- 1. Part Seven The Managementof Financial Institutions
2. Chapter 24 Risk Managementin Financial Institutions 3.
Chapter Preview
- Managing financial institutions has never been an easy
task.But, uncertainty in the economic environment has increased,
making the job of the financial institution manager that much
harder.
4. Chapter Preview
- In this chapter, we examine how financial institutions manage
credit risk, default risk, etc.We explore the tools available to
managers to measure these risks and strategies to reduce
them.Topics include:
-
- Managing Interest-Rate Risk
5. Managing Credit Risk
- A major part of the business of financial institutions is
making loans, and the major risk with loans is that the borrow
willnot repay.
- Credit riskis the risk that a borrowerwill not repay a loan
according to the terms of the loan, either defaulting entirely or
making late payments of interestor principal.
6. Managing Credit Risk
- Once again, the concepts ofadverse selectionandmoral hazardwill
provide our framework to understand the principles financial
managers must follow to minimize credit risk, yet make successful
loans.
7. Managing Credit Risk
- Adverse selection is a problem in the market for loans because
those with the highest credit risk have the biggest incentives to
borrow from others.
- Moral hazard plays as role as well.Once a borrower has a loan,
she has an incentive to engage in risky projects to produce the
highest payoffs, especially if the project is financed mostly with
debt.
8. Managing Credit Risk
- Solving Asymmetric Information Problems: financial managers
have a number oftools available to assist in reducing or
eliminating the asymmetric information problem:
-
- Screening and Monitoring: collecting reliable information about
prospective borrowers.This has also lead some institutions to
specialize in regions or industries, gaining expertise in
evaluating particular firms or individuals.
9. Managing Credit Risk
-
- Screening and Monitoring: also involves requiring certain
actions, or prohibiting others, and then periodically verifying
that the borrower is complying with the terms of the loan
contact.
10. Managing Credit Risk
- Specialization in Lendinghelps in screening.It is easier to
collect data on local firms and firms in specific industries.It
allows them to better predict problems by having better industry
and location knowledge.
11. Managing Credit Risk
- Monitoring and Enforcementalso helps.Financial institutions
write protective covenants into loans contracts and actively manage
them to ensure that borrowers are not taking risks at their
expense.
12. Managing Credit Risk
-
- Long-term Customer Relationships: past information contained in
checking accounts, savings accounts, and previous loans provides
valuable information to more easily determine credit
worthiness.
13. Managing Credit Risk
-
- Loan Commitments: arrangements where the bank agrees to provide
a loan up to a fixed amount, whenever the firm requests the
loan.
-
- Collateral: a pledge of property or other assets that must be
surrendered if the terms of the loan are not met ( the loans are
calledsecured loans ).
14. Managing Credit Risk
-
- Compensating Balances: reserves that a borrower must maintain
in an account that act as collateral should the borrower
default.
-
- Credit Rationing: (1) lenders will refuse to lend to some
borrowers, regardless of how much interest they are willing to pay,
or (2) lenders will only finance part of a project, requiring that
the remaining part come from equity financing.
15. Managing Interest-Rate Risk
- Financial institutions, banks in particular, specialize in
earning a higher rate of return on their assets relative to the
interest paid on their liabilities.
- As interest rate volatility increased in the last 20 years,
interest-rate risk exposure has become a concern for financial
institutions.
16. Managing Interest-Rate Risk
- To see how financial institutions can measure and manage
interest-rate risk exposure, we will examine the balance sheet for
First National Bank (next slide).
- We will develop two tools, (1) Income Gap Analysis and (2)
Duration Gap Analysis, to assist the financial manager in this
effort.
17. Managing Interest-Rate Risk Risk Management Association home
page http://www.rmahq.org 18. Income Gap Analysis
- Income Gap Analysis: measures the sensitivity of a banks
current year net income to changes in interest rate.
- Requires determining which assets and liabilities will have
their interest rate change as market interest rates change.Lets see
how that works for First National Bank.
