Chapter 4

Risk Management
in Financial Institutions
 Contents of the Chapter

4. Chapter 4:- Risk Management in

Financial Institutions
4.1. Types of Risks
4.2. Managing Credit Risk on Balance Sheet
4.3. Managing Liquidity Risk on Balance Sheet
4.4. Managing Interest Rate Risk on Balance
Sheet

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 4.1 Types of risks

Credit Risk
 the chance that debtors default on their obligation
 debt securities with long-term maturity pose more
credit risk than securities with short-term maturity
 banks, thrifts and life insurance companies have
higher degree of exposure to credit risk

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 4.1 Types of risks

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 4.1 Types of risks

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 4.1 Types of risks
Credit Risk...
 managerial efficiency and credit risk management
strategy affects credit risk of a loan portfolio
 Loan diversification can help eliminate firm
specific credit risk

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 4.1 Types of risks
Liquidity risk
 the likelihood that a FI becomes unable to meet
demand for withdrawal, loan, or indemnity.
 may compel FIs to dispose illiquid assets at a cheap
price
 may cause a ‘bank run‘
 deposit insurance

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 4.1 Types of risks
Interest Rate (funding) Risk
 caused by maturity mismatch of assets and liabilities
coupled with interest rate volatility
o Refinancing risk –assets have long-term maturity and
liabilities of short-term maturity. Cost of refinancing
may exceed return on assets
o Reinvestment risk –holding short-term assets relative
to liabilities. Uncertainity about interest rate at which
borrowed funds will be reinvested
o Price risk—effect of change in interest rate on value
of an asset or liability
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 4.1 Types of risks
Market Risk
 risk incurred in trading assets due to change in
interest rate, exchange rate, and other asset prices
 faced by FIs engaged in active trading of assets

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 4.1 Types of risks
Cases of FI failure
1. Barings - a 200-years old british bank
failed in 1995 due to trading losses. It
bought a futures contract that worth
$8bill betting that the Nikkei index
would rise. It became insolvent after a
loss of $1.2bill
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 4.1 Types of risks
2. Societe Generale- a French Bank lost $7.2bill as
Jerome Kerviel, the bank‘s trading clerk, invested
in future contracts in European stock indexes
betting that markets would continue to rise.

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 4.1 Types of risks
Off-balance sheet risk
 arises in relation with contingent assets and
liabilities
Eg. Credit guarantees, LCs
Foreign exchange risk
 risk that exchange rate changes affect the value
of assets and liabilities of a FIs

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 4.1 Types of risks
Country (sovereign) Risk
 Sovereign risk is a country defaulting on its
commercial debt obligations
 the risk that repayment from foreign borrowers may
be interrupted because of interference from foreign
governments
 Country risk covers the downside of a country’s
business environment including legal environment, levels
of corruption, and socioeconomic variables such as
income disparity.
 governments may control foreign currency outflows
to mitigate currency shortages

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 4.1 Types of risks
Technology and operational risk
 technology risk arises when FIs technological
investment fails to fetch the anticipated benefit
 economies of scale and economies of scope

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 4.1 Types of risks
Technology and operational risk...
 operational risk arises when the existing
technology or support system mulfunctions or
breaks down
 may also arise due to employee fraud,
misrepresentations, and account errors

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 4.1 Types of risks
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 is the ongoing inability to meet long-
term financial obligations. While Liquidity risk is a
short-term situation.
 Insolvency is when a company's overall debt
exceeds its total assets.

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 4.2 Managing credit risk

Causes
the problem of information asymmetry
adverse selection and moral hazard
Credit Analysis
 the 5 C‘s (Capacity, Conditions, Character, Capital,
and Collateral)

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 4.2 Managing credit risk
Real estate lending
 Capacity can be assessed by taking into account
 applicant‘s income in light of monthly
mortgage obligations
 monthly financial obligations

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 4.2 Managing credit risk
Real estate lending...
 Credit scoring- a technique in which points are
assigned for selected characteristics of applicants
 Characters may include the ff:

 annual gross income  age

 TDS (total debt
service)  residence
 relation with FI  length of residence
 major credit cards  job stability
 credit history
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 4.2 Managing credit risk
Medium size commercial & Industrial lending
 Cash flow analysis
 Ratio analysis
 Common size analysis

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4.2 Managing credit risk
Large commercial & Industrial lending
 Less risky
 Good financial health and hence can directly issue
securities to raise capital

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4.2 Managing credit risk
Large commercial & Industrial loans
 Credit scoring
 Altman‘s Z-score-measure of overall
default risk classification
Z= 1.2X1+1.4X2+3.3X3+0.6X4+1.0X5
Where X1= WC/TA X2 = RE/TA
X3=EBIT/TA X4= MV of SHE/BV of LTD
X5= Sales/TA

