Types of Risks

Incurred by
Financial
Institutions
 Risks at Financial Institutions

⚫ A major objective of FI management is to increase returns but

must manage multiple source of risk:
⚫ Credit risk
⚫ Liquidity risk
⚫ Interest rate risk
⚫ Market (macro) risk
⚫ Off-balance sheet risk
⚫ Foreign exchange risk
⚫ Country or sovereign risk
⚫ Technology risk
⚫ Operational risk
⚫ Digital disruption and fintech risk
⚫ Insolvency risk

20-2
Risks Faced by Financial
Institutions

20-3
 Credit Risk at FIs

⚫ Credit risk: risk that promised cash flows from loans and
securities not paid in full
⚫ All types of FI face this risk
⚫ More levered and lending FIs more exposed
⚫ Even as losses due to credit risk increase
⚫ Compensation for risk
⚫ Important element: pricing
⚫ Managerial (monitoring) efficiency and credit risk management
strategies key

20-4
 Credit Risk at FIs (Continued)

⚫ Advantage of FIs over individual investors:

⚫ ability to diversify credit risk exposures from a single asset
⚫ exploiting the law of large numbers in their asset investment portfolios
⚫ Diversification reduces firm-specific credit risk
⚫ the risk of default for the borrowing firm associated with the specific
types of project risk taken by that firm
⚫ Diversification does not reduce systemic credit
risk, the risk of default associated with general
economy-wide or macro-conditions affecting all
borrowers
⚫ E.g., an economic recession

20-5
Charge-Off Rates for Commercial
Bank Lending Activities (2019)

20-6
Credit Card Loss Rates and
Personal Bankruptcy Filings

20-7
Impact of Credit Risk on an FI’s
Equity Value

20-8
 Impact of Credit Risk on an FI’s
Equity Value
⚫ As equity holder or analyst:
⚫ Can use Black Scholes to evaluate risk

20-9
 Liquidity Risk
⚫ Liquidity risk: risk of sudden and unexpected increase in
liability withdrawals
⚫ may force quick liquidation in assets in very short period
⚫ Pushes prices of illiquid assets down
⚫ Force expensive borrowing of funds short-term at expensive rates
⚫ On asset side
⚫ loan commitments and other credit lines causes liquidity risk
⚫ Most liquid asset of all is cash
⚫ Reserves for banks
⚫ Deposits for non banks
⚫ Systemic events
⚫ FIs face abnormally large cash demands, the cost of purchased of
borrowed funds rises and the supply of such funds becomes restricted
⚫ Fire sales

20-10
Impact of Liquidity Risk on Equity Value

20-11
 Interest Rate Risk
⚫ Interest rate risk:
⚫ risk when maturities of assets and liabilities mismatched
⚫ interest rates are volatile (undepredictable)
⚫ Asset transformation:
⚫ FI buying primary securities/assets and issuing secondary liabilities
⚫ Primary securities often with longer maturity characteristics
⚫ Refinancing risk:
⚫ risk that the cost of rolling over or reborrowing funds will rise above returns

20-12
 Interest Rate Risk
(Continued)
⚫ Price risk: risk that the price of the security will change
⚫ Rising (falling) interest rates increase (decrease) the discount rate
on future asset or liability cash flows and reduce (increase) the
market price or present value of that asset or liability
⚫ Mismatching maturities by holding longer-term assets than liabilities
means that when interest rates rise, the economic or present value
of the FI’s assets falls by a larger amount than its liabilities
⚫ FIs can seek to hedge against interest rate risk
⚫ matching the maturity of their asset and liabilities, but this strategy is not
necessarily consistent with an active asset transformation function for FIs
⚫ matching maturities hedges interest rate risk only in a very
approximate rather than complete fashion

20-13
 Market Risk (macro)
⚫ Market risk is the risk incurred in trading assets and liabilities
due to changes in interest rates, exchange rates, and other
asset prices
⚫ Closely related to interest rate and foreign exchange risk
⚫ Another dimension of risk: trading activity
⚫ Market risk can impact prices, without rate changes

⚫ FI’s trading portfolio can be differentiated from its investment

portfolio on the basis of time horizon and liquidity
⚫ Trading portfolio contains assets, liabilities, and derivative
contracts that can be quickly bought or sold on organized financial
markets,
⚫ Investment portfolio contains assets and liabilities that are relatively
illiquid and held for longer periods

20-14
The Investment (Banking) Book
and Trading Book of a
Commercial Bank

20-15
 Market Risk (Continued)

⚫ Traditional roles of FIs changed recently

⚫ Large commercial banks such as money center banks
⚫ decline in income from traditional deposit taking and lending activities
⚫ matched by an increased reliance on income from trading
⚫ Decline in underwriting and brokerage income for large
investment banks
⚫ met by more active and aggressive trading in securities, derivatives,
and other assets
⚫ Mutual fund managers
⚫ asset portfolios, are also exposed to market risk

20-16
 Off-Balance-Sheet Risk
⚫ Off-balance-sheet (OBS) risk: result of activities related to
contingent assets and liabilities
⚫ 2022, commercial banks:
⚫ $23.6 trillion in on-balance-sheet items,
⚫ notional off-balance-sheet derivative items was $191.0 trillion
⚫ OBS activities: not appear on an FI’s current balance sheet
⚫ Not involving holding (asset) nor secondary claim (liability)
⚫ OBS: creation of contingent assets and liabilities
⚫ rise to potential placement in the future on the balance sheet
⚫ produce positive or negative future cash flows for an FI or shrink
balance sheet space

20-17
Valuation of an FI’s Net Worth with
and without Consideration of OBS
Activities

