FM CH 23–Risk Management in Financial Institutions

Principles for managing credit risk (6)
screening and monitoring

establishment of long-term customer relationships

loan committments

collateral

compensating balance requirements

credit rationing

Specializing in Lending
Helps in adverse selection

Financial institutions concentrate lending on firms in specific industries

Predict which firms will be able to make timely payments on their debt

easier to financial institutions to collect info and determine credit worthiness

restrictive convennts
restrict borrowers from engaging in risky activities
Advantages of long term customer relationships (for firms and borrowers)
F–reduces the costs of information collection

F–makes it easier to screen out bad credit risks

B–good for customers; easier to obtain loan at a low interest rate

F–borrower has incentive to avoid risky activities to keep low interest rates

loan commitments
banks commitment to provide a firm with loans up to a given amount at an interest rate that is tied to market interest rate
advantage of loan commitment
firm–source of credit when it needs it

bank–long term relationship

compensating balances
firm receiving a loan must keep a required minimum amount of funds in a checking account at the bank

help banks monitor–any drop may mean that the borrower is having financial trouble

credit rationing
refusing to make loans
1. lender refuses to make a loan of any mount
2. lender makes loan but restricts the size of the loan
sometimes financial institutions deny loans because
adverse selection–those with the riskiest projects are those willing to pay the highest interest rates
sometimes financial institutions give less than the loan amount specified because
to avoid moral hazard
rate sensitive
interest rates that will be repriced in a year
obviously rate sensitive assets
maturities less than a year
variable rate mortgages
commercial loans with maturities less than a year

residential mortgages are sometimes rate sensitivie if mortgages are repayed early

obviously rate sensitive liabilities
money market deposit accounts

variable rate CDS
CDS with less than a year to maturity

federal funds

borrowings with maturities of less than a year

partly rate sensitive liabilities
checkable and savings deposits
if a financial institution has more rate-sensitive liabilities than assets, a rise in interest rates
reduce the net interest margin and income
gap analysis
rate sensitive assets–rate sensitive liabilities

-measures effect of interest rate changes on income

effect of banks income (change of interest rates)
GAP (rate sensitive assets–rate sensitive liabilities) * change in interest rates
maturity bucket approach
measure the gap for several maturity subintervals
duration gap analysis
examines sensitivity of the market value of the financial institutions net worth to changes in the interest rate

duration–average life time security’s stream of payments

problems with income gap and duration gap analysis
when level of interest rate changes, interest rates on all maturities DO NOT change by exactly the same amount

Yield curve is not flat

assets and liabilities might be rate sensitive

Strategies for managing interest-rate risk
to increase rate-sensitive assets
shorten the duration of the banks assets–either by purchasing assets of shorter maturity
or converting fixed rate loans into adjustable rate loans

setting duration gap = to 0

equaling the rate sensitive assets to rate sensitive liabilities

Problems with eliminating financial institutions interest rate risk by altering the balance sheet
costly in the short run; locked into assets and liabilities of particular durations because of it’s field of experties