Fluent Essays

Mid term assignment Please write minimum 1500 words, No upper limit Q: Explain relevant saving/investment and insurance plans discussed in class. What are factors affecting individual saving plans? What are determinants that are to be considered before investing into any individual saving plan. Use the real case references* to support your content. *Real case references mean taking real example of financial products offered by any real bank/financial institution with interest rates or returns they are offering. CHAPTER SEVEN: RISK OF FINANCIAL INSTITUTIONS SAUNDERS CORNETT MC GRAW 5TH CANADIAN EDITION Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 1 Chapter Seven: Risks of Financial Institutions Learning Objectives LO2 Define and identify interest rate risk, market risk, credit risk, OBS risk, foreign exchange risk, country or sovereign risk, technology and operational risk, liquidity risk, and insolvency risk for an FI. LO2  Discuss the interaction of risks for an FI. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 2 . Risks Faced by Financial Institutions (Table 7-1) Copyright  2014 McGraw-Hill Ryerson Ltd. All rights reserved. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 3 . Interest Rate Risk interest rate risk The risk incurred by an FI when the maturities of its assets and liabilities are mismatched. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 4 . Refinancing Risk refinancing risk The risk that the cost of rolling over or reborrowing funds will rise above the returns being earned on asset investments. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 5 . Reinvestment Risk reinvestment risk The risk that the returns on funds to be reinvested will fall below the cost of funds. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 6 . Credit Risk credit risk The risk that the promised cash flows from loans and securities held by FIs may not be paid in full. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 7 . Credit Risk firm-specific credit risk The risk of default of the borrowing firm associated with the specific types of project risk taken by that firm. systematic credit risk The risk of default associated with general economy-wide or macroconditions affecting all borrowers. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 8 . Liquidity Risk liquidity risk The risk that a sudden surge in liability withdrawals may leave an FI in a position of having to liquidate assets in a very short period of time and at low prices. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 9 . Foreign Exchange Risk foreign exchange risk The risk that exchange rate changes can affect the value of an FI’s assets and liabilities denominated in foreign currencies. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 10 . Foreign Asset and Liability Position: Net Long Asset in ₤ (Figure 7-1) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 11 . Foreign Asset and Liability Position: Net Short Asset in ₤ (Figure 7-2) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 12 . Sovereign Risk country or sovereign risk The risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 13 . Market Risk market risk The risk incurred in the trading of assets and liabilities due to changes in interest rates, exchange rates, and other asset prices. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 14 . Off-Balance-Sheet Risk off-balance-sheet (OBS) risk The risk incurred by an FI due to activities related to contingent assets and liabilities. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 15 . Off-Balance-Sheet Risk standby letter of credit (LC or L/C) An irrevocable credit guarantee that the issuing FI will pay a third party should its customer default on its obligation. commercial letter of credit A written undertaking that the issuing FI will pay a third party on the presentation of specified documents evidencing the shipment of goods. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 16 . Technology and Operational Risk Technology and operational risks are closely related and in recent years have caused great concern to FI managers and regulators alike. The Bank for International Settlements (BIS), the principal organization of central banks of the major economies of the world, defines operational risk (inclusive of technological risk) as “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events.” Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 17 . Technology and Operational Risk economies of scale The degree to which an FI’s average unit costs of producing financial services fall as its outputs of services increase. economies of scope The degree to which an FI can generate cost synergies by producing multiple financial service products. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 18 . Technology and Operational Risk technology risk The risk incurred by an FI when technological investments do not produce the cost savings anticipated. operational risk The risk that existing technology or support systems may malfunction or break down. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 19 . Insolvency Risk 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. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 20 . Other Risks & the Interaction of Risks Various other risks, often of a more discrete or event type, also impact an FI’s profitability and risk exposure, although, as noted earlier, many view discrete or event risks as part of operational risks. Discrete risks might include events external to the FI, such as a sudden change in taxation. Such changes can affect the attractiveness of some types of assets over others, as well as the liquidity of an FI’s balance sheet. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 21 . Chapter Summary This chapter provided an introductory view of ten major risks faced by modern FIs. They face interest rate risk when the maturities of their assets and liabilities are mismatched. They face credit risk or default risk if their clients default on their loans and other obligations. They encounter liquidity risk as a result of excessive withdrawals or problems in refinancing liabilities. If FIs conduct foreign business, they are subject to additional risks, namely foreign exchange and sovereign risks. They incur market risk on their trading assets and liabilities if adverse movements in interest rates, exchange rates, or other asset prices occur. Modern-day FIs also engage in significant off-balance-sheet activities that expose them to off-balance-sheet risks: contingent asset and liability risks. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 22 . Chapter Summary (cont’d) The advent of sophisticated technology and automation exposes FIs to both technological and operational risks. FI’s face insolvency risk when their capital is insufficient to withstand the losses that they incur as a result of such risks. The interaction of the various risks means that FI managers face making trade-offs among them. As they take actions in an attempt to affect one type of risk, FI managers must consider the possible impact on other risks. The effective management of these risks determines a modern FI’s success or failure. The chapters that follow analyze each of these risks in greater detail. