Budi PurwantoBudi Purwanto

Manajemen Risiko Manajemen Risiko Lembaga KeuanganLembaga Keuangan

IkhtisarIkhtisar

Bagian ini membahas risiko-risiko dalam Bagian ini membahas risiko-risiko dalam intermediasi keuangan, antara lain:intermediasi keuangan, antara lain: Risiko suku bunga;Risiko suku bunga; Risiko nilai tukar;Risiko nilai tukar; Risiko pasar;Risiko pasar; Risiko operasional;Risiko operasional; Risiko politik (country risk);Risiko politik (country risk); Risiko kredit;Risiko kredit; Risiko likuiditas; dan Risiko likuiditas; dan Risiko permodalan (insolvency risk).Risiko permodalan (insolvency risk).

Risiko Suku BungaRisiko Suku Bunga

Risiko suku bunga akibat intermediasi:Risiko suku bunga akibat intermediasi: Ketidakcocokan jatuh tempo aktiva dan Ketidakcocokan jatuh tempo aktiva dan

pasiva.pasiva. Ketidakcocokan merupakan masalah Ketidakcocokan merupakan masalah

sistematis dalam intermediasi keuangan.sistematis dalam intermediasi keuangan.

Risiko pendanaan-kembali.Risiko pendanaan-kembali. Risiko investasi-kembali.Risiko investasi-kembali.

Risiko Nilai Tulkar Risiko Nilai Tulkar

Tingkat imbalan dalam mata uang domestik Tingkat imbalan dalam mata uang domestik dan valas tidak selalu berkorelasi sempurna.dan valas tidak selalu berkorelasi sempurna.

Nilai tukar valas mungkin tidak berhubungan.Nilai tukar valas mungkin tidak berhubungan. Misal: US$/IDR mungkin menguat sementara Misal: US$/IDR mungkin menguat sementara

¥/IDR melemah.¥/IDR melemah.

Konsentrasi pada valas tertentu dapat Konsentrasi pada valas tertentu dapat menimbulkan risiko nilai tukar.menimbulkan risiko nilai tukar.

Risiko PasarRisiko Pasar

Risiko pasar terbuka dalam pertukaran Risiko pasar terbuka dalam pertukaran aktiva dan pasiva (dan turunannya).aktiva dan pasiva (dan turunannya). Contoh: sub-prime mortgage.Contoh: sub-prime mortgage. Cenderung lebih besar ketahanannya pada Cenderung lebih besar ketahanannya pada

pertukaran pendapatan daripada pertukaran pendapatan daripada perdagangan tradisional dalam perdagangan tradisional dalam meningkatkan paparan pasar.meningkatkan paparan pasar.

Risiko ekonomi makroRisiko ekonomi makro

Kenaikan inflasi atau volatilitasnya.Kenaikan inflasi atau volatilitasnya. Keduanya mempengaruhi suku bunga.Keduanya mempengaruhi suku bunga.

Peningkatan pengangguran Peningkatan pengangguran Mempengaruhi risiko kredit.Mempengaruhi risiko kredit.

Risiko Operational Risiko Operational

Risk of direct or indirect loss resulting form Risk of direct or indirect loss resulting form inadequate or failed internal processes, inadequate or failed internal processes, people, and systems or from external people, and systems or from external events.events. Some include reputational and strategic riskSome include reputational and strategic risk

Technological innovation has seen rapid Technological innovation has seen rapid growthgrowth Automated clearing housesAutomated clearing houses CHIPSCHIPS

Risiko Operational Risiko Operational

Risk that technology investment fails to Risk that technology investment fails to produce anticipated cost savings.produce anticipated cost savings.

Risk that technology may break down.Risk that technology may break down. Economies of scale.Economies of scale. Economies of scope.Economies of scope.

Risiko Nilai Tukar ValasRisiko Nilai Tukar Valas

Note that hedging foreign exposure by Note that hedging foreign exposure by matching foreign assets and liabilities matching foreign assets and liabilities requires matching the maturities as well*. requires matching the maturities as well*. Otherwise, exposure to foreign interest rate Otherwise, exposure to foreign interest rate

risk is created.risk is created.

Risiko Politik (atau Risiko Politik (atau Country or Sovereign Country or Sovereign risk)risk)

Result of exposure to foreign government Result of exposure to foreign government which may impose restrictions on which may impose restrictions on repayments to foreigners.repayments to foreigners.

Lack usual recourse via court system.Lack usual recourse via court system. Examples: South Korea, Indonesia, Examples: South Korea, Indonesia,

Thailand.Thailand. More recently, Argentina.More recently, Argentina.

Risiko KreditRisiko Kredit

Risk that promised cash flows are not paid in Risk that promised cash flows are not paid in full.full. Firm specific credit riskFirm specific credit risk Systematic credit riskSystematic credit risk

High rate of charge-offs of credit card debt in High rate of charge-offs of credit card debt in the 80s and 90sthe 80s and 90s

Obvious need for credit screening and Obvious need for credit screening and monitoringmonitoring

Diversification of credit riskDiversification of credit risk

Risiko LikuiditasRisiko Likuiditas

Risk of being forced to borrow, or sell Risk of being forced to borrow, or sell assets in a very short period of time. assets in a very short period of time. Low prices result.Low prices result.

May generate runs.May generate runs. Runs may turn liquidity problem into Runs may turn liquidity problem into

solvency problem.solvency problem. Risk of systematic bank panics.Risk of systematic bank panics.

Risiko Kecukupan Modal Risiko Kecukupan Modal (Insolvency Risk)(Insolvency Risk)

Risk of insufficient capital to offset Risk of insufficient capital to offset sudden decline in value of assets to sudden decline in value of assets to liabilities.liabilities. Continental Illinois National Bank and TrustContinental Illinois National Bank and Trust

Original cause may be excessive interest Original cause may be excessive interest rate, market, credit, off-balance-sheet, rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity technological, FX, sovereign, and liquidity risks.risks.

Interest RisksInterest Risks

Budi PurwantoBudi Purwanto

OverviewOverview

This chapter discusses the interest rate risk This chapter discusses the interest rate risk associated with financial intermediation:associated with financial intermediation: Federal Reserve policyFederal Reserve policy Repricing modelRepricing model Maturity modelMaturity model Duration modelDuration model *Term structure of interest rate risk*Term structure of interest rate risk *Theories of term structure of interest rates*Theories of term structure of interest rates

Central Bank Policy and Central Bank Policy and Interest Rate RiskInterest Rate Risk Japan: March 2001 announced it would Japan: March 2001 announced it would

no longer target the uncollateralized no longer target the uncollateralized overnight call rate. overnight call rate.

New target: Outstanding current account New target: Outstanding current account balances at BOJbalances at BOJ Targeting of bank reserves in U.S. proved Targeting of bank reserves in U.S. proved

disastrousdisastrous

Central Bank and Central Bank and Interest Rate RiskInterest Rate Risk

Effects of interest rate targeting.Effects of interest rate targeting. Lessens interest rate riskLessens interest rate risk

October 1979 to October 1982, October 1979 to October 1982, nonborrowed reserves target regime.nonborrowed reserves target regime.

Implications of return to reserves target Implications of return to reserves target policy:policy: Increases importance of measuring and Increases importance of measuring and

managing interest rate risk.managing interest rate risk.

Repricing ModelRepricing Model

Repricing or funding gap model based on Repricing or funding gap model based on book value.book value.

Contrasts with market value-based maturity Contrasts with market value-based maturity and duration models recommended by the and duration models recommended by the Bank for International Settlements (BIS).Bank for International Settlements (BIS).

Rate sensitivity means time to repricing.Rate sensitivity means time to repricing. Repricing gap is the difference between the Repricing gap is the difference between the

rate sensitivity of each asset and the rate rate sensitivity of each asset and the rate sensitivity of each liability: RSA - RSL.sensitivity of each liability: RSA - RSL.

Maturity BucketsMaturity Buckets

Commercial banks must report repricing gaps Commercial banks must report repricing gaps for assets and liabilities with maturities of:for assets and liabilities with maturities of: One day.One day. More than one day to three months.More than one day to three months. More than 3 three months to six months.More than 3 three months to six months. More than six months to twelve months.More than six months to twelve months. More than one year to five years.More than one year to five years. Over five years.Over five years.

Repricing Gap ExampleRepricing Gap Example

AssetsAssets LiabilitiesLiabilities GapGap Cum. GapCum. Gap

1-day1-day $ 20 $ 20 $ 30 $ 30 $-10 $-10 $-10 $-10

>1day-3mos. 30 40 -10 -20>1day-3mos. 30 40 -10 -20

>3mos.-6mos. 70 85 -15 -35>3mos.-6mos. 70 85 -15 -35

>6mos.-12mos. 90 70 +20 -15>6mos.-12mos. 90 70 +20 -15

>1yr.-5yrs. 40 30 +10 -5>1yr.-5yrs. 40 30 +10 -5

>5 years>5 years 10 5 +5 0 10 5 +5 0

Applying the Repricing Applying the Repricing ModelModel

NIINIIii = (GAP = (GAPii) ) RRii = (RSA = (RSAii - RSL - RSLii) ) rrii

ExampleExample: : In the one day bucket, gap is -$10 million. If rates In the one day bucket, gap is -$10 million. If rates

rise by 1%,rise by 1%,

NIINIIii = (-$10 million) × .01 = -$100,000. = (-$10 million) × .01 = -$100,000.

Applying the Repricing Applying the Repricing ModelModel

Example II:Example II:

If we consider the cumulative 1-year gap,If we consider the cumulative 1-year gap,

NIINIIii = (CGAP = (CGAPii) ) RRii = (-$15 million)(.01) = (-$15 million)(.01)

= -$150,000.= -$150,000.

Rate-Sensitive AssetsRate-Sensitive Assets

Examples fromExamples from hypothetical hypothetical balance sheet: balance sheet: Short-term consumer loans. If repriced at year-Short-term consumer loans. If repriced at year-

end, would just make one-year cutoff.end, would just make one-year cutoff. Three-month T-bills repriced on maturity every Three-month T-bills repriced on maturity every

3 months.3 months. Six-month T-notes repriced on maturity every 6 Six-month T-notes repriced on maturity every 6

months.months. 30-year floating-rate mortgages repriced (rate 30-year floating-rate mortgages repriced (rate

reset) every 9 months.reset) every 9 months.

Rate-Sensitive LiabilitiesRate-Sensitive Liabilities

RSLs bucketed in same manner as RSLs bucketed in same manner as RSAs.RSAs.

Demand deposits and passbook savings Demand deposits and passbook savings accounts warrant special mention.accounts warrant special mention. Generally considered rate-Generally considered rate- insensitive insensitive (act as (act as

core deposits), but there are arguments for core deposits), but there are arguments for their inclusion as rate-sensitive liabilities.their inclusion as rate-sensitive liabilities.

CGAP RatioCGAP Ratio

May be useful to express CGAP in ratio May be useful to express CGAP in ratio form as,form as,

CGAP/Assets.CGAP/Assets. Provides direction of exposure and Provides direction of exposure and Scale of the exposure.Scale of the exposure.

