BANK RISK MANAGEMENT (PART 2)
Because banks are in the business of turning deposit liabilities into loan assets, the two sides of their balance sheet do not match up. One important difference is that a bank’s liabilities tend to be short term, while its assets tend to be long term. The mismatch between the maturities of liability and assets creates interest-rate risk. When interest rates move, it affects revenue from the assets and costs of the liabilities differently. If a bank’s liabilities are more interest-rate sensitive than its assets are, an increase in interest rates will cut into the bank’s profits.
For the bank to make a profit, the interest rate on its liabilities must be lower than the interest rate on its assets. The difference between the two rates is the bank’s net interest margin and this margin is the bank’s profit.
The first step in managing interest-rate risk is to determine how sensitive the bank’s balance sheet is to a change in interest rates. Managers must compute an estimate of the change in the bank’s profit for each one-percentage-point change in the interest rate. This procedure is called gap analysis because it highlights the gap between the yield on interest-rate-sensitive assets and the yield on interest-rate-sensitive liabilities.
Bank managers can use a number of tools to manage interest-rate risk. The simplest approach is to match the interest-rate sensitivity of assets with the interest-rate sensitivity of liabilities. For instance if the bank accepts a variable-rate deposit to purchase securities, it then uses the funds to purchase short-term securities. A similar strategy is to make long-term loans at a floating interest rate instead of at the fixed interest rate characteristic of a conventional mortgage. But while this approach reduces interest-rate risk, it increases credit risk.
While restructuring assets to better match those of liabilities can reduce risk, the fact that it also reduces potential profitability has led bankers to look for other ways to control interest-rate risk. Alternative include the use of derivatives, specifically interest-rate swaps, to manage interest-rate risk.
Banks profit from the difference between the interest rate they pay to depositors and the interest rate they receive from borrowers. But to ensure that this profit-making process works, for the bank to make a profit, borrowers must repay their loans. There is always some risk that they won’t. The risk that a bank’s loans will not be repaid is called credit risk. To manage their credit risk, banks use a variety of tools. The most basic are diversification, in which bank makes a variety of different loans to spread the risk, and credit risk analysis, in which the bank examines the borrower’s credit history to determine the appropriate interest rate to charge.
Diversification means spreading risk, which can be difficult for banks, especially those that focus on certain kinds of lending. Since banks specialize in information gathering, it is tempting to try to gain a competitive advantage in a narrow line of business. The problem is, if a bank lends in only one geographic area or only one industry, it exposes itself to economic downturns that are local or industry-specific. It is important that banks find a way to hedge such risks.
Credit risk analysis uses a combination of statistical models and information that is specific to the loan applicant. The result is an assessment of the likelihood that a particular borrower will default. When the bank’s loan officers decide to make a loan, they use the customer’s credit rating to determine how high an interest rate to charge. The poorer a borrower’s credit rating, the higher the interest rate they will charge.
Banks also use collateral to ensure losses in case customers can’t repay their loans. And to assess the Moral Hazard they tend to maintain a long-term relationship.
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