BANK RISK:Liquidity Risk, Credit Risk, Interest-Rate Risk

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Money & Banking MGT411

Lesson 25

BANK RISK

Bank Risk

Liquidity Risk

Credit Risk

Interest Rate Risk

Trading Risk

Other Risks

Bank Risk

Banking is risky because depository institutions are highly leveraged and because what they do

In all the lines of banking trades, the goal of every bank is to pay less for the deposits the bank

receives than for the loan it makes and the securities it buys.

Liquidity Risk

Liquidity risk is the risk of a sudden demand for funds and it can come from both sides of a

bank's balance sheet (deposit withdrawal on one side and the funds needed for its off-balance

sheet activities on the liabilities side

If a bank cannot meet customers' requests for immediate funds it runs the risk of failure; even

with a positive net worth, illiquidity can drive it out of business

Table: Balance sheet of a bank holding $5 million in excess reserves

Assets

Liabilities

Reserves

$15million

Deposits

$100million

Loans

$100million

Borrowed funds

$30million

Securities

$35million

Bank capital

$20million

One way to manage liquidity risk is to hold sufficient excess reserves (beyond the required

reserves mandated by the central bank) to accommodate customers' withdrawals.

However, this is expensive (interest is foregone)

Two other ways to manage liquidity risk are:

Adjusting assets

Adjusting liabilities

Table: Balance sheet of a bank holding no excess reserves

Assets

Liabilities

Reserves

$10million

Deposits

$100 million

Loans

$100 million

Borrowed funds

$30 million

Securities

$40 million

Bank capital

$20 million

If a customer makes a $5 million withdrawal, the bank can't simply deduct it from reserves.

Rather it will adjust another part of balance sheet

A bank can adjust its assets by

Selling a portion of its securities portfolio,

Or by selling some of its loans,

Or by refusing to renew a customer loan that has come due

Money & Banking MGT411

Table: Balance sheet of a bank following a $5 million withdrawal and asset adjustment

Withdrawal is met by selling securities

Assets

Liabilities

Reserves

$10million

Deposits

$95 million

Loans

$100 million

Borrowed funds

$30 million

Securities

$35 million

Bank capital

$20 million

Withdrawal is met by reducing loans

Assets

liabilities

Reserves

$10 million

Deposits

$95 million

Loans

$95 million

Borrowed funds

$30 million

Securities

$40 million

Bank capital

$20 million

Banks do not like to meet their deposit outflows by contracting the asset side of the balance

sheet because doing so shrinks the size of the bank

Banks can use liability management to obtain additional funds by

Borrowing (from the central bank or from another bank) or

By attracting additional deposits (by issuing large CDs)

Table: Balance sheet of a bank following a $5 million withdrawal and liability adjustment

Withdrawal is met by borrowing

Assets

Liabilities

Reserves

$10million

Deposits

$95 million

Loans

$100 million

Borrowed funds

$35 million

Securities

$40 million

Bank capital

$20 million

Withdrawal is met by attracting deposits

Assets

liabilities

Reserves

$10 million

Deposits

$100 million

Loans

$100million

Borrowed funds

$30 million

Securities

$40 million

Bank capital

$20 million

Credit Risk

This is the risk that loans will not be repaid and it can be managed through diversification and

credit-risk analysis

Diversification can be difficult for banks, especially those that focus on certain kinds of lending

Credit-risk analysis produces information that is very similar to the bond-rating systems and is

done using a combination of statistical models and information specific to the loan applicant

Lending is plagued by adverse selection and moral hazard, and financial institutions use a

variety of methods to mitigate these problems

Screen loan application

Monitor borrowers after they have received loan

Collateral or high net-worth demand

Developing long term relationships

Interest-Rate Risk

The two sides of a bank's balance sheet often do not match up because liabilities tend to be

short-term while assets tend to be long-term; this creates interest-rate risk

In order to manage interest-rate risk, the bank must determine how sensitive its balance sheet

(assets and liabilities) is to a change in interest rates;

If we think of bank's assets and liabilities as bonds, the change in interest rate will affect the

value of these bonds, more importantly due to the term of bonds

So if interest rate rises, the bank face the risk that the value of their assets may fall more than

the value of their liabilities (reducing the bank's capital)

Money & Banking MGT411

Suppose 20% of bank's assets fall into the category of assets sensitive to changes in the interest

rate. While rest of 80%are not sensitive to changes in interest rate

If interest rate is stable 5%, then each $100 yields $5 in interest

Now suppose 50% of bank's deposits (liabilities) are interest rate sensitive and 50% are not

Half of the liabilities are deposits that earn variable returns so costs vary with market rate

For making profit, interest rate on liabilities must be lower than the interest rate on assets.

The difference is the bank's margin!

Assuming interest rate on liabilities is 3%, the net interest margin is 5 3 = 2%

What happens as interest rate rises by 1%

Table: An example of interest rate risk

The impact of an interest rate increase on bank profits (per $100 of assets)

Items

Assets

Liabilities

Interest rate sensitive

$20

$50

Not interest rate sensitive

$80

$50

Initial interest rate

New interest rate on interest rate

sensitive assets and liabilities

Revenue from assets

Cost of liabilities

At initial interest rate

(0.05×$20)+(0.05×$80)=$5.00

(0.03×$50)+(0.03×$50)=$3.00

After interest rate change

(0.06×$20)+(0.05×$80)=$5.20

(0.04×$50)+(0.03×$50)=$3.50

Profits at initial interest rate:

($5.00) ($3.00) = $2.00 per $100 in assets

Profits after interest rate change: ($5.20) ($3.50) = $1.70 per $100 in assets

Gap analysis

Gap between interest rate sensitive assets and interest rate sensitive liabilities:

(Interest rate sensitive assets of $20) (Interest rate sensitive liabilities of $50)

=(Gap of -$30)

When bank has more interest rate sensitive liabilities than does interest rate assets, an increase

in interest rate will cut into the bank's profits.

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