20-18
 Off-Balance-Sheet Risk
(Continued)
⚫ More attention to bank OBS activities
⚫ especially large ones
⚫ Issuing a letter of credit (LC) is an OBS activity
⚫ LC is a credit guarantee issued by a FI for a fee
⚫ Similar to CD
⚫ Other examples of OBS
⚫ collateralized mortgage obligations (CMOs),
⚫ loan commitments by banks,
⚫ mortgage servicing contracts by depository institutions
⚫ positions in forwards, futures, swaps, and other derivative securities by
almost all large FIs
⚫ Earn fee income while not loading up or expanding the balance
sheet

20-19
 Foreign Exchange Risk
⚫ Foreign exchange (FX) risk
⚫ risk that FX changes affect the value of FI’s assets and liabilities in
foreign currencies
⚫ US pension funds
⚫ 5% of their assets in foreign securities 1990s
⚫ now 24%
⚫ Returns on domestic and foreign direct investments and portfolio
investments are not perfectly correlated for two reasons:
1. Underlying performance of various economies differ, as do the
firms in those economies
2. Exchange rate changes are not perfectly correlated across
countries
⚫ FIs expand globally through acquiring foreign firms or opening
new branches in foreign countries, as well as investing in foreign
financial assets

20-20
 Foreign Exchange Risk
(Continued)
⚫ A net long position in a foreign currency involves an FI
holding more foreign assets than liabilities
⚫ FI loses when foreign currency falls relative to the U.S. dollar
⚫ FI gains when foreign currency appreciates relative to the U.S.
dollar
⚫ A net short position in a foreign currency involves an FI
holding fewer foreign assets than liabilities
⚫ FI gains when foreign currency falls relative to the U.S. dollar
⚫ FI loses when foreign currency appreciates relative to the U.S.
dollar
⚫ FI is fully hedged only if we assume that it holds foreign
assets and liabilities of exactly the same maturity
20-21
Foreign Asset and Liability Positions
Net Long Asset Position in Pounds

Net Short Asset Position in Pounds

20-22
 Sovereign Risk
⚫ Country, or sovereign, risk risk that repayments from
foreign borrowers may be interrupted because of
interference from foreign governments
⚫ Differs from credit risk that on domestic assets,
⚫ domestic defaults: FIs usually easy recourse through bankruptcy
courts
⚫ Foreign corporations may be unable to pay principal and
interest even if they desire to do so
⚫ Foreign governments may limit or prohibit debt repayment
⚫ Company may be ok, country not

20-23
 Sovereign Risk
(Continued)
⚫ Restrictions or outright prohibitions on the payment of debt
obligations by sovereign governments, the FI claimholder
has little if any recourse to local bankruptcy courts or to an
international civil claims court
⚫ Measuring sovereign risk includes an analysis of
macroeconomic issues, such as the following:
⚫ Fiscal stance (deficit or surplus) of the government;
⚫ Government intervention in the economy;
⚫ Monetary policy;
⚫ Capital flows and foreign investment;
⚫ Inflation; and
⚫ Structure of its financial system

20-24
 Technology and Operational Risk

⚫ Technology risk risk incurred when technological

investments do not produce anticipated cost savings
⚫ Major objectives of technological expansion are to lower
operating costs, increase profits, and capture new markets for
an FI

⚫ Operational risk is the risk that existing technology or

support systems may malfunction or break down
⚫ Not exclusively the result of technological failure
⚫ Costs that reduce an FI’s profitability and market value
⚫ Loss of customer basis

20-25
 Digital Disruption and Fintech
Risk
⚫ Digital Disruption and Fintech risk
⚫ risk that fintech firms could disrupt business
⚫ lost customers and revenue
⚫ Broader and wider ranging than technology risk
⚫ Fintech services, cryptocurrencies (e.g., bitcoin) and blockchain
compete with payments without the need for financial intermediaries
⚫ Largest fintech companies:
⚫ SoFi, an online personal finance company;
⚫ Transferwise, an international money transfer provider; and
⚫ Credit Karma:
▪ a platform that provides credit scores to users and also serves as a portal for
people to search and apply for various financial services, like loans, credit
cards, and insurance

20-26
Insolvency Risk
⚫ Insolvency risk
⚫ Bankruptcy risk for investor
⚫ Insolvency risk is a consequence or an outcome of one or more of the risks previously
described above

⚫ More equity capital to borrowed funds an FI has (i.e., the

lower its leverage), better able it is to withstand losses
⚫ Less leverage, less profits
⚫ Risk-return tradeoff
⚫ Regulators and managers
⚫ capital adequacy as a key measure of an FI’s ability to remain
solvent
⚫ grow in the face of a multitude of risk exposures

20-27
 Other Risks and Interactions
Among Risks
⚫ All of the previously defined risks are interdependent
⚫ Each risk and its interaction with other risks ultimately affects
solvency risk

⚫ Other risks also impact FI’s profitability and risk exposure:

1. Discrete, or event-type, risks:
⚫ Taxation/regulation
⚫ Large macro risks
▪ war, revolutions, or sudden market collapse
▪ Theft, malfeasance, and breach of fiduciary trust
⚫ Increased inflation and inflation volatility
⚫ Unemployment

20-28
Managing Credit
Risk on the
Balance Sheet
 Credit Risk Management
⚫ Financial institutions (FIs) special
⚫ ability to efficiently transform financial claims of household savers into
claims issued to corporations, individuals, and governments
⚫ FIs’ ability to process and evaluate information and control and
monitor borrowers
⚫ Monitoring function
⚫ Credit allocation is a specific type of financial claim
transformation
⚫ the credit risk involved in lending, and a profit margin reflecting competitive
conditions

21-30
 Credit Risk Management
(Continued)
⚫ Credit risk management important
⚫ involves the determination of pricing of debt instrument
⚫ Interest rate, maturity, collateral, and other covenants

