Introduction to

Financial Institutions
and Risks
Financial Institutions
A financial institution is an organization which works as an
intermediary between the deficit unit (borrower) and surplus unit
(lender) in the financial market to facilitate the flow of funds using
financial instruments.

Examples of financial institutions include commercial banks, savings

banks, credit unions, investment banks, leasing companies, mutual
funds etc.
Why are Financial Institutions needed?
In a perfect market:
◦ All information about any securities for sale in primary and secondary markets
would be continuously and freely available to all investors
◦ All information identifying investors interested in purchasing securities as well
as investors planning to sell securities would be freely available
◦ All securities are infinitely divisible
However, Markets are imperfect
◦ Financial institutions are needed to resolve the problems created by market
imperfections. These problems include:
◦ Maturity mismatch, denomination mismatch, high information search cost, high default risk, high
liquidity risk etc.
Role of Financial Institutions
Financial institutions play various important roles in an economy. These include:
◦ Broker and dealer activities
◦ Maturity intermediation: FI’s can provide savings/investment conduit for lenders/borrowers that better
reflect the maturity needs of these parties. FI’s are better capable to manage the risk of maturity
mismatch of their assets and liabilities.
◦ Denomination intermediation: FI’s, such as mutual funds, allow small investors to overcome constraints
to buying assets imposed by large minimum denomination size.
◦ Superior monitoring: FI’s are better equipped to closely monitor the performance of the borrower
thereby better managing default risk. FI’s can collect more information at a lower average cost due to
economies of scale.
Role of Financial Institutions
Superior credit assessment: FI’s possess the expertise required to conduct a thorough
assessment of the creditworthiness of the borrower (issuer). This also mitigates default risk.
Credit Allocation: FI’s are often the main, and at times the only, source of financing for certain
sectors of the economy.
Transmission of monetary mechanism: Depository financial institutions are the medium
through which the central bank implements/manipulates its monetary policy to impact the rest
of the economy. i.e changing the reserve requirement of banks to tackle inflation, open market
operations etc.
Payment Services: FI’s like banks develop and facilitate the network of payment systems used to
make purchases and consumption in the economy.
Risk Management: FI’s provide risk management services to its clients. i.e diversification of
portfolio
Types of FI
Financial institutions can be broadly be classified into
two types:
1. Depository Financial Institutions
2. Non-depository financial institutions
Types of Depository Financial
Institutions
Depository Financial institutions are financial institutions that mainly obtain their funds by
collecting deposits from the general public and also allow the public to withdraw their funds
when needed. Consequently, depository institutions are highly regulated by the government.
The main types are as follows:
1. Banks
2. Credit Union
3. Savings Associations
Types of non-depository financial institutions
•Non-depository financial institutions refer to those financial institutions that cannot raise
funds from the public through demand deposits and cannot provide checking account
services.
•Rather, these financial institutions raise funds primarily by issuing money market securities,
capital market securities, borrowing from other financial institutions and issuing time
deposits
There are various types of non-depository FI’s. Among these, the more prominent ones are:
◦ Investment Banks
◦ Mutual Funds
◦ Insurance Companies
◦ Leasing companies
◦ Venture capitalists
Safety and Soundness Regulation
Protects borrowers and depositors against failure of the FI
Diversification requirements
Minimum capital to asset ratios
Guaranty funds provisions
Monitoring and surveillance
Monetary Policy Regulation
•Since Financial Intermediaries serve as a conduit for monetary policy
they merit special regulation.
•Reserve requirements, for example.
•The Central Bank can manipulate the reserve requirement of
Financial Institutions in the economy by changing the reserve
requirements thereby controlling the money supply and inflation
rate.
Credit Allocation Regulation
Supports lending to portions of the economy deemed socially
important (housing and farming are two examples).

