part 7 the management of financial institutions. chapter 23 risk management in financial...

Part 7

The Management of FinancialInstitutions

Chapter 23

Risk Managementin Financial Institutions

Copyright ©2015 Pearson Education, Inc. All rights reserved. 23-3

Chapter Preview

• Managing financial institutions is not easy. Uncertainty in the economic environment has increased, making the job of the financial institution manager that much harder. In this chapter, we examine how financial institutions manage credit risk, default risk, etc.


Chapter Preview

• Topics include: ─Managing Credit Risk─Managing Interest-Rate Risk


Managing Credit Risk

• The business of financial institutions is making loans.

• The risk with loans is the borrower will not repay.

• Credit risk is the risk that a borrower will not repay a loan according to the terms of the loan, either defaulting entirely or making late payments of interest or principal.



Once again, the concepts of adverse selection and moral hazard will provide our framework to understand the principles financial managers must follow.



• Adverse selection: Those with the highest credit risk have the biggest incentives to borrow from others.

• Moral hazard: Once a borrower has a loan, she has an incentive to engage in risky projects to produce the highest payoffs.



• Solving Asymmetric Information Problems: financial managers have a number of tools available to assist in reducing or eliminating the asymmetric information problem


Managing Risk

1. Screening and Monitoring Collecting reliable information about prospective borrowers.

This has also lead some institutions to specialize in regions or industries, gaining expertise in evaluating particular firms or individuals.


Managing Risk

2. Screening and Monitoring─ Also involves requiring certain actions, or

prohibiting others, and then periodically verifying that the borrower is complying with the terms of the loan contact.



• Specialization in Lending helps in screening. It is easier to collect data on local firms and firms in specific industries. It allows them to better predict problems by having better industry and location knowledge.



• Monitoring and Enforcement also helps. Financial institutions write protective covenants into loans contracts and actively manage them to ensure that borrowers are not taking risks at their expense.



Long-term Customer Relationships: past information contained in checking accounts, savings accounts, and previous loans provides valuable information to more easily determine credit worthiness.



3. Loan Commitments: arrangements where the bank agrees to provide a loan up to a fixed amount, whenever the firm requests the loan.

4. Collateral: a pledge of property or other assets that must be surrendered if the terms of the loan are not met ( the loans are called secured loans).



5. Compensating Balances: reserves that a borrower must maintain in an account that act as collateral should the borrower default.

6. Credit Rationing: (1) lenders will refuse to lend to some borrowers, regardless of how much interest they are willing to pay, or (2) lenders will only finance part of a project, requiring that the remaining part come from equity financing.


Managing Interest-Rate Risk

• Financial institutions, banks in particular, specialize in earning a higher rate of return on their assets relative to the interest paid on their liabilities.

• As interest rate volatility increased in the last 20 years, interest-rate risk exposure has become a concern for financial institutions.



• To see how financial institutions can measure and manage interest-rate risk exposure, we will examine the balance sheet for First National Bank (next slide).

• We will develop two tools, (1) Income Gap Analysis and (2) Duration Gap Analysis, to assist the financial manager in this effort.


Income Gap Analysis

• Income Gap Analysis: measures the sensitivity of a bank’s current year net income to changes in interest rate.

• Requires determining which assets and liabilities will have their interest rate change as market interest rates change. Let’s see how that works for First National Bank.


Income Gap Analysis: Determining Rate Sensitive Items for First National Bank


Income Gap Analysis: Determining Rate Sensitive Items for First National Bank

Rate-Sensitive Assets $5m $ 10m $15m 20% $20m RSA $32mRate-Sensitive Liabs $5m $25m $5m $10m 10% $15m 20% $15m RSL $49.5m if i 5% Asset Income 5% $32.0m $ 1.6mLiability Costs 5% $49.5m $ 2.5mIncome $1.6m $ 2.5 $ 0.9m


Income Gap Analysis

If RSL RSA, i results in: NIM , Income GAP RSA RSL

$32.0m $49.5m $17.5mIncome GAP i

$17.5m 5% $0.9mThis is essentially a short-term focus on interest-rate risk exposure. A longer-term focus uses duration gap analysis.


Duration Gap Analysis

• Owners and managers care about: interest rate exposure on income, and the impact of interest rate changes on the balance sheet / net worth.

• The concept of duration, which first appeared in chapter 3, plays a role here.



• Duration Gap Analysis: measures the sensitivity of a bank’s current year net income to changes in interest rate.

• Requires determining the duration for assets and liabilities, items whose market value will change as interest rates change. Let’s see how this looks for First National Bank.


Duration of First National Bank’s Assets and Liabilities (a)

Table 23.1 Duration of the First National Bank’s Assets and Liabilities


Duration of First National Bank’s Assets and Liabilities (b)

Table 23.1 Duration of the First National Bank’s Assets and Liabilities



• The basic equation for determining the change in market value for assets or liabilities is:

or



• Consider a change in rates from 10% to 11%. Using the value from Table 23.1, we see:

• Assets:



• Liabilities:

• Net Worth:



• For a rate change from 10% to 11%, the net worth of First National Bank will fall, changing by $1.6m.

• Recall from the balance sheet that First National Bank has “Bank capital” totaling $5m. Following such a dramatic change in rate, the capital would fall to $3.4m.



• For First National Bank, with a rate change from 10% to 11%, these equations are:



• Another version of this analysis, which combines the steps into two equations, is:



• The same analysis can be applied to other financial institutions. For example, let’s look at a simple finance company which makes consumer loans. The balance sheet and duration worksheet for Friendly Finance Co. follows.


Table 23.2 Duration of the Friendly Finance Company’s Assets and Liabilities


Income Gap Analysis: Determining Rate Sensitive Items for Friendly Finance Co.


Income Gap Analysis

• If i 1%



• If i 5%



• Problems with GAP Analysis─ Assumes slope of yield curve unchanged

and flat─Manager estimates % of fixed rate assets and

liabilities that are rate sensitive



• Strategies for Managing Interest-Rate Risk─ In example above, shorten duration of bank

assets or lengthen duration of bank liabilities─ To completely immunize net worth from interest-

rate risk, set DURgap = 0


Chapter Summary

• Managing Credit Risk: basic techniques for managing relationships and rationing credit were reviewed.

• Managing Interest-Rate Risk: the essential techniques of measuring interest-rate risk for both income and capital affects were presented.

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