⚫ Major economic event can cause Portfolio losses

⚫ Hurricanes Katrina and Rita in 2005 resulted in over $1.3 billion in
bad loans for major banks operating in areas
⚫ Financial crisis of 2008-2009 resulted in the largest ever credit risk-
related losses for U.S. financial institutions

⚫ On an international scale, bank loan portfolios were exposed to

losses from the European debt crisis

21-31
 Credit Quality Problems
⚫ Credit Quality
⚫ 1980s - Issues with bank and thrift residential and farm mortgage loans
⚫ Late 1980s and early 1990s –problems relating to commercial real
estate loans and junk bonds
⚫ Late 1990s – concern auto loans and credit cards as well as the
declining quality in commercial lending standards as high-yield
business loan delinquencies started to rise
⚫ Late 1990s and early 2000s – Attention has focused on problems with
telecommunication companies, new technology companies, and a
variety of sovereign countries
⚫ 2008-2009 – Foreclosures hit a record 1.5 million in the first half of
2009, and consumer bankruptcy filings rose to 1.06 million in 2008
⚫ 2010 – 2019 – U.S. economy slowly recovered, and nonperforming
loan rates edged downward to some of the lowest levels seen
throughout the 30-year period
⚫ Today: rise of private lending

21-32
Nonperforming Asset Ratio for
U.S. Commercial Banks

21-33
 Credit Quality Problems
(Continued)
⚫ Managerial efficiency and credit risk management strategies
directly affect the return and risks of the loan portfolio

⚫ Advantages of FIs
⚫ ability to diversify credit risk by exploiting the law of large numbers in
their asset investment portfolios
⚫ but costly to do so

⚫ Credit quality problem:

⚫ worst case, cause insolvency
⚫ significant drain on earnings and net worth

21-34
Credit Analysis: Real Estate Lending

⚫ Mortgage loan applications among most standardized of all

credit applications
⚫ Two considerations for approval of a mortgage loan
application:
1. Ability/willingness to make timely interest and principal
repayments
⚫ Application of qualitative and quantitative models
⚫ Character of applicant: assessed using factors such as stability
of residence, occupation, family status, previous history of
savings, and credit history
2. Value of collateral/location
⚫ Loan officer must establish whether applicant has sufficient
income
21-35
Credit Analysis:
Real Estate Lending (Continued)
⚫ GDS and TDS: key ratios
⚫ GDS refers to the gross debt service ratio
⚫ Total accommodation expenses (mortgage, lease,
condominium, management fees, real estate taxes, etc.)
divided by gross income
⚫ Acceptable standard maximum of 25% to 30%
⚫ TDS refers to the total debt service ratio
⚫ Total accommodation expenses plus all other debt service
payments divided by gross income
⚫ Acceptable threshold generally set around maximum of 35%
to 40%

21-36
Calculation of GDS and TDS Ratios

21-37
 Credit Scoring Systems

⚫ Credit scoring systems

⚫ calculate probability of default
⚫ Credit scoring systems
⚫ mathematical models that use observed characteristics of loan
applicant to calculate a score that represents the applicant’s
probability of default
⚫ Loan officers can often give immediate “yes”, “maybe”, or “no”
answers —along with justifications for the decision

⚫ Lender may use standard FICO credit scores

⚫ FICO scale runs from 300 to 850

⚫ FIs also verify borrower’s financial statements

21-38
 Credit Analysis:
Real Estate Lending (Concluded)
⚫ Perfecting collateral process of ensuring that collateral
used to secure a loan is free and clear to lender

⚫ In default event:
⚫ Foreclosure taking possession of the mortgaged property
⚫ Power of sale is the process of taking the proceedings of the
forced sale of a mortgaged property in satisfaction of the
indebtedness and returning to the mortgagor the excess over
the indebtedness

21-39
Prior to Accepting a Mortgage

⚫ Process:
⚫ Confirming title and legal description of the property
⚫ Obtaining a surveyor’s certificate confirming that the
house is within the property’s boundaries
⚫ Checking with the tax office to confirm that no property
taxes are unpaid
⚫ Requesting a land title search to determine that there are
no other claims against the property
⚫ Obtaining an independent appraisal to confirm the
purchase price is in line with the market value

21-40
 Consumer (Individual) and Small-
Business Lending
⚫ Similar techniques to mortgage lending
⚫ Consumer loans are scored like mortgages
⚫ Nonmortgage consumer loans focus on the individual’s
ability to repay
⚫ Credit-scoring models put more emphasis on personal
characteristics (e.g., annual gross income, TDS score, etc.)
⚫ Small-business scoring models often combine computer-
based financial analysis of borrower financial statements
with behavioral analysis of the business owner
⚫ loans made to small businesses to help start up the company,
and there is less history on which to base the loan

21-41
 Mid-Market Commercial and
Industrial Lending
⚫ Profitable market for credit-granting FIs
⚫ Mid-cap corporates are typically:
⚫ Revenues $5 million to $100 million per year
⚫ Recognizable corporate structure
⚫ No ready access to primary capital markets
⚫ Commercial loans range from a few weeks to as long as 8
years or more
⚫ Short-term commercial loans (those with an original maturity of
one year or less): finance working capital needs
⚫ Long-term loans: finance credit needs that extend beyond one
year (e.g., purchase of real assets, new venture start-up costs,
and permanent increases in working capital)

21-42
 Five C’s of Credit

⚫ Five C’s of credit:

1. Character probability that loan applicant will try to honor
obligation
2. Capacity subjective judgment regarding the applicant’s ability
to repay
3. Collateral assets that the loan applicant offers as security
backing the loan
4. Conditions general economic trends or special developments
in certain geographic regions or economic sectors that may
affect applicant’s ability to repay
5. Capital is measured by the general financial condition of the
applicant as indicated by financial statements and leverage