Example: Example: CGAP/A = $15 million / $270 million = 0.56, CGAP/A = $15 million / $270 million = 0.56,

or 5.6 percent.or 5.6 percent.

Equal Changes in Equal Changes in Rates Rates on RSAs and RSLson RSAs and RSLs

Example: Suppose rates rise 2% for RSAs Example: Suppose rates rise 2% for RSAs and RSLs. Expected annual change in NII,and RSLs. Expected annual change in NII,

NII = CGAP × NII = CGAP × R R

= $15 million × .01= $15 million × .01

= $150,000= $150,000

With positive CGAP, rates and NII move in With positive CGAP, rates and NII move in the same direction.the same direction.

Unequal Changes in Unequal Changes in RatesRates

If changes in rates on RSAs and RSLs are If changes in rates on RSAs and RSLs are not equal, the spread changes. In this case,not equal, the spread changes. In this case,

NII = (RSA × NII = (RSA × R RRSARSA ) - (RSL × ) - (RSL × R RRSLRSL ) )

Unequal Rate Change Unequal Rate Change ExampleExample

Spread effect example: Spread effect example:

RSA rate rises by 1.2% and RSL rate rises by RSA rate rises by 1.2% and RSL rate rises by 1.0%1.0%

NII = NII = interest revenue - interest revenue - interest expense interest expense

= ($155 million × 1.2%) - ($155 million × 1.0%) = ($155 million × 1.2%) - ($155 million × 1.0%)

= $310,000= $310,000

Restructuring Assets Restructuring Assets and Liabilitiesand Liabilities

The FI can restructure its assets and The FI can restructure its assets and liabilities, on or off the balance sheet, to liabilities, on or off the balance sheet, to benefit from projected interest rate benefit from projected interest rate changes.changes. Positive gap: increase in rates increases NIIPositive gap: increase in rates increases NII Negative gap: decrease in rates increases Negative gap: decrease in rates increases

NIINII

Weaknesses of Repricing Weaknesses of Repricing ModelModel

Weaknesses:Weaknesses: Ignores market value effects and off-balance Ignores market value effects and off-balance

sheet cash flowssheet cash flows OveraggregativeOveraggregative

Distribution of assets & liabilities within individual Distribution of assets & liabilities within individual buckets is not considered. Mismatches within buckets buckets is not considered. Mismatches within buckets can be substantial.can be substantial.

Ignores effects of runoffsIgnores effects of runoffs Bank continuously originates and retires consumer and Bank continuously originates and retires consumer and

mortgage loans. Runoffs may be rate-sensitive.mortgage loans. Runoffs may be rate-sensitive.

The Maturity ModelThe Maturity Model

Explicitly incorporates market value effects.Explicitly incorporates market value effects. For fixed-income assets and liabilities:For fixed-income assets and liabilities:

Rise (fall) in interest rates leads to fall (rise) in Rise (fall) in interest rates leads to fall (rise) in market price.market price.

The longer the maturity, the greater the effect of The longer the maturity, the greater the effect of interest rate changes on market price.interest rate changes on market price.

Fall in value of longer-term securities increases Fall in value of longer-term securities increases at diminishing rate for given increase in interest at diminishing rate for given increase in interest rates.rates.

Maturity of PortfolioMaturity of Portfolio

Maturity of portfolio of assets (liabilities) Maturity of portfolio of assets (liabilities) equals weighted average of maturities of equals weighted average of maturities of individual components of the portfolio.individual components of the portfolio.

Principles stated on previous slide apply Principles stated on previous slide apply to portfolio as well as to individual assets to portfolio as well as to individual assets or liabilities.or liabilities.

Typically, MTypically, MAA - M - MLL > 0 for most banks and > 0 for most banks and

thrifts.thrifts.

Effects of Interest Rate Effects of Interest Rate ChangesChanges

Size of the gap determines the size of Size of the gap determines the size of interest rate change that would drive net interest rate change that would drive net worth to zero.worth to zero.

Immunization and effect of setting Immunization and effect of setting

MMAA - M - MLL = 0. = 0.

Maturity Matching Maturity Matching and Interest Rate and Interest Rate ExposureExposure

If MIf MAA - M - MLL = 0, is the FI immunized? = 0, is the FI immunized? Extreme example: Suppose liabilities consist of Extreme example: Suppose liabilities consist of

1-year zero coupon bond with face value $100. 1-year zero coupon bond with face value $100. Assets consist of 1-year loan, which pays back Assets consist of 1-year loan, which pays back $99.99 shortly after origination, and 1¢ at the $99.99 shortly after origination, and 1¢ at the end of the year. Both have maturities of 1 year.end of the year. Both have maturities of 1 year.

NotNot immunized, although maturities are equal. immunized, although maturities are equal. Reason: Differences in Reason: Differences in duration.duration.

DurationDuration

The average life of an asset or liabilityThe average life of an asset or liability The weighted-average time to maturity The weighted-average time to maturity

using present value of the cash flows, using present value of the cash flows, relative to the total present value of the relative to the total present value of the asset or liability as weights. asset or liability as weights.

*Term Structure of *Term Structure of Interest RatesInterest Rates

YTMYTM

Time to Maturity

Time to Maturity

Time to Maturity

Time to Maturity

YTM

*Unbiased Expectations *Unbiased Expectations TheoryTheory

Yield curve reflects market’s expectations Yield curve reflects market’s expectations of future short-term rates.of future short-term rates.

Long-term rates are geometric average Long-term rates are geometric average of current and expected short-term rates.of current and expected short-term rates.__ __ ~~ ~~

RRNN = [(1+R = [(1+R11)(1+E(r)(1+E(r22))…(1+E(r))…(1+E(rNN))]))]1/N1/N - 1 - 1

*Liquidity Premium *Liquidity Premium TheoryTheory

Allows for future uncertainty.Allows for future uncertainty. Premium required to hold long-term.Premium required to hold long-term. Investors have specific needs in terms of Investors have specific needs in terms of

maturity.maturity. Yield curve reflects intersection of demand Yield curve reflects intersection of demand

and supply of individual maturities.and supply of individual maturities.

Market Value-BasedMarket Value-Based

This chapter discusses a market value-This chapter discusses a market value-based model for assessing and managing based model for assessing and managing interest rate risk: interest rate risk: DurationDuration Computation of durationComputation of duration Economic interpretationEconomic interpretation Immunization using durationImmunization using duration * Problems in applying duration* Problems in applying duration

Price Sensitivity and Price Sensitivity and MaturityMaturity

In general, the longer the term to In general, the longer the term to maturity, the greater the sensitivity to maturity, the greater the sensitivity to interest rate changes. interest rate changes.

Example: Suppose the zero coupon yield Example: Suppose the zero coupon yield curve is flat at 12%. Bond A pays curve is flat at 12%. Bond A pays $1762.34 in five years. Bond B pays $1762.34 in five years. Bond B pays $3105.85 in ten years, and both are $3105.85 in ten years, and both are currently priced at $1000.currently priced at $1000.

Example continued...Example continued...

Bond A: P = $1000 = $1762.34/(1.12)Bond A: P = $1000 = $1762.34/(1.12)55 Bond B: P = $1000 = $3105.84/(1.12)Bond B: P = $1000 = $3105.84/(1.12)1010

Now suppose the interest rate increases Now suppose the interest rate increases by 1%. by 1%. Bond A: P = $1762.34/(1.13)Bond A: P = $1762.34/(1.13)55 = $956.53 = $956.53 Bond B: P = $3105.84/(1.13)Bond B: P = $3105.84/(1.13)10 10 = $914.94= $914.94

The longer maturity bond has the greater drop in The longer maturity bond has the greater drop in price price because the payment is discounted a because the payment is discounted a greater number of timesgreater number of times..

Coupon EffectCoupon Effect

Bonds with identical maturities will respond Bonds with identical maturities will respond differently to interest rate changes when the differently to interest rate changes when the coupons differ. This is more readily coupons differ. This is more readily understood by recognizing that coupon understood by recognizing that coupon bonds consist of a bundle of “zero-coupon” bonds consist of a bundle of “zero-coupon” bonds. With higher coupons, more of the bonds. With higher coupons, more of the bond’s value is generated by cash flows bond’s value is generated by cash flows which take place sooner in time. which take place sooner in time. Consequently, less sensitive to changes in R.Consequently, less sensitive to changes in R.

Price Sensitivity of 6% Price Sensitivity of 6% Coupon BondCoupon Bond

r 8% 6% 4% Range

n

40 $802 $1,000 $1,273 $471

20 $864 $1,000 $1,163 $299

10 $919 $1,000 $1,089 $170

2 $981 $1,000 $1,019 $37

Price Sensitivity of Price Sensitivity of 8% Coupon Bond8% Coupon Bond

r 10% 8% 6% Range

n

40 $828 $1,000 $1,231 $403

20 $875 $1,000 $1,149 $274

10 $923 $1,000 $1,085 $162

2 $981 $1,000 $1,019 $38

Remarks on Preceding Remarks on Preceding SlidesSlides

The longer maturity bonds experience The longer maturity bonds experience greater price changes in response to any greater price changes in response to any change in the discount rate.change in the discount rate.

The range of prices is greater when the The range of prices is greater when the coupon is lower. coupon is lower. The 6% bond shows greater changes in price The 6% bond shows greater changes in price

in response to a 2% change than the 8% in response to a 2% change than the 8% bond. The first bond is has greater interest bond. The first bond is has greater interest rate risk.rate risk.

DurationDuration

DurationDuration Weighted average time to maturity using the Weighted average time to maturity using the

relative present values of the cash flows as relative present values of the cash flows as weights.weights.

Combines the effects of differences in Combines the effects of differences in coupon rates and differences in maturity. coupon rates and differences in maturity.

Based on elasticity of bond price with Based on elasticity of bond price with respect to interest rate.respect to interest rate.

DurationDuration

Duration Duration

D = D = nnt=1t=1[C[Ctt• t/(1+r)• t/(1+r)tt]/ ]/ nn

t=1t=1 [C [Ctt/(1+r)/(1+r)tt]]

WhereWhereD = durationD = duration

t = number of periods in the futuret = number of periods in the future

CCtt = cash flow to be delivered in t periods = cash flow to be delivered in t periods

n= term-to-maturity & r = yield to maturity (per n= term-to-maturity & r = yield to maturity (per period basis).period basis).

DurationDuration

Since the price of the bond must equal the Since the price of the bond must equal the present value of all its cash flows, we can present value of all its cash flows, we can state the duration formula another way:state the duration formula another way:

D = D = nnt=1t=1[t [t (Present Value of C (Present Value of C tt/Price)]/Price)]

Notice that the weights correspond to the Notice that the weights correspond to the relativerelative present values of the cash flows. present values of the cash flows.

Duration of Zero-coupon Duration of Zero-coupon BondBond

For a zero coupon bond, duration equals For a zero coupon bond, duration equals maturity since 100% of its present value maturity since 100% of its present value is generated by the payment of the face is generated by the payment of the face value, at maturity.value, at maturity.

