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Chapter 20
Types of Risks Incurred by
Financial Institutions

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Risks at Financial Institutions
A major objective of FI management is to increase the FI’s returns for its
owners, but increased returns typically come at the cost of increased risk:
• Credit risk.
• Liquidity risk.
• Interest rate risk.
• Market risk.
• Off-balance sheet risk.
• Foreign exchange risk.
• Country or sovereign risk.
• Technology risk.
• Operational risk.
• Digital disruption and fintech risk.
• Insolvency risk.

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 Risks Faced by Financial Institutions 1

1. Credit risk—the risk that promised cash flows from loans and
securities held by FI’s may not be paid in full.
2. Liquidity risk—the risk that a sudden and unexpected increase in
liability withdrawals may require an FI to liquidate assets in a very
short period of time and at low prices.
3. Interest rate risk—the risk incurred by an FI when the maturities of
its assets and liabilities are mismatched and interest rates are volatile.
4. Market risk—the risk incurred in trading assets and liabilities due to
changes in interest rates, exchange rates, and other asset prices.
5. Off-balance-sheet risk—the risk incurred by an FI as the result of its
activities related to contingent assets and liabilities.
6. Foreign exchange risk—the risk that exchange rate changes can
affect the value of an FI's assets and liabilities denominated in foreign
currencies.

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 Risks Faced by Financial Institutions 2

7. Country or sovereign risk—the risk that repayments by foreign

borrowers may be interrupted because of interference from foreign
governments or other political entities.
8. Technology risk—the risk incurred by an FI when its technological
investments do not produce anticipated cost savings.
9. Operational risk—the risk that existing technology or support
systems may malfunction, that fraud that impacts the FI's activities
may occur, and/or that external shocks such as hurricanes and floods
may occur.
10. Digital disruption and fintech risk—the risk that fintech firms could
disrupt business of financial services firms in the form of lost
customers and lost revenue.
11. Insolvency risk—the risk that an FI may not have enough capital to
offset a sudden decline in the value of its assets relative to its
liabilities.
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 Credit Risk at FI’s 1

Credit risk is the risk that the promised cash flows from
loans and securities held by FI’s may not be paid in full.
• Virtually all types of FI’s face this risk, but FI’s that make
loans or buy bonds with long maturities are more exposed
than are FI’s that make loans or buy bonds with short
maturities.
• Even as losses due to credit risk increase, FI’s continue to
willingly give loans because they charge a rate of interest
on a loan that compensates for the risk of the loan
• Important element in the credit risk management process is
pricing.
• Managerial (monitoring) efficiency and credit risk
management strategies directly affect the returns and risks
of the loan portfolio.
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 Credit Risk at FI’s 2

Advantage that FI’s have over individual investors is

their ability to diversify credit risk exposures from a
single asset by exploiting the law of large numbers in
their asset investment portfolios.
Diversification reduces firm-specific credit risk, the
risk of default for the borrowing firm associated with the
specific types of project risk taken by that firm.
• For Example, risk specific to holding the bonds or loans of
GM.
Diversification does not reduce systemic credit risk,
the risk of default associated with general economy-
wide or macro-conditions affecting all borrowers.
• For Example, an economic recession.
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 Charge-Off Rates for Commercial Bank
Lending Activities

Sources: FDIC, Quarterly Banking Profile, various issues, www.fdic.gov

Access the text alternative for slide images.

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 Credit Card Loss Rates and Personal
Bankruptcy Filings

Sources: FDIC, Quarterly Banking Profile, various issues, www.fdic.gov

Access the text alternative for slide images.

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 Impact of Credit Risk on an FI’s Equity
Value
Example 20.1: Impact of Credit Risk on an Fl's Equity Value.
Consider an FI with the following balance sheet:
Cash $ 20m Deposits $ 90m
Gross loans 80m Equity (net worth) 10m
$100m $100m

Suppose that the managers of the FI recognize that $5 million of its $80 million in loans is
unlikely to be repaid due to an increase in credit repayment difficulties of its borrowers.
Eventually, the FI's managers must respond by charging off or writing down the value of
these loans on the Fl's balance sheet. This means that the value of loans falls from $80
million to $75 million, an economic loss that must be charged off against the stockholder's
equity capital or net worth (that is, equity capital falls from $10 million to $5 million). Thus,
both sides of the balance sheet shrink by the amount of the loss:

Cash $ 20m Deposits $ 90m

Gross loans 80m Equity after charge-off 5m
Less: Loan loss −5m
Loans after charge-off 75m
$95m $95m

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 Liquidity Risk
Liquidity risk is the risk that a sudden and unexpected
increase in liability withdrawals may require an FI to liquidate
assets in a very short period and at low prices.
• On the asset side of the balance sheet, loan requests and the
exercise by borrowers of their loan commitments and other
credit lines causes liquidity risk.
• Most liquid asset of all is cash.
• To meet the demand for cash by liability holders, F I’s must either
liquidate assets or borrow additional funds.
• When all, or many, FI’s face abnormally large cash demands,
the cost of purchased of borrowed funds rises and the supply of
such funds becomes restricted.
• FI’s may have to sell some of their less liquid assets to meet the
withdrawal demands, resulting in serious liquidity risk.

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 Impact of Liquidity Risk on Equity Value 1

Before the Withdrawal After the Withdrawal

Assets Liabilities/Equity Assets Liabilities/Equity

Cash assets $ 10 Deposits $ 90 Cash assets $0 Deposits $ 75

Nonliquid Nonliquid
assets 90 Equity 10 assets 80 Equity 5
$100 $100 $80 $80

Example 20.2: Impact of Liquidity Risk on an Fl’s Equity Value.

Consider the simple FI balance sheet in Table 20.2. Before deposit
withdrawals, the FI has $10 million in cash assets and $90 million in
nonliquid assets (such as small business loans). These assets were
funded with $90 million in deposits and $10 million in owner's equity.
Suppose that depositors unexpectedly withdraw $15 million in deposits
(perhaps due to the release of negative news about the profits of the Fl)
and the FI receives no new deposits to replace them.

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 Impact of Liquidity Risk on Equity Value 2

To meet these deposit withdrawals, the FI first uses the $10

million it has in cash assets and then seeks to sell some of
its nonliquid assets to raise an additional $5 million in cash.
Assume that the FI cannot borrow any more funds in the
short-term money markets (see Chapter 5), and because it
cannot wait to get better prices for its assets in the future (as
it needs the cash now to meet immediate depositor
withdrawals), the FI has to sell any nonliquid assets at 50
cents on the dollar. Thus, to cover the remaining $5 million in
deposit withdrawals, the FI must sell $10 million in nonliquid
assets, incurring a loss of $5 million from the face value of
those assets. The FI must then write off any such losses
against its capital or equity funds. Since its capital was only
$10 million before the deposit withdrawal, the loss on the fire
sale of assets of $5 million leaves the FI with $5 million.

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 Interest Rate Risk 1

Interest rate risk is the risk incurred by an FI when the maturities

of its assets and liabilities are mismatched and interest rates are
volatile.
• Asset transformation involves an FI buying primary securities/assets
and issuing secondary securities/liabilities to fund the assets.
• Primary securities that FI’s purchase often have maturity characteristics
different from the secondary securities that FI’s sell.
• Refinancing risk is the risk that the cost of rolling over or reborrowing
funds will rise above the returns being earned on asset investments.
• Type of interest rate risk that occurs when an FI holds longer-term assets
relative to liabilities.
• By holding shorter-term assets relative to its liabilities, an FI faces
reinvestment risk, the risk that the returns on funds to be reinvested
will fall below the cost of funds.

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 Interest Rate Risk 2

Price risk is the risk that the price of the security will change when
interest rates change.
• Rising (falling) interest rates increase (decrease) the discount rate on
future asset or liability cash flows and reduce (increase) the market
price or present value of that asset or liability.
Mismatching maturities by holding longer-term assets than
liabilities means that when interest rates rise, the economic or
present value of the FI’s assets falls by a larger amount than its
liabilities.
FIs can seek to hedge or protect themselves against interest rate
risk by matching the maturity of their asset and liabilities, but this
strategy is not necessarily consistent with an active asset
transformation function for F I’s.
• Matching maturities hedges interest rate risk only in a very
approximate rather than complete fashion.