21-43
 Cash Flow Analysis

⚫ Initial step of the loan analysis,

⚫ FIs require business loan applicants to provide cash flow (CF)
information
⚫ Four categories or sections:
⚫ CF from operating activities inflows and outflows from producing
and selling the firm’s products
⚫ CF from investing activities CFs associated with buying or
selling fixed or other long-term assets
⚫ CF from financing activities are CFs that result from debt and
equity financing transactions
⚫ Net change in cash and marketable securities sum of CFs from
operations, investing activities, and financing activities
⚫ Operating activities section are most critical to the FI in
evaluating the loan applicant
21-44
Statement
of Cash
Flows

21-45
 Ratio Analysis

⚫ Financial ratios - financial statement analysis on a mid-

market applicant
⚫ Time series analysis applicant’s business over time, while
cross-sectional analysis vs. competitors
⚫ Liquidity ratios
⚫ variability of liquid resources relative to potential claims
⚫ Asset management ratios
⚫ how well the applicant uses its assets relative to its past performance
⚫ Debt and solvency ratios
⚫ extent to which the applicant finances its assets with debt versus
equity
⚫ Profitability ratios express the profitability of the firm

21-46
 Ratio Analysis (Continued)

⚫ Ratio analysis
⚫ Ratio has has
analysis limitations:
limitations:
⚫ Many
⚫ firms firms
diverse operate
areindifficult
more than one industry,
to compare and
versus it can be
difficult to construct a meaningful set of industry averages for
benchmarks
these firms
⚫ different accounting methods can distort industry
⚫ Different accounting practices can distort industry comparisons
comparisons
⚫ Can be difficult to generalize whether a particular value for a
⚫ applicants can distort financial statements
ratio is good or bad
⚫
⚫ common-size
Common-size analysis
analysis and and
growthgrowth
ratesrates
⚫ ⚫ common-size
Common-size financial
financial statements
statements presentby
are constructed values
dividing
all as percentages
income statementtoamounts
facilitate
bycomparison versusand all
total sales revenue
competitors
balance sheet amounts by total assets
⚫ ⚫ year-to-year
Year-to-year growth
growth rates
rates give can ratios
useful identify
fortrends
identifying trends
⚫ Before drawdown, conditions precedent must be cleared
21-47
 Large Commercial and Industrial
Lending
⚫ Bargaining strength severely diminished dealing with large
corporate customers
⚫ Large corporations:
⚫ Able to issue debt and equity directly
⚫ Maintain credit relationships with several FIs and significant in-house
financial expertise
⚫ Manage cash position through: money markets issuing
⚫ ommercial paper
⚫ use excess funds to buy T-bills, banker’s acceptances, and CP
⚫ Not restricted by international boarders
⚫ Very attractive to FIs
⚫ FI’s relationship include role of broker, dealer, and/or advisor
⚫ Credit management remains an important issue

21-48
Altman’s Z-Score

⚫ Z-score model for analyzing publicly traded

manufacturing firms
⚫ Z is an overall measure of the borrower’s default risk
classification

21-49
Altman’s Z-Score Interpretation

⚫ Default classifications (according to Altman)

⚫ Z < 1.81 – high default risk firm
⚫ 1.81 < Z < 2.99 – indeterminate default risk firm
⚫ Z > 2.99 – low default risk firm

⚫ Problems associated with Z-score model

⚫ Crude measure
⚫ Ignores hard-to-quantify factors that may play a crucial role in
the default or no-default decision
⚫ Accounting variables are updated infrequently

21-50
Calculation of Altman’s Z-Score

21-51
 Moody’s Analytics Credit Monitor
Model
⚫ Firm raises funds either by issuing bonds or by increasing its bank
loans,
⚫ valuable default or repayment option
⚫ If investments fail, option to default
⚫ If things go well, the borrower can keep most of the upside returns

⚫ KMV (Moody’s) Corporation has created credit-monitoring model

⚫ largest U.S. banks to determine expected default frequency (EDF)
⚫ Simulations show model outperforms others as predictors of corporate
failure and distress

21-52
Moody’s Analytics EDF and
Moody’s for Peabody Energy
Corporation

21-53
 Calculating the Return on a Loan:
Return on Assets (ROA)
⚫ Factors that impact the return loan:
⚫ Interest rate on the loan
⚫ Fees
⚫ Credit risk premium (m) on the loan
⚫ Collateral backing

⚫ Direct and indirect fees and charges relating to a loan fall into
three categories:
1. Loan origination fee (f) charged to borrower
2. Compensating balance requirement (b) to be held as generally non-
interest-bearing demand deposits
3. Reserve requirement charge (RR) imposed by the Fed on the bank’s
demand deposits, including any compensating balances

21-54
 Calculating the Return on a Loan:
Return on Assets (ROA)
(Continued)
⚫ Return on assets (ROA) approach shows the contractually
promised gross return on a loan, k, per dollar lent (or 1 + k) –
or ROA per dollar lent – will equal:

⚫ Numerator of formula is promised gross cash inflow to the FI

per dollar lend, reflecting direct fees (f) plus the loan interest
rate (BR + m)
⚫ Net outflow by the FI per $1 of loans is 1 - b (1 - RR), or 1
minus the reserve-adjusted compensating balance
requirement
21-55
Calculation of ROA on a Loan

21-56
 Calculating the Return on a Loan:
RAROC Models
⚫ Essential idea behind RAROC is that rather than evaluating
the actual or promised annual cash flow on a loan as a
percentage of the amount lent (or ROA), the lending officer
balances the loan’s expected income against the loan’s
expected risk

⚫ Loan is approved by FI only if RAROC is sufficiently high

relative to a benchmark return on equity capital
⚫ Loan should be made only if the risk-adjusted return on the loan
adds to the FI’s equity value, as measured by the ROE required by
the FI’s stockholders
⚫ RAROC serves as a credit-risk measure and a loan pricing tool
21-57
Calculation of RAROC