For all other bonds:For all other bonds: duration < maturityduration < maturity

Computing durationComputing duration

Consider a 2-year, 8% coupon bond, with a Consider a 2-year, 8% coupon bond, with a face value of $1,000 and yield-to-maturity of face value of $1,000 and yield-to-maturity of 12%. Coupons are paid semi-annually.12%. Coupons are paid semi-annually.

Therefore, each coupon payment is $40 and Therefore, each coupon payment is $40 and the per period YTM is (1/2) × 12% = 6%.the per period YTM is (1/2) × 12% = 6%.

Present value of each cash flow equals CFPresent value of each cash flow equals CF tt ÷ ÷

(1+ 0.06)(1+ 0.06)tt where where tt is the period number. is the period number.

Duration of 2-year, 8% Duration of 2-year, 8% bond: bond: Face value = $1,000, YTM = 12%Face value = $1,000, YTM = 12%

t years CFt PV(CFt) Weight(x)

x × years

1 0.5 40 37.736 0.041 0.020

2 1.0 40 35.600 0.038 0.038

3 1.5 40 33.585 0.036 0.054

4 2.0 1,040 823.777 0.885 1.770

P = 930.698 1.000 D=1.883(years)

Special CaseSpecial Case

Maturity of a consol: M = Maturity of a consol: M = .. Duration of a consol: D = 1 + 1/RDuration of a consol: D = 1 + 1/R

Duration GapDuration Gap

Suppose the bond in the previous example Suppose the bond in the previous example is the only loan asset (L) of an FI, funded by is the only loan asset (L) of an FI, funded by a 2-year certificate of deposit (D). a 2-year certificate of deposit (D).

Maturity gap: MMaturity gap: MLL - M - MDD = 2 -2 = 0 = 2 -2 = 0

Duration Gap: DDuration Gap: DLL - D - DDD = 1.885 - 2.0 = -0.115 = 1.885 - 2.0 = -0.115 Deposit has greater interest rate sensitivity than Deposit has greater interest rate sensitivity than

the loan, so DGAP is negative. the loan, so DGAP is negative. FI exposed to rising interest rates.FI exposed to rising interest rates.

Features of DurationFeatures of Duration

Duration and maturity:Duration and maturity: D increases with M, but at a decreasing rate.D increases with M, but at a decreasing rate.

Duration and yield-to-maturity:Duration and yield-to-maturity: D decreases as yield increases.D decreases as yield increases.

Duration and coupon interest:Duration and coupon interest: D decreases as coupon increasesD decreases as coupon increases

Economic Interpretation Economic Interpretation

Duration is a measure of interest rate Duration is a measure of interest rate sensitivity or elasticity of a liability or sensitivity or elasticity of a liability or asset:asset:

[dP/P] [dP/P] [dR/(1+R)] = -D [dR/(1+R)] = -D

Or equivalently,Or equivalently,

dP/P = -D[dR/(1+R)] = -MD × dRdP/P = -D[dR/(1+R)] = -MD × dR

where MD is modified duration.where MD is modified duration.

Economic InterpretationEconomic Interpretation

To estimate the change in price, we can To estimate the change in price, we can rewrite this as:rewrite this as:

dP = -D[dR/(1+R)]P = -(MD) × (dR) dP = -D[dR/(1+R)]P = -(MD) × (dR) × (P)× (P)

Note the direct Note the direct linearlinear relationship between dP relationship between dP and -D.and -D.

Semi-annual Coupon Semi-annual Coupon PaymentsPayments

With semi-annual coupon payments:With semi-annual coupon payments:

(dP/P)/(dR/R) = -D[dR/(1+(R/2)](dP/P)/(dR/R) = -D[dR/(1+(R/2)]

An example:An example:

Consider three loan plans, all of which Consider three loan plans, all of which have maturities of 2 years. The loan have maturities of 2 years. The loan amount is $1,000 and the current interest amount is $1,000 and the current interest rate is 3%. Loan #1, is an installment rate is 3%. Loan #1, is an installment loan with two equal payments of $522.61. loan with two equal payments of $522.61. Loan #2 is a discount loan, which has a Loan #2 is a discount loan, which has a single payment of $1,060.90. Loan #3 is single payment of $1,060.90. Loan #3 is structured as a 3% annual coupon bond.structured as a 3% annual coupon bond.

Duration as Index of Duration as Index of Interest Rate RiskInterest Rate Risk

Yield Loan Value 2% 3% dP n D

Installment $1014.67 $1000 $28.98 2 1.493 Discount $1019.70 $1000 $38.84 2 2.000 Coupon $1019.41 $1000 $38.27 2 1.97

Immunizing theImmunizing theBalance Sheet of an FIBalance Sheet of an FI

Duration Gap: Duration Gap: From the balance sheet, E=A-L. Therefore, From the balance sheet, E=A-L. Therefore,

E=E=A-A-L. In the same manner used to L. In the same manner used to determine the change in bond prices, we determine the change in bond prices, we can find the change in value of equity using can find the change in value of equity using duration.duration.

E = [-DE = [-DAAA + DA + DLLL] L] R/(1+R) orR/(1+R) or

DDAA - D - DLLk]A(k]A(R/(1+R))R/(1+R))

Duration and ImmunizingDuration and Immunizing

The formula shows 3 effects:The formula shows 3 effects: Leverage adjusted D-GapLeverage adjusted D-Gap The size of the FIThe size of the FI The size of the interest rate shockThe size of the interest rate shock

An example:An example:

Suppose DSuppose DAA = 5 years, D = 5 years, DLL = 3 years and = 3 years and

rates are expected to rise from 10% to 11%. rates are expected to rise from 10% to 11%. (Rates change by 1%). Also, A = 100, L = 90 (Rates change by 1%). Also, A = 100, L = 90 and E = 10. Find change in E.and E = 10. Find change in E.

DDAA - D - DLLk]A[k]A[R/(1+R)]R/(1+R)]

= -[5 - 3(90/100)]100[.01/1.1] = - $2.09.= -[5 - 3(90/100)]100[.01/1.1] = - $2.09. Methods of immunizing balance sheet.Methods of immunizing balance sheet.

Adjust DAdjust DAA , D , DLL or k. or k.

Immunization and Immunization and Regulatory ConcernsRegulatory Concerns

Regulators set target ratios for a bank’s Regulators set target ratios for a bank’s capital (net worth): capital (net worth): Capital (Net worth) ratio = E/ACapital (Net worth) ratio = E/A

If target is to set If target is to set (E/A) = 0:(E/A) = 0: DDAA = D = DLL

But, to set But, to set E = 0:E = 0: DDAA = kD = kDLL

*Limitations of Duration*Limitations of Duration

Immunizing the entire balance sheet need not be Immunizing the entire balance sheet need not be costly. Duration can be employed in combination costly. Duration can be employed in combination with hedge positions to immunize.with hedge positions to immunize.

Immunization is a dynamic process since Immunization is a dynamic process since duration depends on instantaneous R.duration depends on instantaneous R.

Large interest rate change effects not accurately Large interest rate change effects not accurately captured.captured. ConvexityConvexity

More complex if nonparallel shift in yield curve.More complex if nonparallel shift in yield curve.

*Convexity*Convexity

The duration measure is a linear The duration measure is a linear approximation of a non-linear function. If approximation of a non-linear function. If there are large changes in R, the there are large changes in R, the approximation is much less accurate. All approximation is much less accurate. All fixed-income securities are convex. fixed-income securities are convex. Convexity is desirable, but greater Convexity is desirable, but greater convexity causes larger errors in the convexity causes larger errors in the duration-based estimate of price changes. duration-based estimate of price changes.

*Convexity*Convexity

Recall that duration involves only the first Recall that duration involves only the first derivative of the price function. We can derivative of the price function. We can improve on the estimate using a Taylor improve on the estimate using a Taylor expansion. In practice, the expansion expansion. In practice, the expansion rarely goes beyond second order (using rarely goes beyond second order (using the second derivative).the second derivative).

*Modified duration*Modified duration

P/P = -D[P/P = -D[R/(1+R)] + (1/2) CX (R/(1+R)] + (1/2) CX (R)R)22 or or P/P = -MD P/P = -MD R + (1/2) CX (R + (1/2) CX (R)R)22

Where MD implies modified duration and CX is Where MD implies modified duration and CX is a measure of the curvature effect. a measure of the curvature effect.

CX = Scaling factor × [capital loss from 1bp rise CX = Scaling factor × [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield]in yield + capital gain from 1bp fall in yield]

Commonly used scaling factor is 10Commonly used scaling factor is 1088..

*Calculation of CX*Calculation of CX

Example: convexity of 8% coupon, 8% Example: convexity of 8% coupon, 8% yield, six-year maturity Eurobond priced yield, six-year maturity Eurobond priced at $1,000.at $1,000.

CX = 10CX = 1088[[PP--/P + /P + PP++/P]/P]

= 10= 1088[(999.53785-1,000)/1,000 + [(999.53785-1,000)/1,000 +

(1,000.46243-1,000)/1,000)](1,000.46243-1,000)/1,000)]

= 28.= 28.

*Duration Measure: *Duration Measure: Other IssuesOther Issues

Default riskDefault risk Floating-rate loans and bondsFloating-rate loans and bonds Duration of demand deposits and Duration of demand deposits and

passbook savingspassbook savings Mortgage-backed securities and Mortgage-backed securities and

mortgagesmortgages Duration relationship affected by call or Duration relationship affected by call or

prepayment provisions. prepayment provisions.

*Contingent Claims*Contingent Claims

Interest rate changes also affect value of Interest rate changes also affect value of off-balance sheet claims.off-balance sheet claims. Duration gap hedging strategy must include Duration gap hedging strategy must include

the effects on off-balance sheet items such the effects on off-balance sheet items such as futures, options, swaps, caps, and other as futures, options, swaps, caps, and other contingent claims.contingent claims.

Risiko Nilai TukarRisiko Nilai Tukar

Budi PurwantoBudi Purwanto

Forex RisksForex Risks

This chapter discusses foreign exchange This chapter discusses foreign exchange risk to which FIs are exposed. This issue risk to which FIs are exposed. This issue has become increasingly important for FIs has become increasingly important for FIs due to hedging needs and speculative due to hedging needs and speculative positions taken to increase income. positions taken to increase income.

BackgroundBackground

Globalization of financial markets has Globalization of financial markets has increased foreign exposure of most FIs.increased foreign exposure of most FIs.

FI may have assets or liabilities FI may have assets or liabilities denominated in foreign currency (in denominated in foreign currency (in addition to direct positions in foreign addition to direct positions in foreign currency).currency).

Foreign currency holdings exceed direct Foreign currency holdings exceed direct portfolio investments. portfolio investments.

