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MGT411 - Money & Banking - Lecture Handout 25

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BANK RISK

  • Bank Risk
  • Liquidity Risk
  • Credit Risk
  • Interest Rate Risk
  • Trading Risk
  • Other Risks

Bank Risk

  • Banking is risky because depository institutions are highly leveraged and because what they do
  • In all the lines of banking trades, the goal of every bank is to pay less for the deposits the bank receives than for the loan it makes and the securities it buys.

Liquidity Risk

  • Liquidity risk is the risk of a sudden demand for funds and it can come from both sides of a bank’s balance sheet (deposit withdrawal on one side and the funds needed for its off-balance sheet activities on the liabilities side
  • If a bank cannot meet customers’ requests for immediate funds it runs the risk of failure; even with a positive net worth, illiquidity can drive it out of business
Table: Balance sheet of a bank holding $5 million in excess reserves
Assets Liabilities
Reserves $15million Deposits $100million
Loans $100million Borrowed funds $30million
Securities $35million Bank capital $20million
  • One way to manage liquidity risk is to hold sufficient excess reserves (beyond the required reserves mandated by the central bank) to accommodate customers’ withdrawals.
  • However, this is expensive (interest is foregone)
  • Two other ways to manage liquidity risk are:
  • Adjusting assets
  • Adjusting liabilities
Table: Balance sheet of a bank holding no excess reserves
Assets Liabilities
Reserves $10million Deposits $100 million
Loans $100 million Borrowed funds $30 million
Securities $40 million Bank capital $20 million
  • If a customer makes a $5 million withdrawal, the bank can’t simply deduct it from reserves.
  • Rather it will adjust another part of balance sheet
  • A bank can adjust its assets by
  • Selling a portion of its securities portfolio,
  • Or by selling some of its loans,
  • Or by refusing to renew a customer loan that has come due
Table: Balance sheet of a bank following a $5 million withdrawal and asset adjustment
Withdrawal is met by selling securities
Assets Liabilities
Reserves $10million Deposits $95 million
Loans $100 million Borrowed funds $30 million
Securities $35 million Bank capital $20 million
Withdrawal is met by reducing loans
Assets liabilities
Reserves $10 million Deposits $95 million
Loans $95 million Borrowed funds $30 million
Securities $40 million Bank capital $20 million
  • Banks do not like to meet their deposit outflows by contracting the asset side of the balance sheet because doing so shrinks the size of the bank
  • Banks can use liability management to obtain additional funds by
  • Borrowing (from the central bank or from another bank) or
  • By attracting additional deposits (by issuing large CDs)
Table: Balance sheet of a bank following a $5 million withdrawal and liability adjustment
Withdrawal is met by borrowing
Assets Liabilities
Reserves $10million Deposits $95 million
Loans $100 million Borrowed funds $35 million
Securities $40 million Bank capital $20 million
Withdrawal is met by attracting deposits
Assets liabilities
Reserves $10 million Deposits $100 million
Loans $100million Borrowed funds $30 million
Securities $40 million Bank capital $20 million

Credit Risk

  • This is the risk that loans will not be repaid and it can be managed through diversification and credit-risk analysis
  • Diversification can be difficult for banks, especially those that focus on certain kinds of lending
  • Credit-risk analysis produces information that is very similar to the bond-rating systems and is done using a combination of statistical models and information specific to the loan applicant
  • Lending is plagued by adverse selection and moral hazard, and financial institutions use a variety of methods to mitigate these problems
  • Screen loan application
  • Monitor borrowers after they have received loan
  • Collateral or high net-worth demand
  • Developing long term relationships

Interest-Rate Risk

  • The two sides of a bank’s balance sheet often do not match up because liabilities tend to be shortterm while assets tend to be long-term; this creates interest-rate risk
  • In order to manage interest-rate risk, the bank must determine how sensitive its balance sheet (assets and liabilities) is to a change in interest rates;
  • If we think of bank’s assets and liabilities as bonds, the change in interest rate will affect the value of these bonds, more importantly due to the term of bonds
  • So if interest rate rises, the bank face the risk that the value of their assets may fall more than the value of their liabilities (reducing the bank’s capital)
  • Suppose 20% of bank’s assets fall into the category of assets sensitive to changes in the interest rate. While rest of 80%are not sensitive to changes in interest rate
  • If interest rate is stable 5%, then each $100 yields $5 in interest
  • Now suppose 50% of bank’s deposits (liabilities) are interest rate sensitive and 50% are not
  • Half of the liabilities are deposits that earn variable returns so costs vary with market rate
  • For making profit, interest rate on liabilities must be lower than the interest rate on assets.
  • The difference is the bank’s margin!
  • Assuming interest rate on liabilities is 3%, the net interest margin is 5 – 3 = 2%
  • What happens as interest rate rises by 1%
Table: An example of interest rate risk
The impact of an interest rate increase on bank profits (per $100 of assets)
Items Assets Liabilities
Interest rate sensitive $20 $50
Not interest rate sensitive $80 $50
Initial interest rate 5% 3%
New interest rate on interest rate
sensitive assets and liabilities
6% 4%
  Revenue from assets Cost of liabilities
At initial interest rate (0.05×$20)+(0.05×$80)=$5.00 (0.03×$50)+(0.03×$50)=$3.00
After interest rate change (0.06×$20)+(0.05×$80)=$5.20 (0.04×$50)+(0.03×$50)=$3.50
Profits at initial interest rate: ($5.00) – ($3.00) = $2.00 per $100 in assets
Profits after interest rate change: ($5.20) – ($3.50) = $1.70 per $100 in assets
Gap analysis
Gap between interest rate sensitive assets and interest rate sensitive liabilities:
(Interest rate sensitive assets of $20) – (Interest rate sensitive liabilities of $50)
=(Gap of -$30)
  • When bank has more interest rate sensitive liabilities than does interest rate assets, an increase in interest rate will cut into the bank’s profits.

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