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Budi Purwanto
Ikhtisar
Bagian ini membahas risiko-risiko dalam intermediasi keuangan, antara lain: Risiko suku bunga; Risiko nilai tukar; Risiko pasar; Risiko operasional; Risiko politik (country risk); Risiko kredit; Risiko likuiditas; dan Risiko permodalan (insolvency risk).
Risiko Pasar
Risiko pasar terbuka dalam pertukaran aktiva dan pasiva (dan turunannya).
Contoh: sub-prime mortgage. Cenderung lebih besar ketahanannya pada pertukaran pendapatan daripada perdagangan tradisional dalam meningkatkan paparan pasar.
Peningkatan pengangguran
Mempengaruhi risiko kredit.
Risiko Operational
Risk of direct or indirect loss resulting form inadequate or failed internal processes, people, and systems or from external events.
Some include reputational and strategic risk
Risiko Operational
Risk that technology investment fails to produce anticipated cost savings. Risk that technology may break down. Economies of scale. Economies of scope.
Result of exposure to foreign government which may impose restrictions on repayments to foreigners. Lack usual recourse via court system.
Examples: South Korea, Indonesia, Thailand. More recently, Argentina.
Risiko Kredit
Risk that promised cash flows are not paid in full.
Firm specific credit risk Systematic credit risk
High rate of charge-offs of credit card debt in the 80s and 90s Obvious need for credit screening and monitoring Diversification of credit risk
Risiko Likuiditas
Risk of being forced to borrow, or sell assets in a very short period of time.
Low prices result.
Original cause may be excessive interest rate, market, credit, off-balance-sheet, technological, FX, sovereign, and liquidity risks.
Overview
This chapter discusses the interest rate risk associated with financial intermediation: Federal Reserve policy Repricing model Maturity model Duration model *Term structure of interest rate risk *Theories of term structure of interest rates
Japan: March 2001 announced it would no longer target the uncollateralized overnight call rate. New target: Outstanding current account balances at BOJ
Targeting of bank reserves in U.S. proved disastrous
October 1979 to October 1982, nonborrowed reserves target regime. Implications of return to reserves target policy:
Increases importance of measuring and managing interest rate risk.
Repricing Model
Repricing or funding gap model based on book value. Contrasts with market value-based maturity and duration models recommended by the Bank for International Settlements (BIS). Rate sensitivity means time to repricing. Repricing gap is the difference between the rate sensitivity of each asset and the rate sensitivity of each liability: RSA - RSL.
Maturity Buckets
Commercial banks must report repricing gaps for assets and liabilities with maturities of:
One day. More than one day to three months. More than 3 three months to six months. More than six months to twelve months. More than one year to five years. Over five years.
NIIi = (GAPi) Ri = (RSAi - RSLi) ri Example: In the one day bucket, gap is -$10 million. If rates rise by 1%, NIIi = (-$10 million) .01 = -$100,000.
Rate-Sensitive Assets
Examples from hypothetical balance sheet:
Short-term consumer loans. If repriced at yearend, would just make one-year cutoff. Three-month T-bills repriced on maturity every 3 months. Six-month T-notes repriced on maturity every 6 months. 30-year floating-rate mortgages repriced (rate reset) every 9 months.
Rate-Sensitive Liabilities
RSLs bucketed in same manner as RSAs. Demand deposits and passbook savings accounts warrant special mention.
Generally considered rate-insensitive (act as core deposits), but there are arguments for their inclusion as rate-sensitive liabilities.
CGAP Ratio
May be useful to express CGAP in ratio form as, CGAP/Assets.
Provides direction of exposure and Scale of the exposure.
Example:
CGAP/A = $15 million / $270 million = 0.56, or 5.6 percent.
Example: Suppose rates rise 2% for RSAs and RSLs. Expected annual change in NII, NII = CGAP R = $15 million .01 = $150,000 With positive CGAP, rates and NII move in the same direction.