Sources of FX RiskSources of FX Risk

Spot positions denominated in foreign Spot positions denominated in foreign currencycurrency

Forward positions denominated in foreign Forward positions denominated in foreign currencycurrency

Net exposure = (FX assets - FX liab.) + Net exposure = (FX assets - FX liab.) + (FX bought - FX sold)(FX bought - FX sold)

FX Risk ExposureFX Risk Exposure

FI may have positions in spot and FI may have positions in spot and forward markets. forward markets. Could match foreign currency assets and Could match foreign currency assets and

liabilities to hedge F/X riskliabilities to hedge F/X risk Must also hedge against foreign interest rate risk Must also hedge against foreign interest rate risk

(by matching durations, for example)(by matching durations, for example)

Trends in FXTrends in FX

Value of foreign positions has increasedValue of foreign positions has increased Volume of foreign currency trading has Volume of foreign currency trading has

decreaseddecreased Causes:Causes:

Investment bank mergersInvestment bank mergers Increased trading efficiency through Increased trading efficiency through

technological innovationtechnological innovation Introduction of the euroIntroduction of the euro

FX Risk ExposureFX Risk Exposure

Greater exposure to a foreign currency Greater exposure to a foreign currency combined with greater volatility of the combined with greater volatility of the foreign currency implies greater DEAR.foreign currency implies greater DEAR.

Dollar loss/gain in currency Dollar loss/gain in currency ii

= [Net exposure in foreign currency = [Net exposure in foreign currency ii measured in U.S. $] × Shock (Volatility) measured in U.S. $] × Shock (Volatility) to the $/Foreign currency to the $/Foreign currency i i exchange rateexchange rate

FX TradingFX Trading

FX markets turnover often greater than FX markets turnover often greater than $1.8 trillion per day. $1.8 trillion per day.

The market moves between Tokyo, NYC The market moves between Tokyo, NYC and London over the day allowing for and London over the day allowing for what is essentially a 24-hour market. what is essentially a 24-hour market.

Overnight exposure adds to the risk.Overnight exposure adds to the risk.

Trading ActivitiesTrading Activities

Basically 4 trading activities:Basically 4 trading activities: Purchase and sale of currencies to complete Purchase and sale of currencies to complete

international transactions.international transactions. Facilitating positions in foreign real and Facilitating positions in foreign real and

financial investments.financial investments. Accommodating hedging activitiesAccommodating hedging activities Speculation.Speculation.

Profitability of FX TradingProfitability of FX Trading

For large US banks, trading income is a For large US banks, trading income is a major source of income. major source of income. Volatility of European currencies are Volatility of European currencies are

declining (due to euro)declining (due to euro) Volatility in Asian and emerging markets Volatility in Asian and emerging markets

currencies highercurrencies higher Risk arises from taking open positions in Risk arises from taking open positions in

currenciescurrencies

Foreign Assets & Foreign Assets & Liabilities Liabilities

Mismatches between foreign asset and Mismatches between foreign asset and liability portfoliosliability portfolios

Ability to raise funds from internationally Ability to raise funds from internationally diverse sources presents opportunities diverse sources presents opportunities as well as risksas well as risks Greater competition in well-developed (lower Greater competition in well-developed (lower

risk) marketsrisk) markets

Return and Risk of Return and Risk of Foreign InvestmentsForeign Investments

Returns are affected by:Returns are affected by: Spread between costs and revenuesSpread between costs and revenues changes in FX rateschanges in FX rates

Changes in FX rates are not under the Changes in FX rates are not under the control of the FIcontrol of the FI

Risk and HedgingRisk and Hedging

Hedge can be constructed on balance Hedge can be constructed on balance sheet or off balance sheet.sheet or off balance sheet. On - balance-sheet hedge will also require On - balance-sheet hedge will also require

duration matching to control exposure to duration matching to control exposure to foreign interest rate risk.foreign interest rate risk.

Off-balance-sheet hedge using forwards, Off-balance-sheet hedge using forwards, futures, or options. futures, or options.

Interest Rate Parity Interest Rate Parity TheoremTheorem

Equilibrium condition is that there should Equilibrium condition is that there should be no arbitrage opportunities available be no arbitrage opportunities available through lending and borrowing across through lending and borrowing across currencies. This requires that currencies. This requires that

1+r(domestic) = (F/S)[1+r (foreign)]1+r(domestic) = (F/S)[1+r (foreign)] Difference in interest rates will be offset by Difference in interest rates will be offset by

the expected change in exchange rates. the expected change in exchange rates.

Multicurrency PositionsMulticurrency Positions

Since the banks generally take positions Since the banks generally take positions in more than one currency in more than one currency simultaneously, their risk is partially simultaneously, their risk is partially reduced through diversification.reduced through diversification.

Overall, world bond markets are Overall, world bond markets are significantly, but not fully integrated which significantly, but not fully integrated which leaves open the opportunity to reduce leaves open the opportunity to reduce exposure by diversifying. exposure by diversifying.

Diversification Effects Diversification Effects (continued)(continued)

High correlations between the bond High correlations between the bond returns may be due to high correlation of returns may be due to high correlation of real interest rates over time and/or real interest rates over time and/or inflation expectations.inflation expectations.

rrii = rr = rrii + i + ieeii

Nominal return = real return + E[inflation]Nominal return = real return + E[inflation]

Credit RisksCredit Risks

Budi PurwantoBudi Purwanto

OverviewOverview

This chapter discusses types of loans, and This chapter discusses types of loans, and the analysis and measurement of credit risk the analysis and measurement of credit risk on individual loans. This is important for on individual loans. This is important for purposes of:purposes of: Pricing loans and bondsPricing loans and bonds Setting limits on credit risk exposureSetting limits on credit risk exposure

Credit Quality ProblemsCredit Quality Problems Problems with junk bonds, LDC loans, Problems with junk bonds, LDC loans,

residential and farm mortgage loans. residential and farm mortgage loans. More recently, credit card loans and auto More recently, credit card loans and auto

loans.loans. Crises in Asian countries such as Korea, Crises in Asian countries such as Korea,

Indonesia, Thailand, and Malaysia. Indonesia, Thailand, and Malaysia.

Credit Quality ProblemsCredit Quality Problems

Over the 90s, improvements in NPLs for Over the 90s, improvements in NPLs for large banks and overall credit quality.large banks and overall credit quality.

Recent exposure to borrowers such as Recent exposure to borrowers such as Enron. Enron.

New types of credit risk related to loan New types of credit risk related to loan guarantees and off-balance-sheet activities. guarantees and off-balance-sheet activities.

Increased emphasis on credit risk Increased emphasis on credit risk evaluation.evaluation.

Types of Loans:Types of Loans:

C&I loans: secured and unsecuredC&I loans: secured and unsecured Spot loans, Loan commitmentsSpot loans, Loan commitments Decline in C&I loans originated by commercial Decline in C&I loans originated by commercial

banks and growth in commercial paper market.banks and growth in commercial paper market.

RE loans: primarily mortgagesRE loans: primarily mortgages Fixed-rate, ARMFixed-rate, ARM Mortgages can be subject to default risk when Mortgages can be subject to default risk when

loan-to-value declines.loan-to-value declines.

Consumer loansConsumer loans

Individual (consumer) loans: personal, Individual (consumer) loans: personal, auto, credit card.auto, credit card. Nonrevolving loansNonrevolving loans

Automobile, mobile home, personal loansAutomobile, mobile home, personal loans

Growth in credit card debtGrowth in credit card debt Visa, MasterCard Visa, MasterCard Proprietary cards such as Sears, AT&TProprietary cards such as Sears, AT&T

Risks affected by competitive conditions and Risks affected by competitive conditions and usury ceilingsusury ceilings

Other loansOther loans

Other loans include:Other loans include: Farm loansFarm loans Other banksOther banks Nonbank FIsNonbank FIs Broker margin loansBroker margin loans Foreign banks and sovereign governmentsForeign banks and sovereign governments State and local governmentsState and local governments

Return on a Loan:Return on a Loan:

Factors: interest payments, fees, credit Factors: interest payments, fees, credit risk premium, collateral, other risk premium, collateral, other requirements such as compensating requirements such as compensating balances and reserve requirements. balances and reserve requirements.

Return = inflow/outflow Return = inflow/outflow

kk = ( = (ff + ( + (LL + + MM ))/(1-[ ))/(1-[bb(1-(1-RR)]))]) Expected return: E(r) =Expected return: E(r) = p p(1+k)(1+k)

Lending Rates and Lending Rates and RationingRationing

At retail: Usually a simple accept/reject At retail: Usually a simple accept/reject decision rather than adjustments to the decision rather than adjustments to the rate.rate. Credit rationing.Credit rationing. If accepted, customers sorted by loan If accepted, customers sorted by loan

quantity.quantity.

At wholesale: At wholesale: Use both quantity and pricing adjustments.Use both quantity and pricing adjustments.

Measuring Credit RiskMeasuring Credit Risk

Qualitative models: borrower specific Qualitative models: borrower specific factors are considered as well as market factors are considered as well as market or systematic factors. or systematic factors.

Specific factors include: reputation, Specific factors include: reputation, leverage, volatility of earnings, covenants leverage, volatility of earnings, covenants and collateral.and collateral.

Market specific factors include: business Market specific factors include: business cycle and interest rate levels.cycle and interest rate levels.

Credit Scoring ModelsCredit Scoring Models

Linear probability models: Linear probability models:

ZZi i = =

Statistically unsound since the Z’s obtained are not Statistically unsound since the Z’s obtained are not probabilities at all. probabilities at all.

*Since superior statistical techniques are readily *Since superior statistical techniques are readily available, little justification for employing linear available, little justification for employing linear probability models.probability models.

n

jjijX

1, error

Other Credit Scoring Other Credit Scoring ModelsModels

Logit models: overcome weakness of the Logit models: overcome weakness of the linear probability models using a linear probability models using a transformation (logistic function) that transformation (logistic function) that restricts the probabilities to the zero-one restricts the probabilities to the zero-one interval. interval.

Other alternatives include Probit and Other alternatives include Probit and other variants with nonlinear indicator other variants with nonlinear indicator functions.functions.

Altman’s Linear Altman’s Linear Discriminant Model:Discriminant Model:

Z=1.2XZ=1.2X11+ 1.4X+ 1.4X22 +3.3X +3.3X33 + 0.6X + 0.6X44 + 1.0X + 1.0X55

Critical value of Z = 1.81.Critical value of Z = 1.81. XX11 = Working capital/total assets. = Working capital/total assets.

XX22 = Retained earnings/total assets. = Retained earnings/total assets.

XX33 = EBIT/total assets. = EBIT/total assets.

XX44 = Market value equity/ book value LT debt. = Market value equity/ book value LT debt.

XX55 = Sales/total assets. = Sales/total assets.

Linear Discriminant Linear Discriminant ModelModel

Problems:Problems: Only considers two extreme cases Only considers two extreme cases

(default/no default). (default/no default). Weights need not be stationary over time.Weights need not be stationary over time. Ignores hard to quantify factors including Ignores hard to quantify factors including

business cycle effects. business cycle effects. Database of defaulted loans is not available Database of defaulted loans is not available

to benchmark the model.to benchmark the model.