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 Market Risk 1

Market risk is the risk incurred in trading assets and

liabilities due to changes in interest rates, exchange rates,
and other asset prices.
• Closely related to interest rate and foreign exchange risk.
• Adds another dimension of risk: trading activity.
• Market risk is the incremental risk incurred by an FI when interest
rate and foreign exchange risks are combined with an active trading
strategy, especially on that involves short trading horizons such as a
day.
• FI’s trading portfolio can be differentiated from its investment
portfolio on the basis of time horizon and liquidity.
• Trading portfolio contains assets, liabilities, and derivative contracts
that can be quickly bought or sold on organized financial markets,
whereas investment portfolio contains assets and liabilities that are
relatively illiquid and held for longer periods.

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 The Investment (Banking) Book and
Trading Book of a Commercial Bank
Assets Liabilities
Banking book Loans Capital
Other illiquid assets Deposits
Trading book Bonds (long) Bonds (short)
Commodities (long) Commodities (short)
FX (long) FX (short)
Equities (long) Equities (short)
Derivatives* (long) Derivatives* (short)

*Derivatives are off-balance-sheet (as discussed in Chapter 10).

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 Market Risk 2

Traditional roles of many FI’s have changed in recent years.

• For large commercial banks such as money center banks,
decline in income from traditional deposit taking and lending
activities has been matched by an increased reliance on income
from trading.
• Decline in underwriting and brokerage income for large
investment banks has also been met by more active and
aggressive trading in securities, derivatives, and other assets.

Mutual fund managers, who actively manage their asset portfolios,

are also exposed to market risk.
FI’s are concerned about fluctuations in value, or value at risk (VA
R) of their trading account assets and liabilities for periods as short
as one day – so-called daily earnings at risk (DEAR) – especially if
such fluctuations pose a threat to their solvency.

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 Off-Balance-Sheet Risk 1

Off-balance-sheet (OBS) risk is the risk incurred by an FI

as the result of activities related to contingent assets and
liabilities.
• In 2022, commercial banks had $23.6 trillion in on-balance-
sheet items, while the face or notional value of their off-balance-
sheet derivative items was $191.0 trillion.
• OBS activities do not appear on an FI’s current balance sheet since
it does not involve holding a currency primary claim (asset) or the
issuance of a current secondary claim (liability).
• OBS activities involve the creation of contingent assets and
liabilities that give rise to their potential placement in the future
on the balance sheet.
• Contingent assets and liabilities are assets and liabilities off the
balance sheet that potentially can produce positive or negative
future cash flows for an FI.

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 Valuation of an FI’s Net Worth with and
without Consideration of OBS Activities
Panel A: Traditional valuation of an Fl’s net worth.
Market value of assets (A) 100 Market value of liabilities (L) 90

100 Net worth (E) 10

100

Panel B: Valuation of an Fl’s net worth with on- and off-balance-

sheet activities valued.

Market value of assets (A) 100 Market value of liabilities (L) 90

Market value of contingent Net worth (E) 5
50
assets (CA)
Market value of contingent
150 55
liabilities (CL)
150

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 Off-Balance-Sheet Risk 2

More attention has been drawn to the O BS activities of banks,

especially large ones, as opposed to small depository institutions
or insurers.
Issuing a letter of credit (L C) is an OBS activity.
• LC is a credit guarantee issued by an FI for a fee on which payment is
contingent on some future event occurring, most notably default of the
agent that purchases the LC.
• Other examples of OBS activities are collateralized mortgage
obligations (CMO’s), loan commitments by banks, mortgage servicing
contracts by depository institutions, and positions in forwards, futures,
swaps, and other derivative securities by almost all large FI’s.

Ability to earn fee income while not loading up or expanding the

balance sheet has become an important motivation for F I’s to pursue
OBS business.

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 Foreign Exchange Risk 1

Foreign exchange (FX) risk is the risk that exchange rate

changes can affect the value of an FI’s assets and liabilities
denominated in foreign currencies.
• US pension funds that held approximately 5% of their assets in foreign
securities in the early 1990’s now hold close to 24% of their assets in
foreign securities.
• Returns on domestic and foreign direct investments and portfolio
investments are not perfectly correlated for two reasons:

1. Underlying technologies of various economies differ, as do the firms in

those economies.
2. Exchange rate changes are not perfectly correlated across countries.

• FI’s expand globally through acquiring foreign firms or opening new

branches in foreign countries, as well as investing in foreign financial
assets.

