Fluent Essays

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. 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. Module 12 Insurance Companies Outline Foundations of Insurance Insurance Categories Organization of Insurance Companies Insurance Industry Structure Life Insurance Companies Property and Casualty Insurance Companies Insurance Industry Regulation Insurance Industry Recent Trends © 2021 McGraw-Hill Education Limited Foundations of Insurance Major Issues Adverse selection occurs when the people most likely to benefit from a transaction are the ones who actively seek out the transaction and are thus likely to be selected. Insured have higher risk than general population. Loss probability statistics gathered for the entire population may not truly reflect the loss potential for the people who actually want to buy policies. © 2021 McGraw-Hill Education Limited Foundations of Insurance Major Issues Moral hazard refers to the fact that an insurance policy changes the behaviour of the insured person. A fire insurance policy written for more than the value of the property may induce the owner to arson. A generous automobile insurance policy may encourage reckless driving. Concern arises when we cannot observe people’s actions and so cannot judge whether a poor outcome is intentional or just a result of bad luck. Solutions to the moral hazard problem are hard to find. © 2021 McGraw-Hill Education Limited Foundations of Insurance To alleviate problems, insurance companies try the following: information collection and screening risk-based premium restrictive provisions prevention of fraud by investigations cancellations of insurance deductibles co-insurance limits on the insurance coverage © 2021 McGraw-Hill Education Limited 5 Foundations of Insurance The insured (party covered by insurance) and the beneficiary (party receiving payout if loss occurs) must be related. The insurer (party selling the insurance) must be provided with complete and accurate information by the insured. The insured is not supposed to profit from buying insurance. The payout needs to be adjusted with any compensation from a third party. The insurer must have a pool of insured large enough to diversify the risks. The loss must be quantifiable. The insurer must be able to estimate the loss occurrence. © 2021 McGraw-Hill Education Limited Foundations of Insurance Risk-averse people with incentives buy insurance. Insurance is usually sold through agents. Independent agent: sell insurance for a number of different companies (i.e., insurance broker) Exclusive agent: sell insurance for only one company (i.e., insurance agent) Regardless of the sales approach, insurance companies hire an underwriter who decides whether to accept or reject the issuance of a policy. © 2021 McGraw-Hill Education Limited Insurance Categories Insurance: a device whereby an individual or a business transfers the risk of uncertain financial loss by payment of a premium. Broadly grouped as life insurance and property and casualty insurance with further classifications: Life insurance Health insurance Property insurance Liability insurance Credit insurance Farm insurance Reinsurance © 2021 McGraw-Hill Education Limited Insurance Categories Ten largest insurance companies (as of December 31, 2019): © 2021 McGraw-Hill Education Limited Company Total Assets Manulife Financial Group $809.130 billion Great-West LifeCo $451.167 billion Sun Life Financial $297.202 billion Fairfax Financial $92.203 billion Industrial Alliance Financial Corp. $73.148 billion Desjardins Insurance $53.152 billion Intact Financial $32.292 billion E-L Financial Corp. (Empire Life) $23.749 billion RBC Insurance $18.191 billion Co-operators Group $15.002 billion Organization of Insurance Companies Mutual Insurance company: accumulated profits owned by policyholders. © 2021 McGraw-Hill Education Limited Policyholders Mutual Insurer Policy and Ownership Rights Policy Dividends Organization of Insurance Companies Stock Insurance company: accumulated profits owned by shareholders. © 2021 McGraw-Hill Education Limited Policyholders Mutual Insurer Policy Rights Shareholders Stock Dividends Ownership Rights Insurance Industry Structure Insurance pools risk exposures, allowing losses to be shared and reducing the uncertainty of loss. Insurance industry is a clunky legacy system. Clients have evolving expectations for insurance transactions, insurance products and services. Online distribution platform for insurers with a direct-to-consumer channel. Montreal-based InsurTech: Breath Life © 2021 McGraw-Hill Education Limited Insurance Industry Structure A healthy economy supports earnings growth at Canadian life insurers and premium growth for property and casualty firms, despite the ongoing drag of low interest rates on the insurers’ profitability and investment performance. Solid asset quality remains a driver of the stable outlook. Insurers have the capacity to invest in technology to guard against competitive disruption. This investment should enhance client interface and drive opportunities for all insurers to benefit from claims efficiencies and risk segmentation. © 2021 McGraw-Hill Education Limited Life Insurance Companies Overview Protect nearly 29 million Canadians with various life insurance products and pay $98 billion in benefits. The average life insurance protection per household is $423,000 in 2019, up from $417,000. The industry is competitive, with 100 Canadian insurers and 38 foreign-owned insurers. 