Ch 7 Fully Revised 2011

Ch 7 Fully Revised 2011 - 1 Chapter 7 Risks of Financial...

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Chapter 7 Risks of Financial Intermediation 1
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Overview This chapter discusses the risks associated with financial intermediation: Interest rate risk, market risk, credit risk, off- balance-sheet risk, foreign exchange risk, country or sovereign risk, technology risk, operational risk, liquidity risk, insolvency risk. Note that these risks are not unique to FIs. Faced by all global firms. 2
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Risks of Financial Intermediation A major objective of FIs is to increase the FI’s returns for its owners (stockholders). Often this comes at the cost of increased risk. The effective management of these risks is central to a FI’s performance. In fact, the main business of FIs is to manage risk. Definition of risk management - the process by which managers identify, assess, monitor, and control risks associated with a financial institution’s activities. 3
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Interest Rate Risk Interest rate risk resulting from intermediation: Mismatch in maturities (actually, durations) of assets and liabilities. h Interest rate sensitivity exposes equity to changes in interest rates. 4
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Interest Rate Risk Types of interest rate risk: Refinancing risk (when assets have longer maturities than liabilities): the cost of rolling over or re-borrowing funds will rise above the returns earned on asset investments. h i.e., the risk of refinancing at a higher rate. h Banks usually face refinancing risk because their assets have longer maturities than their liabilities. Reinvestment risk (when liabilities have longer maturities than assets): the risk that the return on funds to be reinvested will fall below the cost of funds. h i.e., the risk of reinvesting at a lower rate. Market Value Risk h Market value of assets and liabilities are present values that depend upon the interest rate. h Mismatching maturities by holding longer-term assets than liabilities means that when interest rates rise, the market value of the FI’s assets falls by a greater amount than its liabilities, causing a market value loss. 5
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Risk Balance sheet hedge via matching maturities of assets and liabilities is problematic for FIs . h Inconsistent with asset transformation role. h Mismatch results from borrowers wanting long-term loans and depositors wanting short-term liquid funds. Have adjustable-rate assets and liabilities.
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Ch 7 Fully Revised 2011 - 1 Chapter 7 Risks of Financial...

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