Risks of

Financial
Intermediation
by Anthony & Marcia
 interest rate risk
 The risk incurred by an FI when the maturities of its assets and
liabilities are mismatched.
 HOW??
 Asset transformation involves an FI’s buying primary securities or
assets (equities, bonds, and other debt claims directly from
corporations) and issuing secondary securities or liabilities (deposits,
insurance policies, mutual funds, and so on) to fund asset purchases.
 The primary securities purchased by FIs often have maturity and
liquidity characteristics different from those of the secondary
securities FIs sell. In mismatching the maturities of assets and
liabilities as part of their asset-transformation function, FIs potentially
expose themselves to interest rate risk.
 The process of turning risky assets into safer assets for investors by
creating and selling assets with risk characteristics that people are
comfortable with and then using the funds acquired by selling these
assets to purchase other assets that may have far more risk.

 example is a certificate of deposit (CD), such as those issued by your

local bank. In this type of asset transformation, the bank issues a CD
and promises to pay a specific rate on the money you have deposited
at a set date in the future. The bank in turn uses your money by
"transforming" it into loans to other customers at a higher rate than
they are paying you.
 refinancing risk The risk that the cost of rolling over or re
borrowing funds will rise above the returns being earned on
asset investment.

 reinvestment risk The risk that the returns on funds to be

reinvested will fall below the cost of funds.

 market value risk that the market (or fair) value of an

asset or liability is conceptually equal to the present value of
current and future cash flows from that asset or liability.
Therefore, rising interest rates increase the discount rate on
those cash flows and reduce the market value of that asset
or liability. Conversely, falling interest rates increase the
market values of assets and liabilities.
 Interest rate risk mitigation

 FIs can seek to hedge, or protect against, interest rate risk

by matching the maturity of their assets and liabilities.
 However FIs can’t do both together, hedge & asset
transformation function. this lowers profitability.(how??)
 Concept Questions

 What is refinancing risk?

 Why does a rise in the level of interest rates adversely affect
the market value of both assets and liabilities?
 Explain the concept of maturity matching.
 Market Risk
 The risk incurred in the trading of assets and liabilities due to
changes in interest rates, exchange rates, and other asset prices.
 Conceptually, an FI’s trading portfolio can be differentiated from
its investment portfolio on the basis of time horizon and
secondary market liquidity.
 The trading portfolio contains assets, liabilities, and derivative
contracts that can be quickly bought or sold on organized financial
markets.
 The investment portfolio contains assets and liabilities that are
relatively illiquid and held for longer holding periods.
 Market risk is the possibility of an investor experiencing losses due
to factors that affect the overall performance of the
financial markets in which he or she is involved. Market risk, also
called "systematic risk,“

 The four most common types of market risks include interest rate
risk, equity risk, currency risk and commodity risk.

 To measure market risk, investors and analysts use the

value-at-risk (VaR) method. VaR modeling is a
statistical risk management method that quantifies a stock or
portfolio's potential loss as well as the probability of that potential
loss occurring. VaR calculations can be applied to specific positions
or portfolios as a whole or to measure firm-wide risk exposure.
 credit risk
 The risk that the promised cash flows from loans and securities
held by FIs may not be paid in full.
 FIs that make loans or buy bonds with long maturities are more
exposed than are FIs that make loans or buy bonds with short
maturities.
 If a borrower defaults, however, both the principal loaned and the
interest payments expected to be received are at risk. some loans
or bonds default on interest payments, principal payments, or
both.
 The potential loss an FI can experience from lending suggests that
FIs need to monitor and collect information about borrowers
whose assets are in their portfolios and to monitor those
borrowers over time. Thus, managerial monitoring efficiency and
credit risk management strategies directly affect the return and
risks of the loan portfolio
 firm-specific credit risk: The risk of default of the borrowing firm
associated with the specific types of project risk taken by that firm.

 systematic credit risk: The risk of default associated with general

economy wide or macro conditions affecting all borrowers.

 diversification across assets, such as loans exposed to credit risk,

reduces the overall credit risk in the asset portfolio and thus
increases the probability of partial or full repayment of principal
and/or interest, that is, moderates the long-tailed downside risk of
the return distribution.
 off-balance-sheet risk