21-58
Interest Rate Risk
 Interest Rate Risk
⚫ Asset-transformation function performed by financial
institutions (FIs)
⚫ exposes them interest rate risk
⚫ mismatching of asset and liability maturities
⚫ FIs use two main methods to measure interest rate risk:
1. Repricing gap: examines the impact of interest rate changes
on an FI’s net interest income (NII)
2. Duration gap: incorporates the impact of interest rate
changes on the overall market value of an FI’s balance sheet
⚫ Insolvency risk: consequence, or outcome of excessive
amount of one or more of the risks

23-60
 Interest Rate Risk Measurement
and Management
⚫ Federal Reserve’s monetary policy strategy:
⚫ most direct influence on the level and movement of interest rates
⚫ If the Fed wants to slow down the economy
⚫ tighten monetary policy taking actions to raise interest rates
⚫ decrease in business and household spending
⚫ If the Fed wants to stimulate the economy
⚫ Opposite
⚫ Promotes borrowing and spending
⚫ Until recently
⚫ regulators based evaluations of bank interest rate risk on repricing
gap model alone
⚫ Bad idea.
⚫ Duration gap important

23-61
Repricing Model

⚫ Repricing or funding gap

⚫ difference between assets whose interest rates will be repriced
or changed over some future period (RSAs)
⚫ liabilities whose interest rates will be repriced or changed over
some future period (RSLs)

⚫ Essentially a book value accounting cash flow: of the

interest income earned on an FI’s assets and the interest
expense paid on its liabilities (or its net interest income)
over some particular period
⚫ Using this approach, DIs report quarterly on their Call
Reports,
⚫ interest-rate sensitivity reports which show the repricing gaps for
assets and liabilities with various maturities

23-62
Repricing Gaps for an FI

23-63
 Repricing Model (Continued)

⚫ Gap in each maturity bucket (or bin)

⚫ estimated the difference between rate-sensitive assets
(RSAs) and the rate-sensitive liabilities (RSLs)
⚫ Rate sensitivity is the time to repricing of an asset or liability
⚫ Repricing model measures the change in an FI’s net
interest income exposure (or profit exposure) to interest
rate changes in each different maturity bucket
⚫ Negative gap (where RSA < RSL) refinancing risk, the risk
that the cost of rolling over or reborrowing funds will rise
above the returns being earned on asset investments
⚫ A positive gap (where RSA > RSL) exposes the FI to
reinvestment risk, the risk that the returns on funds to be
reinvested will fall below the cost of the funds

©McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 23-64
Change in Net Interest Income

⚫ Change in net interest income in the ith maturity bucked

is calculated as follows:

23-65
 Cumulative Gaps (CGAP)

⚫ FI manager can also estimate cumulative gaps (CGAP)

over various repricing categories or buckets
⚫ Common CGAP of interest is the one-year repricing gap
⚫ Cumulative effect on a bank’s net interest income may be
estimated using:

⚫ CGAP effect is the relation between changes in interest

rates and changes in net interest income
23-66
Impact of Rate Changes on Net
Interest Income When CGAP is
Positive

23-67
Spread Effect

⚫ Spread effect is the effect that a change in the spread

between rates on RSAs and RSLs has on net interest
income (NII) as interest rates change

⚫ In general, the spread effect is such that, regardless of the

direction of the change in interest rates, a positive relation
exists between changes in the spread (between rates on
RSAs and RSLs) and changes in NII
⚫ When the spread increases (decreases), NII increases
(decreases)

23-68
Impact of Spread Effect on Net
Interest Income

©McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill. 23-69
 Weaknesses of the Repricing
Model
⚫ Repricing model has four major weaknesses
1. It ignores market value effects of interest rate changes
⚫ Repricing gap is only a partial and short-term measure of overall
interest rate exposure
2. It ignores cash flow patterns within a maturity bucket
⚫ On average, liabilities may be repriced toward the end of the
bucket’s range and assets may be repriced toward the beginning
3. It fails to deal with the problem of rate-insensitive asset and
liability cash flow runoffs and prepayments
⚫ FI receives runoff from its rate-insensitive portfolio that can be
reinvested at current market rates
4. It ignores cash flows from off-balance-sheet (OBS) activities
⚫ Changes in interest rates will affect the cash flows on many OBS
instruments, as well as those listed on the balance sheet

23-70
Duration Gap Model

⚫ Duration measures the interest rate sensitivity of an asset

or liability’s value to small changes in interest rates

⚫ Duration gap is a measure of overall interest rate risk

exposure for an FI
⚫ To estimate the overall duration gap of an FI:
⚫ Determine the duration of an FI’s asset portfolio (A) and the
duration of its liability portfolio (L)
⚫ Calculate the market value weighted average of the duration
of the assets (or liabilities) in the portfolio

23-71
 Duration Gap Model (Continued)

⚫ The dollar change in the market value of the asset portfolio for a
change in interest rates is:

⚫ Similarly, the dollar change in the market value of the liability

portfolio for a change in interest rates is:

⚫ Rearranging and combining these equations results in a measure

of the change in the market value of equity:

23-72
 Duration Gap Model (Concluded)

⚫ Effect of interest rate changes on the market value of an

FI’s equity or net worth (∆E) breaks down into three effects:
1. Leverage-adjusted duration gap = DA – kDL
⚫ Measured in years and reflects degree of duration mismatch in an
FI’s balance sheet
⚫ The larger this gap in absolute terms, the more exposed the FI is
to interest rate risk
2. Size of the FI
⚫ A measures the size of the FI’s assets; the larger the asset size,
the larger the dollar size of the potential net worth exposure from
any given interest rate shock
3. Size of the interest rate shock = ∆R/(1 + R)
⚫ The larger the shock, the greater the FI’s exposure