The FI can restructure its assets and liabilities, on or off the balance sheet, to benefit from projected interest rate changes.
Positive gap: increase in rates increases NII Negative gap: decrease in rates increases NII
Maturity of Portfolio
Maturity of portfolio of assets (liabilities) equals weighted average of maturities of individual components of the portfolio. Principles stated on previous slide apply to portfolio as well as to individual assets or liabilities. Typically, MA - ML > 0 for most banks and thrifts.
If MA - ML = 0, is the FI immunized?
Duration
The average life of an asset or liability The weighted-average time to maturity using present value of the cash flows, relative to the total present value of the asset or liability as weights.
Time to Maturity
Time to Maturity
Time to Maturity
Time to Maturity
RN = [(1+R1)(1+E(r2))(1+E(rN))]1/N - 1
Market Value-Based
This chapter discusses a market valuebased model for assessing and managing interest rate risk:
Duration Computation of duration Economic interpretation Immunization using duration * Problems in applying duration
Example continued...
Bond A: P = $1000 = $1762.34/(1.12)5 Bond B: P = $1000 = $3105.84/(1.12)10
Coupon Effect
Bonds with identical maturities will respond differently to interest rate changes when the coupons differ. This is more readily understood by recognizing that coupon bonds consist of a bundle of zero-coupon bonds. With higher coupons, more of the bonds value is generated by cash flows which take place sooner in time. Consequently, less sensitive to changes in R.
Duration
Duration
Weighted average time to maturity using the relative present values of the cash flows as weights. Combines the effects of differences in coupon rates and differences in maturity. Based on elasticity of bond price with respect to interest rate.
Duration
Duration D = nt=1[Ct t/(1+r)t]/ nt=1 [Ct/(1+r)t] Where
D = duration t = number of periods in the future Ct = cash flow to be delivered in t periods n= term-to-maturity & r = yield to maturity (per period basis).
Duration
Since the price of the bond must equal the present value of all its cash flows, we can state the duration formula another way:
D = nt=1[t (Present Value of Ct/Price)] Notice that the weights correspond to the relative present values of the
Computing duration
Consider a 2-year, 8% coupon bond, with a face value of $1,000 and yield-tomaturity of 12%. Coupons are paid semiannually. Therefore, each coupon payment is $40 and the per period YTM is (1/2) 12% = 6%. Present value of each cash flow equals CFt (1+ 0.06)t where t is the period
Face value = $1,000, YTM = 12% t years CFt PV(CFt) Weight x years (x) 1 0.5 40 37.736 0.041 0.020
2 3 4 1.0 1.5 2.0 40 40 35.600 33.585 0.038 0.036 0.885 1.000 0.038 0.054 1.770 D=1.883 (years)
Special Case
Maturity of a consol: M = . Duration of a consol: D = 1 + 1/R
Duration Gap
Suppose the bond in the previous example is the only loan asset (L) of an FI, funded by a 2-year certificate of deposit (D). Maturity gap: ML - MD = 2 -2 = 0 Duration Gap: DL - DD = 1.885 - 2.0 = -0.115
Deposit has greater interest rate sensitivity than the loan, so DGAP is negative.
Features of Duration
Duration and maturity:
D increases with M, but at a decreasing rate.
Economic Interpretation
Duration is a measure of interest rate sensitivity or elasticity of a liability or asset: [dP/P] [dR/(1+R)] = -D Or equivalently, dP/P = -D[dR/(1+R)] = -MD dR where MD is modified duration.
Economic Interpretation
To estimate the change in price, we can rewrite this as: dP = -D[dR/(1+R)]P = -(MD) (dR) (P)
Note the direct linear relationship between dP and -D.
An example:
Consider three loan plans, all of which have maturities of 2 years. The loan amount is $1,000 and the current interest rate is 3%. Loan #1, is an installment loan with two equal payments of $522.61. Loan #2 is a discount loan, which has a single payment of $1,060.90. Loan #3 is structured as a 3% annual coupon bond.