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 4.2 Managing credit risk
Large commercial & Industrial
lending
 Altman‘s Z-score
Z-score Degree of default risk
< 1.81 High
1.81-2.99 Intermediate
> 2.99 low

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4.2 Managing credit risk
Return on Loans
Return depends on:
 interest rate on the loan
 fees related to the loan (f)
 credit risk premium (m)
 collateral backing the loan
 non-price terms such as compensating
balance and reserve requirements

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4.2 Managing credit risk
Return on Loans (ROA)
Loan rate= Basic lending rate(BR) + Risk
Premium(m)

BR represents cost of capital of a bank

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 4.2 Managing credit risk


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4.2 Managing credit risk
Return on Loans(Example)
Suppose Addis bank sets a loan rate of 11%
(where BR=9% and m=2%), charges loan
origination fee of 1%, imposes 10%
compensating balance(b) and sets aside 15%
reserve (R).
What is ROA per birr lent?

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4.3 Managing liquidity risk

a) When debt holders(depositors or

insurance policy holders) want to
withdraw their financial claim
b) Off balance sheet commitments(loan
commitments) made by FIs are exercised
 to meet demands of short term debt
holders , FIs may at times be compelled
to liquidate assets at fire-sale prices

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 4.3 Managing liquidity risk

 arises due to holding short-term financial

obligations
 a DI has core deposit that remains unwithdrawn
over a long period of time
 withdrawals may be offset by attracting new
deposits, and here only the net deposit drain
becomes a concern
 a drain on deposit can be managed through
(1) purchased liquidity and (2) stored liquidity mgt
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4.3 Managing liquidity risk
(1) Purchased liquidity
 raising short-term funds from the money
market (Repos or interbank loan)
 helps to keep the asset side of the balance
sheet undisturbed
 expensive when cost of the funds is
more than return on asset

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4.3 Managing liquidity risk

(2) Stored liquidity mgt

 keeping excess reserves or by liquidating
near-cash items such as marketable
securities, Loans etc

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4.3 Managing liquidity risk
Impact of purchased liquidity versus
stored liquidity on NI(Example)
Suppose Addis Bank has the following
condensed balance sheet:
Assets(‘000) Liabilities and Equity(‘000)

Cash Br 400 Deposits Br6,500

Non-liquid assets 9,600 Borrowed funds 2,000
Equity 1,500
Total assets Br 10,000 Total Liab & Equity Br 10,000

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4.3 Managing liquidity risk
Example...
Addis Bank pays, on average, 5% on core
deposit and generates average return of 8%
on loans. Increases in market interest rate are
expected to cause a net drain of Br 2mill. Two
options are available to manage the expected
net drain:
(1) Raise short-term debt at a cost of 7%
(purchase liquidity)
(2) Sell loans for cash (store liquidity)

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4.3 Managing liquidity risk
Example...
(1) Raise short-term debt at a cost of 7% (purchase
liquidity)
Decrease in interest exp-
core deposit Br 2mill x 5% = Br 100,000
Increase in interest exp-
short-term debt Br 2mill x 7%= -140,000
Change in Net Income -Br 40,000

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4.3 Managing liquidity risk

Example...
(2) Sell loans for cash (store liquidity)
Decrease in interest exp-
core deposit Br 2mill x 5% = Br 100,000
Decrease in interest income-
loans Br 2mill x 8%= -160,000
Change in Net Income -Br 60,000

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4.3 Managing liquidity risk
Asset side liquidity risk
 arises when borrowers want to exercise
loan commitments made by a bank
 such commitments obligate the bank to
satisfy loan demand by borrowers
 demand for loan can be satisfied through
either purchased liquidity or stored liquidity

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4.3 Managing liquidity risk
Measuring a Bank‘s liquidity exposure
(a) The net liquidity statement
 Shows the sources and uses of liquidity
 Sources of liquidity include selling near
cash items, borrowing in the money market,
or using excess reserves
 Uses of liquidity include repayment of
debts.
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4.3 Managing liquidity risk
Measuring a Bank‘s liquidity exposure
(Example)
The following information has been extracted
from records of a bank.
 Near cash items Br 100,000
 Interbank loan(Debt) 250,000
 Max borrowed funds lim 850,000
 Funds borrowed 550,000
 Excess reserve at NBE 150,000

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4.3 Managing liquidity risk
Measuring a Bank‘s liquidity exposure
The net liquidity statement
A bank can have the ff sources and uses of liquidity
Sources of Liquidity:
-Near cash items Br 100,000
-max borrowed funds lim 850,000
-excess reserve 150,000
Total Br 1,100,000
Uses
- Funds borrowed Br 550,000
- Interbank loan 250,000
Total Br 800,000
Excess liquidity Br 300,000

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4.3 Managing liquidity risk
(b) Peer group ratio comparison
 Comparison of the following ratios may
help
 loan to deposit
 borrowed fund to total asset
 commitments to lend to total asset ratio

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 4.3 Managing liquidity risk
(c) Liquidity index
 measures the pottential loss from
disposal of assets at fire sale prices
compared with market value under
normal conditions

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 4.3 Managing liquidity risk
(c) Liquidity index...

