FINM3006 w4

Additional interest rate risk: Market Value RiskThere are two sources of interest rate risks- cash flow risk (due to financing and reinvestment) and market value risk (also causes asset values and liabilities values to change so equity value will be impacted as well). Think of these two with FI mismatch maturities in mind. Obvious way to reduce these risk is to match maturities but they can't really do that because one of their important functions is asset transformation. If you're short funded you care about interest rates going up. If they fall your profitability increases.The opposite is true, if you're long funded, the maturity of your liabilities are much large than the maturity of your assets. So you go to re-invest your assets but imagine if rates have changed and the reinvestment rate is higher, then your spread will fall (example of reinvestment or cash flow risk)We can also think about market value risk when interest rates change. When interest rates change the securities value changes. As Equity=Assets-Liabilities, changing interest rates can have an adverse impact on the DI's net worth. With a longer asset maturity, the fall in asset value is larger than the fall of the shorter maturity liabilities. This isn't a great thing especially given that banks are so highly levered.

Market Risk: Is associated with trading book of the bank One individual brought down a bank. Nick Leeson took a position on the Nikei that caused losses which forced the bank into insolvency. The Volcker rule will mean the trading book will be lower than the banking book-> the banking book might expand and increase investment in traditional banking activities. We'll talk about how firms measure market risk. Securitisation has increased volume of trading assets. Market risk is present whenever a bank takes an unhedged position. Securitisation changed the liquidity of bank assets and liabilities- they became tradable

Market Risk Ratios ***can be used to understand market risk exposure of a firm. You can infer from income statements about how much exposure banks have by how much they are making on their trading. If you accept the idea that book-values don't change but that the market value does then the more the rations fluctuate, the higher the exposure to trading risk

Credit Risk- We will also think about in great detail, this is risk that a loan a bank issues won't be paid either in part or in full. We'll talk about how they estimate this and measuring aggregate and individual risk in a portfolio. Banks often require collateral e.g. mortgage is secured lending. Credit risk is risk that cash flows on loans and securities held by DI are not repaid in full. In other words, the probability that some of the DI's assets will decline in value and perhaps become worthless. There is collateral which moves and collateral which doesn't move

Implications of Growing Credit Risk Large component of credit risk is diversifiable. Total risk can be broken into systematic and unsystematic risk. This was the reasoning used to issue sub-prime mortgages, secure them and send them to the marketWe can break credit risk into three categories. The pool of loan that was being securitised the idea being a large component of these individuals won't default at the same time (largely unsystematic) The asset transformation exists for individuals to hedge against their own liquidity risk, banks can only do this if risk is mainly unsystematic but can't if it;s systematic because everyone wills withdraw at the same time meaning banks will run out of cash. A large fraction of liquidity risk must be diversifiable (unsystematic) and same with credit risk so banks try to not have their portfolios concentrated in areas or demographics. Big four banks are much more diversified because they have asset portfolio over whole country. This is contrary to bank of Queensland

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