Duration Gap:
An example:
Suppose DA = 5 years, DL = 3 years and rates are expected to rise from 10% to 11%. (Rates change by 1%). Also, A = 100, L = 90 and E = 10. Find change in E. = DA - DLk]A[R/(1+R)] [
But, to set E = 0:
DA = kDL
*Limitations of Duration
Immunizing the entire balance sheet need not be costly. Duration can be employed in combination with hedge positions to immunize. Immunization is a dynamic process since duration depends on instantaneous R. Large interest rate change effects not accurately captured.
Convexity
*Convexity
The duration measure is a linear approximation of a non-linear function. If there are large changes in R, the approximation is much less accurate. All fixed-income securities are convex. Convexity is desirable, but greater convexity causes larger errors in the duration-based estimate of price changes.
*Convexity
Recall that duration involves only the first derivative of the price function. We can improve on the estimate using a Taylor expansion. In practice, the expansion rarely goes beyond second order (using the second derivative).
*Modified duration
P/P = -D[R/(1+R)] + (1/2) CX (R)2 or P/P = -MD R + (1/2) CX (R)2 Where MD implies modified duration and CX is a measure of the curvature effect.
CX = Scaling factor [capital loss from 1bp rise in yield + capital gain from 1bp fall in yield]
Commonly used scaling factor is 108.
*Calculation of CX
Example: convexity of 8% coupon, 8% yield, six-year maturity Eurobond priced at $1,000. CX = 108[P-/P + P+/P] = 108[(999.53785-1,000)/1,000 + (1,000.46243-1,000)/1,000)] = 28.
*Contingent Claims
Interest rate changes also affect value of off-balance sheet claims.
Duration gap hedging strategy must include the effects on off-balance sheet items such as futures, options, swaps, caps, and other contingent claims.
Forex Risks
This chapter discusses foreign exchange risk to which FIs are exposed. This issue has become increasingly important for FIs due to hedging needs and speculative positions taken to increase income.
Background
Globalization of financial markets has increased foreign exposure of most FIs. FI may have assets or liabilities denominated in foreign currency (in addition to direct positions in foreign currency). Foreign currency holdings exceed direct portfolio investments.
Sources of FX Risk
Spot positions denominated in foreign currency Forward positions denominated in foreign currency Net exposure = (FX assets - FX liab.) + (FX bought - FX sold)
FX Risk Exposure
FI may have positions in spot and forward markets.
Could match foreign currency assets and liabilities to hedge F/X risk
Must also hedge against foreign interest rate risk (by matching durations, for example)
Trends in FX
Value of foreign positions has increased Volume of foreign currency trading has decreased Causes:
Investment bank mergers Increased trading efficiency through technological innovation Introduction of the euro
FX Risk Exposure
Greater exposure to a foreign currency combined with greater volatility of the foreign currency implies greater DEAR. Dollar loss/gain in currency i = [Net exposure in foreign currency i measured in U.S. $] Shock (Volatility) to the $/Foreign currency i exchange rate
FX Trading
FX markets turnover often greater than $1.8 trillion per day. The market moves between Tokyo, NYC and London over the day allowing for what is essentially a 24-hour market. Overnight exposure adds to the risk.
Trading Activities
Basically 4 trading activities:
Purchase and sale of currencies to complete international transactions. Facilitating positions in foreign real and financial investments. Accommodating hedging activities Speculation.
Profitability of FX Trading
For large US banks, trading income is a major source of income.
Volatility of European currencies are declining (due to euro) Volatility in Asian and emerging markets currencies higher Risk arises from taking open positions in currencies
Multicurrency Positions
Since the banks generally take positions in more than one currency simultaneously, their risk is partially reduced through diversification. Overall, world bond markets are significantly, but not fully integrated which leaves open the opportunity to reduce exposure by diversifying.
