Transcript Introduction - Drake University

Finance 286
Financial Risk Management
Drake Fin 286
DRAKE UNIVERSITY
Drake
Syllabus
Drake University
Fin 286
Textbooks
Financial Institutions Management
Prerequisites
Rules of the Game
Office Hours /Contact Information
Grades
Website
Examinations
Academic Misconduct
Assignments
Disabilities
Evaluations
Grades
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Drake University
Fin 286
Individual Assignments 100 points (33.33%)
Due Approximately at the middle and end of
semester.
Short Group Assignments (2 per group)
5 @ 20 points each, total=100 points (33.33%)
Due every Monday starting July 10
Semester Long Group Project (4 per group)
100 points each
Course Description
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Bank Vs. Financial Institutions Management
Financial Services Modernization Act 1999
(Gramm-Leach Bliley Act)
Breaking down the barriers between Banking,
Investment Banking and Insurance.
The Modern Bank
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Services Provided:
Credit (loan) services
Thrift (savings) services
Payment (transaction) services
Investment and financial planning services
Investment Banking (security underwriting)
Brokerage (trading) services
Insurance Services
Other
Course Topics
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Depository Institutions and the Financial System.
Introduction, financial intermediation
Intro to Management
UBPR, Dupont Analysis, Financial Analysis
Measuring Risk in FI’s
GAP analysis (Rate sensitive assets and liabilities)
Market, Liquidity, Credit, Operational and other Risks
Managing Risk
Liability and Liquidity Risk, Capital Adequacy
International Aspects
Foreign Exchange and Sovereign Risk
Geographic Diversification
Background
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Financial Institutions (FI) – Channel funds
from individuals and institutions with a
surplus of funds to (suppliers) to those with a
shortage or funds (users of capital).
Banks
Credit Unions
Insurance Companies
Mutual Funds
Total assets 2000 = $14.75 trillion
Categories of FI’s
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Depository Institutions
Banks, Savings and loans, Thrifts, Credit
Unions
Nondepository Institutions
Insurance Co’s, Investment Banks, securities
firms, mutual funds and finance companies
Similar Risks and Rewards
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All Financial Institutions:
Hold Assets that are subject to default (or
credit) risk
Are exposed to interest rate risk based on
maturity of assets and liabilities
Exposed to liquidity (withdraw) risks
Face operational costs and risks
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Without FIs
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Equity & Debt
Households
Corporations
(net savers)
(net borrowers))
Cash
©2003 McGraw-Hill Companies Inc. All rights reserved
Problems w/o FI’s
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Monitoring is costly
Exposes households to increased risk
Lack of Liquidity
Households may not be able to easily convert
claims to cash
Price Risks
Prices fluctuate
With FIs as Intermediaries
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FI
Households
Cash
(Brokers)
FI
Corporations
Equity & Debt
(Asset
Transformers)
Deposits/Insurance
Policies
Cash
©2003 McGraw-Hill Companies Inc. All rights reserved
Special Roles played by FI’s
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Economy - Wide Services
Information, Liquidity, Price risk reduction,
Transaction cost and Maturity intermediation
services
Institution Specific Services
Monetary policy transmission (depository
Institutions), Credit allocation (thrifts, farm
banks), Intergenerational Transfers (Insurance
and pensions, payments services (depository
institutions) and Denomination intermediation
Special Roles played by FI’s
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Brokerage Function
Research and information provider (reduces
information costs such as agency costs)
Economies of Scale (decreases transaction costs
and information costs)
Asset – Transformation Function
Purchase primary claims and issue secondary
claims (reducing contracting costs)
Allows for risk sharing via diversification (reduces
price and liquidity risk)
Special Roles played by FI’s
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Transmission of Monetary Policy
The liquid nature of depository institutions
make them the main way monetary policy is
transmitted to the public
Credit Allocation
Primary suppliers of capital to special sectors
of the economy (Residential lending for
example)
Intergenerational Transfer of Wealth
Insurance and pension funds
Other Functions
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Maturity Intermediation
Provides households with desirable maturities
Intermediaries are willing to accept longer term
risks and finance them with short term deposits.
Denomination Intermediation
Commercial paper is issued in $250,000 units,
too large for most households
Payment Mechanism
Facilitate the payment of claims w/o cash.