78 private life insurers, 8 not-for-profit health benefit providers and 14 fraternal benefit societies Many private life insurers are diversified financial institutions offering more than life insurance. © 2021 McGraw-Hill Education Limited Life Insurance Companies Overview Top six life insurers based on annual revenues (2019): © 2021 McGraw-Hill Education Limited Company Founded A.M. Rating Annual Revenues Net Income Manulife Financial 1887 A+ $77.83 B $5,276 M Great-West LifeCo (Canada Life) 1891 A+ (Superior) $44.71 B $2,492 M Sun Life Financial 1846 A+ $39.69 B $2,713 M IA Financial 1892 A $15.27 B $708 M RBC Insurance 1864 A $4.27 B $775 M Empire Life (E-L Financial) 1923 A (Excellent) $2.12 B $187.44 M In 2019, life insurers in Canada hired 156,000 workers locally and 169,000 employees outside Canada Although there has been an annual growth of 2.5\% over the past decade, the momentum may not continue due to different challenges ahead. Life insurance companies hold over $850 billion of assets in Canada. Canadian life and health insurers operate in more than 20 countries serving 60 million people with total assets of $898 billion 57.2\% Canada, 12.\% US, Asia 11.1\%, Europe 9.0\%, others 10.5\% 15 Life Insurance Companies Insurance Contract Pay upon insurance event © 2021 McGraw-Hill Education Limited Life Insurance Policy Insurance Company Beneficiary Asset Mgmt. Policyholder Life Insurance Companies Lines of Life Insurance: Ordinary Life Ordinary life insurance is sold to individuals—policyholders make periodic premium payments in exchange for coverage. Term life policy is pure life insurance with expiry date and no savings element attached. Permanent life policy offers a package of pure life insurance protection and investing opportunities with no expiry. Whole life Universal life © 2021 McGraw-Hill Education Limited Life Insurance Companies Lines of Life Insurance: Ordinary Life Term life insurance temporary insurance protection low cost no cash value usually renewable likely convertible to permanent life insurance without further underwriting © 2021 McGraw-Hill Education Limited Life Insurance Companies Lines of Life Insurance: Ordinary Life Permanent Life Insurance meet life-long protection needs have an investment component no expiry date as long as premiums are paid more expensive to own build cash value loans are permitted against the policy favourable tax treatment of policy earnings flexible premium allocation © 2021 McGraw-Hill Education Limited Life Insurance Companies Lines of Life Insurance: Ordinary Life Permanent Life insurance can be divided into two categories: Whole Life: traditional form where insurer takes on all risks related to death and the underlying investment performance. Premiums partly fund an increase in cash value. Expensive. Universal Life: policyholders select investment options and insurer assumes the risk related to death. Policyholder may vary the timing and amount of premium as circumstances change. Cash value depends on the pace of the premium. © 2021 McGraw-Hill Education Limited Life Insurance Companies Lines of Life Insurance: Group and Credit Group life insurance covers a large number of people under a single policy. Contributory: both the employer and the employee cover a share of the premiums. Noncontributory: the costs are borne entirely by the employer. Credit life insurance protects lenders in the event a borrower dies prior to the repayment of a debt contract, such as a mortgage or car loan. © 2021 McGraw-Hill Education Limited Life Insurance Companies Lines of Life Insurance: Other Activities Other activities of life insurers include the sale of annuities, private pension plans, and accident and health insurance. Annuities protect against the risk of outliving your retirement money. Contract is initiated by investing a lump sum or making periodic payments before the annuity payments begin. Canadians’ retirement savings in RRSP, TSFA and RRIF are managed by the industry. Health insurance supplements government benefits. © 2021 McGraw-Hill Education Limited Life Insurance Companies Assets and Liabilities With a steady flow of premiums and