Class 4 Risks of Financial Intermediation By stepping in between those who have excess funds and those who need funds, banks take on many different types of risk. The most important risks are Interest Rate, Market, Credit, Liquidity, and Technology Risk. There are other risks such as off balance sheet risk which tie back to the principal risks mentioned here. We will only discuss each risk briefly at this point since we will have an entire lecture devoted to most of these topics later in the quarter. Before, however, going into the specifics of the above risks, the student needs to be aware of two fundamental risks: Systemic Risk and Non-systemic risk. The former involves risks to the financial system as a whole i.e. whereby all financial institutions are affected by systemic risk. Examples would be a change in economic or political climate which damages or improves the outlook of financial institutions. Non-systemic risk would involve more how financial institutions manage interest rate, market, credit, liquidity, and technology risk. Again, bear in mind what risks financial institutions control and what they do not control. In stepping in between savers and borrowers, FI’s actually transform assets. In doing so they take cash from investors turn them into savings deposits such as certificates of deposits (CD’s). The CD’s are now a general claim on the bank’s assets and if FDIC insured also carry a government guarantee. Of course, banks don’t just keep your money in the vault. They lend that cash along with other cash it collects from depositors ultimately taking in thousands or even millions of depositors’ money. The banks then redistribute all this cash in the form of loans to many different borrowers (usually in higher concentrations than when the take it in i.e. lots of small deposits = fewer larger loans). For the bank, the loan it makes is a primary security since it bears directly the risk of the borrower. The CD is a secondary security from the depositors’ perspective because of the general claim on the bank’s assets with the additional backing of the FDIC. This transformation has diversified the depositors’ risk and added insurance to it which reduces the risk of the investor going directly to a corporation and buying one of its bonds. The transformation has also created liquidity in that the depositor can break the CD since the bank can find other CD investors or it can use some reserve cash to pay back the depositor. In contrast, a corporation might not be able to find a substitute investor or spare cash. Again, let us remember this transformation process when we discuss the intermediation risks and how the bank handles these. Interest Rate Risk We see many different interest rates out in the market. These rates vary depending on risk and tenor. When we talk about interest rate risk here we are interested in the different rates for different periods of time. In the market we typically speak of an upward sloping yield curve: The above shows that interest rates are lower for short periods of time and increase over longer periods. Some will argue that this is a patience premium and to a certain extent that is true. I believe however it is better to look at the phenomenon of an upward sloping yield curve as being compensated for risk. Under most circumstances, we cannot look too far into the future and know what is going to happen. This regards both our personal situation as well as that of the economy. We may need the money in 6 months or 6 years time due to unforeseen circumstances so if we could get the same reward for keeping the money for 6 months vs. 6 years we would opt for the shorter period (this assumes penalties for early or even no possibility of withdrawal). As for the economy, we can trust that the government can control inflation in the short run based on current actions. However, we may see issues such as trade imbalances, deficits and other factors that are growing and if kept unchecked may change the interest rate environment. How future governments and Federal Reserve Chairmen handle the economy is an unknown – uncertainty is risk. Now, typically we see upward sloping curves. However, on occasion we have flat and even inverted yield curves (downward sloping). These occur due to unusual economic circumstances – often when inflation rears its ugly head, the Fed raises rates to combat inflation and slow down the economy. Investors view the inflation as temporary and therefore try to lock in future rates that they believe will drop as the government successfully fights inflation. Therefore, depending on how high current inflation versus what investors view future inflation to be will either result in a downward sloping yield curve (high short term rates and lower long term rates) or a flat yield curve where current rates reflect inflation plus a typical short term premium, which together is equal to long term premium plus anticipated long term inflation. Mismatching of Interest Rates Banks are not required to match fund their balance sheets. In other words, they are not required to keep a balance between for example 10 year deposits and 10 year loans, 5 year deposits and 5 year loans and so on…. In fact, banks typically short fund their balance sheets which means they lock in deposits with an average tenor of 2 years and lend to borrowers with an average loan maturity of more than 5 years (illustrative example directionally true but not exact since the matching of each bank is different and will vary over time). Now, bearing in mind the typical upward sloping yield curve, banks pay depositors on average short term interest rates and lend on the longer end of the scale. We know already that banks pay depositors less interest than they collect from borrowers on the lending side. Therefore, by taking advantage of the yield curve they can enhance their returns even more. This sounds dangerous and can be when economic circumstances take a turn for the worse. Short term interest rates can shoot up and banks can be stuck with loans that have low long term returns. Therefore, banks could potentially end up paying more out to depositors than they receive from their borrowers. That being said the risks here are not nearly as big since banks typically lend long term but on a “floating rate basis”. This means that the bank adjusts its rate that it charges from the borrower every 3 to 6 months. The one exception in the past was for mortgage loans where there weren’t all the floating options we see today. This phenomenon of mismatching and the prevalence fixed rate mortgages helped create the S&L Crisis of the past. Today, banks still lend at fixed rates on mortgages but can hedge the exposure. We will learn hedging techniques later in the course. So bottom line here is banks could seriously abuse the mismatching concept, but regulators watch this carefully and would act on banks that they felt were taking too much risk. Market Risk Market risk is usually defined as “trading risk” as opposed to “positioning risk”. Banks do a lot of business where they take large exposures for a very short period of time. Banks for example may purchase billions of dollars of Foreign exchange to take advantage of slight movements of currency. They may only hold these large positions for minutes or even seconds. This would be opposed to taking billions of dollars of deposits in US dollars from US retail customers and then lending the same amount out in Euros to European corporations. Such deposits and loans would be on the balance sheet for years and as we know currencies can change dramatically over time with respect to one another (e.g. Euro has appreciated against the dollar by almost 100% over the past several years). Imagine the losses (or gains) a bank could incur in such a situation. Some trading is done on behalf of clients to collect an agency or broker’s fee. In other words, GMC asks to buy $2 billion worth of Euros at a fixed price. Whether the Euro goes up or down GMC is contracted to buying the currency at that price – so unless GM defaults GM is bearing the market risk not the bank. Credit Risk The last example runs into the credit risk domain. The bank contracts with GM to buy currency on behalf of GMC. If GMC gets in trouble and is unable to purchase the currency and the currency has moved in an unfavorable direction, the bank could lose money. Market risk may have caused the unfavorable move but GMC’s inability to meet its contractual risk causes the loss. Hence the definition of credit risk (or default risk) is when a company is unable to meet its contractual obligations. This doesn’t mean that the bank never gets its money back. It might get it back but much later than contractually agreed upon. We call this a default. Not repaying principal or interest on time are examples of events of default. As you can imagine, in most cases defaults turn into serious losses to the bank. Liquidity Risk Our banking crisis started with the credit or default risk of sub-prime mortgage holders. However, that was the spark that led to a much more serious liquidity crisis. Therefore, understanding liquidity risk is going to be a very important part of this course. An asset may be low credit risk. In other words, a bank may lend to a company that is quite profitable and will have no trouble paying interest and repaying principal per the terms of the loan agreement. However, the company may not be well known to anybody else other than the bank. In such a case, there may be very few people willing to purchase the loan because they don’t know the name and don’t have much information on it. If the bank were ever forced to sell the loan, it would have a hard time finding a buyer at the appropriate return for the underlying credit risk of the asset. It might have to sell the loan at a very steep discount to entice investors to study the company in order to get interested in purchasing the asset. Therefore, the bank could lose a lot of money here on a company that is in theory a very good credit. Assets that are illiquid usually have very wide bid ask spreads – the difference between what a broker offers to pay for the asset versus what the broker offers to sell the asset. JPM bid ask spread might be 41.11-41.12 while a troubled country’s sovereign loans might trade at a bid ask of 30%-50% of face value. We will discuss this topic more in a later chapter. Off-Balance-Sheet Risk Off balance sheet risks involve all of the above risks. However, as the term suggests they are kept off balance sheet which means that when we look at a corporation or a bank, we don’t immediately see the risk. Also, such risks can be described but can be difficult to measure. In the text book, they talk about Stand-by-letters of credit which are in effect guarantees that banks provide companies or municipalities. However, guarantees are very similar to direct loan exposure. If I guarantee a company’s loan repayment then if the loan defaults I bear the risk of incurring a significant loss. I would have incurred the same loss if I had leant the money to the corporation. So why would I treat the risk differently? Quirky bank regulations answer this question. Capital Adequacy We showed a balance sheet the other day in class and referred to the equity piece of the balance sheet as the banks capital. I mentioned that this was an oversimplification. This is because banks study market, off balance sheet, liquidity, and credit risk so as to come up with a global exposure number. They then figure out what their capital is which actually includes subordinated debt (loans that only get paid back after depositors have been paid in full) and equity capital. They then calculate a ratio of Capital to Exposure and come up with a number of say 10% to show that they have adequate protection (cushion) from losses to depositors or adequate capital. Again we will do a whole chapter on this. Technology and Operational Risk Banks can fail because of problems with their computer systems and accounting controls. Somebody could hack the banks system and move money out to some unfriendly jurisdiction. Employees can direct funds into secret accounts and then abscond. Employees can hide growing losses from the bank by taking advantage of lax accounting controls and rules. These losses can grow to the point that the bank’s capital is wiped out. If you aren’t good at keeping track of what you are doing, you are going to make bad decisions based on bad information and get in big trouble. So there are many ways that this type of risk can manifest itself.