Financial Institution Management

1
Financial Institution Management

• Lecture 7
• Part II
• Risk Management in Banks

2
Main Contents

• Managing credit risk
• Managing interest-rate risk
• Income gap analysis
• Duration gap analysis

3
Managing Credit Risk

• Banks must make successful loans to earn high
  returns. In other words, they must reduce credit
  risk as much as possible.
• To be profitable, financial institutions must
  overcome the following two things caused by
  asymmetric information
• Adverse selection
• Moral hazard

4
Screening and Monitoring

• Two information-producing activities can help
  banks
• Screening Lenders must collect sufficient and
  reliable information from prospective borrowers
  in order to screen out the bad credit risk from
  the good ones.
• Monitoring and enforcement of restrictive
  covenants Once a loan has been made, financial
  institution must adhere to the principle for
  managing credit risk that a lender should write
  provisions into loan contracts restricting
  borrower from engaging in risky activities

5
Specializing in Lending

• Specialization in lending also can help to reduce
  the credit risk. Some financial institutions
  often specialize in lending to local firms or to
  firms in particular industries. Specialization
  makes financial institutions become more
  knowledgeable about the borrowers and therefore
  be better able to predict which firms will be
  able to make timely payment on their debt.

6
Long-Term Customer Relationship

• Long-term customer relationship is an additional
  important principle of credit risk management.

7
Collateral and Compensating Balance

• Collateral requirements for loans are important
  credit risk management tools. Collateral is
  property promised to the lender as compensation
  if the borrower defaults.
• One particular collateral required for commercial
  loans is compensating balances. A firm receiving
  a loan must keep a required minimum funds in an
  account at the bank.

8
Credit Rationing

• Another way in which financial institutions deal
  with adverse selection and moral hazard is
  through credit rationing refusing to make loans
  even though borrowers are willing to pay the
  stated interest rate or even a higher rate.
• Credit rationing takes two forms.
• Refusing to make a loan of any amount
• Making a loan but restricting the size to less
  than the borrower would like.

9
Managing Interest-Rate Risk

• One lesson from the bankruptcy of Orange County,
  California.
• County Treasurer Robert Citron borrowed money at
  lower short-term rates and lent money at higher
  long-term rates. That is a profitable strategy in
  most normal circumstances.
• However, things got bad around the end of 1994
  when interests inverted, i.e., long-term debts
  have lower interest than short-term debts.
• Losses to Orange County were estimated at 1.6
  billion and resulted in the bankruptcy of the
  municipality

10
Find Interest-Sensitive Instruments

• The first step in assessing interest-rate risk is
  for the bank manager to decide which assets and
  liabilities are rate-sensitive.
• Adjustable-rate mortgages, loans and deposits.
• Loans with short maturities
• Some fixed-rate loans which could be repaid
  earlier.

11
Income Gap Analysis

• One simple and quick approach to measuring the
  sensitivity of bank income to changes in interest
  rates is income gap analysis.
• GAP RSA RSL
• RSA rate-sensitive assets
• RSL rate-sensitive liabilities

12
Income Gap Analysis

• GAP reveals a basic idea about how the interest
  rate influences the banks income.
• For example, when interest rate increases 1, the
  interest incomes from assets will increase
• 1 RSA
• and interest payment required by liabilities
  will increase
• 1 RSL
• Total income will change 1 GAP

13
Duration Gap Analysis

• The income gap analysis focuses only on the
  effect of interest rate changes on bank incomes.
• Stockholders and bank managers care about the
  effect of interest rates on the market value of
  the net worth of the bank because the stock price
  is related with the difference of market prices
  of assets and liabilities.
  

14
Duration Gap Analysis

• For example, First National Bank has 10M
  investment in a government bond. We may use
  duration to analyze the effect of interest rate
  change on the bond market values.
• Suppose the duration of the bond is 4. Then when
  interest rate increases from 4 to 5,
• 
  

15
Duration Gap Analysis

• Of course, it is impossible for a bank to have
  only one asset.
• To evaluate the effect of interest rates on the
  market value of all assets, we need to treat all
  the assets as a whole and calculate the average
  duration.
• Asset 1 The
  average duration of all assets
• Asset 2
• Asset N

16
Duration Gap Analysis

• Follow a similar procedure, we can calculate
  duration for all liabilities.
• Example
• The bank manager wants to know what happen
  when interest rates rise from 10 to 11. The
  total asset value is 100M and its duration is
  2.7, and the total liability value is 95M and
  its duration is 1.03. What are the changes for
  the market values of assets and liabilities?
• The net worth of the bank is -2.50.9-1.6M

17
Duration Gap Analysis

• The bank manager could have obtained the answer
  even quickly by calculating a duration gap
• In the previous example, the banks duration gap
  is
• The net worth change is