predictable benefit payments, life insurers can securely invest in long-term capital markets. The mix of investments within general and segregated funds reflects the nature of the underlying insurance contracts of two funds. Liabilities come from the premiums paid by insured clients and from pension funds under management. © 2021 McGraw-Hill Education Limited Invest over $780 billion in long-term capital markets bonds (36\%), mutual funds (30\%), stocks (18\%), mortgages (6\%), real estate (3\%) and others (7\%) Total premiums have grown to $117 billion in 2019 written on various life insurance lines: $22.7 billion (19\%) from life insurance policies with 80\% individuals and 20\% group $48.0 billion (41\%) from annuities with 83\% from registered plans (e.g. RRSP, TSFA, RRIF) $46.3 billion (40\%) from health plans with 10\% individuals, 90\% group Benefit payments increase to $98 billion or nearly $1.9 billion a week, up 50\% from 10 years ago. $13.2 billion on life insurance benefits $7.7 billion paid as death benefits and $553 billion paid to living policyholders as disability benefits, cash surrenders or dividends $36.1 billion on health insurance benefits $11.7 billion for prescription drugs, which accounts for about 35\% of Canada’s total spending on prescription drugs $48.7 billion on retirement benefits with annuity payments on employer-sponsored and individual products Increase at an average rate of 6\% per year since 2008 23 Life Insurance Companies Assets and Liabilities Segregated funds are kept separate from the rest of the insurer’s activities. © 2021 McGraw-Hill Education Limited Assets ($762 B) Liabilities ($665 B) and Equities ($97 B) General Funds ($470 B) 5\% short-term investment 72\% policyholder liabilities 87\% long-term investment 7\% other liabilities 8\% other investment 21\% equities and long-term debt Segregated Funds ($292 B) 16\% cash & other investment 100\% policyholder liabilities 34\% real estate & mortgages 50\% mutual funds 24 Property-Casualty Insurance Companies Currently, 198 companies sell property-casualty (P&C) insurance in Canada, and approximately half of them are foreign firms. Top 10 firms hold 65\% market share. In 2018, Intact Financial was the top firm, writing 14.4\% of all P&C insurance premiums. Most banks have insurance subsidiaries, as they are not allowed to sell insurance through their branch networks. © 2021 McGraw-Hill Education Limited Property-Casualty Insurance Companies Property insurance protects the insured against losses of real and personal property from fire, theft, storm, explosion and even neglect. The policy can be either a named-peril policy or an open-peril policy. Named-peril policies cover losses associated with specific named events (e.g., flood insurance). Open-peril policies insure against all perils except those specifically excluded by the policy (e.g., war) © 2021 McGraw-Hill Education Limited Property-Casualty Insurance Companies Casualty insurance offers protection from legal responsibility for losses stemming from damage to another’s property or an injury to another person. Distinctions between property and casualty insurance are increasingly become blurred because they are often sold together. Auto insurance: you wrecking your car is covered under property insurance, while you accidentally hitting another car with yours is covered under casualty insurance. © 2021 McGraw-Hill Education Limited Property-Casualty Insurance Companies Top ten leading private P&C Insurers (2019): © 2021 McGraw-Hill Education Limited Company Market share Intact Group 14.44\% Aviva Group 8.91\% Desjardins Group 8.33\% Lloyd’s Underwriters 5.91\% Cooperators Group 5.57\% Wawanesa Mutual Insurance Company 5.47\% TD Insurance Group 5.39\% RSA Group 5.13\% Economical Group 4.10\% Northbridge Group 2.88\% P&C Insurance Companies Lines of P&C Insurance Insurance companies earn revenues through premiums and on investments they make. Report premiums in two ways: Direct written premiums: total premiums collected Net written premiums: total amounts adjusted for portions paid to reinsurers To spread the risk, a reinsurance company agrees to accept risks of another insurance company in exchange for a payment. © 2021 McGraw-Hill Education Limited P&C Insurance Companies Lines of P&C Insurance P&C insurers have $59.6 billion in direct written premiums on six major lines in 2019. Among the net written premiums of $54.1 billion: Automobile Insurance: 44.1\% Property Insurance: Personal: 22.2\% Commercial:14.2\% Liability Insurance: 10.2\% Specialized Insurance: 7.1\% Accident and Sickness Insurance: 2.2\% © 2021 McGraw-Hill Education Limited P&C Insurance Companies Lines of P&C Insurance Total direct claim costs by line in 2019: Net claims incurred are the total claim costs less any share to be paid by reinsurers. © 2021 