10- Types of Risk of FI and Management

risk of being unable to reinvest cash flows from investment at an interest rate similar to the current rate of return

potential risk of decline in price of an asset or security relative to the rest of the market
- specific to a security and company (internal decision)

risk in trading assets and liabilities due to changes in interest rates, exchange rates and other asset prices
- general for the market (all securities)

risk that promised cash flows from loans and securities may not be paid back in full.
- loans or bonds with long maturities are more exposed to it
- nature of FI institutions, make loans or buy bonds backed by small percentage of capital

limited upside return (high probability) = principal and interest payments to FI
large downside risk (low probability) = loss of loan principal and promised interest

therefore, key role of FI is screening loan applicants and insterest rates charged are directly related to riskiness of the borrower

evidence of this risk: net charge offs
- this risk can be partially diversified away but systemic credit risk will always exist

risk of default for the borrowing firm associated with the specific type of project risk

risk of default associated with general ecocomy or marco conditions - effects all borrowers

risk that FI may be unable to meet short term financial obligations due to inability to convert a security or hard asset to cash
- day to day withdrawls and loan demands are predictable, sudden increase may require FI to liquidtae assets in a short time
- to meet the demand for cash FI must either liquidate assets or borrow additioanl funds (fed funds or brokered deposits)

unusually large withdrawls by liability holders can create liquidity problems where;
1. cost of puchasedorrowed funds rises
2. the supply of funds decreases
3. FI may be forced to sell less liquid assets at "fire sale price" aka less than market value

risk related to the maturity mismatch between assets and liabilities in the FI financial statements and interest rate volatility

asset transformation: FI buys primary securities and issues secondary securities or liabilities to fund the assets
- if assets are longer term than liabilities, faces refinancing risk = risk that the cost of rolling over or re-borrowing funds will rise above the returns being earned on asset investments
- if assets are shorter term than liabilities, faces reinvestment risk = risk that returns on funds to be reinvested will be below the cost of funds

can hedge against interest rate risk by matching the maturities of assets and liabilities
- match the rate sensitivity or duration

risk that the price of a security will change when interest rate changes
- if interest rate decreases, PV of future cash flows increases
- if interest rate increases, PV of future cash flows decreases
All FI face price risk (market value uncertainty)

risk incurred trading assets and liabilities due to changes in interest rates, exchange rates and other asset prices
- when interest rates and foreign exchange risk combined with active trading strategy (especially short trading horizons = 1 day)

FI trading portfolios do not equal investment portfolios (with respect to time horizon and liquidity)
- trading assets, liabilities and derivatives are highly liquid + held short
- investment portfolio are relatively illiquid and held for longer time

Financial crisis illustrated market risk, when FI take open or unhedged long or short positions in securities prices may change in opposite direction to whats expected
- Value at risk and daily earnings at risk are measures to asses market risk exposure
+ volatility of asset prices = + market risk of FI adopting open trading positions

risk incurred as a result of activities related to contingent assets and liabilities, obs activities are;
- not on FI current balance sheet (do not involve holding currency primary claim or issuance of secondary claim)
- involve creation and contingigent assets and liability which have potential in future balance sheet
- only become on balance sheet if some future event occurs
- have direct impact on future profitability (below the bottom line on BS)
- can affect future shape of FI balance sheet

examples: positions in forwards, futures, swaps, other derivatives held

risk that exchange rate changes affect the value of assets denominated in foreign currencies
- can be reduced through domesict foreign investment diversification

1. acquiring foreign firms or opening new branches in other countries
2. investing in foreign financial asssets

1. underlying technologies of various economies differ, as do firms in these economies (economy contracting or economy expanding)
2. exchange rate changes are not perflectly correlated across countries (exchange rate appreciating or depreciating)

holding more foreign assets than foreign liabilities
GAIN - when foreign currency appreciates relative to USD
LOSS - when currency depreciates relative to USD

hold fewer foreign assets than foreign liabilties
GAIN - when foreign currency depreciates relative to USD
LOSS - when foreign currency appreciates relative to USD

match both size and maturities of exposures in assets and liabilities in given currency

FULLY HEDGED = equal amount of foreign currency denominated assets and liabilities with same maturity

risk that repayments from foreign borrowers are interrupted because of intereference from foreign governments
- foreign govermments may limit or prohibit debt repayments due to currency shortages or adverse political events
- risk of investing or lending in a country arises from possible changes in the business enviornment
- a FI may have little or no recourse to local bankruptcy courts

risk incurred when technological invetments do not produce anticipated cost savings
- the major objective of tech expanision is to allow FI to exploit economies of scale and scope by; lowering operating costs, increasing profits, capturing new markets

risk that existing tech malfunctions or support system breaks down
- not exclusive to tech
- can be result of direct, indirect, or opportunity cost that reduces profitability and market value

risk that fintech firms could distrupt business of financial services firms
- loose customers and revenue

risk to be unable to satisfy debts
- a consquence of other risks outlined
- more equity capital to borrowed funds an FI has (lower leverage) the less insolvency risk it is exposed to
- focus on capital adequancy as a measure of a FI ability to remain solvent