Cr edit Risks
Budi Purwanto
Overview
This chapter discusses types of loans, and the analysis and measurement of credit risk on individual loans. This is important for purposes of:
Pricing loans and bonds Setting limits on credit risk exposure
Types of Loans:
C&I loans: secured and unsecured
Spot loans, Loan commitments Decline in C&I loans originated by commercial banks and growth in commercial paper market.
Consumer loans
Individual (consumer) loans: personal, auto, credit card.
Nonrevolving loans
Automobile, mobile home, personal loans
Other loans
Other loans include:
Farm loans Other banks Nonbank FIs Broker margin loans Foreign banks and sovereign governments State and local governments
Return on a Loan:
Factors: interest payments, fees, credit risk premium, collateral, other requirements such as compensating balances and reserve requirements. Return = inflow/outflow k = (f + (L + M ))/(1-[b(1-R)]) Expected return: E(r) = p(1+k)
At wholesale:
Use both quantity and pricing adjustments.
j X i , j + error
j =1
Statistically unsound since the Zs obtained are not probabilities at all. *Since superior statistical techniques are readily available, little justification for employing linear probability models.
X5 = Sales/total assets.
p (1+ k) = 1+ i
May be generalized to loans with any maturity or to adjust for varying default recovery rates. The loan can be assessed using the inferred probabilities from comparable quality bonds.
MMR1 = (Value Grade B default in year 1) (Value Grade B outstanding yr.1) MMR2 = (Value Grade B default in year 2) (Value Grade B
RAROC Models
Risk adjusted return on capital. This is one of the more widely used models. Incorporates duration approach to estimate worst case loss in value of the loan: L = -DL x L x (R/(1+R)) where R is an estimate of the worst change in credit risk premiums for the loan class over the past year. RAROC = one-year income on loan/L
Option Models:
Employ option pricing methods to evaluate the option to default. Used by many of the largest banks to monitor credit risk. KMV Corporation markets this model quite widely.
*CreditMetrics
If next year is a bad year, how much will I lose on my loans and loan portfolio? VAR = P 1.65 Neither P, nor observed. Calculated using:
(i)Data on borrowers credit rating; (ii) Rating transition matrix; (iii) Recovery rates on defaulted loans; (iv) Yield spreads.
* Credit Risk +
Developed by Credit Suisse Financial Products.
Based on insurance literature:
Losses reflect frequency of event and severity of loss.
2 p
i =1
2 2 Xi i
+ X i X j i , j
i =1 j =1
Partial Applications
Loan volume-based models (continued)
Provide market benchmarks.
Standard deviation measure of loan allocation deviation.
j =
i =1
( X i, j X i )2 N
[sectoral losses in ith sector] [ loans to ith sector ] = + i [total loan losses] [ total loans ]
Regulatory Models
Credit concentration risk evaluation largely subjective. Life and PC insurance regulators propose limits on investments in securities or obligations of any single issuer.
Diversification limits.
Overview
This chapter discusses the nature of market risk and appropriate measures
Dollar exposure RiskMetrics Historic or back simulation Monte Carlo simulation Links between market risk and capital requirements
Market Risk:
Market risk is the uncertainty resulting from changes in market prices . It can be measured over periods as short as one day. Usually measured in terms of dollar exposure amount or as a relative amount against some benchmark.
Confidence Intervals
If we assume that changes in the yield are normally distributed, we can construct confidence intervals around the projected DEAR. (Other distributions can be accommodated but normal is generally sufficient). Assuming normality, 90% of the time the disturbance will be within 1.65 standard deviations of the mean.
Measure risk
Actual percentage changes in FX rates for each of past 500 days.
Weaknesses
Disadvantage: 500 observations is not very many from statistical standpoint. Increasing number of observations by going back further in time is not desirable. Could weight recent observations more heavily and go further back.
Employ historic covariance matrix and random number generator to synthesize observations.
Objective is to replicate the distribution of observed outcomes with synthetic data.
Regulatory Models
BIS (including Federal Reserve) approach:
Market risk may be calculated using standard BIS model.