23-73
Fannie Mae Duration Gap

23-74
Difficulties in Applying the the
Duration Model to Real-World FI
Balance Sheets
⚫ Duration matching can be costly
⚫ Critics claim that restructuring the balance sheet can be time-
consuming and costly
⚫ Note that this argument isn’t as true today as is has been in the
past, given the growth of purchased funds, asset securitization,
and loan sales markets have eased the speed and lowered the
transaction costs of major balance sheet restructurings
⚫ Immunization is a dynamic problem
⚫ The duration of assets and liabilities changes as they approach
maturity, and the rate at which their durations change through
time may not be the same on the asset and liability sides of the
balance sheet
⚫ Large interest rate changes and convexity
⚫ Convexity is the degree of curvature of the price-yield curve
around some interest rate level
23-75
Duration Estimated versus True
Bond Price

23-76
 Insolvency Risk Management

⚫ To ensure survival, an FI manager must protect against the

institution against the risk of insolvency
⚫ The primary means of protection against the risk of
insolvency and failure is an FI’s equity capital
⚫ Capital is also a source of funds
⚫ Capital is a necessary requirement for growth under existing
minimum capital-to-asset ratios set by regulators
⚫ FI managers often prefer low levels of capital in order to
generate a higher return on equity (ROE) for stockholders
⚫ The moral hazard problem of deposit insurance exacerbates
this tendency
⚫ Strategy results in a greater chance of insolvency

23-77
Insolvency Risk Management
(Continued)
⚫ Capital Purchase Program, part of the Troubled Asset
Relief Program (TARP) of 2008-2009, was designed to
encourage U.S. FIs to build capital to increase the flow
of financing to U.S. businesses and consumers and to
support the U.S. economy
⚫ Under the program, the Treasury purchased over $205
billion in senior preferred stock issued by FIs
⚫ In addition to capital injections received as part of the
CPP, TARP provided additional emergency funding to
Citigroup ($25 billion) and Bank of America ($20 billion)
⚫ Through December 2019, $245 billion of TARP capital
injections had been allocated to DIs, of which $239.8
billion had been paid back, along with a return of $35.8
billion in dividends and assessments
23-78
Capital

⚫ The economic meaning of capital is net worth, the

difference between the market value of an FI’s assets
and the market value of its liabilities
⚫ Essentially a market value accounting concept
⚫ The market value or mark-to-market value basis uses
balance sheet values that reflect current rather than
historical prices
⚫ Regulatory- and accounting-defined capital and required
leverage ratios are based in whole or in part on
historical or book values (BV) accounting concepts
⚫ Book value is the value of assets and liabilities based on
their historical costs
23-79
 Market Value of Capital

⚫ The market value of capital and credit risk

⚫ Declines in current and expected future cash flows on assets
lowers the market value of the FI’s asset portfolio
⚫ Decreases in the MVs of assets are charged directly against
the equity owners’ capital or net worth
⚫ Liability holders are only hurt when losses on the asset
portfolio exceed FI’s net worth
⚫ Capital acts as “insurance”, protecting liability holders against
insolvency risk
⚫ The market value of capital and interest rate risk
⚫ Rising interest rates reduce the market value of the FI’s long-
term securities and loans, while floating-rate instruments find
their market values largely unaffected if interest rates on such
securities are instantaneously reset
23-80
The Book Value of Capital

⚫ Book value (BV) of capital is the difference between the

BV of assets and the BV of liabilities
⚫ BV of capital usually comprises the following three
components in banking:
⚫ Par value of shares – the face value of the common shares
issued by the FI times the number of shares outstanding
⚫ Surplus value of shares – the difference between the price
the public paid for common shares when originally offered
and their par values, times the number of shares outstanding
⚫ Retained earnings – the accumulated value of past profits
not yet paid in dividends to shareholders
⚫ Since these earnings could be paid in dividends, they are part of the
equity owners’ stake in the FI

23-81
The Book Value of Capital
(Continued)

⚫ Book value of capital and credit risk

⚫ Managers of FIs may resist writing down the values of bad
assets as long as possible to try to present a more favorable
picture to depositors, shareholders, and regulators
⚫ FI managers can selectively sell assets to inflate their
reported capital
⚫ Only pressure from auditors and regulators may force loss
recognition and write-downs of the values of problem assets
⚫ Book value of capital and interest rate risk
⚫ Failure of BV accounting systems to recognize the impact of
interest rate risk is extreme relative to their partial and lagged
recognition of credit risk problems
23-82
Discrepancy between the Market
and Book Values of Equity
⚫ Degree to which the BV of an FI’s capital deviates from
its true economic market value depends on a number of
factors, especially:
⚫ Interest rate volatility – the higher the interest rate
volatility, the greater the discrepancy
⚫ Examination and enforcement – the more frequent are
on-site and off-site examinations and the stiffer the
examiner/regulator standards regarding charging off
problem loans, the small the discrepancy
⚫ Asset trading – the more assets that are traded, the
easier it is to assess the true MV of the asset portfolio
⚫ Market-to-book ratio shows the discrepancy between
the stock market value of an FI’s equity and the book
value of its equity
23-83
Market-to-Book Value Ratios for
U.S. DIs

23-84
 Arguments Against Market Value
Accounting
⚫ Arguments against market value accounting include the
following:
⚫ Difficult to implement
⚫ Especially true for small commercial banks and thrifts with large
amounts of nontraded assets, such as small loans, in their balance
sheets
⚫ When market prices or values for assets cannot be determined
accurately, marking to market may be done only with error
⚫ Introduces unnecessary degree of variability into FI’s reported
earnings – and thus net worth – because paper capital gains
and losses on assets are passed through the income statement
⚫ FIs are less willing to accept longer-term asset exposures if
these assets must be continually marked-to-market to reflect
changing credit quality and interest rates
23-85
 Chapter Twenty-
Two

