Risk of Financial Institution
Transcript of Risk of Financial Institution
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Risk Of Financial
Institution
Firman Pribadi
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Risk Of Financial Institution
A major objective FI management is to increase the FIreturn for its owner but, it is increase the risk of FI
Risk faced by FI: Interest rate risk
Market risk
Credit risk
Off balance sheet risk
Foreign exchange risk
Country of sovereign risk
Technology risk
Operational risk
Liquidity risk
Insolvency risk
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Interest rate risk
Refinancing risk: the risk that the cost of rolling overor reborrowing fund will rise above the return beingearned on asset investment
Liabilities($ 100 million)
Assets$ 100 million
0 1
0 1 2
Short funded: the maturity of FIs liabilities is less than the maturity of its asset borrowing short term (one year) and lending long term (two year)
First year: cost of fund liabilities 9%; return on asset 10%;profit (10% - 9%) x $100 million = $1 million
Second year:Profit for the second year are uncertain, if interest rate liabilities were to rise 11%;Profit (10% - 11%) x $100 million = - $1 million
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Reinvestment risk: the risk that return on
fund to be reinvested will fall below the costof fundHolding short term asset relative to liabilities, FI faces uncertainty about interestrate at which it can reinvest fund in the second period
First year: cost of fund liabilities 9%; return on asset 10%;profit (10% - 9%) x $100 million = $1 million
Liabilities($ 100 million)
Assets
$ 100 million
0 1
10 2
Second Year: cost of fund liabilities 9%; return on asset 8%; profit (8% - 9%) x $100 million = - $ 1 million
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Impact of an interest rate change to marketvalue risk:
Market value (fair value) of an asset and liability isconceptually equal to present value of current andfuture cash flow from that asset or liability
Raising interest rate increase the discount rate on
those cash flow and reduce the market value of thatasset or liability
Falling interest rate increase the market value ofasset and liabilities
Risk of Economic Loss or risk of insolvencyMismatching maturities by holding longer term asset
than liabilities means that when interest rate rise, themarket value of the FI asset falls by a greater than it
liabilities
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Maturity Matching
Interest rate risk
Mismatching maturities asset
and liabilities of FI
Matching maturities asset andliabilities by Hedging
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Market Risk Market risk: the risk incurred in the trading of asset and
liabilities due to changes in interest rate, exchange rate,and other asset prices
Market risk arises when FI actively trade asset andliabilities (and derivative) rather than hold them for longer
term investment, funding, or hedging purposes FIs trading portfolio contains asset, liabilities, and
derivative contract that can be quickly bought or sold onorganized financial market
Securitization have become asset more liquid and
tradable ex. Mortgage FI concern about VaR of their trading account of asset
and liabilities for periods as short as one day DailyEarning at Risk (DEAR), especially if the fluctuation posea threat to their solvency
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Credit Risk
Credit Risk: the risk that the promised cash flowsfrom loan and securities held by FIs may not bepaid in fullarises when the borrower default
FIs that make loans or buy bond with long
maturities are more exposed to credit risk thanare FIs that make loans or buy bonds with shortmaturities
Firm Specific credit risk: the risk of default of theborrowing firm associated with the specific typesof project risk taken by that firm risk specificto holding the bond or loans of general motor
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Systematic credit risk: The risk of defaultassociated with general economy wide ormacro condition affecting all borrowers
Diversification can reduce individual firmspecific credit risk, but is still exposed tosystematic credit risk
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Off Balance Sheet Risk
Off balance sheet risk: the risk incurred by an FIdue to activities related to contingent asset andliabilities
An off balance sheet activity by definition does
not appear on an FIs current balance sheet,because it does not involve holding a currentprimary claim (asset) or current secondary claim(liability) tetapi mempengaruhi masa depan
neraca FI karena penciptaan contingent assetand liabilities ex letter of credit
Letter of Credit: A credit guarantee issued by anFI for a fee on which payment is contingent on
some future event occurring
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Foreign Exchange Risk
Foreign exchange risk: the risk thatexchange rate change can affect the valueof an FIs asset and liabilities denominatedin foreign currency
Ex US FI that hold 100 million in poundloans as asset and fund 80 million withpound certificate of deposit. The difference
between the 100 million in pound loanand 80 million in in pund CDs is fundedby dollar CDs (i.e 20 million worth ofdollar).
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The foreign asset and liability position: Netlong asset position in pound
The US FI suffers losses if exchange rateof pound falls or depreciate against thedollar over this period
Ex 1 = $2 ; 1 = $1
Foreign Asset0 100 million
0 80 millionForeign Liabilities
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The foreign asset and liability position: Net
short asset position in pound
The FI is exposed to foreign exchange riskif the pound appreciate against the dollarover the investment period
Ex 1 = $2; 0.5 = $ 2
Foreign Asset
Foreign Liabilities
0
100 million0
80 million
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Country or Sovereign Risk
Country or sovereign risk: the risk thatrepayment from foreign borrower maybeinterrupted because of interference from
foreign government
foreign currencyshortages and adverse political reasons
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Insolvency Risk
The risk that an FI may not have enoughcapital to offset a sudden decline in thevalue of its asset relative to its liabilities
Technically insolvency occurs when thecapital or equity resources of an FIsowner are driven to, or near to, zerobecause of losses incurred as the result of
one or more of the risk of interest rate,market, credit, off balance sheet,technology, foreign exchange, sovereign,and liquidity.