Requiring a % of assets in a particular sector of the economy for

example. Also interest rate restrictions.
Consumer Protection Regulation
◦ Prevents discrimination in lending based upon gender, race, age, or
income. Requires standardized form on why credit is granted or
denied

◦ May provide a heavy net regulatory burden without an offsetting

social benefit.
Investor Protection Regulation
Protection of investors that use investment banks directly.
Insider trading restrictions, lack of disclosure and breach of
fiduciary responsibility are examples.
Risks of Financial
Institutions
Risk and Risk Management
•In Finance, Risk refers to the probability that actual outcomes will
deviate or vary from expected outcomes.
•Risk arises due to uncertainty regarding future events.
•Risk Management refers to the systematic process of identifying,
measuring, and evaluating different risks faced by an entity and
developing and executing appropriate strategies to minimize or
mitigate those risks.
 Capital Market
• Capital Market is the financial market from where long-term capital is raised by organizations by
issuing financial instruments such as shares, bonds, and debentures.
•A capital market eco-system is composed of several participants:
• Investors (surplus units)
• Issuing firms (deficit units)
• Financial Institutions (Banks, Investment Banks, Asset Management Companies, Mutual Funds, Pension
Funds etc.)
• Regulators (BSEC, Bangladesh Bank)
• Government

• All of these stakeholders are exposed to various types of risk in the capital market.
Types of Risks in Capital Market
Interest Rate Risk

Market Risk

Credit Risk

Off-Balance Sheet risk

Foreign Exchange Risk

Sovereign Risk

Operational Risk
Interest Rate Risk
•Interest Rate Risk refers to the risk that a change in interest rates will adversely
affect the earnings or the asset value of an organization.
•Interest rate risk mainly arises due to a mismatch between the maturity of an
organizations interest bearing assets and it’s interest bearing liabilities.
•Interest rate risk can be further sub-classified into two categories:
• Refinancing risk: Short term liability but long term asset
• Re-investment risk: Long term liability but short term asset
Interest Rate Risk
•Most financial institutions serving an intermediary role make some income
from interest margins.
•They borrow funds at a given level of interest rates then generate a higher
interest rate from their business (making loans for example).
•They then receive interest income due to the difference in interest rates. This
is called the net interest margin.
•The Interest rates on both Assets and Liabilities are tied to the length of the
commitments among other factors.
•A mismatch in this length commitment exposes the firm to refinancing and
re-investment risks.
Refinancing Risk
Assume that IDLB Finance has borrowed Tk. 100 million in liabilities
financed at 9% per year and that the interest rate resets at the end
of the year. IDLB Finance has used this money to provide margin
loans to its clients worth $100 million that mature in 2 years at a
fixed rate of 10% per year.
What happens if the interest rate increases to 11% after 1 year?
◦ The cost of refinancing your liabilities increases, but your income from
assets stays the same. Thus, the net interest income is adversely
affected.
Reinvestment Risk
Assume that Shanto Finance Ltd. Has TK. 100 million in liabilities
financed at 9% per year that mature in 2 years. The FI has made
margin loans of TK. 100 million that mature in 1 year at a rate of 10%
per year.
What happens if the interest rate decreases to 8% after 1 year?
◦ The cost of your liabilities stays fixed but in year two your income from
assets decreases.
Interest Rate risks
Interest rate risk: Market Value risk
◦ A change in interest rates might adversely affect the market value of the
assets of a financial institutions.

◦ The market value of an asset depends upon the discounted value of the
future cash flows generated from that asset.