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. 23 . Financial Institutions Management: A Risk Management Approach SAUNDERS CORNETT MC GRAW 5TH CANADIAN EDITION Copyright  2014 McGraw-Hill Ryerson Ltd. All rights reserved. Chapter 8: Interest Rate Risk I Learning Outcomes LO 1 Discuss the Bank of Canada’s role in setting monetary policy and influencing the level and movement of interest rates LO2  Discuss the re-pricing model and apply it to the balance sheet of an FI. LO3  Discuss the weaknesses of the re-pricing model. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Introduction: Net Worth The value of an FI to its owners. This is equal to the difference between the market value of assets and that of liabilities. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Level and Movement of Interest Rates While many factors influence the level and movement of interest rates, it is the central bank’s monetary policy strategy that most directly underlies the level and movement of interest rates that, in turn, affect an FI’s cost of funds and return on assets. Since 1991, the Bank of Canada, Canada’s central bank, has carried out monetary policy actions based on a target range for inflation. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Level and Movement of Interest Rates Consumer Price Index (CPI) A measure of the cost of living tracked monthly by Statistics Canada based on changes in the retail prices of a basket of consumer goods and services. Overnight Rate The rate that major FIs charge on one-day funds borrowed and lent to each other. It is at the middle of the operating band. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Level and Movement of Interest Rates Bank Rate The rate charged by the Bank of Canada on overnight loans to FIs. Operating Band The range (0.5 percent wide) of the overnight rates charged by the Bank of Canada. The bottom of the band is the rate the Bank of Canada will pay on deposits. The top of the band is the rate charged by the Bank of Canada on loans (the bank rate). Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Level & Movement of Interest Rates. (Figure 8-1) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. The Re-pricing Model Repricing or funding gap model based on book value. Contrasts with market value-based maturity and duration models recommended by the Bank for International Settlements (BIS). Rate sensitivity means time to repricing. Repricing gap is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA - RSL. Refinancing risk. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. The Re-Pricing Gap Commercial banks must report re-pricing gaps for assets and liabilities with maturities of: One day. More than one day to three months. More than 3 three months to six months. More than six months to twelve months. More than one year to five years. Over five years. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Re-pricing Gap Example (Table 8-1) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. The Re-pricing Model DNIIi = (GAPi) DRi = (RSAi - RSLi) DRi Example I: In the one day bucket, gap is -$10 million. If rates rise by 1\%: DNII(1) = (-$10 million) × .01 = -$100,000. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. The Re-pricing Model Example II: If we consider the cumulative 1-year gap, DNII = (CGAPone year) DR = (-$15 million)(.01) = -$150,000. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. The Re-pricing Model (Table 8-2) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Rate-Sensitive Assets Examples from hypothetical balance sheet: Short-term consumer loans. If re-priced at year-end, would just make one-year cutoff. Three-month T-bills re-priced on maturity every 3 months. Six-month T-notes re-priced on maturity every 6 months. 30-year floating-rate mortgages re-priced (rate reset) every 9 months. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Rate-Sensitive Liabilities RSLs bucketed in same manner as RSAs. Demand deposits and passbook savings accounts warrant special mention. Generally considered rate-insensitive (act as core deposits), but there are arguments for their inclusion as rate-sensitive liabilities. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. CGAP Ratio May be useful to express CGAP in ratio form as, CGAP/Assets. Provides direction of exposure and scale of the exposure. Example: CGAP/A = $15 million / $270 million = 0.56, or 5.6 percent. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Equal Rate Changes on RSAs, RSLs Example: Suppose rates rise 2\% for RSAs and RSLs. Expected annual change in NII, NII = CGAP ×  R = $15 million × .01 = $150,000 With positive CGAP, rates and NII move in the same direction. Change proportional to CGAP. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Equal Rate Changes on RSAs, RSLs (Table 8-3) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Unequal Changes in Rates If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case, NII = (RSA ×  RRSA ) - (RSL ×  RRSL ) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Unequal Rate Change Spread effect example: RSA rate rises by 1.2\% and RSL rate rises by 1.0\% NII =  interest revenue -  interest expense = ($155 million × 1.2\%) - ($155 million × 1.0\%) = $310,000 Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Example of a Change in Rates (Table 8-2) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Weaknesses of Re-pricing Model Weaknesses: Market Value Effects Over aggregation Distribution of assets & liabilities within individual buckets is not considered. Mismatches within buckets can be substantial. Ignores effects of runoffs Bank continuously originates and retires consumer and mortgage loans. Runoffs may be rate-sensitive. Ignores market value effects and off-balance sheet (OBS) cash flows. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. The Over Aggregation Problem (Figure 8-3) Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. The Run-Off Problem Runoff Periodic cash flow of interest and principal amortization payments on long-term assets, such as conventional mortgages, that can be reinvested at market rates. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Off Balance Sheet Items RSAs and RSLs used in the basic re-pricing model include only the assets and liabilities listed on the balance sheet. Changes in interest rates will affect the cash flows on many off-balance-sheet (OBS) instruments as well. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved. Chapter Summary This chapter introduced a method of measuring an FI’s interest rate risk exposure: the repricing model. The repricing model looks at the difference, or gap, between an FI’s rate-sensitive assets and rate- sensitive liabilities to measure interest rate risk. The chapter showed that the repricing model has difficulty in accurately measuring the interest rate risk of an FI. In particular, the repricing model ignores the market value effects of interest rate changes. More complete and accurate measures of an FI’s exposure are duration and the duration gap, which are explained in the next chapter. Copyright © 2014 McGraw-Hill Ryerson Ltd. All rights reserved.