Risk of Financial Institution

8/2/2019 Risk of Financial Institution

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Risk Of Financial

Institution

Firman Pribadi


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Risk Of Financial Institution

A major objective FI management is to increase the FIreturn for its owner but, it is increase the risk of FI

Risk faced by FI: Interest rate risk

Market risk

Credit risk

Off balance sheet risk

Foreign exchange risk

Country of sovereign risk

Technology risk

Operational risk

Liquidity risk

Insolvency risk


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Interest rate risk

Refinancing risk: the risk that the cost of rolling overor reborrowing fund will rise above the return beingearned on asset investment

Liabilities($ 100 million)

Assets$ 100 million

0 1

0 1 2

Short funded: the maturity of FIs liabilities is less than the maturity of its asset borrowing short term (one year) and lending long term (two year)

First year: cost of fund liabilities 9%; return on asset 10%;profit (10% - 9%) x $100 million = $1 million

Second year:Profit for the second year are uncertain, if interest rate liabilities were to rise 11%;Profit (10% - 11%) x $100 million = - $1 million


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Reinvestment risk: the risk that return on

fund to be reinvested will fall below the costof fundHolding short term asset relative to liabilities, FI faces uncertainty about interestrate at which it can reinvest fund in the second period

First year: cost of fund liabilities 9%; return on asset 10%;profit (10% - 9%) x $100 million = $1 million

Liabilities($ 100 million)

Assets

$ 100 million

0 1

10 2

Second Year: cost of fund liabilities 9%; return on asset 8%; profit (8% - 9%) x $100 million = - $ 1 million


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Impact of an interest rate change to marketvalue risk:

Market value (fair value) of an asset and liability isconceptually equal to present value of current andfuture cash flow from that asset or liability

Raising interest rate increase the discount rate on

those cash flow and reduce the market value of thatasset or liability

Falling interest rate increase the market value ofasset and liabilities

Risk of Economic Loss or risk of insolvencyMismatching maturities by holding longer term asset

than liabilities means that when interest rate rise, themarket value of the FI asset falls by a greater than it

liabilities


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Maturity Matching

Interest rate risk

Mismatching maturities asset

and liabilities of FI

Matching maturities asset andliabilities by Hedging


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Market Risk Market risk: the risk incurred in the trading of asset and

liabilities due to changes in interest rate, exchange rate,and other asset prices

Market risk arises when FI actively trade asset andliabilities (and derivative) rather than hold them for longer

term investment, funding, or hedging purposes FIs trading portfolio contains asset, liabilities, and

derivative contract that can be quickly bought or sold onorganized financial market

Securitization have become asset more liquid and

tradable ex. Mortgage FI concern about VaR of their trading account of asset

and liabilities for periods as short as one day DailyEarning at Risk (DEAR), especially if the fluctuation posea threat to their solvency


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Credit Risk

Credit Risk: the risk that the promised cash flowsfrom loan and securities held by FIs may not bepaid in fullarises when the borrower default

FIs that make loans or buy bond with long

maturities are more exposed to credit risk thanare FIs that make loans or buy bonds with shortmaturities

Firm Specific credit risk: the risk of default of theborrowing firm associated with the specific typesof project risk taken by that firm risk specificto holding the bond or loans of general motor


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Systematic credit risk: The risk of defaultassociated with general economy wide ormacro condition affecting all borrowers

Diversification can reduce individual firmspecific credit risk, but is still exposed tosystematic credit risk


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Off Balance Sheet Risk

Off balance sheet risk: the risk incurred by an FIdue to activities related to contingent asset andliabilities

An off balance sheet activity by definition does

not appear on an FIs current balance sheet,because it does not involve holding a currentprimary claim (asset) or current secondary claim(liability) tetapi mempengaruhi masa depan

neraca FI karena penciptaan contingent assetand liabilities ex letter of credit

Letter of Credit: A credit guarantee issued by anFI for a fee on which payment is contingent on

some future event occurring


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Foreign Exchange Risk

Foreign exchange risk: the risk thatexchange rate change can affect the valueof an FIs asset and liabilities denominatedin foreign currency

Ex US FI that hold 100 million in poundloans as asset and fund 80 million withpound certificate of deposit. The difference

between the 100 million in pound loanand 80 million in in pund CDs is fundedby dollar CDs (i.e 20 million worth ofdollar).


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The foreign asset and liability position: Netlong asset position in pound

The US FI suffers losses if exchange rateof pound falls or depreciate against thedollar over this period

Ex 1 = $2 ; 1 = $1

Foreign Asset0 100 million

0 80 millionForeign Liabilities


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The foreign asset and liability position: Net

short asset position in pound

The FI is exposed to foreign exchange riskif the pound appreciate against the dollarover the investment period

Ex 1 = $2; 0.5 = $ 2

Foreign Asset

Foreign Liabilities

0

100 million0

80 million


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Country or Sovereign Risk

Country or sovereign risk: the risk thatrepayment from foreign borrower maybeinterrupted because of interference from

foreign government

foreign currencyshortages and adverse political reasons


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Insolvency Risk

The risk that an FI may not have enoughcapital to offset a sudden decline in thevalue of its asset relative to its liabilities

Technically insolvency occurs when thecapital or equity resources of an FIsowner are driven to, or near to, zerobecause of losses incurred as the result of

one or more of the risk of interest rate,market, credit, off balance sheet,technology, foreign exchange, sovereign,and liquidity.

Documents

Risk of Financial Institution