Term Structure Based Term Structure Based MethodsMethods

If we know the risk premium we can infer the If we know the risk premium we can infer the probability of default. Expected return equals probability of default. Expected return equals risk free rate after accounting for probability of risk free rate after accounting for probability of default. default.

p p (1+ (1+ kk) = 1+ ) = 1+ ii May be generalized to loans with any maturity May be generalized to loans with any maturity

or to adjust for varying default recovery rates.or to adjust for varying default recovery rates. The loan can be assessed using the inferred The loan can be assessed using the inferred

probabilities from comparable quality bonds. probabilities from comparable quality bonds.

Mortality Rate ModelsMortality Rate Models

Similar to the process employed by insurance Similar to the process employed by insurance companies to price policies. The probability of companies to price policies. The probability of default is estimated from past data on defaults.default is estimated from past data on defaults.

Marginal Mortality Rates:Marginal Mortality Rates:

MMRMMR11 = = (Value Grade B default in year 1)(Value Grade B default in year 1)

(Value Grade B outstanding yr.1) (Value Grade B outstanding yr.1)

MMRMMR22 = = (Value Grade B default in year 2)(Value Grade B default in year 2)

(Value Grade B outstanding yr.2) (Value Grade B outstanding yr.2)

RAROC ModelsRAROC Models

Risk adjusted return on capital. This is one Risk adjusted return on capital. This is one of the more widely used models.of the more widely used models.

Incorporates duration approach to estimate Incorporates duration approach to estimate worst case loss in value of the loan:worst case loss in value of the loan:

L = -DL = -DLL x L x ( x L x (R/(1+R)) where R/(1+R)) where R is an R is an

estimate of the worst change in credit risk estimate of the worst change in credit risk premiums for the loan class over the past premiums for the loan class over the past year.year.

RAROC = one-year income on loan/RAROC = one-year income on loan/LL

Option Models:Option Models:

Employ option pricing methods to evaluate Employ option pricing methods to evaluate the option to default. the option to default.

Used by many of the largest banks to Used by many of the largest banks to monitor credit risk. monitor credit risk.

KMV Corporation markets this model quite KMV Corporation markets this model quite widely. widely.

Applying Option Applying Option Valuation ModelValuation Model

Merton showed value of a risky loanMerton showed value of a risky loan

F(F() = Be) = Be-i-i[(1/d)N(h[(1/d)N(h11) +N(h) +N(h22)])]

Written as a yield spreadWritten as a yield spread

k(k() - i = (-1/) - i = (-1/))lnln[N(h[N(h22) +(1/d)N(h) +(1/d)N(h11)])]

where k(where k() = Required yield on risky debt) = Required yield on risky debt

lnln = Natural logarithm = Natural logarithm

i = Risk-free rate on debt of equivalent i = Risk-free rate on debt of equivalent maturity.maturity.

*CreditMetrics*CreditMetrics

““If next year is a bad year, how much will If next year is a bad year, how much will I lose on my loans and loan portfolio?”I lose on my loans and loan portfolio?”

VAR = P × 1.65 × VAR = P × 1.65 × Neither P, nor Neither P, nor observed. observed.

Calculated using:Calculated using: (i)Data on borrower’s credit rating; (ii) Rating (i)Data on borrower’s credit rating; (ii) Rating

transition matrix; (iii) Recovery rates on transition matrix; (iii) Recovery rates on defaulted loans; (iv) Yield spreads.defaulted loans; (iv) Yield spreads.

* Credit Risk* Credit Risk++

Developed by Credit Suisse Financial Developed by Credit Suisse Financial Products.Products. Based on insurance literature:Based on insurance literature:

Losses reflect frequency of event and severity of loss.Losses reflect frequency of event and severity of loss.

Loan default is random.Loan default is random. Loan default probabilities are independent.Loan default probabilities are independent.

Appropriate for large portfolios of small loans.Appropriate for large portfolios of small loans. Modeled by a Poisson distribution.Modeled by a Poisson distribution.

Loan Portfolio RisksLoan Portfolio Risks

This chapter discusses the management of This chapter discusses the management of credit risk in a loan (asset) portfolio context. credit risk in a loan (asset) portfolio context. It also discusses the setting of credit It also discusses the setting of credit exposure limits to industrial sectors and exposure limits to industrial sectors and regulatory approaches to monitoring credit regulatory approaches to monitoring credit risk. The National Association of Insurance risk. The National Association of Insurance Commissioners has also developed limits Commissioners has also developed limits for different types of assets and borrowers for different types of assets and borrowers in insurers’ portfolios. in insurers’ portfolios.

Simple Models of Loan Simple Models of Loan ConcentrationConcentration

Migration analysisMigration analysis Track credit rating changes within sector or pool Track credit rating changes within sector or pool

of loans.of loans. Rating transition matrix.Rating transition matrix.

Rating Transition Matrix Rating Transition Matrix

Risk grade: end of yearRisk grade: end of year

11 22 33DefaultDefault

Risk grade: Risk grade: 1|1| .85.85 .10.10 .04.04 .01.01

beginningbeginning 2|2| .12.12 .83.83 .03.03 .02.02

of yearof year 3|3| .03.03 .13.13 .80.80 .04.04

Simple Models of Loan Simple Models of Loan ConcentrationConcentration

Concentration limits Concentration limits On loans to individual borrower.On loans to individual borrower. Concentration limit = Maximum loss Concentration limit = Maximum loss Loss Loss

rate.rate. Maximum loss expressed as percent of capital.Maximum loss expressed as percent of capital.

Diversification and Modern Diversification and Modern Portfolio TheoryPortfolio Theory

Applying portfolio theory to loansApplying portfolio theory to loans Using loans to construct the efficient frontier.Using loans to construct the efficient frontier. Minimum risk portfolio.Minimum risk portfolio.

Low riskLow risk Low return.Low return.

Applying Portfolio Theory to Applying Portfolio Theory to LoansLoans

Require Require (i) expected return on loan(measured by (i) expected return on loan(measured by all-all-

in-spreadin-spread); ); (ii) loan risk; (ii) loan risk; (iii) correlation of loan default risks.(iii) correlation of loan default risks.

Modern Portfolio TheoryModern Portfolio Theory

n

iiip RXR

1

n

i

n

ijiji

n

jiip XXX

1 1,

1

222

KMV Portfolio Manager KMV Portfolio Manager ModelModel

RRii = AIS = AISii - E(L - E(Lii) = AIS) = AISii - [EDF - [EDFii × LGD × LGDii]]

ii = UL = ULii = = ii × LGD × LGDii

= [EDF= [EDFii(1-EDF(1-EDFii)])]½½ × LGD × LGDii

ijij = correlation between systematic = correlation between systematic

return components of equity returns of return components of equity returns of borrower borrower ii and borrower and borrower jj..

Partial Applications of Portfolio Partial Applications of Portfolio TheoryTheory

Loan volume-based modelsLoan volume-based models Commercial bank call reportsCommercial bank call reports

Can be aggregated to estimate national Can be aggregated to estimate national allocations.allocations.

Shared national creditShared national credit National database that breaks commercial and National database that breaks commercial and

industrial loan volume into 2-digit SIC codes.industrial loan volume into 2-digit SIC codes.

Partial ApplicationsPartial Applications

Loan volume-based models (continued)Loan volume-based models (continued) Provide market benchmarks.Provide market benchmarks.

Standard deviation measure of loan allocation Standard deviation measure of loan allocation deviation.deviation.

N

XXN

iiji

j

1

2, )(

Loan Loss Ratio-Based Loan Loss Ratio-Based ModelsModels

Estimate loan loss risk by SIC sector.Estimate loan loss risk by SIC sector. Time-series regression:Time-series regression:

[[sectoral losses in sectoral losses in iithth sectorsector] ]

[ loans to [ loans to iith sector ]th sector ]

= = + + ii [ [total loan lossestotal loan losses]]

[ total loans ][ total loans ]

Regulatory ModelsRegulatory Models

Credit concentration risk evaluation Credit concentration risk evaluation largely subjective. largely subjective.

Life and PC insurance regulators Life and PC insurance regulators propose limits on investments in propose limits on investments in securities or obligations of any single securities or obligations of any single issuer.issuer. Diversification limits.Diversification limits.

Market RisksMarket Risks

Budi PurwantoBudi Purwanto

OverviewOverview

This chapter discusses the nature of This chapter discusses the nature of market risk and appropriate measuresmarket risk and appropriate measures Dollar exposureDollar exposure RiskMetricsRiskMetrics Historic or back simulationHistoric or back simulation Monte Carlo simulationMonte Carlo simulation Links between market risk and capital Links between market risk and capital

requirementsrequirements

Market Risk:Market Risk:

Market risk is the uncertainty resulting Market risk is the uncertainty resulting from changes in market prices . It can be from changes in market prices . It can be measured over periods as short as one measured over periods as short as one day.day.

Usually measured in terms of dollar Usually measured in terms of dollar exposure amount or as a relative amount exposure amount or as a relative amount against some benchmark.against some benchmark.

Market Risk Market Risk MeasurementMeasurement

Important in terms of:Important in terms of: Management informationManagement information Setting limitsSetting limits Resource allocation (risk/return tradeoff)Resource allocation (risk/return tradeoff) Performance evaluationPerformance evaluation RegulationRegulation

Calculating Market Risk Calculating Market Risk ExposureExposure

Generally concerned with estimated Generally concerned with estimated potential loss under adverse potential loss under adverse circumstances.circumstances.

Three major approaches of measurementThree major approaches of measurement JPM RiskMetrics (or variance/covariance JPM RiskMetrics (or variance/covariance

approach)approach) Historic or Back SimulationHistoric or Back Simulation Monte Carlo SimulationMonte Carlo Simulation

JP Morgan RiskMetrics JP Morgan RiskMetrics ModelModel

Idea is to determine the daily earnings at risk Idea is to determine the daily earnings at risk = dollar value of position × price sensitivity × = dollar value of position × price sensitivity × potential adverse move in yield or, potential adverse move in yield or,

DEAR = Dollar market value of position × DEAR = Dollar market value of position × Price volatility.Price volatility.

Can be stated as (-MD) × adverse daily yield Can be stated as (-MD) × adverse daily yield move where,move where,

MD = D/(1+R)MD = D/(1+R)

Modified duration = MacAulay duration/(1+R)Modified duration = MacAulay duration/(1+R)

Confidence IntervalsConfidence Intervals

If we assume that changes in the yield are If we assume that changes in the yield are normally distributed, we can construct normally distributed, we can construct confidence intervals around the projected confidence intervals around the projected DEAR. (Other distributions can be DEAR. (Other distributions can be accommodated but normal is generally accommodated but normal is generally sufficient).sufficient).

Assuming normality, 90% of the time the Assuming normality, 90% of the time the disturbance will be within 1.65 standard disturbance will be within 1.65 standard deviations of the mean.deviations of the mean.

