• BEO2000 Financial Institutions & Monetary Theory
• Lecture 10: Risks of Financial Institutions
• Primary Source:
• Lange et al. 2013, Ch. 4
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
• a. Understand the significance of market risk and interest rate risk for financial institutions;
• b. Gain an understanding of the influence of credit risk on financial institutions;
• c. Understand the emphasis placed on liquidity risk management by financial institutions;
• d. Learn the importance of various risks of financial institutions.
• Risks of Financial Institutions
• Despite the ‘dilemma’ managers of financial institutions (FIs) aim to increase the FIs returns
for its owners.
• Increased returns often come at the cost of increased risk, which comes in many forms:
– credit risk – off balance sheet risk
– market risk – foreign exchange risk
– operational risk – reputational risk
– interest rate risk – liquidity risk
– country or sovereign risk – insolvency risk
• Risks at Financial Institutions
• Financial institution (FI) risk has increased due to interconnectedness of the global market.
– Overseas market conditions can impact local FIs
– Exposure to risk has two main sources:
i. Direct: FI direct business dealing activities
ii. Indirect: FI customer exposures
– Need to understand risk in order to manage the risks one is exposed to.
• Credit Risk
• Credit risk:
– The risk that the promised cash flows from loans and securities held by FIs may not
be paid in full.
– Classification of risk via credit rating agencies
– Specialise in rating default risk of loans, equity and bonds
, – Rank them in accordance to highest to lowest
– Low credit risk, high credit rating
– Credit Risk
• Two different types of credit risk:
– firm-specific: default risk of the borrowing firm associated with the specific types of
project risk taken by that firm.
– systematic: default risk associated with general economy-wide or macro conditions,
affecting all borrowers.
• Unlike systematic credit risk, firm-specific credit risk can be managed through diversification.
– Limit the probabilities of the bad outcomes in the portfolio.
– Reducing Credit Risk of Individual Loans
– To minimise adverse selection:
i. A key role of FIs involves screening and monitoring loan applicants to ensure
only the creditworthy receive loans.
– Reducing Credit Risk of Loan Portfolios
• A high concentration of loans in the same industry in portfolio increases credit risk of the
portfolio.
– Set concentration limits (How have Australian banks been faring?).
– Market Risk
• Market risk:
– The risk incurred in the trading of assets and liabilities in a financial institutions'
trading book due to changes in interest rates, exchange rates and other asset prices.
– By trading securities, FIs take positions in the market.
– This exposes them to adverse market movements (e.g. bond prices and changes in
yield).
– Trading portfolios (i.e. trading book) is differentiated from investment portfolio (i.e.
banking book).
• Market Risk
Derivatives* (long) Derivatives* (short)
• Measuring Market Risk
• FIs are concerned with fluctuations in trading account assets and liabilities.
• Banks can measure their exposure to market risk via:
i. Daily Earnings at Risk (DEaR)
• Lecture 10: Risks of Financial Institutions
• Primary Source:
• Lange et al. 2013, Ch. 4
• Learning Outcomes
• With respect to learning outcomes, you should be able to:
• a. Understand the significance of market risk and interest rate risk for financial institutions;
• b. Gain an understanding of the influence of credit risk on financial institutions;
• c. Understand the emphasis placed on liquidity risk management by financial institutions;
• d. Learn the importance of various risks of financial institutions.
• Risks of Financial Institutions
• Despite the ‘dilemma’ managers of financial institutions (FIs) aim to increase the FIs returns
for its owners.
• Increased returns often come at the cost of increased risk, which comes in many forms:
– credit risk – off balance sheet risk
– market risk – foreign exchange risk
– operational risk – reputational risk
– interest rate risk – liquidity risk
– country or sovereign risk – insolvency risk
• Risks at Financial Institutions
• Financial institution (FI) risk has increased due to interconnectedness of the global market.
– Overseas market conditions can impact local FIs
– Exposure to risk has two main sources:
i. Direct: FI direct business dealing activities
ii. Indirect: FI customer exposures
– Need to understand risk in order to manage the risks one is exposed to.
• Credit Risk
• Credit risk:
– The risk that the promised cash flows from loans and securities held by FIs may not
be paid in full.
– Classification of risk via credit rating agencies
– Specialise in rating default risk of loans, equity and bonds
, – Rank them in accordance to highest to lowest
– Low credit risk, high credit rating
– Credit Risk
• Two different types of credit risk:
– firm-specific: default risk of the borrowing firm associated with the specific types of
project risk taken by that firm.
– systematic: default risk associated with general economy-wide or macro conditions,
affecting all borrowers.
• Unlike systematic credit risk, firm-specific credit risk can be managed through diversification.
– Limit the probabilities of the bad outcomes in the portfolio.
– Reducing Credit Risk of Individual Loans
– To minimise adverse selection:
i. A key role of FIs involves screening and monitoring loan applicants to ensure
only the creditworthy receive loans.
– Reducing Credit Risk of Loan Portfolios
• A high concentration of loans in the same industry in portfolio increases credit risk of the
portfolio.
– Set concentration limits (How have Australian banks been faring?).
– Market Risk
• Market risk:
– The risk incurred in the trading of assets and liabilities in a financial institutions'
trading book due to changes in interest rates, exchange rates and other asset prices.
– By trading securities, FIs take positions in the market.
– This exposes them to adverse market movements (e.g. bond prices and changes in
yield).
– Trading portfolios (i.e. trading book) is differentiated from investment portfolio (i.e.
banking book).
• Market Risk
Derivatives* (long) Derivatives* (short)
• Measuring Market Risk
• FIs are concerned with fluctuations in trading account assets and liabilities.
• Banks can measure their exposure to market risk via:
i. Daily Earnings at Risk (DEaR)
