ACFI330 - Commercial banks risk management

Interest rate risk

The risk incurred by an FI when the maturities of its assets
and liabilities are mismatched and interest rates are volatile.

Liquidity risk

the risk that a sudden and unexpected increase in liability
withdrawals may require an FI to liquidate assets in a very short period of time
and at low prices.

Credit Risk

the risk that promised cash flows from loans and securities held by
FI’s may not be paid in full.

Market Risk

The risk incurred in trading assets and liabilities due to changes in
interest rates, exchange rates, and other asset prices.

Off balance sheet risk

the risk incurred by an FI as the result of its activities
related to contingent assets and liabilities.

Foreign exchange risk

the risk that exchange rate changes can affect the value
of an FI's assets and liabilities denominated in foreign currencies.

Country or Sovereign risk

the risk that repayments by foreign borrowers may
be interrupted because of interference from foreign governments or other
political entities.

Technology Risk

the risk incurred by an FI when its technological investments
do not produce anticipated cost savings.

Operational risk

the risk that existing technology or support systems may
malfunction, that fraud that impacts the FI's activities may occur, and/or that
external shocks such as hurricanes and floods may occur.

Digital disruption and fintech risk

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

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.

Interest rate risk 

Interest rate risk is the type of risk incurred by a Financial
Institution (FI) when the maturities of its assets and liabilities are
mismatched.

Two methods of measuring interest rate risk exposure for Financial institutions

Repricing gap model

Duration model

Repricing gap model

Repricing gap is the difference between the rate sensitive assets (𝑅𝑆𝐴) and the rate sensitive liabilities (𝑅𝑆𝐿) calculated at their book values over a specified tixme horizon ti

Duration Model

Duration is weighted-average time to maturity on an
investment, using the relatives

Repricing funding gap model

• Concentrates on the impact of interest rate changes on
an FI’s net interest income (NII)

• NII is the difference between an FI’s interest income
and interest expense.

• Advantage of the repricing model lies in its
information value and its simplicity in pointing to an
FI’s net interest income exposure (or profit exposure)
to interest rate changes.

• Because of its simplicity, smaller depository
institutions (DIs) (the vast majority of them) still use
this model as their primary measure of interest rate
risk.

Repricing

Repricing can be the result of:
• a rollover of an asset or liability
• e.g., a loan is paid off at or prior to maturity and the funds are
used to issue a new loan at current market rates,
• or it can occur because the asset or liability is a variable-
rate instrument
• e.g., a variable-rate mortgage whose interest rate is reset every
quarter based on movements in a prime rate.

Goal of repricing gap model

Measure the asset-liability gap exposure of an FI

Rate sensitivity

Rate sensitivity means that the asset/ liability will be repriced at
current market interest rates within a certain time horizon.

Maturity Buckets

Commercial banks report quarterly repricing gaps
for assets and liabilities with maturities of:
• One day.
• More than one day to three months.
• More than three months to six months.
• More than six months to twelve months.
• More than one year to five years.
• More than five years.

Repricing Gap:
Example

Refinancing risk

• The risk that the cost of rolling over or re-borrowing funds will rise above the
returns being earned on asset investments.
• Assuming equal changes in interest rates on RSAs and RSLs, interest expense
will increase by more than interest revenue.

Reinvestment Risk

• The risk that the returns on funds to be reinvested will fall below the cost of the
funds.
• By holding shorter-term assets relative to liabilities, the FI faces uncertainty
about the interest rate at which it can reinvest funds borrowed over a longer
period.
• Thus, a drop in rates over this period would lower the FI’s net interest income

Applying the repricing model: Within each maturity bucket

Applying the repricing model:

Rate sensitive assets

Examples from hypothetical balance sheet:
• Short-term consumer loans: Repriced at year-end, would just make one-
year cutoff.
• Three-month T-bills: Repriced on maturity every 3 months.
• Six-month T-notes: Repriced on maturity every 6 months.
• 30-year floating-rate mortgages: Repriced (rate reset) every 9 months.

Summing these four items produces total one-year rate-sensitive assets (RSAs) of $155 million.

• The remaining $115 million of assets are not rate sensitive over the one-year repricing horizon.
• That is, a change in the level of interest rates will not affect the size of the interest income generated by these assets over the next year.
• Although the $115 million in long-term consumer loans, 3-year Treasury
bonds, and 10-year, fixed-rate mortgages generate interest income, the size
of income generated will not change over the next year, since the interest
rates on these assets are not expected to change (i.e., they are fixed over the
next year).

Rate-sensitive liabilities

Liability items that fit the one-year rate or repricing sensitivity test.
• Three-month CDs.
• Three-month bankers acceptances.
• Six-month commercial paper.
• One-year time deposits.
• These mature in less than one year time and are repriced on rollover.
• Summing these four items produces one-year rate-sensitive liabilities (RSLs)
of $140 million.
• The remaining $130 million is not rate sensitive over the one-year period.
• The $20 million in equity capital and $40 million in demand deposits do not pay
interest and are therefore classified as noninterest paying.
• The $30 million in passbook savings and $40 million in two-year time deposits
generate interest expense over the next year, but the level of the interest expense
generated will not change if the general level of interest rates changes.
• Thus, we classify these items as rate-insensitive liabilities.