Confidence Intervals: Confidence Intervals: ExampleExample Suppose that we are long in 7-year zero-coupon Suppose that we are long in 7-year zero-coupon

bonds and we define “bad” yield changes such bonds and we define “bad” yield changes such that there is only 5% chance of the yield change that there is only 5% chance of the yield change being exceeded in either direction. Assuming being exceeded in either direction. Assuming normality, 90% of the time yield changes will be normality, 90% of the time yield changes will be within 1.65 standard deviations of the mean. If the within 1.65 standard deviations of the mean. If the standard deviation is 10 basis points, this standard deviation is 10 basis points, this corresponds to 16.5 basis points. Concern is that corresponds to 16.5 basis points. Concern is that yields will rise. Probability of yield increases yields will rise. Probability of yield increases greater than 16.5 basis points is 5%.greater than 16.5 basis points is 5%.

Confidence Intervals: Confidence Intervals: ExampleExample

Price volatility = (-MD) Price volatility = (-MD) (Potential (Potential adverse change in yield)adverse change in yield)

= (-6.527) = (-6.527) (0.00165) = -1.077% (0.00165) = -1.077%

DEAR = Market value of position DEAR = Market value of position (Price (Price volatility)volatility)

= ($1,000,000) = ($1,000,000) (.01077) = (.01077) = $10,770$10,770

Confidence Intervals: Confidence Intervals: ExampleExample

To calculate the potential loss for more To calculate the potential loss for more than one day:than one day:

Market value at risk (VAR) = DEAR × Market value at risk (VAR) = DEAR × NN Example: Example:

For a five-day period, For a five-day period,

VAR = $10,770 × VAR = $10,770 × 5 = $24,0825 = $24,082

Foreign Exchange & Foreign Exchange & EquitiesEquities

In the case of Foreign Exchange, DEAR In the case of Foreign Exchange, DEAR is computed in the same fashion we is computed in the same fashion we employed for interest rate risk.employed for interest rate risk.

For equities, if the portfolio is well For equities, if the portfolio is well diversified then diversified then

DEAR = dollar value of position × stock DEAR = dollar value of position × stock market return volatility where the market market return volatility where the market return volatility is taken as 1.65 return volatility is taken as 1.65 MM..

Aggregating DEAR Aggregating DEAR EstimatesEstimates

Cannot simply sum up individual DEARs.Cannot simply sum up individual DEARs. In order to aggregate the DEARs from In order to aggregate the DEARs from

individual exposures we require the individual exposures we require the correlation matrix. correlation matrix.

Three-asset case:Three-asset case:

DEAR DEAR portfolioportfolio = [DEAR = [DEARaa22 + DEAR + DEARbb

22 + DEAR + DEARcc22

+ 2+ 2abab × DEAR × DEARaa × DEAR × DEARbb + 2 + 2acac × DEAR × DEARaa × ×

DEARDEARcc + 2 + 2bcbc × DEAR × DEARbb × DEAR × DEARcc]]1/21/2

Historic or Back Historic or Back SimulationSimulation Advantages:Advantages:

SimplicitySimplicity Does not require normal distribution of Does not require normal distribution of

returns (which is a critical assumption for returns (which is a critical assumption for RiskMetrics)RiskMetrics)

Does not need correlations or standard Does not need correlations or standard deviations of individual asset returns.deviations of individual asset returns.

Historic or Back Historic or Back SimulationSimulation

Basic idea: Revalue portfolio based on Basic idea: Revalue portfolio based on actual prices (returns) on the assets that actual prices (returns) on the assets that existed yesterday, the day before, etc. existed yesterday, the day before, etc. (usually previous 500 days).(usually previous 500 days).

Then calculate 5% worst-case (25Then calculate 5% worst-case (25thth lowest value of 500 days) outcomes.lowest value of 500 days) outcomes.

Only 5% of the outcomes were lower.Only 5% of the outcomes were lower.

Estimation of VAR: Estimation of VAR: ExampleExample

Convert today’s FX positions into dollar Convert today’s FX positions into dollar equivalents at today’s FX rates.equivalents at today’s FX rates.

Measure sensitivity of each positionMeasure sensitivity of each position Calculate its delta.Calculate its delta.

Measure risk Measure risk Actual percentage changes in FX rates for each Actual percentage changes in FX rates for each

of past 500 days.of past 500 days.

Rank days by risk from worst to best.Rank days by risk from worst to best.

WeaknessesWeaknesses

Disadvantage: 500 observations is not Disadvantage: 500 observations is not very many from statistical standpoint.very many from statistical standpoint.

Increasing number of observations by Increasing number of observations by going back further in time is not going back further in time is not desirable.desirable.

Could weight recent observations more Could weight recent observations more heavily and go further back.heavily and go further back.

Monte Carlo SimulationMonte Carlo Simulation

To overcome problem of limited number of To overcome problem of limited number of observations, synthesize additional observations, synthesize additional observations.observations. Perhaps 10,000 real and synthetic observations.Perhaps 10,000 real and synthetic observations.

Employ historic covariance matrix and Employ historic covariance matrix and random number generator to synthesize random number generator to synthesize observations.observations. Objective is to replicate the Objective is to replicate the distributiondistribution of of

observed outcomes with synthetic data.observed outcomes with synthetic data.

Regulatory ModelsRegulatory Models

BIS (including Federal Reserve) approach:BIS (including Federal Reserve) approach: Market risk may be calculated using standard Market risk may be calculated using standard

BIS model.BIS model. Specific risk charge.Specific risk charge. General market risk charge.General market risk charge. Offsets.Offsets.

Subject to regulatory permission, large banks Subject to regulatory permission, large banks may be allowed to use their internal models as may be allowed to use their internal models as the basis for determining capital requirements. the basis for determining capital requirements.

BIS ModelBIS Model

Specific risk charge: Specific risk charge: Risk weights × absolute dollar values of long and Risk weights × absolute dollar values of long and

short positionsshort positions

General market risk charge:General market risk charge: reflect modified durations reflect modified durations expected interest expected interest

rate shocks for each maturityrate shocks for each maturity

Vertical offsets:Vertical offsets: Adjust for basis riskAdjust for basis risk

Horizontal offsets within/between time zones Horizontal offsets within/between time zones

Large Banks: BIS versus Large Banks: BIS versus RiskMetricsRiskMetrics

In calculating DEAR, adverse change in rates In calculating DEAR, adverse change in rates defined as 99th percentile (rather than 95th defined as 99th percentile (rather than 95th under RiskMetrics)under RiskMetrics)

Minimum holding period is 10 days (means that Minimum holding period is 10 days (means that RiskMetrics’ daily DEAR multiplied by RiskMetrics’ daily DEAR multiplied by 10.10.

Capital charge will be higher of:Capital charge will be higher of: Previous day’s VAR (or DEAR Previous day’s VAR (or DEAR 10)10) Average Daily VAR over previous 60 days times a Average Daily VAR over previous 60 days times a

multiplication factor multiplication factor 3. 3.

Operational RisksOperational Risks

Budi PurwantoBudi Purwanto

OverviewOverview

This chapter discusses the factors affecting This chapter discusses the factors affecting operational returns and risks, and the operational returns and risks, and the importance of optimal management and importance of optimal management and control of labor, capital, and other input control of labor, capital, and other input sources and their costs. The emphasis is on sources and their costs. The emphasis is on technology and its impact on risk and return.technology and its impact on risk and return.

Examples: Risks resulting from innovations Examples: Risks resulting from innovations in IT, and effects of terrorist attacks on key in IT, and effects of terrorist attacks on key technologies. technologies.

Sources of Operational Sources of Operational RiskRisk

TechnologyTechnology EmployeesEmployees Customer relationshipsCustomer relationships Capital assetsCapital assets ExternalExternal

Importance of Importance of TechnologyTechnology

Efficient technological base can result in:Efficient technological base can result in: Lower costsLower costs

Through improved allocation of inputs.Through improved allocation of inputs.

Increased revenuesIncreased revenues Through wider range of outputs.Through wider range of outputs.

Earnings before taxes = (Interest income - Earnings before taxes = (Interest income - Interest expense) + (Other income - Interest expense) + (Other income - Noninterest expense) - Provision for loan Noninterest expense) - Provision for loan losseslosses

Impact of TechnologyImpact of Technology

Interest income can be increased Interest income can be increased Through wider array of outputs or cross Through wider array of outputs or cross

selling.selling.

Interest expense can be decreasedInterest expense can be decreased Through improved access to markets for Through improved access to markets for

liabilitiesliabilities Fedwire, CHIPSFedwire, CHIPS

Impact of TechnologyImpact of Technology

Other income can be increasedOther income can be increased Through electronic handling of fee Through electronic handling of fee

generating OBS activities such as LCs and generating OBS activities such as LCs and derivativesderivatives

Noninterest expenses can be reducedNoninterest expenses can be reduced Through improved efficiency of back office Through improved efficiency of back office

operations using technology. Especially true operations using technology. Especially true for securities-related activities.for securities-related activities.

Impact on Wholesale BankingImpact on Wholesale Banking

Improvements to cash managementImprovements to cash management Controlled disbursement accountsControlled disbursement accounts Account reconciliationAccount reconciliation Wholesale lockboxWholesale lockbox Electronic lockboxElectronic lockbox Funds concentrationFunds concentration

Impact on Wholesale Banking Impact on Wholesale Banking (continued)(continued)

Electronic funds transferElectronic funds transfer Check deposit servicesCheck deposit services Electronic initiation of letters of creditElectronic initiation of letters of credit Treasury management softwareTreasury management software Electronic data interchangeElectronic data interchange Facilitating B2B e-commerceFacilitating B2B e-commerce Electronic billingElectronic billing

Impact on Wholesale Banking Impact on Wholesale Banking (continued)(continued)

Verifying identitiesVerifying identities Issue of law enforcement access to Issue of law enforcement access to

encrypted data since September 11, 2001encrypted data since September 11, 2001

Assisting small business entry into e-Assisting small business entry into e-commercecommerce

Impact on Retail BankingImpact on Retail Banking

Automated teller machinesAutomated teller machines Point-of-sale debit cardsPoint-of-sale debit cards Home bankingHome banking Preauthorized debits/creditsPreauthorized debits/credits Pay-by-phonePay-by-phone E-mail billingE-mail billing Online bankingOnline banking Smart cardsSmart cards

Effects of Technology Effects of Technology on Revenues and Costson Revenues and Costs

Investments in technology are riskyInvestments in technology are risky Potentially Potentially negative negative NPV projects due to NPV projects due to

uncertainty and potential competitive uncertainty and potential competitive responsesresponses

Potential agency conflicts:Potential agency conflicts: Growth-oriented investments may not maximize Growth-oriented investments may not maximize

shareholder’s valueshareholder’s value Losses on technological investments can weaken Losses on technological investments can weaken

an FIan FI

Effects of Technology Effects of Technology on Revenues and Costson Revenues and Costs

Evidence shows the impact of regulation Evidence shows the impact of regulation on value of technological innovations.on value of technological innovations. Branching restrictions in U.S. affect the Branching restrictions in U.S. affect the

value of cash management services, for value of cash management services, for example. example.

