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