PART SEVEN

THE
MANAGEMENT
OF FINANCIAL
INSTITUTIONS

Copyright © 2012 Pearson Prentice Hall.

All rights reserved.
CHAPTER 23

Risk
Management in
Financial
Institutions

Copyright © 2012 Pearson Prentice Hall.

All rights reserved.
 Chapter Preview
 Managing financial institutions has never
been an easy task. But, uncertainty in the
economic environment has increased,
making the job of the financial institution
manager that much harder.

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 Chapter Preview
 In this chapter, we examine how financial
institutions manage credit risk, default risk,
etc. We explore the tools available to
managers to measure these risks and
strategies to reduce them. Topics include:
─ Managing Credit Risk
─ Managing Interest-Rate Risk

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 Managing Credit Risk
 A major part of the business of financial
institutions is making loans, and the major
risk with loans is that the borrow will
not repay.
 Credit risk is the risk that a borrower will
not repay a loan according to the terms of
the loan, either defaulting entirely or making
late payments of interest or principal.

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 Managing Credit Risk
 Once again, the concepts of adverse
selection and moral hazard will provide
our framework to understand the principles
financial managers must follow to minimize
credit risk, yet make successful loans.

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 Managing Credit Risk
 Adverse selection is a problem in the market
for loans because those with the highest
credit risk have the biggest incentives to
borrow from others.
 Moral hazard plays as role as well. Once a
borrower has a loan, she has an incentive to
engage in risky projects to produce the
highest payoffs, especially if the project is
financed mostly with debt.

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 Managing Credit Risk
 Solving Asymmetric Information Problems:
financial managers have a number of tools
available to assist in reducing or eliminating
the asymmetric information problem:
1. Screening and Monitoring: collecting reliable
information about prospective borrowers. This
has also lead some institutions to specialize in
regions or industries, gaining expertise in
evaluating particular firms or individuals.

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 Managing Credit Risk

1. Screening and Monitoring: also involves

requiring certain actions, or prohibiting
others, and then periodically verifying that
the borrower is complying with the terms
of the loan contact.

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 Managing Credit Risk
 Specialization in Lending helps in
screening. It is easier to collect data on
local firms and firms in specific industries. It
allows them to better predict problems by
having better industry and location
knowledge.

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 Managing Credit Risk
 Monitoring and Enforcement also helps.
Financial institutions write protective
covenants into loans contracts and actively
manage them to ensure that borrowers are
not taking risks at their expense.

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 Managing Credit Risk

2. Long-term Customer Relationships:

past information contained in checking
accounts, savings accounts, and previous
loans provides valuable information to
more easily determine credit worthiness.

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 Managing Credit Risk

3. Loan Commitments: arrangements

where the bank agrees to provide a loan
up to a fixed amount, whenever the firm
requests the loan.
4. Collateral: a pledge of property or other
assets that must be surrendered if the
terms of the loan are not met ( the loans
are called secured loans).

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 Managing Credit Risk
5. Compensating Balances: reserves that a
borrower must maintain in an account that
act as collateral should the borrower default.
6. Credit Rationing: (1) lenders will refuse to
lend to some borrowers, regardless of how
much interest they are willing to pay, or (2)
lenders will only finance part of a project,
requiring that the remaining part come from
equity financing.
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 Managing Interest-Rate Risk
 Financial institutions, banks in particular,
specialize in earning a higher rate of return
on their assets relative to the interest paid
on their liabilities.
 As interest rate volatility increased in the
last 20 years, interest-rate risk exposure
has become a concern for financial
institutions.

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 Managing Interest-Rate Risk
 To see how financial institutions can
measure and manage interest-rate risk
exposure, we will examine the balance
sheet for First National Bank (next slide).
 We will develop two tools, (1) Income Gap
Analysis and (2) Duration Gap Analysis, to
assist the financial manager in this effort.