Less valuable in Europe where comparable Less valuable in Europe where comparable restrictions are absentrestrictions are absent

Effects of Technology on Effects of Technology on Revenues and CostsRevenues and Costs

Revenue effects:Revenue effects: Facilitates cross-marketingFacilitates cross-marketing Increases innovationIncreases innovation Service quality effectsService quality effects

Survival of small banks and value of “human touch”Survival of small banks and value of “human touch”

Cost effects:Cost effects: Technological improvementsTechnological improvements

Shift in cost curve.Shift in cost curve.

Effects on Costs Effects on Costs (continued)(continued)

Economies of scaleEconomies of scale Optimal size depends on shape of average Optimal size depends on shape of average

cost curve.cost curve.

AC

Size Size

AC AC

Size

Effects on Costs Effects on Costs (continued)(continued)

Economies of scopeEconomies of scope Multiple outputs may provide synergies in Multiple outputs may provide synergies in

production.production.

Diseconomies of scopeDiseconomies of scope Specialization may have cost benefits in Specialization may have cost benefits in

production and delivery of some FI servicesproduction and delivery of some FI services

Testing for Economies Testing for Economies of Scale and Scopeof Scale and Scope

Production approach:Production approach: Views FI as producing output of services Views FI as producing output of services

using inputs of labor and capital.using inputs of labor and capital. C = f(y,w,r)C = f(y,w,r)

Intermediation Approach:Intermediation Approach: Includes funds used to produce Includes funds used to produce

intermediated services among the inputs. intermediated services among the inputs. C = f(y,w,r, k)C = f(y,w,r, k)

Empirical FindingsEmpirical Findings

Evidence economies of scale for banks Evidence economies of scale for banks up to the $10 billion to $25 billion range.up to the $10 billion to $25 billion range.

X-inefficiencies may be more important.X-inefficiencies may be more important. Inconclusive evidence on scope.Inconclusive evidence on scope. Recent studies using a profit-based Recent studies using a profit-based

approach find that large FIs tend to be approach find that large FIs tend to be more efficient in revenue generation.more efficient in revenue generation.

Technology and Technology and Evolution Evolution of the Payments Systemof the Payments System

Use of electronic transactions higher in Use of electronic transactions higher in other countries. (E.g., TARGET).other countries. (E.g., TARGET).

U.S. Payments system:U.S. Payments system: FedWireFedWire Clearing House Interbank Payments System Clearing House Interbank Payments System

(CHIPS)(CHIPS) Combined value of transactions often more Combined value of transactions often more

than $2.7 trillion per day.than $2.7 trillion per day.

Wire Transfer System Wire Transfer System RisksRisks

Daylight overdraft riskDaylight overdraft risk FedWire settlement at 6:30 ESTFedWire settlement at 6:30 EST Example of magnitude of daylight overdraft Example of magnitude of daylight overdraft

risk: Bank of New York (BONY)risk: Bank of New York (BONY) Regulation J guarantees payment finality of Regulation J guarantees payment finality of

wire transfer messages by the Fedwire transfer messages by the Fed Regulation F sets exposure limits to Regulation F sets exposure limits to

individual correspondent banks.individual correspondent banks.

Risks (continued)Risks (continued)

International Technology Transfer RiskInternational Technology Transfer Risk Crime and Fraud RiskCrime and Fraud Risk Regulatory RiskRegulatory Risk

Technology facilitates avoidance of Technology facilitates avoidance of regulation by locating in least regulated state regulation by locating in least regulated state or country.or country.

Tax AvoidanceTax Avoidance Competition RiskCompetition Risk

Other Operational RisksOther Operational Risks

EmployeesEmployees Turnover Turnover Key personnelKey personnel FraudFraud ErrorsErrors Rogue trading (Barings, Allied Irish/Allfirst)Rogue trading (Barings, Allied Irish/Allfirst) Money launderingMoney laundering Confidentiality breachConfidentiality breach

Technology RisksTechnology Risks

Programming errorProgramming error Model riskModel risk Mark-to-market errorMark-to-market error Management informationManagement information IT/Telecomm systems outageIT/Telecomm systems outage Technology provider failureTechnology provider failure Contingency planningContingency planning

Customer Relationship Customer Relationship RisksRisks

Contractual disagreementContractual disagreement Dissatisfaction from poorly performing Dissatisfaction from poorly performing

technologytechnology Default Default

Capital Asset RiskCapital Asset Risk

Safety Safety SecuritySecurity Operating costsOperating costs Fire/floodFire/flood

External risksExternal risks

External fraudExternal fraud Taxation riskTaxation risk Legal riskLegal risk WarWar Market collapseMarket collapse Reputation riskReputation risk Relationship riskRelationship risk

Controlling Operational Controlling Operational RiskRisk Loss prevention: Loss prevention:

Training, development, review of employeesTraining, development, review of employees

Loss control: Loss control: Planning, organization, back-upPlanning, organization, back-up

Loss financing: Loss financing: External insuranceExternal insurance

Loss insulation: Loss insulation: FI capitalFI capital

Optimal Risk Optimal Risk ManagementManagement

Cost

RME

Regulatory IssuesRegulatory Issues

1999 Basel Committee on Banking 1999 Basel Committee on Banking Supervision noted the importance of Supervision noted the importance of operational risksoperational risks

Required capital:Required capital: Basic Indicator ApproachBasic Indicator Approach Standardized ApproachStandardized Approach Internal Measurement ApproachInternal Measurement Approach

Consumer protection issuesConsumer protection issues

Liquidity RiskLiquidity Risk

Budi PurwantoBudi Purwanto

Overview Overview

This chapter explores the problem of This chapter explores the problem of liquidity risk faced to a greater or lesser liquidity risk faced to a greater or lesser extent by all FIs. Methods of measuring extent by all FIs. Methods of measuring liquidity risk, and its consequences are liquidity risk, and its consequences are discussed. The chapter also discusses discussed. The chapter also discusses the regulatory mechanisms put in place the regulatory mechanisms put in place to control liquidity risk.to control liquidity risk.

Causes of Liquidity RiskCauses of Liquidity Risk

Asset sideAsset side May be forced to liquidate assets too rapidlyMay be forced to liquidate assets too rapidly May result from loan commitmentsMay result from loan commitments

Traditional approach: reserve asset Traditional approach: reserve asset management. management.

Alternative: liability management.Alternative: liability management.

Causes of Liquidity RiskCauses of Liquidity Risk

Liability sideLiability side Reliance on demand depositsReliance on demand deposits

Core depositsCore deposits Need to be able to predict the distribution of Need to be able to predict the distribution of

netnet deposit drains. deposit drains. Managed by:Managed by:

purchased liquidity managementpurchased liquidity management stored liquidity managementstored liquidity management

Liability ManagementLiability Management

Purchased liquidityPurchased liquidity Federal funds market or repo market.Federal funds market or repo market. Managing the liability side preserves asset Managing the liability side preserves asset

side of balance sheet. side of balance sheet. Borrowed funds likely at higher rates than Borrowed funds likely at higher rates than

interest paid on deposits. interest paid on deposits. Deposits are insuredDeposits are insured Regulatory concerns: growth of wholesale Regulatory concerns: growth of wholesale

fundsfunds

Liability ManagementLiability Management

Alternative: Stored Liquidity Management Alternative: Stored Liquidity Management Liquidate assets. Liquidate assets.

In absence of reserve requirements, banks tend to hold In absence of reserve requirements, banks tend to hold reserves. E.g. In U.K. reserves ~ 1% or more. Downside: reserves. E.g. In U.K. reserves ~ 1% or more. Downside: opportunity cost of reserves.opportunity cost of reserves.

Decreases size of balance sheetDecreases size of balance sheet Requires holding excess noninterest-bearing assetsRequires holding excess noninterest-bearing assets

Combine Combine purchasedpurchased and and storedstored liquidity liquidity managementmanagement

Asset Side Liquidity RiskAsset Side Liquidity Risk

Risk from loan commitments and other Risk from loan commitments and other credit lines:credit lines: met either by borrowing funds or met either by borrowing funds or by running down reservesby running down reserves

Current levels of loan commitments Current levels of loan commitments are dangerously high according to are dangerously high according to regulatorsregulators

Measuring Liquidity Measuring Liquidity ExposureExposure

Net liquidity statement: shows sources Net liquidity statement: shows sources and uses of liquidity.and uses of liquidity. Sources: (i) Cash type assets, (ii) maximum Sources: (i) Cash type assets, (ii) maximum

amount of borrowed funds available, (iii) amount of borrowed funds available, (iii) excess cash reservesexcess cash reserves

Uses include: borrowed or money market Uses include: borrowed or money market funds already utilized, and any amounts funds already utilized, and any amounts already borrowed from the Fed.already borrowed from the Fed.

Other Measures:Other Measures:

Peer group comparisons: usual ratios Peer group comparisons: usual ratios include borrowed funds/total assets, loan include borrowed funds/total assets, loan commitments/assets etc.commitments/assets etc.

Liquidity index: weighted sum of “fire sale Liquidity index: weighted sum of “fire sale price” price” PP to fair market price, to fair market price, P*P*, where the , where the portfolio weights are the percent of the portfolio weights are the percent of the portfolio value formed by the individual portfolio value formed by the individual assets. assets. I = I = wwii(P(Pi i /P/Pii*)*)

Measuring Liquidity RiskMeasuring Liquidity Risk

Financing gap and the financing requirement:Financing gap and the financing requirement: Financing gap = Average loans - Average Financing gap = Average loans - Average

deposits or, deposits or,

financing gap + liquid assets = financing financing gap + liquid assets = financing requirement.requirement.

The gap can be used in peer group The gap can be used in peer group comparisons or examined for trends within an comparisons or examined for trends within an individual FI.individual FI. Example of excessive financing requirement: Example of excessive financing requirement:

Continental Illinois, 1984.Continental Illinois, 1984.

BIS Approach: BIS Approach:

Maturity ladder/Scenario AnalysisMaturity ladder/Scenario Analysis For each maturity, assess all cash inflows For each maturity, assess all cash inflows

versus outflowsversus outflows Daily and cumulative net funding Daily and cumulative net funding

requirements can be determined in this requirements can be determined in this mannermanner

Must also evaluate “what if” scenarios in this Must also evaluate “what if” scenarios in this frameworkframework

Liquidity PlanningLiquidity Planning

Important to know which types of Important to know which types of depositors are likely to withdraw first in a depositors are likely to withdraw first in a crisis.crisis.

Composition of the depositor base will Composition of the depositor base will affect the severity of funding shortfalls. affect the severity of funding shortfalls.

Allow for seasonal effects. Allow for seasonal effects. Delineate managerial responsibilities Delineate managerial responsibilities

clearly.clearly.

Bank RunsBank Runs

Can arise due to concern about bank’s Can arise due to concern about bank’s solvency.solvency.