Managing
Liquidity Risk on
the Balance
Sheet
 Liquidity Risk Management

⚫ Unlike other risks, liquidity risk is a normal aspect of the

everyday management of an FI
⚫ Banks must manage liquidity so they can pay out cash as
deposit holders request withdrawals of their funds
⚫ At the extreme, liquidity risk can lead to insolvency
⚫ Some FIs are more exposed to liquidity risk than others
⚫ Depository institutions (DIs) are highly exposed
⚫ Mutual funds, hedge funds, pension funds, and property-
casualty insurers have relatively low liquidity risk exposure
⚫ Financial crisis of 2008-2009 was, in part, due to liquidity risk
⚫ Central banks around the world had to pump short-term cash
into strained markets to stem the post-2007 liquidity crisis
22-87
 Causes of Liquidity Risk

⚫ Liquidity risk arises for two reasons:

1. Liability-side reason occurs when FI’s liability holders, such as
depositors or insurance policyholders, seek to cash in their
financial claims immediately
⚫ FIs must meet withdrawals by borrowing additional funds or
liquidating assets
⚫ Some assets may be liquidated only at fire-sale prices
2. Asset-side reason arises when FI needs to fund loans
immediately
⚫ Loan commitment allows a customer to borrow funds from an FI on
demand, and when a borrower draws on its loan commitment, the
FI must fund the loan on the balance sheet immediately
⚫ FIs may meet this need by running down cash assets, selling off
other liquid assets, or borrowing additional funds

22-88
Liquidity Risk and
Depository Institutions (DIs)
⚫ DIs’ balance sheets typically have large amounts of short-
term liabilities, such as demand deposits and other
transaction accounts, that fund relatively long-term, illiquid
assets (e.g., commercial loans and mortgages)
⚫ Demand deposit accounts and other transaction accounts
are contracts that give holders the right to put their
financial claims back to the DI on any given day and
demand immediate repayment of the face value in cash
⚫ DIs know that normally only a small portion of demand
deposits will be withdrawn on any given day
⚫ Most demand deposits act as core deposits—i.e., they are a
stable and long-term funding source
⚫ Deposit withdrawals are normally, in part, offset by the
inflow of new deposits
22-89
Effect of Net Deposit Drains on the
Balance Sheet

22-90
 Liquidity Risk and
Depository Institutions (DIs)
(Continued)
⚫ DI managers monitor net deposit drains, the amount by
which cash withdrawals exceed additions; a net cash outflow
⚫ FIs manage a drain on deposits in two major ways:
⚫ Purchased liquidity management is an adjustment to a deposit
drain that occurs on the liability side of the balance sheet
⚫ DI manager utilizes the markets for purchased funds, which are
interbank markets for short-term loans
⚫ Can be expensive, since DI must pay market rates to offset drains
⚫ Availability may be limited should the DI incur insolvency difficulties
⚫ Stored liquidity management is an adjustment to a deposit
drain that occurs on the asset side of the balance sheet
⚫ FI liquidates some of its assets, utilizing stored liquidity

22-91
Stored Liquidity vs Purchased Liquidity
Management on DI’s Net Income

22-92
Liquidity Risk and
Depository Institutions (DIs)
(Concluded)
⚫ Just as deposit drains can cause a DI liquidity problems,
so can loan requests, resulting form the exercise, by
borrowers, of loan commitments and other credit lines

⚫ DIs increased their loan commitments tremendously in

recent years, with the belief they would not be exercised
⚫ Unused loan commitments to cash grew from 529.4% in
1994 to 1,014.6% in October 2008 (before falling back to
608.6% during the financial crisis)

22-93
Financing Gap and the Financing
Requirement
⚫ One way to measure liquidity risk exposure is to determine
the DI’s financing gap, the difference between a DI’s
average loans and average (core) deposits

⚫ If financing gap is positive, DI must find liquidity to fund gap

⚫ Funding may come from via either purchase liquidity management
(i.e., borrowing funds) or stored liquidity management (i.e.,
liquidating assets)

⚫ Relationship may be written as follows:

22-94
 Financing Gap and the Financing
Requirement (Continued)
⚫ Financing requirement is the financing gap plus a DI’s
liquid assets
⚫ Larger financing gap and liquid asset holdings, the higher the
amount of funds it needs to borrow in the money market and
the greater is its exposure to liquidity problems

Financing Requirement (or Borrowed Funds) =

Financing Gap + Liquid Assets

⚫ Widening financing gap can warn of future liquidity

problems since it may indicate increased deposit
withdrawals and increasing loans due to more exercise of
loan commitments
22-95
 Sources and Uses of Liquidity

⚫ Net liquidity statement lists sources and uses of liquidity,

and, thus, provides a measure of a DI’s net liquidity position
⚫ Used by DI managers to measure DI’s daily liquidity position,
serving as the second method by which to measure liquidity
risk exposure
⚫ DI can obtain liquid funds in three ways:
1. Sell its liquid assets, such as T-bills, immediately with little
price risk and low transaction costs
2. Borrow funds in the money/purchased funds market up to a
maximum amount
3. Use any excess cash reserves over and above the amount
held to meet regulatory imposed reserve requirements
⚫ All DIs report historical sources and uses of liquidity in
annual and quarterly reports
22-96
Net Liquidity Position

22-97
 Peer Group Ratio Comparisons

⚫ Third way to measure a DI’s liquidity exposure is to

compare certain of its key ratios and balance sheet features
with those for DIs of a similar size and geographic location
⚫ As shown below, BOA was exposed to substantially greater
liquidity risk from unexpected takedowns of these
commitments

22-98
 Liquidity Index

⚫ Final way to measure liquidity risk is to use a liquidity index,

which measures potential losses a DI could suffer as a result of a
sudden (or fire-sale) disposal of assets
⚫ Larger the differences between fire-sale asset prices and fair market
prices, the less liquid the DI’s asset portfolio
⚫ Liquidity index will always lie between 0 and 1
⚫ Liquidity index for particular DI could also be compared with indexes
calculated for a peer group of similar DIs

