This document discusses risk management strategies for financial institutions. It examines how they manage credit risk from loans and interest rate risk from changes in market rates. For credit risk, the key strategies are screening borrowers, monitoring loans, using collateral, and credit rationing. For interest rate risk, tools like income gap analysis and duration gap analysis are used to measure risks and immunize the balance sheet from changes in rates. The chapter provides examples of calculating duration and gaps to illustrate how financial managers can assess and address risks.

1. CHAPTER 23
Risk
Management in
Financial
Institutions
Copyright © 2012 Pearson Prentice Hall.
All rights reserved.

2. Chapter Preview
 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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23-2

3. 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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23-3

4. 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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5. Managing Credit Risk
 Solving Asymmetric Information Problems:
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
─ also involves requiring certain actions, or
prohibiting others, and then periodically verifying
that the borrower is complying with the terms of
the loan contract.
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23-5

6. 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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7. 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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23-7

8. 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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23-8

9. 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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10. 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:

lenders will refuse to lend to some borrowers,
regardless of how much interest they are willing to pay,
or

lenders will only finance part of a project, requiring that
the remaining part come from equity financing.
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23-10

11. 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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23-11

12. 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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23-12

13. Managing Interest-Rate Risk
Risk Management Association home page http://www.rmahq.org
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23-13

14. Income Gap Analysis: Determining Rate
Sensitive Items for First National Bank
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23-14

15. 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
Liability Costs
Income
= +5% × $32.0m
= +5% × $49.5m
= $1.6m − $ 2.5
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= +$ 1.6m
= +$ 2.5m
= −$ 0.9m
Estimate of % of checkable
deposits and savings
accounts that will
experience rate change
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16. 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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23-16

17. 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 on net worth.
 The concept of duration, which first
appeared in chapter 3, plays a role here.
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23-17

18. 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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23-18

19. Duration of First
National Bank's
Assets and
Liabilities

20. Duration Gap Analysis
 The basic equation for determining the change in
market value for assets or liabilities is:
or:
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23-20

21. 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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23-21

22. Duration Gap Analysis
 Liabilities:
 Net Worth:
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23-22

23. 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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23-23

24. 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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23-24

25. Managing Interest-Rate Risk
 Problems with GAP Analysis
─ Assumes slope of yield curve unchanged
and flat, but
http://stockcharts.com/charts/YieldCurve.html
─ Manager estimates % of fixed rate assets and
liabilities that are rate sensitive
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23-25

26. 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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23-26