McGraw-Hill Education Limited Line of Business $ million \% of the total claims Auto 18,205 44.6 Personal property 7,810 20.0 Commercial property 6,466 16.5 Liabilities 3,746 9.6 Specialized 1,985 5.1 Accident and sickness 871 2.2 $39,084 100\% P&C Insurance Companies Assets and Liabilities Assets Out of the total investment of $117 billion, many of those assets have fixed returns that can be liquidated easily. © 2021 McGraw-Hill Education Limited Assets Amount Fraction Bonds $80,586 M 68.9\% Stocks $10,904 M 9.3\% Mortgages $1,202 M 1.0\% Real estates $530 M 0.5\% Term deposits $4,436 M 3.8\% Others $19,366 M 16.5\% P&C Insurance Companies Assets and Liabilities Liabilities About 57\% of the total liabilities and equity are unpaid claims and adjustment expenses items. Risk exposure of property insurance is limited to the property value, but liability risk exposure is much more difficult to determine. Liability risk exposure can have long lag times (tails). Liability lines may be subject to social inflation. © 2021 McGraw-Hill Education Limited P&C Insurance Companies Assets and Liabilities To determine insurance premiums, insurers consider the likelihood of a customer making a claim and how much those claims will like cost. Underwriting risk is the risk that premiums are insufficient to cover losses and operating expenses after taking into account investment income. Three sources of underwriting risk: unexpected increases in loss rates unexpected increases in expenses unexpected decreases in investment yields © 2021 McGraw-Hill Education Limited P&C Insurance Companies Assets and Liabilities Four key ratios: Loss ratio: the actual claims incurred on a business line relative to the net premium earned Expense ratio: the expenses incurred relative to the net premium written, including loss adjustment expenses and mainly employee compensations Combined ratio: includes both the loss ratio and the expense ratio Operating ratio: measures overall profitability by subtracting the investment yield from the combined ratio Investment yield is measured as net interest income divided by premiums earned © 2021 McGraw-Hill Education Limited P&C industry ratios in 2019: earned loss ratio = 67.7\% expense ratio = 30.9\% combined ratio = 98.6\% investment yield = 2\% lowest on record operating ratio = 98.6\% − 2\% = 96.6\% Overall profitability = 100\% − 96.6\% = 3.4\% Less profitable firms exit the industry, and there is a rapid increase in premiums among the survivors. © 2021 McGraw-Hill Education Limited P&C Insurance Companies Assets and Liabilities 36 Insurance Industry Regulation Life Insurance Companies Federal and provincial governments share jurisdiction. OSFI: governs through the Insurance Companies Act prudential regulation, concerned with safety and soundness of the industry Provincial regulation marketing of insurance products and licensing requirements Canadian Life and Health Insurance Compensation Corporation: industry-funded organization to protect policyholders $200,000 on claims in case of bankruptcy $60,000 in cash policy coverage. © 2021 McGraw-Hill Education Limited 37 Insurance Industry Regulation P&C Insurance Companies As P&C insurers may be federally or provincially incorporated, regulation is shared by provincial and federal government. OSFI is the federal regulator responsible for 75\% of companies. Property and Casualty Insurance Compensation Corporation: pay outstanding claims and refund premiums paid in advance up to the following limits: auto and commercial insurance policies: up to $250,000 home insurance policies: up to $300,000 per policy © 2021 McGraw-Hill Education Limited Insurance Industry Recent Trends Major Issues Insurance industry becoming more global cross-country mergers (insurance companies as well as universal banks) Insurance crime Severe weather claims Catastrophic losses Introduction and acceleration of insurance market reforms auto insurance © 2021 McGraw-Hill Education Limited Insurance Industry Recent Trends InsurTech Insurers are increasingly focused on consumers’ needs with more tailored product offerings. Despite lower premium growth and rising claims costs, insurance companies continue to innovate and adapt through the following: artificial Intelligence (AI) robotic process automation (RPA) machine learning © 2021 McGraw-Hill Education Limited Insurance Industry Recent Trends InsurTech Insurance companies must resolve the “synthesis challenge”—integrating innovation into the legacy resistant environment. Many are beginning to pivot from investments that support business as usual to financing innovations that facilitate more fundamental business model changes. All need to adapt a more customer-centric approach to run their businesses. © 2021 McGraw-Hill Education Limited 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 .