The Impact of FI’s on
Economic Growth
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Traditional Economic Theories of Growth
Labor Usage and Capital Accumulation
Limited explanation due to decreasing
marginal returns to capital, sustained growth
requires productivity growth
New Growth Theory
Technological change increases productivity
that offsets diminishing marginal returns
Termed “Endogenous Growth”
The Impact of FI’s on
Economic Growth
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Financial Development’s Impact
Promotes Capital Accumulation & Productivity Growth
Rajan and Zingales (1998)
Young firms in higher productivity sectors depend upon
external financing and benefit from low cost financing
associated with financial development
Galindo, Schiantarelli, and Weiss (2002)
Financial liberalization in developing economies improves
capital allocation
Both Studies stress the importance of the quality of
regulation, supervision and enforcement.
Regulation
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Given their vital role in the economy FI’s are
highly regulated. The goal of this regulation is
to protect against a disruption in the services
they offer (provide confidence in the system).
Some segments of the population could be
discriminated against without regulation (race,
gender etc)
The difference the private benefits and private
costs of regulation are the net regulatory
burden.
Safety and Soundness
Regulation
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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
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Since Financial Intermediaries serve as a
conduit for monetary policy they merit special
regulation.
Reserve requirements, for example.
Might make control of monetary policy more
predictable.
Credit Allocation Regulation
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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
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Home Mortgage Disclosure Act
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
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Protection of investors that use investment
banks directly. Insider trading restrictions,
lack of disclosure and breach of fiduciary
responsibility are examples.
Entry Regulation
Barriers to entry can promote safety and
soundness.
Also impose costs on current market
participants.
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Trends in the US
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% Share of Total Assets for US Financial Institutions
Commercail Banks
Thrift Institutions
Insurance Companies
investment co's
Pension Funds
Finance Co's
Securities Brokers
Mortgage Co's
Real Estate Ivest. Trusts
Total
Total Trillion dollars
1860
1880
1900
1922
1939
71.4%
17.8%
10.7%
60.6%
22.8%
13.9%
62.9%
18.2%
13.8%
0.0%
0.0%
2.7%
0.0%
0.0%
3.8%
1.3%
63.3%
13.9%
16.7%
0.0%
0.0%
0.0%
5.3%
0.8%
51.2%
13.6%
27.2%
1.9%
2.1%
2.0%
1.5%
0.3%
0.0%
0.0%
99.9%
0.00
100.0% 100.0% 100.0% 99.8%
0.01
0.02
0.08
0.13
1960
1980
38.2% 34.8%
19.7% 21.4%
23.8% 16.1%
2.9%
3.6%
9.7%
17.4%
4.6%
5.1%
1.1%
1.1%
0.0%
0.4%
0.0%
0.1%
100.0% 100.0%
0.60
4.03
2000
35.6%
10.0%
16.8%
17.0%
10.7%
7.9%
1.5%
0.3%
0.2%
100.0%
14.75
Risks of Financial
Intermediation
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Common Risks
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All Financial Intermediaries face similar risks
from their operations.
The importance of each type of risk depends
upon the intermediary and business lines
We will spend today introducing the types of
risk present. The remainder of the semester
is spent detailing each type of risk and
discussing management techniques used by
firms to limit the impact of each risk.
Margin Income
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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.
Interest Rate Risk
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The Interest rates on both Assets and
Liabilities are tied to the length of the
commitments.
Interest rate risk results from a mismatch in
maturities of assets and liabilities.
Balance sheet hedge via matching maturities
of assets and liabilities is problematic for FIs.
Refinancing risk.
Reinvestment risk.
Interest Rate Risk:
Refinancing Risk
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Assume you have $100 million in liabilities
financed at 9% per year and the rate that
you pay resets at the end of the year. Your
FI also has $100 million in assets that mature
in 2 years paying 10% per year.
What happens if the interest rate increases?
The cost of refinancing your liabilities
increases, but your income from assets stays
the same.
Interest Rate Risk:
Reinvestment Rate Risk
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Assume you have $100 million in liabilities
financed at 9% per year that mature in 2
years. Your FI also has $100 million in assets
that mature in 1 years financed at a cost of
10% per year.
