Risks of Financial Intermediation
Chapter 7
Financial Institutions Management, 3/e
By Anthony Saunders
Irwin/McGraw-Hill
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Risks of Financial Intermediation

Interest rate risk
• Mismatch in maturities of assets and liabilities.
• Balance sheet hedge via matching maturities of
assets and liabilities is problematic for FIs.
• Refinancing risk.
• Reinvestment risk.
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Risks of Financial Intermediation

Market risk
• Incurred in trading of assets and liabilities (and
derivatives).
• Examples: Barings & decline in ruble.
• Trend to greater reliance on trading income
rather than traditional activities increases
market exposure.
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Risks of Financial Intermediation

Credit Risk
• Risk that promised cash flows are not paid in
full.
• Firm specific credit risk
• Systematic credit risk

Off-balance-sheet risk
• Letters of credit, loan commitments, derivative
positions, etc.
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Risks of Financial Intermediation

Technology and operational risk
• Risk that technology investment fails to
produce anticipated cost savings.
• Risk that technology may break down.
• Economies of scale.
• Economies of scope.
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Risks of Financial Intermediation

Foreign exchange risk
• Returns on foreign and domestic investment are
not perfectly correlated.
• FX rates may not be correlated.
» Example: $/DM may be increasing while $/¥
decreasing.
• Undiversified foreign expansion creates FX
risk.
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Risks of Financial Intermediation

Country or Sovereign Risk
• Result of exposure to foreign government
which may impose restrictions on repayments
to foreigners.
• Lack usual recourse via court system.
• Examples: Korea, Indonesia, Thailand 1998.
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Risks of Financial Intermediation

Liquidity Risk
• Risk of being forced to borrow, or sell assets in
a very short period of time.
» Low prices result.
• May generate runs.
» Runs may turn liquidity problem into solvency
problem.
» Risk of systematic bank panics.
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Risks of Financial Intermediation

Insolvency Risk
• Risk of insufficient capital to offset sudden
decline in value of assets to liabilities.
• Original cause may be excessive interest rate,
market, credit, off-balance-sheet, technological,
FX, sovereign, and liquidity risks.
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Risks of Financial Intermediation

Other Risks and Interaction of Risks
• Interdependencies among risks.
» Example: Interest rates and credit risk.
• Discrete Risks
» Example: Tax Reform Act of 1986.
» Other examples include effects of war, market
crashes, theft, malfeasance.
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Risks of Financial Intermediation

Macroeconomic Risks
• Increased inflation or increase in its volatility.
» Affects interest rates as well.
• Increases in unemployment
» Affects credit risk as one example.
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