Question

Please define and discuss the following risks; loan portfolio/concentration, foreign exchange, and liquidity within the context of financial institutions. How are the FIs affected by these risks and how so they deal with them?

Answer 1

Loan Portfolio / Concentration risk: The financial institutions are in the business of financial intermediation and they essentially collect funds from various investors and utilise them for lending to borrowers (institutional as well as retail). When lending to large institutional borrowers, the FI may extend very large amounts (relative to their capital) which would expose them to risk of a single obligor disproportionately. This is called the concentration risk since if this one large obligor fails, it can significantly impact the health of the FI balance sheet . The FI manage this risk as below:

(i) Most FI will have singly obligor & even Group borrowing limits which will restrict them to lend beyond a certain proportion of their capital. These limits are set in percentage terms and go up when the capital increases.

(ii) If the FI is already in with a large concentration, they can sell down and reduce their exposure alternatively at the time of sourcing, they form consortium which allows them to share the risks with other FI

Foreign Exchange: Since the FI deal with international clients and also borrow / lend in various currencies either as part of their own balance sheet management or as part of their business operations, they are exposed to fluctuation in foreign currency where in they may have assets & income in one currency and liabilities & payment in another currency. This could lead to a mismatch of cash flows or the values of assets and liabilities may change imacting the balance sheet of the FI. This is called foreign exchange risk and is managed actively by FI:

(i) Hedging: In addition to hedging instruments available, they also may have a natural hedge because they would be dealing with multiple clients who will have different foreign currency flows and the FI can net off their risks across multiple clients.

(ii) Match assets and liabilities in each currency to avoid mismatch and risk thereoff that is borrow and lend in the same currency and match the respective cash flows

Liquidity Risk: The FI aggregate the funds from various investors and use them for further lending. The repayment schedule of the FI to their investors may not be same as the repayment profile of the loans extended by the FI and this creates a liquidity mismatch. This is very important to manage since if the investors loose confidence in the ability of the FI to repay, there may be a run on the FI which could not only severly impact the said FI but also the entire financial system incase of large FI. Generally FI manage their liquidity in buckets and match the inflows and outflows such that they are not sitting with idle funds (and loosing on earning opportunity) and they are also not short on liquidity which could hamper their ability to make payments. The FI have treasury departments who are managing the liquidity (and FX also) risks for the FI and they raise & place funds accordingly to manage balance of profitability as well as liquidity.