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 Foreign Exchange Risk 2

A net long position in a foreign currency involves an FI

holding more foreign assets than liabilities.
• FI loses when foreign currency falls relative to the US dollar.
• FI gains when foreign currency appreciates relative to the U S
dollar.

A net short position in a foreign currency involves an FI

holding fewer foreign assets than liabilities.
• FI gains when foreign currency falls relative to the US dollar.
• FI loses when foreign currency appreciates relative to the U S
dollar.

FI is fully hedged only if we assume that it holds foreign

assets and liabilities of exactly the same maturity.

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 Foreign Asset and Liability Positions
Net Long Asset Position in Pounds.

Net Short Asset Position in Pounds.

Access the text alternative for slide images.

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 Sovereign Risk 1

Country, or sovereign, risk is the risk that repayments

from foreign borrowers may be interrupted because of
interference from foreign governments.
• Differs from the type of credit risk that is faced by an FI that
purchases domestic assets, such as the bonds and loans
of domestic corporations.
• With domestic defaults, FI’s usually have some recourse
through bankruptcy courts (that is, F I’s can recoup some of
their losses when defaulted firms are liquidated or
restructured).
• Foreign corporations may be unable to pay principal and
interest even if they desire to do so.
• Foreign governments may limit or prohibit debt repayment
due to foreign currency shortages or adverse political events.
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 Sovereign Risk 2

In the event of restrictions or outright prohibitions on the

payment of debt obligations by sovereign governments, the FI
claimholder has little if any recourse to local bankruptcy courts
or to an international civil claims court.
Measuring sovereign risk includes an analysis of
macroeconomic issues, such as the following:
• Trade policy;
• Fiscal stance (deficit or surplus) of the government;
• Government intervention in the economy;
• Its monetary policy;
• Capital flows and foreign investment;
• Inflation; and,
• Structure of its financial system.
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 Technology and Operational Risk
Technology risk is the risk incurred by an FI when its
technological investments do not produce anticipated
cost savings.
• Major objectives of technological expansion are to lower
operating costs, increase profits, and capture new markets
for an FI.
Operational risk is the risk that existing technology or
support systems may malfunction or break down.
• Not exclusively the result of technological failure.
• Other sources of operational risk can result in direct costs,
indirect costs, and opportunity costs that reduce an FI’s
profitability and market value.

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 Digital Disruption and Fintech Risk
Digital Disruption and Fintech risk is the risk that fintech
firms could disrupt business of financial services firms in the
form of lost customers and lost revenue.
• Broader and wider ranging than technology risk.
• Fintech services such as cryptocurrencies (for example, bitcoin)
and blockchain provide a system that supports the exchange of
value between two parties unknown to each other in a swift and
effective way, without the need for financial intermediaries.
• Largest fintech companies include the following:
• SoFi, an online personal finance company;
• Transferwise, an international money transfer provider; and,
• Credit Karma, a platform that provides credit scores to users and
also serves as a portal for people to search and apply for various
financial services, like loans, credit cards, and insurance.

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 Insolvency Risk
Insolvency risk is the risk that an FI may not have enough
capital to offset a sudden decline in the value of its assets
relative to its liabilities.
• Insolvency risk is a consequence or an outcome of one or more
of the risks previously described:
• Interest rate, market, credit, OBS, technological, digital disruption
and fintech, foreign exchange, sovereign, and liquidity risk.
• Generally, the more equity capital to borrowed funds an F I has
(that is, the lower its leverage), the better able it is to withstand
losses due to risk exposures such as adverse liquidity changes,
unexpected credit losses, and so on.
• Both regulators and managers focus on capital adequacy as a
key measure of an FI’s ability to remain solvent and grow in the
face of a multitude of risk exposures.

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 Other Risks and Interactions Among Risks
All of the previously defined risks are interdependent.
• Each risk and its interaction with other risks ultimately affects solvency
risk.
Various other risks also impact FI’s profitability and risk exposure:
1. Discrete, or event-type, risks:
• Sudden change in taxation.
• Changes in regulatory policy, including lifting the regulatory barriers to
lending or to entry or on products offered.
• Sudden and unexpected changes in financial market conditions due to war,
revolutions, or sudden market collapse.
• Theft, malfeasance, and breach of fiduciary trust.
2. Macroeconomic risks:
• Increased inflation and inflation volatility.
• Unemployment.
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