IFM - Chapter 23 - Risk management in Financial institutions

What is credit risk in banking?

The risk that a borrower will not repay a loan on time or at all.

• Includes defaults and late payments

• Related to adverse selection and moral hazard

What is the purpose of screening and monitoring?

To collect reliable information about borrowers:

• Institutions may specialize in regions or industries

• Require/prohibit actions and verify compliance

How does specialization in lending reduce credit risk?

• Easier to collect data on specific industries

• Improves prediction of borrower problems

• Allows better monitoring and enforcement of protective covenants

What is the role of long-term customer relationships in managing credit risk?

• Past data from accounts and loans help assess creditworthiness

• Facilitates easier and more accurate risk evaluation

What are loan commitments?

Agreements where the bank promises to lend up to a fixed amount whenever requested by the borrower.

What is collateral?

property/assets pledged as security. If the borrower defaults, the lender can seize the collateral (→ secured loans).

What are compensating balances?

Reserves held in an account by the borrower that serve as collateral in case of default.

What is credit rationing?

1. Lenders refuse to lend regardless of interest offered

2. Lenders finance only part of a project; the rest must be equity-financed

Why is interest-rate risk a concern for banks?

• Banks aim to earn more on assets than they pay on liabilities

• Volatile rates create interest-rate risk exposure

What is income gap analysis?

• Measures how sensitive net income is to interest rate changes

• Identifies which assets/liabilities are rate-sensitive

What are rate-sensitive assets (RSA)?

Examples:

• Short-term securities

• Variable-rate mortgages

• Short-term commercial loans

• Early repayments on fixed-rate mortgages
  

: What are rate-sensitive liabilities (RSL)?

• Money market deposits

• Variable CDs

• Short-term CDs

• Federal funds

• Short-term borrowings

What is duration gap analysis?

A measurement of the difference in the sensitivity of the duration of assets and liabilities to interest rate changes, assessing the potential impact on market value and income.