Failure of a related FI.Failure of a related FI. Sudden changes in investor preferences.Sudden changes in investor preferences. Demand deposits are first come first Demand deposits are first come first

served. Depositor’s place in line matters.served. Depositor’s place in line matters. Bank panic: systemic or contagious bank Bank panic: systemic or contagious bank

run.run.

Alleviating Bank Runs:Alleviating Bank Runs:

Regulatory measures to reduce likelihood Regulatory measures to reduce likelihood of bank runs:of bank runs: FDICFDIC Discount windowDiscount window

Not without economic costs.Not without economic costs.

Liquidity Risk for Other Liquidity Risk for Other FIsFIs

Life Cos. Hold reserves to offset policy Life Cos. Hold reserves to offset policy cancellations. The pattern is normally cancellations. The pattern is normally predictable.predictable.

An example: First Capital in California, 1991.An example: First Capital in California, 1991. CA regulators placed limits on ability to CA regulators placed limits on ability to

surrender policies.surrender policies. Problem is less severe for P&C insurers Problem is less severe for P&C insurers

since assets tend to be shorter term and since assets tend to be shorter term and more liquid.more liquid.

Mutual FundsMutual Funds

Net asset value (NAV) of the fund is market Net asset value (NAV) of the fund is market value. value.

The incentive for runs is not like the situation The incentive for runs is not like the situation faced by banks. faced by banks.

Asset losses will be shared on a Asset losses will be shared on a pro ratapro rata basis so there is no advantage to being first basis so there is no advantage to being first in line.in line.

Liability and LiquidityLiability and Liquidity

Depository institutions and life insurance Depository institutions and life insurance companies are highly exposed to liquidity companies are highly exposed to liquidity risk. This chapter discusses how these risk. This chapter discusses how these firms can control liquidity risk, the firms can control liquidity risk, the motives for holding liquid assets, and motives for holding liquid assets, and specific issues associated with liability specific issues associated with liability and liquidity risk management.and liquidity risk management.

Liquid Asset ManagementLiquid Asset Management

Examples: T-bills, T-notes, T-bondsExamples: T-bills, T-notes, T-bonds Benefits of holding large quantities of liquid Benefits of holding large quantities of liquid

assetsassets Costs of holding liquid assetsCosts of holding liquid assets

Liquid Asset ManagementLiquid Asset Management

Reasons for regulating minimum holdings Reasons for regulating minimum holdings of liquid assets:of liquid assets: Monetary policyMonetary policy TaxationTaxation

CompositionComposition

Composition of liquid asset portfolioComposition of liquid asset portfolio Liquid assets ratioLiquid assets ratio

Cash and government securities in countries Cash and government securities in countries such as U.K.such as U.K.

Similar case for U.S. life insurance companies Similar case for U.S. life insurance companies (regulated at state level)(regulated at state level)

U.S. banks: cash-based, but banks view U.S. banks: cash-based, but banks view government securities as buffer reserves.government securities as buffer reserves.

Return-Risk Trade-offReturn-Risk Trade-off

Cash immediacy versus reduced returnCash immediacy versus reduced return Constrained optimizationConstrained optimization

Privately optimal reserve holdings Privately optimal reserve holdings Regulator imposed reserve holdingsRegulator imposed reserve holdings

U.S. Cash Reserve U.S. Cash Reserve RequirementsRequirements

Incremental reserve requirements for Incremental reserve requirements for transaction accountstransaction accounts:: First $5.5 million First $5.5 million 0.0%0.0% $5.5 million to $42.8 million $5.5 million to $42.8 million 3.0%3.0% $42.8 million + $42.8 million + 10.0%10.0%

Reserve Management Reserve Management ProblemProblem

Computation period runs from a Tuesday to Computation period runs from a Tuesday to a Monday, 14 days later. Average daily a Monday, 14 days later. Average daily reserves are computed as a fraction of the reserves are computed as a fraction of the average daily deposits over the period. This average daily deposits over the period. This means that Friday deposit figures count 3 means that Friday deposit figures count 3 times in the average. times in the average.

“ “Weekend Game”Weekend Game” Sweep accountsSweep accounts

Reserve ManagementReserve Management

The reserve maintenance period, differs The reserve maintenance period, differs from the computation period by 17 days. from the computation period by 17 days. Lagged reserve accounting as of July 1998.Lagged reserve accounting as of July 1998. Previously, contemporaneous (2-day lag).Previously, contemporaneous (2-day lag).

Benefits of lagged reserve accounting Benefits of lagged reserve accounting

Under-/Over-shootingUnder-/Over-shooting

Allowance for up to a 4% error in average Allowance for up to a 4% error in average daily reserves without penalty. daily reserves without penalty. Surplus reserves required for next 2-week periodSurplus reserves required for next 2-week period

Undershooting by more than 4% penalized Undershooting by more than 4% penalized by a 2% markup on rate charged against by a 2% markup on rate charged against shortfall. shortfall.

Frequent undershooting likely to attract Frequent undershooting likely to attract scrutiny by regulatorsscrutiny by regulators

UndershootingUndershooting

DI has two options near the end of the DI has two options near the end of the maintenance periodmaintenance period Liquidate assetsLiquidate assets Borrow reservesBorrow reserves

fed fundsfed funds repurchase agreementsrepurchase agreements

Discount WindowDiscount Window

Reserve shortfalls in the pastReserve shortfalls in the past Discount window borrowingDiscount window borrowing

discount rate usually lower than market ratesdiscount rate usually lower than market rates

Risks of gaming the systemRisks of gaming the system

OvershootingOvershooting

First 4 percent can be carried forward to First 4 percent can be carried forward to next periodnext period

Excess reserves typically low due to Excess reserves typically low due to opportunity costsopportunity costs

Knife-Edge problemKnife-Edge problem

Funding Risk versus CostFunding Risk versus Cost

Funding CostFunding Cost

Funding Risk

Liability ManagementLiability Management

Note the tradeoff between funding risk Note the tradeoff between funding risk and funding cost. and funding cost. Demand deposits are a source of cheap Demand deposits are a source of cheap

funds but there is high risk of withdrawal. funds but there is high risk of withdrawal. NOW accounts: manager can adjust the NOW accounts: manager can adjust the

explicit interest rate, implicit rate and explicit interest rate, implicit rate and minimum balance requirements to alter minimum balance requirements to alter attractiveness of NOW deposits.attractiveness of NOW deposits.

Deposit AccountsDeposit Accounts

Passbook Savings Accounts: Not Passbook Savings Accounts: Not checkable. Bank also has power to delay checkable. Bank also has power to delay withdrawals for as long as a month.withdrawals for as long as a month.

Money market deposit accounts: Money market deposit accounts: Somewhat less liquid than demand Somewhat less liquid than demand deposits and NOW accounts. Impose deposits and NOW accounts. Impose minimum balance requirements and limit minimum balance requirements and limit the number and denomination of checks the number and denomination of checks each month.each month.

Time Deposits and CDsTime Deposits and CDs

Retail CDs: Face values under $100,000 Retail CDs: Face values under $100,000 and maturities from 2 weeks to 8 years. and maturities from 2 weeks to 8 years. Penalties for early withdrawal. Unlike T-bills, Penalties for early withdrawal. Unlike T-bills, interest earned on CDs is taxable.interest earned on CDs is taxable.

Wholesale CDs: Minimum denominations of Wholesale CDs: Minimum denominations of $100,000. Wholesale CDs are negotiable. $100,000. Wholesale CDs are negotiable.

Fed FundsFed Funds

Fed funds is the interbank market for excess Fed funds is the interbank market for excess reserves. 90% have maturities of 1 day. reserves. 90% have maturities of 1 day.

Fed funds rate can be highly variable Fed funds rate can be highly variable Prior to July 1998: especially around the Prior to July 1998: especially around the

second Tuesday and Wednesday of each second Tuesday and Wednesday of each period. (as high as 30% and lows close to period. (as high as 30% and lows close to 0% on some Wednesdays).0% on some Wednesdays).

Rollover riskRollover risk

Repurchase AgreementsRepurchase Agreements

RPs are collateralized fed funds RPs are collateralized fed funds transactions.transactions.

Usually backed by government securities. Usually backed by government securities. Can be more difficult to arrange than simple Can be more difficult to arrange than simple

fed funds loans.fed funds loans. Generally below fed funds rate Generally below fed funds rate

Other BorrowingsOther Borrowings

Bankers acceptancesBankers acceptances Commercial paperCommercial paper Medium-term notesMedium-term notes Discount window loansDiscount window loans

Historical NotesHistorical Notes

Since 1960, ratio of liquid to illiquid assets Since 1960, ratio of liquid to illiquid assets has fallen from about 52% to about 26%. has fallen from about 52% to about 26%. But, loans themselves have also become But, loans themselves have also become more liquid. more liquid.

Securitization of DI loansSecuritization of DI loans In the same period, there has been a shift In the same period, there has been a shift

away from sources of funds that have a high away from sources of funds that have a high risk of withdrawal. risk of withdrawal.

Historical NotesHistorical Notes

During the period since 1960:During the period since 1960: Noticeable differences between large and Noticeable differences between large and

small banks with respect to use of low small banks with respect to use of low withdrawal risk funds.withdrawal risk funds.

Reliance on borrowed funds does have its Reliance on borrowed funds does have its own risks as with Continental Illinois.own risks as with Continental Illinois.

Liquidity Risk in Other FIsLiquidity Risk in Other FIs

Insurance companiesInsurance companies Diversify across contractsDiversify across contracts Hold marketable assetsHold marketable assets

Securities firmsSecurities firms Example: Drexel Burnham LambertExample: Drexel Burnham Lambert

KepustakaanKepustakaan

Siamat, Dahlan. 2004. Manajemen Lembaga Keuangan. Lembaga Penerbit Siamat, Dahlan. 2004. Manajemen Lembaga Keuangan. Lembaga Penerbit Fakultas Ekonomi Universitas Indonesia. Fakultas Ekonomi Universitas Indonesia.

Saunders, A., Cornett M.M. 2006. Financial Institution Management. McGraw-Hill Saunders, A., Cornett M.M. 2006. Financial Institution Management. McGraw-Hill International. International.

Kasmir. 2002. Manajemen Perbankan. Jakarta: Divisi Buku Perguruan Tinggi PT Kasmir. 2002. Manajemen Perbankan. Jakarta: Divisi Buku Perguruan Tinggi PT RajaGrafindo Persada.RajaGrafindo Persada.

Kuncoro, M & Suhardjono. 2002. Manajemen Perbankan: Teori dan Aplikasi. Kuncoro, M & Suhardjono. 2002. Manajemen Perbankan: Teori dan Aplikasi. BPFE Yogyakarta.BPFE Yogyakarta.

Riyadi, S. 2004. Banking Assets Liability Management. Penerbitan FE-UIRiyadi, S. 2004. Banking Assets Liability Management. Penerbitan FE-UI

Gandapradja, P. 2004. Dasar dan Prinsip Pengawasan Bank. Penerbit PT Gandapradja, P. 2004. Dasar dan Prinsip Pengawasan Bank. Penerbit PT Gramedia Utama. Gramedia Utama.