 The risk incurred by an FI due to activities related to

contingent assets and liabilities.
 A contingent asset is a potential economic benefit
dependent solely on future events that can't be
controlled by the company. Due to the uncertainty of
the future events, these assets are not placed on the
balance sheet. However, upon meeting certain
conditions, contingent assets are reported in the
financial statements in the accompanying notes.
 Example-A company involved in a lawsuit with the
expectation to receive compensation has a contingent
asset, because the outcome of the case is not yet
known and the dollar amount is yet to be determined.
 A contingent liability is a potential liability that may occur,
depending on the outcome of an uncertain future event. A
contingent liability is recorded in the accounting records if the
contingency is probable and the amount of the liability can be
reasonably estimated. If both of these conditions are not met, the
liability may be disclosed in a footnote to the financial statements
or not reported at all.

 Example: Outstanding lawsuits and product warranties are

common examples of contingent liabilities, fine for not following
government law, guarantees
 letter of credit: A credit guarantee issued by an FI for a fee on
which payment is contingent on some future event occurring.
 foreign exchange risk
 The risk that exchange rate changes can affect the value of an FI’s
assets and liabilities denominated in foreign currencies.
 FIs have recognized that both direct foreign investment and
foreign portfolio investments can extend the operational and
financial benefits available from purely domestic investments.

 The returns on domestic and foreign direct investing and portfolio

investments are not perfectly correlated for two reasons. The first
is that the underlying technologies of various economies differ, as
do the firms in those economies.
 For example, one economy may be based on agriculture while
another is industry based. Given different economic
infrastructures, one economy could be expanding while another is
contracting.
 foreign investment exposes an FI to foreign exchange risk
 To understand how foreign exchange risk arises, suppose that a U.S.
FI makes a loan to a British company in pounds sterling (£). Should
the British pound depreciate in value relative to the U.S. dollar, the
principal and interest payments received by U.S. investors would be
devalued in dollar terms.

 Indeed, were the British pound to fall far enough over the investment
period, when cash flows are converted back into dollars, the overall
return could be negative. That is, on the conversion of principal and
interest payments from pounds into dollars, foreign exchange losses
can offset the promised value of local currency interest payments at
the original exchange rate at which the investment occurred
 sovereign risk

 The risk that repayments from foreign borrowers may be

interrupted because of interference from foreign governments.
 Sovereign risk is a different type of credit risk that is faced by an
FI that purchases assets such as the bonds and loans of foreign
corporations.
 For example, when a domestic corporation is unable or unwilling
to repay a loan, an FI usually has recourse to the domestic
bankruptcy courts and eventually may recoup at least a portion of
its original investment when the assets of the defaulted firm are
liquidated or restructured.
 By comparison, a foreign corporation may be unable to repay the
principal or interest on a loan even if it would like to. Most
commonly, the government of the country in which the
corporation is headquartered may prohibit or limit debt payments
because of foreign currency shortages and adverse political
reasons
 liquidity risk

 The risk that a sudden surge in liability withdrawals may leave an

FI in a position of having to liquidate assets in a very short period
of time and at low prices.
 Because of a lack of confidence by liability holders in the FI or
some unexpected need for cash, liability holders may demand
larger withdrawals than normal.
 When all, or many, FI face abnormally large cash demands, the
cost of additional purchased or borrowed funds rises and the
supply of such funds becomes restricted. As a consequence, FIs
may have to sell some of their less liquid assets to meet the
withdrawal demands of liability holders. This results in a more
serious liquidity risk, especially as some, assets with “thin”
markets generate lower prices when the asset sale is immediate
than when the FI has more time to negotiate the sale of an asset.
 insolvency risk
 The risk that an FI may not have enough capital to offset a sudden
decline in the value of its assets relative to its liabilities
 Insolvency risk is a consequence or outcome of one or more of
the risks described above: interest rate, market, credit, off-balance-
sheet, technology, foreign exchange, sovereign, and liquidity risks
 In general, the more equity capital to borrowed funds an FI has—
that is, the lower its leverage—the better able it is to withstand
losses, whether due to adverse interest rate changes, unexpected
credit losses, or other reasons.
 Thus, both management and regulators of FIs focus on an FI’s
capital (and adequacy) as a key measure of its ability to remain
solvent.
 A.
 Interest income $1,000 $10,000 x 0.10
 Interest expense 600 $10,000 x
0.06
 Net interest income $400