What happens if the interest rate decreases?
The cost of your liabilities stays fixed but in
year two your income from assets decreases.
Matching Maturities
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It is difficult for the FI to match maturities
and it may not eliminate interest rate risk
anyway:
Not consistent with asset transformation plan
Matching maturities may reduce profitability
(one of the functions of intermediation is
accepting some of this risk.
Assets are financed with both debt and
equity
Duration and Portfolios
Interest Rate Risk:
Market Value Risk
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Market value is tied to the level of interest
rates.
As rates increase market value decreases, as
rates decrease market value increases
The impact of rate changes is tied to maturity
Market Risk
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The combination of interest rate, foreign
exchange, and equity return risks are
combined with an active trading strategy.
Greater reliance on trading income rather
than traditional activities has increased
market exposure for FI’s.
Anytime an FI takes an unhedged speculative
position it is exposed to market risk
Credit Risk
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Risk that promised cash flows are not paid in
full.
Firm specific credit risk
Systematic credit risk
High rate of charge-offs of credit card debt in
the 80s and 90s
Obvious need for credit screening and
monitoring
Diversification of credit risk
Off-Balance-Sheet Risk
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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
Technology and Operational Risk
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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
Technological innovation has seen rapid
growth
Automated clearing houses
CHIPS
Technology and Operational Risk
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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
Economies of
Scale and Scope
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Economies of Scale: Goal of the FI is to lower
its average cost per unit via new technology
or operations
Economies of Scope: The generation of cost
synergies by offering more services using the
same inputs
Foreign Exchange Risk
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Foreign Assets and Foreign Liabilities change
in value with changes in exchange rates.
Net Long Asset Position – Exposure to foreign
denominated assets is greater than foreign
liabilities
Net Short Asset Position – Exposure to foreign
denominated assets is less than exposure to
foreign liabilities
Foreign Exchange Risk
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Returns on foreign and domestic investment
are not perfectly correlated.
FX rates may not be correlated.
Example: $/DM may be increasing while $/¥
decreasing.
Foreign Exchange Risk
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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
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Result of exposure to foreign government
which may impose restrictions on repayments
to foreigners.
Lack usual recourse via court system.
Liquidity Risk
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Risk of being forced to borrow, or sell assets
in a very short period of time.
Low prices result.
May generate runs.
Runs may turn liquidity problem into solvency
problem.
Risk of systematic bank panics.
Insolvency Risk
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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.
Risks of Financial Intermediation
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Other Risks and Interaction of Risks
Interdependencies among risks.
Example: Interest rates and credit risk.
Discrete Risks
Example: Tax Reform Act of 1986.
Other examples include effects of war, market
crashes, theft, malfeasance.
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Macroeconomic Risks
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Increased inflation or increase in its volatility.
Affects interest rates as well.
Increases in unemployment
Affects credit risk as one example.
Changes in Consumer Confidence
Changes in home building
Risk Management Techniques
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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
Business Lines vs. Total Operations
Risk Measurement Tools
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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
Consolidated
Risk Management
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“A coordinated process of measuring and
managing risk on firm wide basis.”*
Requires a system that includes identification
of risks, measurement of risk, methods for
controlling the level of risk accepted, checks
and balances, review and oversight at all
levels of management (including the board of
directors)
*Cumming and Hirtle, The Challenges
of Risk Management in DIversified
Financial Compaies.
Benefits of Consolidating
Risk Management
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Diversification benefits are ignored without
consolidation, leading to increased risk management
costs
Lack of coordination can increase firm wide risk in
times of market problems (unwinding similar position
in different business lines for example).
Without consolidation contagion risks are ignored
Improves the “internal capital market” of the firm.
Promote more transparency and better risk analysis
by creditors.
Barriers to Consolidated
Risk Management
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Consolidation of financial firms has produced
increased product and geographic
diversification which has made business wide
risk management more difficult.
Information Costs
The cost of integrating, recording and
analyzing risk across separate business lines.
Barriers to Consolidated
Risk Management
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Regulatory Costs
Consolidation has created a framework where
firms are required to respond to multiple
regulators.
Capital and Liquidity requirements may
prohibit the movement of funds from one
business line to another.
Cost associated with managing the separate
regulatory requirements including opportunity
costs