INTEREST RATE RISK:Trading Risk, Other Risks, The Globalization of Banking

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

NON- DEPOSITORY INSTITUTIONS:Insurance Companies, Securities Firms >>

Money & Banking MGT411

Lesson 26

INTEREST RATE RISK

Bank Risk

Interest Rate Risk (Cont.)

Trading Risk

Other Risks

Globalization of Banking

The Future of Banks

Non-depository Institutions

Insurance Companies

Securities Firms

Finance Companies

Government Sponsored Enterprises

Interest-Rate Risk

Gap analysis highlights the gap or difference between the yield on interest sensitive assets and

the yield on interest-sensitive liabilities

Multiplying the gap by the projected change in the interest rate yields the change in the bank's

profit

Gap analysis can be further refined to take account of differences in the maturity of assets and

liabilities

Banks can manage interest-rate risk by matching the interest-rate sensitivity of assets with the

interest-rate sensitivity of liabilities,

Purchase short term securities to match variable rate deposits

Make long term loans at floating rates

But this approach increases credit risk

Trading Risk

Banks today hire traders to actively buy and sell securities, loans, and derivatives using a

portion of the bank's capital in the hope of making additional profits

However, trading such instruments is risky (the price may go down instead of up); this is called

trading risk or market risk

Managing trading risk is a major concern for today's banks, and bank risk managers place limits

on the amount of risk any individual trader is allowed to assume

Banks also need to hold more capital if there is more risk in their portfolio

Other Risks

Banks that operate internationally will face

Foreign exchange risk (the risk from unfavorable moves in the exchange rate)

Sovereign risk (the risk from a government prohibiting the repayment of loans)

Banks manage their foreign exchange risk by attracting deposits denominated in the same

currency as the loans and by using foreign exchange futures and swaps to hedge the risk

Banks manage sovereign risk by diversification, by refusing to do business in a particular

country or set of countries, and by using derivatives to hedge the risk

Banks also face operational risk, the risk that their computer system may fail or that their

buildings may burn down

To manage operational risk the bank must make sure that its computer systems and buildings

are sufficiently robust to withstand potential disasters

The Globalization of Banking

Toward the end of the 20th century, sharp rise in international trade increased the need for

international financial services

Banks can operate in other countries by

Money & Banking MGT411

Opening a foreign branch,

Offer same services as in home country

Creating an International Banking Facility (IBF)

Accept deposits from and make loans to foreigners outside the country

Creating an Edge Act subsidiary,

Engage in international banking transactions

Purchasing a controlling interest in a foreign bank

Foreign banks can take advantage of similar options.

The growth of international banking has had an economic impact, increasing the competition in

and efficiency of banking markets

A borrower from France, Brazil, Singapore or Pakistan can shop for loan virtually anywhere in

the world, while a depositor seeking the highest return can do the same

This phenomenon has made banking a tougher job

Profits are harder to come by as borrowers and depositors have more options

But overall the improved efficiency of financial system has enhanced growth everywhere

One of the most important aspects of international banking is the Eurodollar market, in which

dollar-denominated deposits in foreign banks are exchanged

The Eurodollar market was created in response to restrictions on the movement of international

capital imposed at the end of World War II with the creation of Bretton Woods system

Today, the Eurodollar market in London is one of the biggest and most important financial

markets in the world,

The interest rate at which banks lend each other Eurodollars (the London Interbank Offered

Rate or LIBOR) is the standard against which many private loan rates are measured

The Future of Banks

Today's banks are bigger, fewer in number and more international than those of the past, and

they offer more services

Financial holding companies are a limited form of universal banks, firms that engage in non-

financial as well as financial activities

Banking, Insurance and securities

The owners and managers of these financial firms cite three reasons to create them:

They are well diversified,

They are large enough to take advantage of economies of scale,

They hope to benefit from economies of scope

Offering many products under the same "brand" name can also reduce costs

Individual firms provide the same services as more traditional intermediaries do

Money market mutual funds provide liquidity

Mortgage brokers help in borrowing for home purchase

Leasing companies provide car, and consumer financing

Discount brokers provide low cost access to financial markets

Thanks to recent technological advances, almost every service traditionally provided by

financial intermediaries can now be produced independently, without the help of a large

organization

Moreover, the production of information to mitigate the problems of adverse selection and

moral hazard has become a business in and of itself

As we survey the financial industry we can discern two opposite trends:

Large firms are working hard to provide one-stop shopping for financial services

Industry is splintering into a host of small firms, each of which serves a very specific purpose

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