Where
Wi = percentage of each asset in the portfolio
Pi = price of asset if sold today(fire-sale price)
Pj =price of asset if liquidated at the end of the
month

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4.3 Managing liquidity risk
(c) Liquidity index(Example)
Suppose a bank has two assets: 40% in government
treasury bill and 60% in real estate loans. It can liquidate
the treasury bill today at a price of Br 95 per Br 100 face
value, instead of Br 100 after a month. If it has to liquidate
real estate loans it will receive only Br 80 per Br 100 face
value, instead of Br 90 per Br 100 face value after one
month.
I = 0.40 x (95/100) + 0.60 x (80/90)
= 0.913

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 4.3 Managing liquidity risk
(d) Financing Gap and the financing
requirement
 financing Gap is the difference between average
deposit and average loans
Financing Gap = Average – Average
Loans Deposits
If FG is positive then a bank must find liquidity through
either purchasing or storing liquidity. Therefore,
FG = - Liquid assets + Borrowed funds
Financing reqrt(Borrowed funds) = FG+Liquid A
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4.3 Managing liquidity risk on the BS
(e) Maturity ladder/senario analysis
 Developed by Bank for International
Settlements (BIS)
 Involves comparison of cash inflows and
outflows on a daily, monthly, and semi-
annual basis

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4.4 Managing interest rate risk
Measuring interest rate risk
 central banks often manipulate interest rate
as part of the government‘s monetary policy
measure
 two techniques
(1) Repricing (funding gap) model
(2) Duration gap model

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4.4 Managing interest rate risk
(1) Repricing (funding gap) model
 analysis of the interest income earned on
assets and interest expense paid on liabilities
over a certain period
 Repricing gaps can be computed for Rate
sensitive assets(RSAs) and Rate sensitive
Liabilities (RSLs) over different maturity
periods(maturity bucket)

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4.4 Managing interest rate risk
 A negative Gap (RSA<RSL) means a Bank‘s net
interest income will fall
 NIIi = (GAPi)  Ri= (RSAi-RSLi)  Ri
Where
 NIIi = Change in Net Interest Income in maturity bucket i
GAPi = Size of the Gap (Book Value of RSA- RSL)
in maturity bucket i
 Ri = Change in interest rate affecting assets and liabilities in
the ith maturity bucket

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4.4 Managing interest rate risk
Example: Consider the following list of RSAs and
RSLs of Addis Bank (in millions)
Assets Liabilities Gaps
1. 1 Day Br 15 Br 20 Br – 5
2. More than 1 day -3 months 25 35 - 10
3. More than 3 months-6months 65 80 - 15
4. More than 6 months- 90 70 20
12months
5. More than 1 year-5 years 40 35 5
6. More than 5 years 15 10 5
Br 250 Br 250 0
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4.4 Managing interest rate risk
Example...
Suppose short-term interest rate increases by 1%
affecting assets and liabilities in the first bucket.
 NII= - Br 5mill x 1%
= - Br 50,000
What would be the change in NII if the
change in short-term interest rate affects
RSAs and RSLs that can be reprised within
6months to a year?
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4.4 Managing interest rate risk
(2) Duration model
 duration measures interest sensitivity of
an asset or liability‘s value to small
changes in interest rates
D = - %  security market value/
( R/1+R)

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4.4 Managing interest rate risk
(2) Duration model
Duration of portfolio of assets or liabilities is a
weighted average of the duration of components
of the portfolio
DA= X1A D1A + X2AD2A+......+XnADnA
DL= X1L D1L + X2LD2L+......+XnLDnL

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4.4 Managing interest rate risk
(2) Duration model...
 E = -(DA- kDL) x A x ( R/(1+R))
where
k= L/A –measure of financial leverage
Effect of interest rate on a firm‘s equity has three
components
(i) Leverage adjusted duration gap (DA- kDL). The larger
the gap the more exposed the FI is to interest rate risk
(ii) Size of the FI-measured by its total assets(A)
(iii) Size of interest rate shock =  R/(1+R)
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4.4 Managing interest rate risk
(2) Duration model(Example)
Suppose Financial manager of Addis Bank finds
that duration of assets (DA) is 5 years and
duration of liabilities(DL) is 3 years, and estimates
that interest rate will increase to 11% from its
present level of 10%. The Bank has total assets
of Br 100mill and liabilities of Br 85mill.
What would be loss of value of equity
due to rise in interest rate?
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4.4 Managing interest rate risk
(2) Duration model...
Example...
 E = -(5-(0.85)(3))x Br 100million x (0.01/1.1)
= -Br 2.22 million
-to eliminate loss in value of equity set
DA = kDL

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End of Chapter 4