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Chapter 19:Types of Risks Incurred by Financial Institutions

46. Why do banks continue to make credit card loans even though credit card default rates are often at least twice as high as other loan types?

Answer: Credit card loss rates are higher than many other loan types, but FIs charge high enough interest rates (and fees) to make them worthwhile. FIs also extend credit card loans to large numbers of borrowers and the ensuing diversification reduces the risk. Level: Medium

47. A bank has $150 million in 1 year loans earning a fixed rate equal to 4.75%. The assets are funded by $150 million in liabilities that have a cost of 4.25% and a maturity of 3 years. If all interest rates are projected to fall 100 basis points by next year, by how much will the bank’s profits and loan NIM change in year 2? Does this bank face refinancing risk or reinvestment risk? Explain.

Answer:
Year 1 profits = (4.75% – 4.25%) * $150 million = $750,000; NIMyr1 = $750,000/ $150 million = 0.50%
Year 2 profits = (3.75% – 4.25%) * $150 million = -$750,000 Change in profits = -$1,500,000
NIMyr2 = -$1,500,000/ $150 million = -0.50%, so NIM decreases by 100 basis points. This bank faces reinvestment risk. When interest rates fall the NIM and profits fall because the asset return decreases and the liability cost stay the same due to the shorter maturity of the assets. Level: Medium

51. How does foreign exchange risk arise for an FI?

Answer: Trading in foreign currencies; making foreign currency loans; buying foreign currency securities; and borrowing foreign currencies. Level: Easy

52. What is sovereign risk? How is this different from credit risk on a domestic loan? How can sovereign risk be limited?

Answer: Sovereign risk is the risk that loan repayments from foreign borrowers may be interrupted by the foreign government. This differs from credit risk on a domestic loan in that legal recourse in the event of nonrepayment of principle or interest is generally less in many developing countries. Even in more developed countries collection will normally be more complex and expensive with longer delays than would be experienced in the U.S. Moreover, the borrower may wish to repay, but may be prevented from repaying the loan by the local government. Sovereign risk is difficult to eliminate but it can be limited by not lending to foreign governments, but instead lending to foreign private interests, and by threatening to not make any new loans to entities in that country, including the foreign government. Level: Easy

53. What are the three major objectives of technological investments at FIs? What are the major risks involved with these investments?

Answer:
1. Lower operating costs via exploiting economies of scale and scope 2. Increase profits
3. Capture new markets/customers.
The major risks include failures in technology, increased opportunities for fraud using the technology and failure to generate additional business that utilizes the technology. Level: Medium

54. What is insolvency risk? How can liquidity risk and credit risk cause insolvency? What are the two best protections against insolvency at a FI?

Answer: Insolvency occurs when equity becomes zero or negative. Hence, one of the best protections against insolvency is equity capital. The more equity a FI has the lower the insolvency risk. The second best protection is prudent management. The job of a FI manager is to decide how much risk is appropriate. Too much risk can cause an institution to fail. Liquidity risk can cause insolvency when a bank's creditors refuse to renew deposits or other borrowings, this may force the bank to have to liquidate assets at fire sale prices. The loss in value of the assets sold would reduce equity and could cause insolvency. Credit risk occurs when money invested in loans or securities is not paid back to the lending institution. These losses reduce equity capital and can...
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