Chapter Nineteen

Types of Risks Incurred by Financial Institutions

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Why FIs Need to Manage Risk

Major objective of FI management is to increase the FIs returns for its owners Risks of financial intermediation have increased as the U.S. and overseas economies have become more integrated FIs that have no foreign customers can still be exposed to foreign exchange and sovereign risk if their customers have dealings with foreign countries
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Risks Faced by Financial Intermediaries

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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Credit Risk

Credit risk Firm-specific credit risk Systematic credit risk

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Liquidity Risk Liquidity risk Liquidity risk arises when an FIs liability holders demand immediate cash for their financial claim Serious liquidity problems may result in a run

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Interest Rate Risk

Interest rate risk Federal Reserves influence on interest rate volatility through daily open-market operations Effect of increased globalization of financial market Refinancing risk Reinvestment risk
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Maturity Mismatching and Interest Rate Risk Asset transformation can involve differing maturities Economic or present-value uncertainty arises when interest rates change FIs can seek to hedge by matching the maturity of their assets and liabilities

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Market Risk
Market risk Closely related to interest rate and foreign exchange risk Decline in income from deposit taking and lending matched by increased reliance on income from trading FI management required to establish controls or limits on day-to-day exposure to risk
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Off-Balance-Sheet Risk
Off-balance-sheet risk
Interest rate risk Credit risk Currency risk Unique risks

Letter of credit Loan commitments by banks, mortgage servicing contracts by thrifts, and positions in forwards, futures, swaps, options, etc
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Foreign Exchange Risk Foreign exchange risk Returns on domestic and foreign direct investments not perfectly correlated
underlying technologies of various economies differ exchange rate changes are not perfectly correlated across countries

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Country or Sovereign Risk

Country or Sovereign Risk When a foreign country is unwilling or unable to repay a loan, the FI has little recourse The leverage available to ensure or increase repayment probabilities is control over the future supply of loans or funds to the country concerned

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Technology and Operational Risk

Technology risk Operational risk Major objective of technological expansion is to increase economies of scale and scope

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Insolvency Risk
Insolvency risk A consequence or an outcome of one or more of these risks:
interest rate Market credit OBS Technological foreign exchange Sovereign liquidity
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Interaction Among Risks These risks are all interdependent Various other risks
sudden changes in taxation changes in regulatory policy sudden and unexpected changes in financial market conditions due to war, revolution, or market collapse theft, malfeasance, and breach of fiduciary trust increased inflation, inflation volatility, and unemployment
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