Risks Faced by Financial Institutions

Sudheer Chava
Fall 2016

Sudheer Chava

Financial Institutions

September 2016

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Review

In the last few classes, we have studied mostly definitional and

institutional details
Review
this class:
Depository Institutions
An overview of various risks faced by Financial Institutions

Where do we go from here? Next module: Indepth look at Credit Risk

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Financial Institutions

September 2016

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Reserve Requirements for Banks in US

Reserve requirements are the amount of funds that a depository institution
must hold in reserve against specified deposit liabilities.
Within limits specified by law, the Board of Governors has sole authority
over changes in reserve requirements.
Depository institutions must hold reserves in the form of vault cash or
deposits with Federal Reserve Banks.
Beginning October 2008, the Federal Reserve Banks will pay interest
(0.25%) on required reserve balances and excess balances, now 0.50%
(http:
//www.federalreserve.gov/monetarypolicy/reqresbalances.htm)
Liability Type
Net transaction accounts $0-$10.7 mn
>$10.7 - $58.8 mn
>$58.8 mn
Non personal time deposits
Eurocurrency liabilities

Requirment (% of liabilities)
0%
3%
10%
0%
0%

source:

Sudheer Chava
Financial Institutions
September 2016
http://www.federalreserve.gov/monetarypolicy/reservereq.htm

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Bank Transaction Accounts

A new customer opens an account at GT Bank
She puts in $100 in her checking account
Assets (in million)
Reserves + $100

Liabilities
Checkable Deposits

+$100

Vault cash counts as reserves

But the requried reserves are only 10%
Assets
Required Reserves
Excess Reserves

+ $10
+ $90

Liabilities
Checkable Deposits

+$100

If the firm uses the excess reserves to make loans

Assets
Required Reserves
Loans
Sudheer Chava

+ $10
+ $90

Liabilities
Checkable Deposits

Financial Institutions

+$100

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Bank Balance Sheet

Assets = Liabilities + Equity Capital

Accumulated Uses of Funds (Assets) = Accumulated Sources of
Funds (Liabilities and Equity Capital)

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Financial Institutions

September 2016

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Simple Bank Balance Sheet

Say a GT Bank has a $110 million balance sheet and the required reserves
are 10% of deposits
What are the excess reserves for the bank?
Assets ($ mn)
Reserves
$20
Loans
$80
Securities
$10

Liabilities ($ mn)
Deposits
$100
Bank Capital
$10

Say there is deposit outflow of $10mn, does the bank have enough reserves?
Assets ($ mn)
Reserves
$10
Loans
$80
Securities
$10

Sudheer Chava

Liabilities ($ mn)
Deposits
$90
Bank Capital
$10

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Simple Bank Balance Sheet: Negative Shock to Liabilities

Say a GT Bank has a $110 million balance sheet and the required reserves
are 10% of deposits as before
But the bank decided to increase its loan portfolio by $10mn with the same
deposit base
Assets ($ mn)
Reserves
$10
Loans
$90
Securities
$10

Liabilities ($ mn)
Deposits
$100
Bank Capital
$10

Say there is deposit outflow of $10mn, does the bank have enough reserves?
Assets ($ mn)
Reserves
$0
Loans
$90
Securities
$10

Liabilities ($ mn)
Deposits
$90
Bank Capital
$10

Now, the bank needs to adjust its balance sheet

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Financial Institutions

September 2016

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Which option is the costliest to the bank?

Option 1: Borrow funds from other banks or corporations (what is the cost of this
option?)
Assets ($ mn)
Reserves
$9
Loans
$90
Securities
$10

Liabilities ($ mn)
Deposits
Borrowings from other banks or firms
Bank Capital

$90
$9
$10

Option 2: Sell security portfolio (what is the cost of this option?)

Assets ($ mn)
Reserves
$9
Loans
$90
Securities
$1

Liabilities ($ mn)
Deposits
Bank Capital

$90
$10

Option 3: Borrow from FED (what is the cost of this option?)

Assets ($ mn)
Reserves
$9
Loans
$90
Securities
$10
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Liabilities ($ mn)
Deposits
Borrowings from the FED
Bank Capital
Financial Institutions

$90
$9
$10
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Simple Bank Balance Sheet: Negative Shock to Liabilities

Option 4: Sell or reduce loan portfolio (what is the cost of this option?)
Assets ($ mn)
Reserves
$9
Loans
$81
Securities
$10

Liabilities ($ mn)
Deposits
$90
Bank Capital
$10

When a bank receives additional deposits, it gains an equal amount of

reserves; when it loses deposits, it loses an equal amount of reserves
If a bank has ample excess reserves, a deposit outflow doesnt necessitate
changes in other parts of its balance sheet
Excess reserves are insurance against costs associated with deposit outflows.
The higher the costs associated with deposit outflows, the more excess
reserves the banks would want to hold.

