Types of Risks Faced by All Financial Institutions
by
Charles Lamson
To get a clearer picture of how the services that financial institutions (FIs) provide reduce the risks associated with borrowing and lending, it is usual to visualize the various FIs as being exposed to, and having to deal with, several types of risks and uncertainties.
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If a stranger knocked on your door at 1 A.M. and asked to borrow $1,000 you would probably react quite negatively, regardless of the interest rate the stranger was willing to pay. Your reluctance is of course, tied to the risk or likelihood that the borrower will default and not repay the loan. You do not know the person's financial history and current situation, and you are suspicious about why anyone would show up at this hour making such a request. How would one use a loan of $1,000 at 1 A.M.?
But every time an intermediary makes a loan or purchases a security issued by a DSU (firm/business), it faces the same risk. Credit or default risk is the risk that the DSU will be unwilling or unable to live up to the terms of the liability it has sold. Perhaps the DSU is a firm that uses the funds for expansion, but the business it thought would boom turns out to be a bust because of some unanticipated complication or a general slow-down in the economy. Perhaps the borrower is morally unscrupulous and takes the money and runs. Thus, for whatever reason when making a loan or buying a financial asset issued by a DSU, the intermediary whether it be a bank, mutual fund, or insurance company, is exposed to the risk that the DSU will default.
Interest Rate Risk
Another type of risk that must be managed is the interest rate risk. This is the risk that the interest rate will unexpectedly change so that the costs of an FI's liabilities exceed the earnings on its assets. This risk emanates from the relationship between the interest rate (return) earned on assets and the cost of, or interest rate paid on liabilities. An FI's profitability is directly related to the spread between these rates. FIs obviously strive for a large positive spread in which the return on assets significantly exceeds the cost of liabilities.
Liquidity risk is the risk when an FI (financial institution) will be required to make a payment when the assets that the intermediary has available to make the payment are long-term and cannot be converted to liquid funds quickly without capital. Such a situation could occur when depositors unexpectedly withdrew funds, or when an insurance company incurs unexpectedly high claim losses, as a result of an earthquake, fire, flood, or hurricane. All intermediaries may experience a sudden unexpected need for funds, but depository institutions are particularly vulnerable to a deposit run that can cause a financial crisis, because their reserves are only a fraction of their liabilities and those liabilities are often payable on demand. The Fed stands ready to provide liquidity for depository institutions, by acting as a lender of last resort. Intermediaries can reduce their liquidity risk by holding highly liquid assets that can be quickly converted into the funds needed to meet unexpected withdrawals or contingencies. They can also make other arrangements to mitigate this risk such as backup lines of credit to meet unexpected needs.
Exchange Rate Risk
Lastly, financial markets have become increasingly international in scope. As a consequence, many large intermediaries, as well as other large corporations, maintain stocks of foreign exchange that are used in international transactions. In addition, some FIs may hold financial assets (investments) that are denominated in foreign currencies, such as foreign stocks or bonds. In either case, the FI is exposed to a risk that the dollar exchange rate between the two currencies will appreciate, causing the dollar value of the foreign currency or foreign financial assets to fall. Thus, an FI, like any holder of foreign exchange or foreign financial assets, is subject to an exchange rate risk---the risk changes in the exchange rate will cause the dollar value of foreign currency or foreign financial assets to fall. For example, assume an intermediary holds 10,000,000 yen or a financial asset valued at 10,000,000 yen. If the exchange rate is $1 = 100 yen, then 10,000,000 yen are worth $100,000. If the dollar exchange rate appreciates to $1 = 200 yen, then the 10,000,000 yen are worth only $50,000. In this case, the FI incurs a loss that is proportional to the amount of foreign currency or foreign financial assets that it holds and to the change in the exchange rate.
Recap
All FIs face several risks in varying degrees. Default risk is the risk that the borrower will not pay the financial claim. Interest rate risk is the risk when changes in the interest rate will turn a profitable spread into a loss. Liquidity risk is the risk that funds will not be available when needed. Exchange rate risk is the risk when changes in exchange rates will cause the FI to experience losses in the dollar value of foreign currency or foreign financial assets.
*ANALYSIS OF THE FINANCIAL SYSTEM AND THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 229-231*
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