BANK RISKS

1
BANK RISKS

• Banks are faced with the following types of risks
  in their everyday operations
• ? Interest rate risk
• ? Credit risk
• ? Market risk
• ? Off-balance-sheet risk
• ? Technology and operational risk
• ? Country or sovereign risk

2

• ? Liquidity risk
• ? Insolvency risk
• Interest rate risk refers to the risk incurred by
  a bank when the maturity of its assets and
  liabilities are mismatched
• The typical banks summary balance sheet looks as
  follows

3
ASSETS
LIABILITIES
CASH
INTERBANK DEPOSITS
INTERBANK LOANS
RETAIL AND OTHER DEPOSITS
LOANS
SUBORDINATED DEBT
EQUITY HOLDINGS
EQUITY
PHYSICAL ASSETS
4

• A bank is exposed to refinancing risk when it
  holds longer-term assets relative to liabilities
• A bank is exposed to reinvestment risk when the
  returns on funds to be reinvested will fall below
  the cost of funds
• This occurs when the bank holds shorter-term
  assets relative to liabilities

5

• Market risk refers to the risk incurred in the
  trading of assets and liabilities due to changes
  in interest rates, exchange rates, and other
  asset prices
• Credit risk refers to the risk that the promised
  cash flows from loans and securities held by a
  bank will not be paid in full
• Two types of credit risk firm-specific and
  systemic

6

• Off-balance-sheet risk refers to risk incurred by
  activities related to contingent assets and
  liabilities
• Technology risk occurs when technological
  investments do not produce the anticipated cost
  savings in economies of scale or scope
• Operational risk is the risk that existing
  technology or support systems may malfunction or
  break down

7

• Country or sovereign risk is the risk that
  repayments from foreign borrowers may be
  interrupted because of interference from foreign
  governments
• Liquidity risk is the risk that a sudden surge in
  liability withdrawals may leave a bank in a
  position of having to liquidate assets in a very
  short period of time and at low prices

8

• Insolvency risk is the risk that a bank may not
  have enough capital to offset a sudden decline in
  the value of its assets relative to its
  liabilities

9
REVIEW OF BOND PRICING

• The price of any financial instrument is equal to
  the present value of the expected cash flows from
  the financial instrument
• The cash flows of a bond (held up to maturity)
  are
• ? Periodic coupon interest payments to the
  maturity date
• ? The par value at maturity

10

• The price of a bond is given by
• P (C/1r) (C/(1r)2) (C/(1r)n)
  (M/(1r)n)
• or
• P ?t(C/(1r)t) (M/(1r)n)
• for t 1 n
• P bond price
• C coupon payment

11

• r required yield (periodic interest rate)
• M maturity (par) value
• Notice that the annual/semiannual coupon payments
  are equivalent to an ordinary annuity and their
  present value is
• C1-(1/(1r)n/r

12

• E.g. 20-year, 10 semiannual coupon bond with a
  par value of 1,000 suppose the required yield
  on the bond is 11
• Cash flows for this bond are
• ? 40 semiannual coupon payments of 50
• ? 1,000 to be received 40 six-month periods
  from now

13

• Thus,
• C 50
• n 40
• r (0.11/2) 0.055
• Present value of semiannual coupon payments is
• 501-(1/(1.055)40)/0.055 802.31

14

• Present value of par value is
• 1,000/(1.055)40 117.46
• Price of bond is
• P 802.31 117.46 919.77
• Note that
• ? If yield ? ? P ?
• ? If yield coupon rate ? price par value

15

• E.g. Two year semiannual coupon bond with face
  value 500 and coupon rate of 10 annual yield
  is 8
• Price of bond is
• P (25/1.04) (25/(1.04)2) (25/(1.04)3)
  (525/(1.04)4)

16

• Zero-coupon bonds do not make periodic coupon
  payments
• Investors realize interest as the difference
  between the maturity value and the purchase price
• These bonds sell at a discount
• P M/(1r)n

17
INTEREST RATE RISK THE MATURITY MODEL

• Due to their role as qualitative asset
  transformers, banks often mismatch the maturities
  of their assets and liabilities
• Changes in interest rates affect a banks net
  worth
• A banks net worth is the value to its owners and
  is equal to
• Market value of assets Market value of
  liabilities

18

• Banks in most countries report balance sheets
  using book value accounting
• This means that assets and liabilities are
  recorded at historic values
• If assets and liabilities are recorded based on
  their market values, then reporting is based on
  market value accounting
• This means that assets and liabilities are
  revalued according to the current level of
  interest rates (marking-to-market)

19

• E.g. Suppose a bank holds a bond with the
  following features
• ? one year to maturity
• ? one single annual coupon of 10
• ? a face value of 100
• The price of the bond is
• P1 (CM)/(1r) 110/1.1 100

20

• Suppose interest rates rise and yield is 11
• Price of bond is
• P1 (CM)/(1r) 110/1.11 99.10
• Note that
• ? Market value of assets decreased
• ? Given everything else, bank has suffered a
  capital loss

21

• Why? Net worth is
• NW Bank Capital Assets Liabilities
• ?NW ?A - ?L
• In our example, bank has suffered a loss of
• ?P1 99.10 100 - 0.9
• Result A rise in the required yield reduces the
  market value of fixed-income securities held in a
  banks portfolio (?P/?rlt0)

22

• Note that the same result would apply in the case
  of a loan that makes periodic payments
  (installments) (e.g. auto loans, mortgages, etc)
• If the bank has issued the bond as a liability,
  then if r ? market value of liability ? and
  banks net worth increases (ceteris paribus)
• E.g. A fixed-rate deposit such as a certificate
  of deposit (CD)

23

• Alternatively, a fall in r, raises the market
  values of both assets and liabilities
• What if, in the above example, the bond had a
  two-year maturity with the same annual coupon
  rate?
• In this case, the initial bond price is
• P2 (10/1.1) (110/(1.1)2) 100

24

• When r goes to 11
• P2 (10/1.11) (110/(1.11)2) 98.29
• ?P2 98.29 100 - 1.71
• Result The longer the maturity of a fixed-income
  asset or liability, the greater is its fall in
  price and market value for any given increase in
  the level of market interest rates