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 Managing Interest-Rate Risk

Risk Management Association home page http://www.rmahq.org

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 Income Gap Analysis
 Income Gap Analysis: measures the
sensitivity of a bank’s current year net
income to changes in interest rate.
 Requires determining which assets and
liabilities will have their interest rate change
as market interest rates change. Let’s see
how that works for First National Bank.

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 Income Gap Analysis: Determining Rate
Sensitive Items for First National Bank

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 Income Gap Analysis: Determining Rate
Sensitive Items for First National Bank

Rate-Sensitive Assets  $5m  $ 10m  $15m  20%  $20m

RSA  $32m
Rate-Sensitive Liabs  $5m  $25m  $5m  $10m  10%  $15m
 20%  $15m
RSL  $49.5m
if i  5% 
Asset Income  5%  $32.0m  $ 1.6m
Liability Costs  5%  $49.5m  $ 2.5m
Income  $1.6m  $ 2.5  $ 0.9m

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 Income Gap Analysis
If RSL  RSA, i  results in: NIM , Income 
GAP  RSA  RSL
 $32.0m  $49.5m  $17.5m
Income  GAP  i
 $17.5m  5%  $0.9m
This is essentially a short-term focus on interest-rate risk
exposure. A longer-term focus uses duration gap analysis.

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 Duration Gap Analysis
 Owners and managers do care about the
impact of interest rate exposure on current
net income. They are also interested in the
impact of interest rate changes on the
market value of balance sheet items and
the impact on net worth.
 The concept of duration, which first
appeared in chapter 3, plays a role here.

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 Duration Gap Analysis
 Duration Gap Analysis: measures the
sensitivity of a bank’s current year net
income to changes in interest rate.
 Requires determining the duration for
assets and liabilities, items whose market
value will change as interest rates change.
Let’s see how this looks for First National
Bank.

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 Duration of First National
Bank’s Assets and Liabilities (a)

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 Duration of First National
Bank’s Assets and Liabilities (b)

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 Duration Gap Analysis
 The basic equation for determining the change in market value for assets or liabilities is:

or:

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 Duration Gap Analysis
 Consider a change in rates from 10% to
11%. Using the value from Table 23.1,
we see:
 Assets:

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 Duration Gap Analysis
 Liabilities:

 Net Worth:

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 Duration Gap Analysis
 For a rate change from 10% to 11%, the net
worth of First National Bank will fall,
changing by $1.6m.
 Recall from the balance sheet that First
National Bank has “Bank capital” totaling
$5m. Following such a dramatic change in
rate, the capital would fall to $3.4m.

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 Duration Gap Analysis
 For First National Bank, with a rate change
from 10% to 11%, these equations are:

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 Duration Gap Analysis
 Another version of this analysis, which
combines the steps into two equations, is:

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 Duration Gap Analysis
 So far, we have focused on how to apply income
gap analysis and duration gap analysis in a
banking environment.
 The same analysis can be applied to other
financial institutions. For example, let’s look at a
simple finance company which makes consumer
loans. The balance sheet and duration worksheet
for Friendly Finance Co. follows.

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 Duration Gap Analysis

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 Income Gap Analysis: Determining Rate
Sensitive Items for Friendly Finance Co.

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 Income Gap Analysis
 If i  1%

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 Duration Gap Analysis
 If i  5%

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 Managing Interest-Rate Risk
 Problems with GAP Analysis
─ Assumes slope of yield curve unchanged
and flat
─ Manager estimates % of fixed rate assets and
liabilities that are rate sensitive

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 Managing Interest-Rate Risk
 Strategies for Managing Interest-Rate Risk
─ In example above, shorten duration of bank
assets or lengthen duration of bank liabilities
─ To completely immunize net worth from
interest-rate risk, set DURgap = 0

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 Chapter Summary
 Managing Credit Risk: basic techniques for
managing relationships and rationing credit
were reviewed.
 Managing Interest-Rate Risk: the essential
techniques of measuring interest-rate risk
for both income and capital affects were
presented.

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