19. Income Gap Analysis: Determining Rate Sensitive Items for
First National Bank
-
- assets with maturity less than one year
-
- short-term commercial loans
-
- portion of fixed-rate mortgages (say 20%)
-
- portion of checkable deposits (10%)
20. Income Gap Analysis: Determining Rate Sensitive Items for
First National Bank
- Rate-Sensitive Assets= $5m + $ 10m + $15m +20%$20m
- Rate-Sensitive Liabs= $5m + $25m + $5m+ $10m+ 10%$15m
- Asset Income= +5% $32.0m =+$ 1.6m
- Liability Costs = +5% $49.5m =+$ 2.5m
- Income =$1.6m $ 2.5 = $0.9m
21. Income Gap Analysis
- IfRSL >RSA ,i results in:NIM ,Income
- This is essentially a short-term focus on interest-rate risk
exposure.A longer-term focus usesduration gap analysis .
22. Duration Gap Analysis
- Owners and managers do care about the impact of interest rate
exposure on current net income.They are also interested in the
impact of interest rate changes on the market value of balance
sheet items and the impact on net worth.
- The concept of duration, which first appeared in chapter 3,
plays a role here.
23. Duration Gap Analysis
- Duration Gap Analysis: measures the sensitivity of a banks
current year net income to changes in interest rate.
- Requires determining the duration for assets and liabilities,
items whose market value will change as interest rates change.Lets
see how this looks for FirstNational Bank.
24. Duration of First National Bank'sAssets and Liabilities 25.
Duration Gap Analysis
- The basic equation for determining the change in market value
for assets or liabilities is:
- % Change in Value = DUR x [ i/ (1 +i )]
- Change in Value = DUR x [ i/ (1 +i )] x Original Value
26. Duration Gap Analysis
- Consider a change in rates from 10% to 15%.Using the value from
Table 1, we see:
- Asset Value = 2.7.05/(1 + .10)$100m
27. Duration Gap Analysis
- Liability Value= 1.03.05/(1 + .10)$95m
- NW = $12.3m( $4.5m) = $7.8m
28. Duration Gap Analysis
- For a rate change from 10% to 15%, the net worth of First
National Bank will fall, changing by $7.8m.
- Recall from the balance sheet that First National Bank has Bank
capital totaling $5m.Following such a dramatic change in rate, the
capital would fall to $2.8m.
29. Duration Gap Analysis
- For First National Bank, with a rate change from 10% to 15%,
these equations are:
- DUR gap =DUR a [ L / A DUR l ]
- % NW = DUR gap i /(1 +i )
30. Duration Gap Analysis
- Another version of this analysis, which combines the steps into
two equations, is:
- DUR gap =DUR a [ L / A DUR l ]
- % NW = DUR gap i /(1 +i )
31. Duration Gap Analysis
- So far, we have focused on how to apply income gap analysis and
duration gap analysis in a banking environment.
- The same analysis can be applied to other financial
institutions.For example, lets look at a simple finance company
which makes consumer loans.The balance sheet and duration worksheet
for Friendly Finance Co. follows.
32. Duration Gap Analysis 33. 34. Income Gap Analysis:
Determining Rate Sensitive Items for Friendly Finance Co.
-
- securities with a maturity less than one year
-
- consumer loans with a maturity less than one year
-
- bank loans with a maturity less than one year
35. Income Gap Analysis
- GAP=RSA RSL= $55 m$43 m = $12 million
- Income=GAP i= $12 m5% = $0.6 million
36. Duration Gap Analysis
- DUR gap = DUR a [ L / A DUR l ]
37. Managing Interest-Rate Risk
- Problems with GAP Analysis
-
- Assumes slope of yield curve unchangedand flat
-
- Manager estimates % of fixed rate assets and liabilities that
are rate sensitive
38. Managing Interest-Rate Risk
- Strategies for Managing Interest-Rate Risk
-
- In example above, shorten duration of bank assets or lengthen
duration of bank liabilities
-
- To completely immunize net worth from interest-rate risk,
setDUR gap= 0
-
- ReduceDUR a= 0.98 DUR gap= 0.98[(95/100)1.03] = 0
-
- RaiseDUR l= 2.80 DUR gap= 2.7[(95/100)2.80] = 0
39. Chapter Summary
- Managing Credit Risk: basic techniques for managing
relationships and rationing credit were reviewed.
- Managing Interest-Rate Risk: the essential techniques of
measuring interest-rate risk for both income and capital
affectswere presented.