Lecture 18 - Risk management of commercial banks

Lecture 18 - Risk management of commercial banks -...

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Unformatted text preview: Financial Markets and Institutions Commercial Banks Risk Management Mishkin & Eakins 6 th ed. Chapter 24 Preview • 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 that much harder. • We examine how financial institutions manage credit risk, default risk, etc. We explore the tools available to managers to measure these risks and strategies to reduce them. Topics include: – Managing Credit Risk – Managing Interest-Rate Risk 2 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 entirely or making late payments of interest or principal. • Once again, the concepts of adverse selection and moral hazard will provide our framework to understand the principles financial managers must follow to minimize credit risk, yet make successful loans. 3 • 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. • Moral hazard plays a role as well. Once a borrower has a loan, she has an incentive to engage in risky projects to produce the highest payoffs, especially if the project is financed mostly with debt. Managing Credit Risk 4 • Solving Asymmetric Information Problems: 1. Screening and Monitoring: – Collect reliable information about prospective borrowers. – Specialize in lending: in regions or industries, gaining expertise in evaluating particular firms or individuals. – Require certain actions, or prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contact. – Write protective covenants into loans contracts and actively manage them to ensure that borrowers are not taking risks at their expense. Managing Credit Risk 5 2. Long-term Customer Relationships: past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine creditworthiness....
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This note was uploaded on 10/12/2011 for the course BIEMF 30006 taught by Professor Ippolito during the Fall '10 term at Università Bocconi.

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Lecture 18 - Risk management of commercial banks -...

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