◦ An increase/Decrease in interest rates will increase/decrease the

discounting rate and this will result in a fall/rise in the market value of
the assets.
Market Risk
•Market risk refers to the risk incurred from asset and liabilities in an
FI’s trading book due to changes in interest rates, exchange rates,
and for other macroeconomic shocks.
•Most FI’s in the capital market nowadays maintain a short-term
trading portfolio comprised of different stocks, bonds, and derivative
instruments.
•A potential loss in value of this portfolio due to interest rate shock,
or exchange rate shock or some other shocks is called market risk.
Market Risk
Market Risk
Market Risk
•Market risk is a major source of risk for FI’s in the capital market.
•The more volatile the asset/instrument prices are the greater the level of risk
faced by the FI’s.
•Thus, it is important for regulators and FI’s to adopt policies and practices to
control the limit positions take by traders and to measure the market risk
exposure on a day to day basis.
Credit Risk
• This is the risk that a borrower will not be able to repay the interest and/or
principal amount to the lender resulting in a loss for the lender.
•This too is a major form of risk for Commercial Banks in Bangladesh (high NPL)
as well as for investment banks and securities firm (Non-performing margin
loans).
•Credit risk is of two types:
1. Firm-specific credit risk- The risk of default of the borrowing firm associated with
the specific types of project risk taken by that firm.
2. Systematic credit risk- The risk of default associated with general economy wide or
macro-conditions affecting all the borrowers.
Credit Risk
Off-Balance Sheet Risks
Risk associated with contingent claims that do not show up on the
balance sheet. It is not on the Balance sheet since it does not involve
holding a current primary claim or issuing a current secondary claim.
Increased importance of off-balance-sheet activities
◦ Letters of credit
◦ Loan commitments
◦ Derivative positions
Speculative activities using off-balance-sheet items create considerable
risk
Foreign Exchange Risks
•Foreign Exchange risk refers to the risk that a firms earnings from foreign
denominated asset and the value of these assets might decline due to a change
in the exchange rate.
• Net Long Asset Position – Exposure to foreign denominated assets is greater than
foreign liabilities. Depreciation of foreign currency results in loss.
• Net Short Asset Position – Exposure to foreign denominated assets is less than
exposure to foreign liabilities. Appreciation of foreign currency results in loss.
Foreign Exchange Risks-Example
•Suppose that a US investment company called “Wall Street Incorporated” has
invested Tk 850 million for buying stocks and bonds in the Dhaka Stock Exchange on
31 December 2021. The exchange rate on that day was Tk 85/$1. Of these 500
million, 170 million was financed through equity while the rest was borrowed from
local banks in Bangladesh. The investment portfolio of Wall Street Inc. has generated
earnings of Tk. 85 million in the past year. Assume that the market value of the
portfolio is still 850 million taka on 31 December, 2022.. Over the past 1 year, the
BDT has depreciated against the US dollar and the current exchange rate is Tk.
105/$1.
•Q) What type of position does Wall Street Inc. have?
•Q) What is the impact of the depreciation of Taka on Wall Street Inc. portfolio value.
Managing foreign exchange risks
•One way to manage foreign exchange risk is to hold a “zero”
position. In other words, to match the value of foreign denominated
assets and foreign denominated liabilities.
•However ,Note that hedging foreign exposure by matching foreign
assets and liabilities requires matching the maturities as well.
◦ Otherwise, exposure to foreign interest rate risk is created.
Country or Sovereign Risk
•Result of loss arising due to changes in the political condition or
policies of foreign government which may impose restrictions on
repayments to foreigners.
•An important characteristics of country risk is that there is a lack of
usual recourse via the court system.
Country or Sovereign Risk
Liquidity Risk
• This is the risk of not being able to convert an asset into cash quickly
enough without having to sacrifice the value of the asset.
•FI’s and retail investors both might face liquidity risks/
•For FI’s, liquidity risk could result in reputational risk and may even
generate “runs”.
• Runs may turn liquidity problem into solvency problem.
• Risk of systematic bank panics.
Technological and operational risks.
Risk of direct or indirect loss resulting from inadequate or failed internal
processes, people, and systems or from external events.
◦ Some include reputational and strategic risk
Technology Risk: Technology investment may fail to produce anticipated cost
savings.
Operational Risk: The risk that support systems (often based on new technology)
may break down.
◦ Bank of New York – failed to register incoming payments on Fedwire, but continued
to process outgoing payments
◦ Well’s Fargo – Failure to correctly post deposits to acquired firms account holders –
cost $180 Million
Insolvency Risk
•Risk of insufficient capital to offset sudden decline in value of assets
to liabilities.
•Original cause may be excessive interest rate, market, credit, off-
balance-sheet, technological, FX, sovereign, and liquidity risks.
•It is imperative to ensure sound capital adequacy to protect oneself
against insolvency risk.
Risk Management Techniques
•Deciding what risks to accept and how to manage them
•Set Asides
• Financial firms often set aside funds to cover potential losses, this
requires the ability to estimate the possibility and size of loss
•Limits on Risky Positions
•Hedging
Risk Measurement Tools
•Value at Risk and Earnings at Risk
• Models that predict the probability and magnitude of potential loss from market risk

•Stress Testing
• What is the worst case Scenario

•GAP, Duration GAP

•Financial Statement Analysis
•Impact of Regulation