Specific risk charge. General market risk charge. Offsets.
Subject to regulatory permission, large banks may be allowed to use their internal models as the basis for determining capital requirements.
BIS Model
Specific risk charge:
Risk weights absolute dollar values of long and short positions
Vertical offsets:
Adjust for basis risk
Overview
This chapter discusses the factors affecting operational returns and risks, and the importance of optimal management and control of labor, capital, and other input sources and their costs. The emphasis is on technology and its impact on risk and return. Examples: Risks resulting from innovations in IT, and effects of terrorist attacks on key technologies.
Importance of Technology
Efficient technological base can result in:
Lower costs
Through improved allocation of inputs.
Increased revenues
Through wider range of outputs.
Earnings before taxes = (Interest income Interest expense) + (Other income Noninterest expense) - Provision for loan losses
Impact of Technology
Interest income can be increased
Through wider array of outputs or cross selling.
Impact of Technology
Other income can be increased
Through electronic handling of fee generating OBS activities such as LCs and derivatives
Cost effects:
Technological improvements
Shift in cost curve.
Size
Size
Size
Diseconomies of scope
Specialization may have cost benefits in production and delivery of some FI services
Intermediation Approach:
Includes funds used to produce intermediated services among the inputs. C = f(y,w,r, k)
Empirical Findings
Evidence economies of scale for banks up to the $10 billion to $25 billion range. X-inefficiencies may be more important. Inconclusive evidence on scope. Recent studies using a profit-based approach find that large FIs tend to be more efficient in revenue generation.
Use of electronic transactions higher in other countries. (E.g., TARGET). U.S. Payments system:
FedWire Clearing House Interbank Payments System (CHIPS) Combined value of transactions often more than $2.7 trillion per day.
Risks (continued)
International Technology Transfer Risk Crime and Fraud Risk Regulatory Risk
Technology facilitates avoidance of regulation by locating in least regulated state or country.
Technology Risks
Programming error Model risk Mark-to-market error Management information IT/Telecomm systems outage Technology provider failure Contingency planning
External risks
External fraud Taxation risk Legal risk War Market collapse Reputation risk Relationship risk
Loss control:
Planning, organization, back-up
Loss financing:
External insurance
Loss insulation:
FI capital
RME
Regulatory Issues
1999 Basel Committee on Banking Supervision noted the importance of operational risks Required capital:
Basic Indicator Approach Standardized Approach Internal Measurement Approach
Liquidity Risk
Budi Purwanto
Overview
This chapter explores the problem of liquidity risk faced to a greater or lesser extent by all FIs. Methods of measuring liquidity risk, and its consequences are discussed. The chapter also discusses the regulatory mechanisms put in place to control liquidity risk.
Liability Management
Purchased liquidity
Federal funds market or repo market. Managing the liability side preserves asset side of balance sheet. Borrowed funds likely at higher rates than interest paid on deposits. Deposits are insured Regulatory concerns: growth of wholesale funds
Liability Management
Alternative: Stored Liquidity Management
Liquidate assets.
In absence of reserve requirements, banks tend to hold reserves. E.g. In U.K. reserves ~ 1% or more. Downside: opportunity cost of reserves.
Other Measures:
Peer group comparisons: usual ratios include borrowed funds/total assets, loan commitments/assets etc. Liquidity index: weighted sum of fire sale price P to fair market price, P*, where the portfolio weights are the percent of the portfolio value formed by the individual assets. I = wi(Pi /Pi*)
BIS Approach:
Maturity ladder/Scenario Analysis
For each maturity, assess all cash inflows versus outflows Daily and cumulative net funding requirements can be determined in this manner Must also evaluate what if scenarios in this framework
Liquidity Planning
Important to know which types of depositors are likely to withdraw first in a crisis. Composition of the depositor base will affect the severity of funding shortfalls. Allow for seasonal effects. Delineate managerial responsibilities clearly.
