Managing Financial Institutions I. Performance and Risk in Financial Institutions

1. Managing Financial Institutions • I. Performance and Risk in Financial Institutions • Financial institutions attempt to obtain adequate returns on equity capital. This requires managing both return and risk. • Return • Spread • Default Rates • Cost of Operations => Return on Assets (ROA) • Return on Equity (ROE) • Risk • Credit Risk • Interest Rate Risk • Foreign Exchange Risk • Liquidity Risk • Operating Risk

2. II. Managing Credit Risk • The two types of credit risk are default and price risk. • The key tools of risk reduction are quality standards and diversification. • Market prices of bonds may decrease because of changes in: investor perceptions, supply and demand factors, regulatory policy, etc. • Insert 25.1, 25.2, & 25.3 • These are referred to as systematic credit risk. The risk associated with a specific offering is known as specific credit risk. • Systematic credit risk can be lessened by broad diversification across sectors as well as across firms and ratings. • An institution may reduce credit risk through strong reserves and sufficient equity capital. • Another method is to restrict investment to primarily high grade assets only.

3. Alternatively, a firm may seek to transfer risk to the liability side, where the investor bears the risk. • III. Managing Interest Rate Risk • Asset/liability management (ALM) deals with managing interest rate risk. • A change in interest rates may cause the value of liabilities to change at a different rate than the value of assets. • By matching the dollar duration of the assets and liabilities we can immunize equity against changing interest rates. • The change in the value of equity due to changes in interest rates is calculated:

4. Small asset/liability duration mismatches can result in large rate sensitivity of the equity, because equity is small relative to assets. • The sensitivity of equity to interest rate movement is given by: • Effective immunization takes into account the convexities of assets and liabilities. Ideally, the convexity of assets should be greater than that of liabilities. • Insert 25.4 & 25.5 • The passage of time will result in changes in dollar durations and convexities. Periodic rebalancing of portfolios must occur.

5. IV. Managing Liquidity Risk • Liquidity risk is the sudden need for funds that will put a strain on the institution’s ability to finance itself. • The first type of risk is associated with the need for cash in normal daily operations. • The second type of risk relates to the real or perceived integrity of the asset portfolio. Rumors of declining quality of assets can lead to rapid withdrawals by creditors. • Asset portfolios can be constructed with a portion invested in lower yielding, higher liquidity assets. • These may be divided into primary and secondary reserves which are distinguished by the degree of liquidity.

6. V. Managing Foreign Exchange Rate Risk • Risk arises when an institution has assets and revenues in one currency(ies) and liabilities and costs in another currency(ies). • A change in the value of one currency will cause a value change. • This risk can be eliminated by denominating all categories in the same currency. • Alternatively, the firm can undertake actions (i.e. currency swaps and/or forward rate agreements) that reduce exposure to foreign exchange rate risk. • Insert 25.6 • Sometimes, exposures in many different currencies can lead to a reduction in risk. This is due to the covariance which we have discussed earlier.

7. VI. Measuring Potential Loss • How much could the firm lose as a result of risk exposure? • The concept of value-at-risk (VaR) • Insert 25.7 • VII. Passing the Risks Through to Investors • Risk transfer mechanisms come in two forms. • Some assets, created by an institution, are packaged and sold to investors willing to take the risk. Mortgage-backed securities are an example of this type. • Another method is to manage the correlation of returns. An example of this is a mutual fund.

8. VIII. Differences Between Financial Institutions Some institutions are more prone to certain risks than others. • A. Open-End and Closed-End Mutual Funds • Open-end mutual funds pass all risks through to the investor. • The fund retains some of its funds in short- term, highly liquid securities to meet cash needs associated with withdrawals. • A closed-end fund does not have as great a need for liquidity. Investors merely trade shares which does not entail any liquidation of the portfolio. • B. Pension Plans • A defined benefit plan must take into account the long duration of its liabilities. • Because of the long-term nature of its liabilities, pension plans face little convexity risk and very little liquidity risk. • Defined contribution plans pass most duration risk, convexity risk, and default risk onto the customer.

9. C. Insurance Companies • Life insurance policies often grant the holder numerous options, such as loan privileges. These options impart a positive convexity to the liabilities. • At the same time, firms invest in assets that have options embedded. The assets therefore have negative convexity. • This combination of assets and liabilities creates a short straddle. If interest rates remain unchanged the firm reaps high profits. If interest rates move, then the surplus is depleted. • Insert 25.8 & 25.9 • Insurance companies generally have low credit risk because they invest in high grade securities. • The lack of federal insolvency guarantees leads investors to worry about the quality of investment portfolios. The possibility of a run compels insurers to hold some liquidity in their portfolios.

10. D. Commercial Banks • Loan origination and collection have traditionally been sources of credit risk. • The possibility of runs has prompted use of primary and secondary reserves, supplemented by deposit insurance and the discount window. • The interest rate structure of assets and liabilities is reported in the GAP report. The dollar amount of the mismatch is called the GAP. • The banking industry has tended to use GAP analysis instead of duration analysis in the past, but the trend is toward duration analysis. • As the focus on market values increases, duration analysis will become more widespread, and derivatives used. • Insert 25.10 & 25.11 • Commercial banks also have foreign exchange risk. • They manage this through net currency exposure reports and position limits.

11. E. Thrifts, Credit Unions, and Finance Companies • Other depository institutions’ product lines are becoming similar to commercial banks’. They are therefore subject to the same risks with some exceptions. • Finance companies have substantial exposure to credit risk. • Savings banks and S&Ls often have severe duration mismatches and liquidity risks. The latter are somewhat alleviated by FDIC insurance. • The risks of credit unions tend to be minor. Regulatory oversight is attempting to improve the skills of management staff.

12. IX. Summary • We have focused on four major types of financial risk and the management techniques employed to deal with these risks. • Increased competition has meant that financial risks must be better managed in order to survive. Survival is, in fact, dependent upon improved risk management.