Gap ratio

• Sometimes it is useful to express interest rate
sensitivity in ratio form as CGAP/Assets, referred
to as “gap ratio.”
• Provides direction and scale of exposure.
• Example:
Gap ratio = CGAP/A = $15 million / $270 million
= 0.056, or 5.6 percent.

Equal changes in rates on RSAs and RSLs

Unequal changes in rates on RSAs and RSLs

• The previous relationship holds when we have equal changes in the rates of
rate-sensitive assets and liabilities.
• What if there’s a spread (difference) between these two?
• In this case, the change in the net interest income is given by the spread
effect

The spread effect

The effect that a change in the spread between rates on RSAs and RSLs has on
Net Interest Income

Weaknesses of the repricing model

1. Ignores market value effects on the assets/ liabilities due to interest
rate changes (i.e. ignores capital losses)

2. Over-aggregative: The distribution of assets & liabilities within
individual buckets is not considered. Mismatches within maturity
buckets can be substantial.

3. Ignores effects of runoffs: Bank continuously originates and retires
consumer and mortgage loans.
• Runoff of rate-insensitive asset/liability is rate-sensitive

4. Ignores off-balance sheet (OBS) cash flows. Off-balance-sheet items
are not included when considering cash flows.
• Hedging effects of off-balance-sheet items not captured.
• Example: Interest rate futures contracts.

Causes of liquidity risk

• Liability-side liquidity risk
When depositors seek to cash in their financial claims immediately
• With low cash holdings, FI may be forced to liquidate assets too
rapidly
• Faster sale may require much lower prices (fire-sale price)
• Asset-side liquidity risk
When a borrower requests its loan commitments
A FI can meet such liquidity need by running down its cash assets,
selling other assets, or borrowing additional funds.

Liquid assets

Liquid assets are those that can be converted to cash quickly if needed to meet financial obligations

To remain viable, a financial institution must have enough liquid assets to meet its near-term obligations, such as withdrawals by depositors

Capital

Capital acts as a financial cushion to absorb unexpected losses and its the difference between all of a firm’s assets and its liabilities

Liability-side liquidity risk for DIs

• In theory at least, a DI that has 20% of its liabilities in demand deposits
must stand ready to pay out that amount by liquidating an equivalent
amount of assets on any banking day.
• In reality, a depository institution knows that normally only a small
proportion of its deposits will be withdrawn on any given day.

Depository institutions need to be able to predict the distribution of net
deposit drains (difference between deposit withdrawals and deposit
additions)

Purchased liquidity management

• A DI manager who purchases liquidity turns to the market for
purchased funds such as the federal funds market and/or the
repurchase agreement markets, which are interbank markets for
short-term loans
• The higher the costs of purchased funds relative to the rates
earned on assets, the less attractive this approach becomes
• This approach allows the DI to maintain its overall balance sheet
size without disturbing the size and composition of the asset side of
its balance sheet

Stored liquidity management

• The FI liquidates some of its assets
• Also the FI should have a minimum reserve requirements for
the cash reserves (established by the Federal Reserve)
• In addition, banks tend to hold excess reserves
• Downsides:
• Opportunity cost of holding excessive cash or other liquid
assets
• Requires holding excess low return or zero return assets
• Decreases size of balance sheet

Asset side liquidity risk

Asset side liquidity risk is the risk that an entity cannot convert assets into cash quickly enough to meet short-term payment obligations without incurring significant losses. This can occur due to the illiquid nature of the assets themselves, a market crisis that reduces the liquidity of many assets, or high withdrawal demands that require quick asset sales. For example, a fund manager might face this risk if many investors try to redeem their shares at once, but the fund's assets are illiquid, forcing the manager to sell them at a lower-than-market price

Liquidity coverage ratio

Maintenance of LCR is intended to ensure that DIs can survive a severe
liquidity stress scenario for at least 30 days

Net stable funding ratio

Ensure that long-term assets are funded with minimum amount of stable
liabilities. It limits reliance on short-term funding which was a major problem
in the financial crisis

consequences of liquidity risk

• Major liquidity problems can arise if deposit drains are
abnormally large and unexpected due to:
• Concerns about a DI’s solvency relative to those of other DIs
• Failure of a related DI leading to depositor concerns about the
solvency of other DIs (the contagion effect)
• Sudden changes in investor preferences
• As a bank run increases in intensity, more depositors join the
withdrawal line, and liquidity crisis develops, which may turn
into a solvency problem

Measures to reduce likelihood of bank runs

• Deposit insurance (FDIC)
• Direct government actions (e.g. TARP in 2008)
• Federal reserve lending to financial institutions