Bank Runs
Can arise due to concern about banks solvency. Failure of a related FI. Sudden changes in investor preferences. Demand deposits are first come first served. Depositors place in line matters. Bank panic: systemic or contagious bank run.
Mutual Funds
Net asset value (NAV) of the fund is market value. The incentive for runs is not like the situation faced by banks. Asset losses will be shared on a pro rata basis so there is no advantage to being first in line.
Composition
Composition of liquid asset portfolio
Liquid assets ratio
Cash and government securities in countries such as U.K. Similar case for U.S. life insurance companies (regulated at state level) U.S. banks: cash-based, but banks view government securities as buffer reserves.
Return-Risk Trade-off
Cash immediacy versus reduced return Constrained optimization
Privately optimal reserve holdings Regulator imposed reserve holdings
Reserve Management
The reserve maintenance period, differs from the computation period by 17 days.
Lagged reserve accounting as of July 1998. Previously, contemporaneous (2-day lag).
Benefits of lagged reserve accounting
Under-/Over-shooting
Allowance for up to a 4% error in average daily reserves without penalty.
Surplus reserves required for next 2-week period
Undershooting by more than 4% penalized by a 2% markup on rate charged against shortfall. Frequent undershooting likely to attract scrutiny by regulators
Undershooting
DI has two options near the end of the maintenance period
Liquidate assets Borrow reserves
fed funds repurchase agreements
Discount Window
Reserve shortfalls in the past
Discount window borrowing
discount rate usually lower than market rates
Overshooting
First 4 percent can be carried forward to next period Excess reserves typically low due to opportunity costs Knife-Edge problem
Funding Risk
Liability Management
Note the tradeoff between funding risk and funding cost.
Demand deposits are a source of cheap funds but there is high risk of withdrawal. NOW accounts: manager can adjust the explicit interest rate, implicit rate and minimum balance requirements to alter attractiveness of NOW deposits.
Deposit Accounts
Passbook Savings Accounts: Not checkable. Bank also has power to delay withdrawals for as long as a month. Money market deposit accounts: Somewhat less liquid than demand deposits and NOW accounts. Impose minimum balance requirements and limit the number and denomination of checks each month.
Fed Funds
Fed funds is the interbank market for excess reserves. 90% have maturities of 1 day. Fed funds rate can be highly variable Prior to July 1998: especially around the second Tuesday and Wednesday of each period. (as high as 30% and lows close to 0% on some Wednesdays). Rollover risk
Repurchase Agreements
RPs are collateralized fed funds transactions. Usually backed by government securities. Can be more difficult to arrange than simple fed funds loans. Generally below fed funds rate
Other Borrowings
Bankers acceptances Commercial paper Medium-term notes Discount window loans
Historical Notes
Since 1960, ratio of liquid to illiquid assets has fallen from about 52% to about 26%. But, loans themselves have also become more liquid. Securitization of DI loans In the same period, there has been a shift away from sources of funds that have a high risk of withdrawal.
Historical Notes
During the period since 1960:
Noticeable differences between large and small banks with respect to use of low withdrawal risk funds. Reliance on borrowed funds does have its own risks as with Continental Illinois.
Securities firms
Example: Drexel Burnham Lambert
Kepustakaan
Siamat, Dahlan. 2004. Manajemen Lembaga Keuangan. Lembaga Penerbit Fakultas Ekonomi Universitas Indonesia. Saunders, A., Cornett M.M. 2006. Financial Institution Management. McGraw-Hill International. Kasmir. 2002. Manajemen Perbankan. Jakarta: Divisi Buku Perguruan Tinggi PT RajaGrafindo Persada. Kuncoro, M & Suhardjono. 2002. Manajemen Perbankan: Teori dan Aplikasi. BPFE Yogyakarta. Riyadi, S. 2004. Banking Assets Liability Management. Penerbitan FE-UI Gandapradja, P. 2004. Dasar dan Prinsip Pengawasan Bank. Penerbit PT Gramedia Utama.