to another for a specified time.
RRB Organized FIs Unorganized FIs
Hire purchase is an arrangement for buying expensive consumer goods, where the buyer makes an initial down
Foreign payment and pays the balance plus interest in installments. Example car buying on Installments

A factor is an intermediary agent that provides cash or financing to companies by purchasing their accounts
receivables. A factor is essentially a funding source that agrees to pay the company the value of an invoice less
a discount for commission and fees. Factoring can help companies improve their short-term cash needs by
selling their receivables in return for an injection of cash from the factoring company. The practice is also
known as factoring, factoring finance, and accounts receivable financing.
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Foreign Exchange (FX) Markets
➢FX markets
❖trading one currency for another (e.g., dollar for yen)
➢Spot FX
❖the immediate exchange of currencies at current exchange rates
➢Forward FX
❖the exchange of currencies in the future on a specific date and at a pre-specified exchange
rate

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Flow of Funds in a world without Financial Institutions (FIs)

Financial Claims
(Equity and Debt Instruments)
Users of Funds Suppliers of Funds
(Corporations) (households)

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Flow of Funds in a world with Financial Institutions (FIs)

FIs
Users of Funds (Brokers) Suppliers of Funds
(Corporations) (households)
>>>>>>>>>>>>>>>>>>>>>>

FIs
(Asset Transfers)

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FIs Benefit Suppliers of Funds
❖Reduce monitoring costs
❖Increase liquidity and lower price risk
❖Reduce transaction costs
❖Provide maturity intermediation
❖Provide denomination intermediation

FIs Benefit the Overall Economy

❖Conduit through which Central Bank (i.e. Federal Reserve / RBI) conducts monetary policy
❖Provides efficient credit allocation
❖Provide for intergenerational wealth transfers
❖Provide payment services

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Risks at Financial Institutions
➢One of the major objectives of a financial institution’s (FI’s) managers is to increase the
FI’s returns for its owners
➢Increased returns often come at the cost of increased risk, which comes in many forms:
❑credit risk
❑liquidity risk
❑interest rate risk
❑market risk
❑off-balance-sheet risk
❑foreign exchange risk
❑Country or sovereign risk
❑technology risk
❑operational risk
❑insolvency risk

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Risks at Financial Institutions - Credit risk
Credit risk is the risk that the promised cash flows from loans and securities held
by FIs may not be paid in full
➢FIs that make loans or buy bonds with long maturities are relatively more exposed to credit
risk
• thus, banks, thrifts, and insurance companies are more exposed than MMMFs and property-casualty insurance
companies
➢many financial claims issued by individuals or corporations have:
• limited upside return with a high probability
• large downside risk with a low probability
➢a key role of FIs involves screening and monitoring loan applicants to ensure only the
creditworthy receive loans
• FIs also charge interest rates commensurate with the riskiness of the borrower
➢the effects of credit risk are evidenced by charge-offs
• the Bankruptcy Reform Act of 2005 makes it more difficult for consumers to declare bankruptcy
➢FIs can diversify away some individual firm-specific credit risk, but not systematic credit risk
• firm-specific credit risk is the risk of default for the borrowing firm associated with the specific types of project risk
taken by that firm
• systematic credit risk is the risk of default associated with general economy-wide or macroeconomic conditions
affecting all borrowers
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Risks at Financial Institutions - Liquidity risk
Liquidity risk is the risk that a sudden and unexpected increase in liability
withdrawals may require an FI to liquidate assets in a very short period of time and
at low prices
➢day-to-day withdrawals by liability holders are generally predictable
➢unusually large withdrawals by liability holders can create liquidity problems
• the cost of purchased and/or borrowed funds rises for FIs
• the supply of purchased or borrowed funds declines
• FIs may be forced to sell less liquid assets at “fire-sale” prices

Thota Nagaraju BITS-Pilani Hyderabad Campus Fundamentals of Finance & Accounting Second Sem 2022-23 10
Risks at Financial Institutions - Interest rate risk
Interest rate risk is the risk incurred by an FI when the maturities of its assets and
liabilities are mismatched and interest rates are volatile
➢asset transformation involves an FI issuing secondary securities or liabilities to fund the
purchase of primary securities or assets
➢if an FI’s assets are longer-term than its liabilities, it faces refinancing risk
• the risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset
investments
➢if an FI’s assets are shorter-term than its liabilities, it faces reinvestment risk
• the risk that the returns on funds to be reinvested will fall below the cost of funds
➢all FIs face price risk (or market value risk)
• the risk that the price of the security changes when interest rates change
➢FIs can hedge or protect themselves against interest rate risk by matching the maturity of
their assets and liabilities
• this approach is inconsistent with their asset transformation function

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Risks at Financial Institutions - Market risk
Market risk is the risk incurred in trading assets and liabilities due to changes in interest
rates, exchange rates, and other asset prices
➢closely related to interest rate and foreign exchange risk
➢adds trading activity—i.e., market risk is the incremental risk incurred by an FI (in addition to
interest rate or foreign exchange risk) caused by an active trading strategy
➢FIs’ trading portfolios are differentiated from their investment portfolios on the basis of time
horizon and liquidity
• trading assets, liabilities, and derivatives are highly liquid
• investment portfolios are relatively illiquid and are usually held for longer periods of time
➢declines in traditional banking activity and income at large commercial banks have been offset by
increases in trading activities and income
➢declines in underwriting and brokerage income at large investment banks have been offset by
increases in trading activity and income
➢actively managed MFs are also exposed to market risk
➢FIs are concerned with fluctuations in trading account assets and liabilities
• value at risk (VAR) and daily earnings at risk (DEAR) are measures used to assess market risk exposure
➢market risk exposure has caused some highly publicized losses
• the failure of the 200-year old British merchant bank Barings in 1995
• $7.2 billion in market risk related loss at Societe Generale in 2008

