Risk Management in Financial Institutions

1. Risk Management in Financial Institutions • Managing Credit Risks • Managing Interest Rate Risks • Income Gap Analysis • Duration Gap Analysis • Hedging with Financial Derivatives • Forward • Futures • Options • Swaps

2. Managing Credit Risk • Solving Asymmetric Information Problems • 1. Screening • 2. Monitoring and Enforcement of Restrictive Covenants • 3. Establish Long-Term Customer Relationships • 4. Loan Commitment Arrangements • 5. Collateral and Compensating Balances • 6. Credit Rationing

3. Benefit of Long-Term Relationship • Reducing the cost of information collection -- check firms’ past activities • Reducing monitoring costs • Reducing borrowers’ moral hazard when they want to preserve a long-term relationship

4. Loan Commitments • Banks’ commitment to provide a firm with loans up to a given amount at • fixed interest rate or at a rate that is tied to some market interest rates • Promote long-term relationship • Collateral requirement / Secured Loans • Collateral is a property promised to the lender as compensation if the • borrow defaults • Reducing adverse selection

5. Compensating Balances • A firm receiving a loan must keep a required minimum amount of funds • in a check account at the bank • serving as collateral • monitoring • Credit Rationing • lenders refuse to make loans even though borrows are willing to pay the • stated interest rate or even a higher rate • two types: (1) no loan; (2) loan with restricted size • Deal with Adverse Selection and Moral Hazard

6. Managing Interest Rate Risks Income Gap Analysis Duration Gap Analysis

7. Managing Interest-Rate Risk • First National Bank • Assets Liabilities • --------------------------------------------------------------------------------------------------------------------- • Reserves and cash items $ 5 m | Checkable deposits $ 15 m • | • Securities | Money market deposit accounts $ 5 m • less than 1 year $ 5 m | • 1 to 2 year $ 5 m | Savings deposits $ 15 m • greater than 2 year $ 10 m | • | CDs: Variable-rate $10 m • Residential mortgages | less than 1 year $ 15 m • Variable rate $ 10 m | 1 to 2 year $ 5 m • Fixed rate (30 year) $ 10 m | greater than 2 year $ 5 m • | • Commercial Loans | Fed funds $ 5 m • less than 1 year $ 15 m | • 1 to 2 year $ 10 m | Borrowings: less than 1 year $10 m • greater than 2 year $ 25 m | 1 to 2 year $ 5 m • | greater than 2 year $ 5 m • Physical capital $ 5 m | • | Bank capital $ 5 m

8. Income Gap Analysis • identifying rate sensitive assets and liabilities • finding GAP = RSA – RSL • Income change = GAP * • About reinvestment risk

9. Income Gap Analysis • Rate-Sensitive Assets = $5m + $ 10m + $15m + 20% x $20m • RSA = $32 m • Rate-Sensitive Liabs = $5m + $25m + $5m+ $10m + 10% x $15m • + 20%x$15m • RSL = $49.5 m • i  5%  • ΔAsset Income = • ΔLiability Costs = • ΔIncome = • If RSL > RSA, i , Income • GAP = RSA - RSL • = • ΔIncome = GAP x Δi • =

10. Duration Gap Analysis • Examining the sensitivity of market value of financial • institutions’ net worth to changes in interest rate • %P = -DUR* i/(1+i) • if we know the duration of assets and liabilities, we could • calculate the change in net worth due to interest rate change • duration is additive – using market values as weights • DURgap = DURa - [L/A x DURl] • About interest rate risk

12. Example 3 (page 630) • Interest rate rise from 10% to 15% • Total asset value $100 million • Total liability value $95 million • Durations for each asset and liability as illustrated in Table 1

13. Duration Gap Analysis • %ΔP - DUR x Δi/(1+i) • i 5%, from 10% to 15%  • ΔAsset Value = %ΔP x Assets • ΔLiability Value = %ΔP x Liabilities • ΔNW = • DURgap = DURa - [L/A x DURl] • %ΔNW = - DURgap x Δi/(1+i) • ΔNW =

14. Managing Interest-Rate Risk • Problems with GAP Analysis • 1. Assumes slope of yield curve unchanged and flat • 2. Manager estimates % of fixed rate assets and liabilities that are rate sensitive

15. Managing Interest-Rate Risk • Strategies for Managing Interest-Rate Risk • To completely immunize net worth from interest-rate risk, set DURgap = 0

16. Hedging with Financial Derivatives • Forwards • Futures • Options • Swaps

17. Suppose in Nov 2002, Fleet holds $10 million face value of 10%-coupon rate Treasury bonds selling at par that mature in Nov 2013.

18. How will Fleet hedge its interest rate risks?

19. Forward Contracts • Agreements by two parties to engage in a financial transaction at a future point of time

20. Interest-Rate Forward Markets • Long contract = buy securities at future date • Locks in future interest rate • Short contract = sell securities at future date • Locks in future price, so reduces price risk from change in interest rates • Pros • 1. Flexible • Cons • 1. Lack of liquidity: hard to find counter party • 2. Subject to default risk: Requires info to screen good from bad risk

21. Fleet could short (sell), at today’s price and interest rate, $10 million of the Treasury bond to another party one year later (in Nov 2003) – forward contract The other party could take a short position on US Treasury bonds

22. Financial Futures Markets • Traded on Exchanges: Global competition Regulated by CFTC • Financial Futures Contract • 1. Specifies delivery of type of security at future date • 2. Arbitrage  At expiration date, price of contract = price of the underlying asset delivered • 3. i, long contract has loss, short contract has profit • Differences in Futures from Forwards • 1. Futures more liquid: standardized, can be traded again, delivery of range of securities • 2. Delivery of range prevents corner • 3. Mark to market: avoids default risk • 4. Don't have to deliver: net long and short

23. Alternatively, Fleet could take a short position of $10 million 10% 2003 Treasury bond futures contract

25. Options • Options Contract • Right to buy (call option) or sell (put option) instrument at exercise (strike) price up until expiration date (American) or on expiration date (European) • Hedge Fleet’s Risks with Put Options

27. Payoffs of Call option versus Put Options