 B.
 Interest income $1,000 $10,000 x 0.10
 Interest expense 700 $10,000 x 0.07
 Net interest income $300
 C
 Cash $1,000 Certificate of deposit $10,000
 Bond $9,446 Equity $ 446
 Total assets $10,446 Total liabilities and equity $10,446

 D
 The market value of the equity would be higher ($1,600) because
the value of the bond would be higher ($10,600) and the value of
the CD would remain unchanged
 E
 The operating performance has been affected by
the changes in the market interest rates that have
caused the corresponding changes in interest
income, interest expense, and net interest
income. These specific changes have occurred
because of the unique maturities of the fixed-rate
assets and fixed-rate liabilities. Similarly, the
economic market value of the firm has changed
because of the effect of the changing rates on the
market value of the bond.
QUESTION

 Two 10-year bonds are being considered for an

investment that may have to be liquidated before
the maturity of the bonds. The first bond is a 10-
year premium bond with a coupon rate higher
than its required rate of return, and the second
bond is a zero-coupon bond that pays only a
lump-sum payment after 10 years with no interest
over its life. Which bond would have more interest
rate risk? That is, which bond’s price would
change by a larger amount for a given change in
interest rates? Explain your answer.
ANSWER

 The zero-coupon bond would have more interest

rate risk. Because the entire cash flow is not
received until the bond matures, the entire cash
flow is exposed to interest rate changes over the
entire life of the bond. The cash flows of the
coupon-paying bond are returned with periodic
regularity, thus allowing less exposure to interest
rate changes. In effect, some of the cash flows
may be received before interest rates change.
QUESTION

 Consider again the two bonds in PREVIOUS

problem . If the investment goal is to leave the
assets untouched until maturity, such as for a
child’s education or for one’s retirement, which of
the two bonds has more interest rate risk? What is
the source of this risk?
ANSWER

 In this case the coupon-paying bond has more

interest rate risk. The zero-coupon bond will
generate exactly the expected return at the time
of purchase because no interim cash flows will be
realized. Thus the zero has no reinvestment risk.
The coupon-paying bond faces reinvestment risk
each time a coupon payment is received. The
results of reinvestment will be beneficial if interest
rates rise, but decreases in interest rate will cause
the realized return to be less than the expected
return.
 Characterize the risk exposure(s) of the following FI transactions by choosing one or more
of the risk types listed below:
 A) Interest rate risk
 B) Credit risk
 C) Off-balance-sheet risk
 D) Technology risk
 E) Foreign exchange risk
 F) Country or sovereign risk
 (1) A bank finances a $10 million, six-year fixed-rate commercial loan by
 selling one-year certificates of deposit.
 (2) An insurance company invests its policy premiums in a long-term municipal
 bond portfolio.
 (3) A French bank sells two-year fixed-rate notes to finance a two-year
 fixed-rate loan to a British entrepreneur.
 (4) A Japanese bank acquires an Austrian bank to facilitate clearing
 operations.
 (5) A mutual fund completely hedges its interest rate risk exposure by using
 forward contingent contracts.
 (6) A bond dealer uses his own equity to buy Mexican debt on the less developed
 country (LDC) bond market.
 (7) A securities firm sells a package of mortgage loans as mortgage-backed
 (1) A bank finances a $10 million, six-year fixed-rate commercial
loan by selling one-year certificates of deposit. a, b
 (2) An insurance company invests its policy premiums in a
long-term municipal bond portfolio. a,
b
 (3) A French bank sells two-year fixed-rate notes to finance a
two-year fixed-rate loan to a British entrepreneur. b,
e, f
 (4) A Japanese bank acquires an Austrian bank to facilitate
clearing operations. a, b, c, d, e, f
 (5) A mutual fund completely hedges its interest rate risk
exposure using forward contingent contracts. b, c
 (6) A bond dealer uses his own equity to buy Mexican debt on
the less-developed country (LDC) bond market. a, b, e, f
 (7) A securities firm sells a package of mortgage loans as
mortgage backed securities.
 A, b, c