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Financial Institutions

September 2016

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Simple Bank Balance Sheet: Negative Shock to Assets

Consider two banks with identical balance sheets, except the amount of capital
Bank H:
Assets ($ mn)
Reserves
$10
Loans
$90

Liabilities ($ mn)
Deposits
$90
Bank Capital
$10

Assets ($ mn)
Reserves
$10
Loans
$90

Liabilities ($ mn)
Deposits
$96
Bank Capital
$4

Bank L:

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Financial Institutions

September 2016

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Simple Bank Balance Sheet: Negative Shock to Assets

Now say, both banks suffer a loss of $5mn on the loan portfolio
total value of assets decreases by $5mn
equity capital decreases by $5mn (writeoff)
Bank H after the capital write off
Assets ($ mn)
Reserves
$10
Loans
$85

Liabilities ($ mn)
Deposits
$90
Bank Capital
$5

Bank L after the capital write off

Assets ($ mn)
Reserves
$10
Loans
$85

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Liabilities ($ mn)
Deposits
$96
Bank Capital
$-1

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Bank Capital
So, a bank needs to maintain capital to reduce the probability of insolvency
Higher the capital the bank has, the lower the chance of probability of
insolvency
What is the cost of holding higher capital?
Do the banks shareholders want the bank to maintain high capital?
net profit after taxes
assets
net profit after taxes
ROE =
equity capital
assets
define Equity Multiplier EM =
equity capital
ROE = ROA EM
ROA =

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Financial Institutions

September 2016

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Bank Capital

Shareholder - Depositor conflict

Moral Hazard
So, there is a need for regulation
Reserve Requirements
Deposit Insurance
Capital Requirements

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September 2016

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Bank Capital
Tier one (core) capital: Tier 1 (core) capital includes: common equity plus
noncumulative perpetual preferred stock plus minority interests in
consolidated subsidiaries less goodwill and other ineligible intangible assets.
The amount of eligible intangibles (including mortgage servicing rights)
included in core capital is limited in accordance with supervisory capital
regulations.
Tier two capital: Risk-based capital-tier 2 is based on the risk-based capital
definitions for prompt corrective action (PCA). Includible Tier 2 capital
components consist of, but are not limited to, limited subordinated debt,
cumulative perpetual preferred stock, allowance for loan and lease losses,
total mandatory convertible debt and a portion of unrealized gains on
available-for-sale equity securities. The maximum amount of supplementary
capital elements that qualify as Tier 2 capital is limited to 100 percent of
Tier 1 capital. In addition, the combined maximum amount of subordinated
debt and intermediate-term preferred stock that qualifies as Tier 2 capital is
limited to 50 percent of Tier 1 capital.
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Bank Capital

Basel II
Basel III
www.bis.org

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Bank Balance Sheet

http://www2.fdic.gov/sdi/main.asp

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Assets and Liabilities of Banks in US

http://www.federalreserve.gov/releases/h8/current/
See page 2 (Assets) and Page 3 (Liabilities)

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Bank of America (BAC)

http://www2.fdic.gov/sdi/main.asp
BHC id 1073757

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Risks faced by Financial Institutions

Interest Rate Risk
Market Risk
Off-Balance-Sheet Risk
Foreign Exchange Risk
Country or Sovereign Risk
Operational Risk
Liquidity Risk
Insolvency Risk
Credit Risk
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Interest Rate Risk

the risk incurred by an FI when the maturities and liabilities of its assets
and liabilities are mismatched and interest rates are volatile
interest rate
floating rate
fixed rate

maturity transformation and maturity gap

demand and other short-term deposits
long maturity loans

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Market Risk

the risk incurred in trading assets and liabilities due to changes in asset
prices
Interest rates
Exchange rates
Credit prices

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Off-Balance-Sheet Risk
the risk incurred by an FI as the result of activities related to contingent
assets and liabilities
Loan guarantees
Letters of Credit
Securitization vehicles
Commercial Paper
Credit Card Receivables
Auto Lease Receivables
Mortgages
Corporate Loans

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Foreign Exchange Risk

the risk that exchange rate changes can affect the value of an FIs
assets denominated in foreign currencies
liabilities denominated in foreign currencies

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Country or Sovereign Risk

the risk that repayments by foreign borrowers may be interrupted because

of interference from foreign governments or other political entities
Sovereign Default
Suspension of foreign currency payments

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Whats the common link????

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Financial Institutions

September 2016

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Operational Risk

Nick Leeson (Barings)

Yasuo Hamanaka (Sumitomo Corporation)
John Rusnak (Allied Irish Banks)
Toshihide Iguchi (Daiwa)
Jerome Kerviel (Societe Generale)
Kweku Adoboli (UBS)
London Whale (JP Morgan)

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Operational Risk

the risk that existing technology or control systems may malfunction or

external shocks can impact the FI
technology or support systems
fraud
natural disasters

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Liquidity Risk

the risk that a sudden and unexpected increase in contractually obligated

payment of funds may require the financial institution to liquidate assets in
a very short period of time and at a low price
liability side
loan commitments from corporate customers

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Financial Institutions

September 2016

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Insolvency Risk

the risk that the FI many not have enough capital to offset a sudden
decline in the value of its assets relative to its liabilities
shocks to asset values
shocks to liabilities

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Financial Institutions

September 2016

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Credit Risk

Credit risk is the risk that a borrower or counter-party will fail to meet a
contractual payment obligation.
Consumer Loans
Corporate Loans
Counter-party Credit Risk
Sovereign Risk

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Financial Institutions

September 2016

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Credit Risk

Credit risk is the risk that a borrower or counter-party will fail to meet a
contractual payment obligation.
Corporate Distress
Technical Default
Default
Failure
Insolvency
Bankruptcy

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Financial Institutions

September 2016

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