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Risks at Financial Institutions - Off-balance-sheet (OBS) risk
Off-balance-sheet (OBS) risk is the risk incurred by an FI as the result of activities
related to contingent assets and liabilities
➢OBS activity can increase FIs’ interest rate risk, credit risk, and foreign exchange risk
➢OBS activity can also be used to hedge (i.e., reduce) FIs’ interest rate risk, credit risk, and
foreign exchange risk
➢large commercial banks (CBs) in particular engage in OBS activity
• on-balance-sheet assets of all U.S. CBs totaled $10.8 trillion in 2007
• the notional value of OBS items totaled $180.6 trillion in 2007
➢ OBS activities can affect the future shape of FIs’ balance sheets
• OBS items become on-balance-sheet items only if some future event occurs
• a letter of credit (LOC) is a credit guarantee issued by an FI for a fee on which payment is contingent on some future
event occurring, most notably default of the agent that purchases the LOC
• other examples include:
❖ loan commitments by banks
❖ mortgage servicing contracts by savings institutions
❖ positions in forwards, futures, swaps, and other derivatives held by almost all large FIs

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Risks at Financial Institutions - Foreign exchange (FX) risk
Foreign exchange (FX) risk is the risk that exchange rate changes can affect the value of
an FI’s assets and liabilities denominated in foreign currencies
➢FIs can reduce risk through domestic-foreign activity/investment diversification
➢FIs expand globally through
• acquiring foreign firms or opening new branches in foreign countries
• investing in foreign financial assets
➢returns on domestic and foreign direct and portfolio investment are not perfectly correlated
• underlying technologies of various economies differ
• exchange rate changes are not perfectly correlated across countries
➢ a net long position in a foreign currency involves holding more foreign assets than foreign
liabilities
• FI loses when foreign currency falls relative to the U.S. dollar
• FI gains when foreign currency appreciates relative to the U.S. dollar
➢a net short position in a foreign currency involves holding fewer foreign assets than foreign
liabilities
• FI gains when foreign currency falls relative to the U.S. dollar
• FI loses when foreign currency appreciates relative to the U.S. dollar
➢an FI is fully hedged if it holds an equal amount of foreign currency denominated assets and
liabilities (that have the same maturities)
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Risks at Financial Institutions - Country or sovereign risk
Country or sovereign risk is the risk that repayments from foreign borrowers may be
interrupted because of interference from foreign governments
➢differs from credit risk of FIs’ domestic assets
• with domestic assets, FIs usually have some recourse through bankruptcy courts—i.e., FIs can recoup some of their losses
when defaulted firms are liquidated or restructured
➢foreign corporations may be unable to pay principal and interest even if they would desire to do so
• foreign governments may limit or prohibit debt repayment due to foreign currency shortages or adverse political events
➢ thus, an FI claimholder may have little or no recourse to local bankruptcy courts or to an
international claims court
➢measuring sovereign risk includes analyzing:
• the trade policy of the foreign government
• the fiscal stance of the foreign government
• potential government intervention in the economy
• the foreign government’s monetary policy
• capital flows and foreign investment
• the foreign country’s current and expected inflation rates
• the structure of the foreign country’s financial system

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Risks at Financial Institutions - Technology risk and operational risk
Technology risk and operational risk are closely related
➢technology risk is the risk incurred by an FI when its technological investments do not
produce anticipated cost savings
• the major objectives of technological expansion are to allow the FI to exploit potential economies of scale and scope
by:
❖ lowering operating costs
❖ increasing profits
❖ capturing new markets
➢operational risk is the risk that existing technology or support systems may malfunction or
break down
• the BIS defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people, and
systems or from external events”

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Risks at Financial Institutions - Insolvency risk
Insolvency risk is the risk that an FI may not have enough capital to offset a sudden
decline in the value of its assets relative to its liabilities
➢insolvency risk is a consequence or an outcome of one or more of the risks previously
described:
• interest rate, market, credit, OBS, technological, foreign exchange, sovereign, and/or liquidity risk
➢generally, the more equity capital to borrowed funds an FI has the less insolvency risk it is
exposed to
➢both regulators and managers focus on capital adequacy as a measure of a FI’s ability to
remain solvent

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Risks at Financial Institutions - Other risks and interactions among risks
Other risks and interactions among risks
➢in reality, all of the previously defined risks are interdependent
• e.g., liquidity risk can be a function of interest rate and credit risk
➢when managers take actions to mitigate one type of risk, they must consider such actions
on other risks
➢changes in regulatory policy constitute another type of discrete or event-specific risk
➢other discrete or event specific risks include
• war, revolutions, sudden market collapses, theft, malfeasance, and breach of fiduciary trust
➢macroeconomic risks include increased inflation, inflation volatility and unemployment

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Regulators in the Indian Financial System
1. The Ministry of Finance (MoF)
2. The Reserve Bank of India (RBI)
3. Securities Exchange Board of India (SEBI)
4. Insurance Regulatory Development Authority (IRDA)

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Globalization of Financial Markets and Institutions
➢The pool of savings from foreign investors is increasing and investors look to
diversify globally now more than ever before
➢Information on foreign markets and investments is becoming readily accessible
and deregulation across the globe is allowing even greater access
➢International mutual funds allow diversified foreign investment with low
transactions costs

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