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Risk Of Financial Institution

Firman Pribadi

Risk Of Financial Institution


A major objective FI management is to increase the FI return 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

Interest rate risk

Refinancing risk: the risk that the cost of rolling over or reborrowing fund will rise above the return being earned on asset investment
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 = - $1 million 0 Liabilities ($ 100 million) 1

Assets $ 100 million

Reinvestment risk: the risk that return on fund to be reinvested will fall below the cost of fund
Holding short term asset relative to liabilities, FI faces uncertainty about interest rate 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 Second Year: cost of fund liabilities 9%; return on asset 8%; profit (8% - 9%) x $100 million = - $ 1 million 0 1 Liabilities ($ 100 million) Assets $ 100 million 1 2

Impact of an interest rate change to market value risk:


Market

value (fair value) of an asset and liability is conceptually equal to present value of current and future cash flow from that asset or liability Raising interest rate increase the discount rate on those cash flow and reduce the market value of that asset or liability Falling interest rate increase the market value of asset and liabilities

Risk of Economic Loss or risk of insolvency


Mismatching

maturities by holding longer term asset than liabilities means that when interest rate rise, the market value of the FI asset falls by a greater than it liabilities

Maturity Matching
Interest rate risk

Mismatching maturities asset and liabilities of FI

Matching maturities asset and liabilities by Hedging

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 and liabilities (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 on organized 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 Daily Earning at Risk (DEAR), especially if the fluctuation pose a threat to their solvency

Credit Risk

Credit Risk: the risk that the promised cash flows from loan and securities held by FIs may not be paid in full arises when the borrower default FIs that make loans or buy bond with long maturities are more exposed to credit risk than are FIs that make loans or buy bonds with short maturities Firm Specific credit risk: the risk of default of the borrowing firm associated with the specific types of project risk taken by that firm risk specific to holding the bond or loans of general motor

Systematic credit risk: The risk of default associated with general economy wide or macro condition affecting all borrowers Diversification can reduce individual firm specific credit risk, but is still exposed to systematic credit risk

Off Balance Sheet Risk

Off balance sheet risk: the risk incurred by an FI due to activities related to contingent asset and liabilities An off balance sheet activity by definition does not appear on an FIs current balance sheet, because it does not involve holding a current primary claim (asset) or current secondary claim (liability) tetapi mempengaruhi masa depan neraca FI karena penciptaan contingent asset and liabilities ex letter of credit Letter of Credit: A credit guarantee issued by an FI for a fee on which payment is contingent on some future event occurring

Foreign Exchange Risk


Foreign exchange risk: the risk that exchange rate change can affect the value of an FIs asset and liabilities denominated in foreign currency Ex US FI that hold 100 million in pound loans as asset and fund 80 million with pound certificate of deposit. The difference between the 100 million in pound loan and 80 million in in pund CDs is funded by dollar CDs (i.e 20 million worth of dollar).

The foreign asset and liability position: Net long asset position in pound

Foreign Asset

100 million

0 Foreign Liabilities

80 million

The US FI suffers losses if exchange rate of pound falls or depreciate against the dollar over this period Ex 1 = $2 ; 1 = $1

The foreign asset and liability position: Net short asset position in pound

Foreign Asset

80 million

Foreign Liabilities

100 million

The FI is exposed to foreign exchange risk if the pound appreciate against the dollar over the investment period Ex 1 = $2; 0.5 = $ 2

Country or Sovereign Risk

Country or sovereign risk: the risk that repayment from foreign borrower maybe interrupted because of interference from foreign government foreign currency shortages and adverse political reasons

Insolvency Risk
The risk that an FI may not have enough capital to offset a sudden decline in the value of its asset relative to its liabilities Technically insolvency occurs when the capital or equity resources of an FIs owner are driven to, or near to, zero because 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.

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