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MGT411 - Money & Banking - Lecture Handout 26

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INTEREST RATE RISK

  • Bank Risk
  • Interest Rate Risk (Cont.)
  • Trading Risk
  • Other Risks
  • Globalization of Banking
  • The Future of Banks
  • Non-depository Institutions
  • Insurance Companies
  • Securities Firms
  • Finance Companies
  • Government Sponsored Enterprises

Interest-Rate Risk

  • Gap analysis highlights the gap or difference between the yield on interest sensitive assets and the yield on interest-sensitive liabilities
  • Multiplying the gap by the projected change in the interest rate yields the change in the bank’s profit
  • Gap analysis can be further refined to take account of differences in the maturity of assets and liabilities
  • Banks can manage interest-rate risk by matching the interest-rate sensitivity of assets with the interest-rate sensitivity of liabilities,
  • Purchase short term securities to match variable rate deposits
  • Make long term loans at floating rates
  • But this approach increases credit risk

Trading Risk

  • Banks today hire traders to actively buy and sell securities, loans, and derivatives using a portion of the bank’s capital in the hope of making additional profits
  • However, trading such instruments is risky (the price may go down instead of up); this is called trading risk or market risk
  • Managing trading risk is a major concern for today’s banks, and bank risk managers place limits on the amount of risk any individual trader is allowed to assume
  • Banks also need to hold more capital if there is more risk in their portfolio

Other Risks

  • Banks that operate internationally will face
  • Foreign exchange risk (the risk from unfavorable moves in the exchange rate)
  • Sovereign risk (the risk from a government prohibiting the repayment of loans)
  • Banks manage their foreign exchange risk by attracting deposits denominated in the same currency as the loans and by using foreign exchange futures and swaps to hedge the risk
  • Banks manage sovereign risk by diversification, by refusing to do business in a particular country or set of countries, and by using derivatives to hedge the risk
  • Banks also face operational risk, the risk that their computer system may fail or that their buildings may burn down
  • To manage operational risk the bank must make sure that its computer systems and buildings are sufficiently robust to withstand potential disasters

The Globalization of Banking

  • Toward the end of the 20th century, sharp rise in international trade increased the need for international financial services
  • Banks can operate in other countries by
  • Opening a foreign branch,
  • Offer same services as in home country
  • Creating an International Banking Facility (IBF)
  • Accept deposits from and make loans to foreigners outside the country
  • Creating an Edge Act subsidiary,
  • Engage in international banking transactions
  • Purchasing a controlling interest in a foreign bank
  • Foreign banks can take advantage of similar options.
  • The growth of international banking has had an economic impact, increasing the competition in and efficiency of banking markets
  • A borrower from France, Brazil, Singapore or Pakistan can shop for loan virtually anywhere in the world, while a depositor seeking the highest return can do the same
  • This phenomenon has made banking a tougher job
  • Profits are harder to come by as borrowers and depositors have more options
  • But overall the improved efficiency of financial system has enhanced growth everywhere
  • One of the most important aspects of international banking is the Eurodollar market, in which dollar-denominated deposits in foreign banks are exchanged
  • The Eurodollar market was created in response to restrictions on the movement of international capital imposed at the end of World War II with the creation of Bretton Woods system
  • Today, the Eurodollar market in London is one of the biggest and most important financial markets in the world,
  • The interest rate at which banks lend each other Eurodollars (the London Interbank Offered Rate or LIBOR) is the standard against which many private loan rates are measured

The Future of Banks

  • Today’s banks are bigger, fewer in number and more international than those of the past, and they offer more services
  • Financial holding companies are a limited form of universal banks, firms that engage in nonfinancial as well as financial activities
  • Banking, Insurance and securities
  • The owners and managers of these financial firms cite three reasons to create them:
  • They are well diversified,
  • They are large enough to take advantage of economies of scale,
  • They hope to benefit from economies of scope
  • Offering many products under the same “brand” name can also reduce costs
  • Individual firms provide the same services as more traditional intermediaries do
  • Money market mutual funds provide liquidity
  • Mortgage brokers help in borrowing for home purchase
  • Leasing companies provide car, and consumer financing
  • Discount brokers provide low cost access to financial markets
  • Thanks to recent technological advances, almost every service traditionally provided by financial intermediaries can now be produced independently, without the help of a large organization
  • Moreover, the production of information to mitigate the problems of adverse selection and moral hazard has become a business in and of itself
  • As we survey the financial industry we can discern two opposite trends:
  • Large firms are working hard to provide one-stop shopping for financial services
  • Industry is splintering into a host of small firms, each of which serves a very specific purpose

Related Content: MGT411 - VU Lectures, Handouts, PPT Slides, Assignments, Quizzes, Papers & Books of Money & Banking