Risks of Financial Institutions

Interest Rate Risk

results from a mismatch in asset and liability maturities:

• Spread changes as interest rates change.

• Since value = PV(Cash flows), equity affected

Credit Risk

• Risk that promised cash flows will not be paid in full.

• High rate of charge-offs of debt in the 1980s, most of the 1990s, and 2000s.

• Charge-offs continued to grow until late 2008.

Implications of growing credit risk

• Importance of credit screening and monitoring.

• Diversification of credit risk.

• Loan sales, reschedulings, good bank-bad bank structure.

• Credit derivatives.

Liquidity risk 

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. May generate runs.

Foreign Exchange Risk

FI may be net long or net short in various currencies. Returns on foreign and domestic investments are not perfectly correlated.

• Technological and economical differences.

• FX rates are not perfectly correlated across countries.

• $/€ may be appreciating while $/¥ falling.

Country or Sovereign Risk

Risk that foreign borrowers may be unable to repay due to interference from foreign governments.

• Type of credit risk.

Often lack usual recourse via court system.

Market Risk

Risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices.

• Short trading horizons. Financial crisis of 2008 to 2009.

• FIs were major purchasers of mortgages. • Rising interest rates in mid-2000s led to significant increases in mortgage defaults.

• “Toxic” assets at deeply reduced values.

Off Balance Sheet Risk

Striking growth of off-balance-sheet activities for many FIs.

• Letter of credit.

• Loan commitments.

• Derivative securities.

Contingent assets and liabilities.

Direct impact on future profitability and performance of FI.

Technology and Operational Risk

Economies of scale.

Economies of scope.

Technology risk includes risk of not embracing new technology. Operational risk not exclusively the result of technological failure.

• Employee fraud and errors.

Digital Disruption and Fintech

Technology-enabled innovation in financial services that could result in new business models, applications, processes or products with an associated material effect on the provision of financial services.

• Involves the risk that fintech firms could disrupt business of financial services firms in the form of lost customers and revenue.

• Broader than technology risk.

• For example, Stripe, Klarna, cryptocurrency.

Insolvency Risk

• Risk of insufficient capital to offset sudden decline in value of assets relative to liabilities.

• Original cause may be excessive interest rate, market, credit, off-balance-sheet, technology, FX, sovereign, and liquidity risks.

• Washington Mutual.

• “Too big to fail” (for example, Citigroup)