Finance 4000

Money and Capital Markets

Twelfth class

• Management of Risk

  
  
  
  
  

  • Credit risk

    
    
    

    • Default leading to loss

      
      
      
      
      

  • Interest rate risk

    
    
    

    • Interest rate change leading to loss

• Credit risk

  
  
  

  • Without asymmetric information, there still would be credit risk

    
    
    

    • Bad things happen

      
      
      

  • Banks want to

    
    
    

    • Make losses less likely, within limits

      
      
      

      • Do not want to "minimize losses"

        
        
        

      • Do not want to have no losses

        
        
        

    • How low does a bank want loan losses if not zero?

      
      
      

      • Want the amount of losses such that the marginal benefit of reducing loan losses equals the marginal cost of reducing such losses

        
        
        

      • Want the amount of losses such that the marginal benefit of loan losses equals the marginal cost

• How can a bank reduce credit risk?

  
  
  

  • Screening

    
    
    

  • Monitoring

    
    
    

  • Collateral

    
    
    

  • Compensating balances

    
    
    

    • Collateral

      
      
      

    • Useful for monitoring

      
      
      

  • Long-term customer relationships

    
    
    

    • Gives borrower an incentive to have a continuing relationship

      
      
      

    • Lender has an incentive to have a continuing relationship also

• • Can also reduce credit risk by making smaller loans than some borrowers might be willing to take

    
    
    

    • Extreme example: I borrow $1 billion at any interest rate

      
      
      

      • Take the money and run

        
        
        

or

• • • • Spend the money and file for bankruptcy

        
        
        

      • Interest rate is irrelevant in either case

        
        
        

    • The larger the loan relative to a borrower's equity, the more severe the moral hazard problem

• • A bank may not make any loans at some interest rates even if borrowers willing to pay them

    
    
    

    • Loans are too risky

      
      
      

    • A higher interest rate may not compensate a bank for the higher risk because adverse selection may increase the risk more the higher interest rate compensates for the risk

      
      
      

    • Probably a more important reason that banks do not make very risky loans is their specialization in lower risk customers and loans

      
      
      

      • After all, finance companies and pawn brokers make loans that banks won't

        
        
        

• Managing interest rate risk

  
  
  

  • Basic idea is to estimate the effect of changes in interest rates on assets and liabilities

    
    
    

    • Simplest is change in interest rate times (interest rate-sensitive assets - interest-rate-sensitive liabilities

      
      
      

    • More complex computations use duration

      
      
      

  • Problems with these computations

    
    
    

    • Interest rates change by the same amount

      
      
      

    • Estimates of sensitive assets and liabilities or durations of assets and liabilities are subject to error

      
      
      

    • Erroneous idea of immunizing the balance sheet suggested by duration gap

      
      
      

      • Immunizing the balance sheet is compensating for a large amount of interest rate-sensitive assets relative to liabilities by having a low duration (and therefore lower sensitivity of market value of assets to changes in interest rates) or vice versa