22-99
Calculation of the Liquidity Index

22-100
 New Liquidity Risk Measures
Implemented by BIS
⚫ Two regulatory standards were developed by BIS for
liquidity risk supervision:
1. Liquidity coverage ratio (LCR) aims to ensure a DI maintains
an adequate level of high-quality liquid assets (HQLA) that
can be converted into cash to meet liquidity needs for a 30-
day time horizon under an “acute liquidity stress scenario”
specified by supervisors

2. Net stable funds ratio (NSFR) takes a longer-term look at

liquidity on a DI’s balance sheet

22-101
 Liquidity Planning

⚫ Liquidity planning allows managers to make important

borrowing priority decisions before liquidity problems arise
⚫ Lowers costs of funds by determining an optimal funding mix
⚫ Minimizes amount of excess reserves a DI needs to hold
⚫ Liquidity plans have a number of components:
1. Delineation of managerial details and responsibilities
2. Detailed list of fund providers most likely to withdraw
funds and a pattern of fund withdrawals
3. Identification of the size of potential deposit and fund
withdrawals over various time horizons in the future
4. Internal limits on separate subsidiaries’ and branches’
borrowings as well as acceptable risk premiums to pay in
each market (fed funds, RPs, CDs, etc.)
22-102
Deposit Distribution and Possible
Withdrawals Involved in DI’s
Liquidity Plan

22-103
 Liquidity Risk, Unexpected
Deposit Drains, and Bank Runs
⚫ Major liquidity problems arise if deposit drains are
abnormally large and unexpected
⚫ Abnormal deposit drains can occur for a number of reasons,
including the following:
⚫ Concerns about a DI’s solvency relative to that of other DIs
⚫ Failure of a related DI, leading to heightened depositor
concerns about the solvency of surviving DIs (i.e., a contagion
effect)
⚫ Sudden changes in investor preferences regarding holding
nonbank financial assets (e.g., T-bills or mutual funds shares)
relative to DI deposits
⚫ A bank run is a sudden and unexpected increase in deposit
withdrawals from a DI
22-104
Deposit Drains and Bank Run
Liquidity Risk
⚫ Demand deposits are first-come, first-served contracts in
the sense that a depositor’s place in line determines the
amount he or she will be able to withdraw from a DI
⚫ Incentives for depositors to withdraw their funds at the first
sign of trouble creates a fundamental instability in the
banking system
⚫ A bank panic is a systemic or contagious run on the deposits
of the banking industry as a whole
⚫ Regulatory mechanisms are in place to ease banks’
liquidity problems and to deter bank runs and panics
1. Deposit insurance
2. Discount window
22-105
 Deposit Insurance

⚫ FDIC was created in 1933 in the wake of the banking panics

of 1930-1933, when some 10,000 commercial banks failed
⚫ Deposit insurance was first introduced in the U.S. in 1934
with coverage up to $2,500
⚫ Coverage was increased to $100,000 in 1980 and to $250,000
in October 2008
⚫ Individuals can achieve many times the $250,000 coverage
cap on deposits by structuring their deposits in a particular
fashion
⚫ Primary intention of deposit insurance is to deter DI runs
and panics, but a secondary and related objective has been
to protect the smaller, less informed saver against the
reduction in wealth that would occur if that person were last
in line were the DI to fail
22-106
Calculation of Insured Deposits

22-107
The Discount Window

⚫ Federal Reserve also provides a “discount window”

lending facility, serving as a lender of last resort
⚫ Interest rate at which securities are discounted is called
the discount rate and is set by the central bank
⚫ While the discount window has traditionally been
available to DIs, in the spring of 2008 investment banks
gained access to the discount window through the
Primary Dealer Credit Facility (PDCF)
⚫ After March 2008, several new broad-based lending
programs were implemented, providing funding to a wide
array of new parties, including U.S. money market mutual
funds, commercial paper issuers, insurance companies,
and others
22-108
Liquidity Risk and Insurance
Companies
⚫ Life insurance companies hold cash reserves and other
liquid assets for the following reasons:
⚫ Meet policy payments
⚫ Meet cancellation (surrender) payments
⚫ Surrender value of a life insurance policy is amount that
insurance policyholder receives when cashing in a policy early
⚫ Other working capital needs
⚫ Property-casualty (P&C) insurance companies
⚫ Claims against P&C insurers are relatively short-term and
unpredictable
⚫ P&C insurance companies have a greater need for liquidity
than life insurance companies
22-109
 Guarantee Programs

⚫ Both life insurance and property-casualty insurance

companies are regulated at the state level
⚫ Unlike banks and thrifts, neither life nor P&C insurers have a federal
guarantee fund
⚫ Beginning in the 1960s, most states began to sponsor state
guarantee funds for firms selling insurance in that state
⚫ Differ from deposit insurance in several important ways:
⚫ Programs are run and administered by the private insurance
companies themselves
⚫ No permanent guarantee fund exists for the insurance industry,
with the sole exception of the state of New York
⚫ Size of required contributions that surviving insurers make vary
widely from state to state
⚫ Delay usually occurs before cash surrender values or other
payment obligations are received from the guarantee fund
22-110
Liquidity Risk and Investment
Funds
⚫ Investment funds, such as mutual funds and hedge funds,
sell shares as liabilities to investors and invest the
proceeds in assets such as bonds and equities

⚫ Face similar liquidity problems as DIs when the number of

withdrawals rises to abnormally high or unexpected levels
⚫ Fundamental difference in the way investment fund
contracts are valued compared to the valuation of DI deposit
contracts, thereby reducing the incentives for investment
fund shareholders to engage in deposit-like runs

22-111