LECTURE 6 NOTES

LECTURE 6 NOTES - LECTURE 6 NOTES: - WHY DO FINANCIAL...

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LECTURE 6 NOTES: -- WHY DO FINANCIAL INSTITUTIONS NEED TO MANAGE RISK? --TYPES OF RISKS INCURRED BY FINANCIAL INSTITUTIONS: Liquidity Risk, Interest Rate Risk, Market Risk, Off-Balance Sheet Risk, Foreign Exchange Risk, Country or Sovereign Risk, Technology Risk, Operational Risk, Insolvency Risk, Credit Risk --HOW ARE THE VARIOUS RISKS FACED BY FINANCIAL INSTITUTIONS RELATED? WHY DO FINANCIAL INSTITUTIONS NEED TO MANAGE RISK? --Increased returns come at the cost of increased risk. FI’s performance will depend on how they manage risk. --FI’s overall safety and soundness is important and regulators evaluate financial institutions using the CAMELS ratings, e.g. by looking at C apital Adequacy, A sset Quality, M anagement, E arnings, L iquidity, S ensitivity to Market Risk. TYPES OF RISKS INCURRED BY FINANCIAL INSTITUTIONS: Liquidity Risk: --Liability Side Liquidity Risk: is the risk that a sudden and unexpected increase in liability withdrawals (e.g., deposit withdrawals in the case of commercial banks) may require a FI to liquidate assets in a very short period of time and at low prices. Fire Sale Prices: Prices at less than fair market value. --Asset Side Liquidity Risk: is the risk that holders of loan commitments suddenly exercise their right to borrow. --In general, FIs prefer to limit their cash holdings (due to the opportunity cost of holding cash). When they’re faced by a liquidity risk and they lack cash, they either borrow additional funds or sell assets (which might be both costly). --When all or many FIs face abnormally large cash demands, the cost of purchased or borrowed funds increases and the supply of such funds becomes restricted. --In more severe cases, unusual or unexpected need for cash or lack of confidence might cause crisis; and liquidity risk can turn into insolvency risk for many companies. 1
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Insolvency Risk: --Insolvency risk is the risk that a FI may not have enough capital to offset a sudden decline in the value of its assets relative to its liabilities. --The more equity capital to borrowed funds (the lower the leverage) a FI has, the more chances it’ll withstand losses due to risk exposures such as adverse liquidity changes and unexpected credit losses that can lead to insolvency risk. Interest Rate Risk:
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This note was uploaded on 11/18/2011 for the course FIN 353 taught by Professor Cobus during the Fall '08 term at S.F. State.

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LECTURE 6 NOTES - LECTURE 6 NOTES: - WHY DO FINANCIAL...

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