RISK5001 Chap.5 Financial Risks and Institutions
Financial Risks and Institutions
This chapter maps market, credit, liquidity and interest-rate risk onto the balance sheets of banks and insurers. It distinguishes solvency from liquidity and uses a repricing gap to connect rate changes with net interest income. The categories interact through cash flow, valuation and confidence: a credit concern can trigger withdrawals, forced sales can realise market losses, and declining capital can increase funding cost.
A strong answer identifies the first transmission channel, the threatened objective and the conditions under which pressure migrates into another risk class.
What this chapter covers
- 01
Financial institution balance sheets
- 02
Market risk
- 03
Credit risk
- 04
Liquidity and solvency
- 05
Interest-rate repricing
- 06
Contagion across risk channels
Worked example · free
Interpreting a negative repricing gap
- 1Gap = $42 million - $50 million = -$8 million.
- 1Convert the change to 0.005 and multiply by the gap.
- 1Approximate income change is -$40,000, so margin falls.
Key terms
- Repricing gap
- Rate-sensitive assets minus rate-sensitive liabilities within a chosen repricing horizon.
- Liquidity risk
- The risk that obligations cannot be met when due without unacceptable cost or loss.
- Solvency
- The condition in which the economic value of assets is sufficient to meet liabilities, assessed separately from the timing of available cash.
- Funding liquidity
- The ability to obtain cash or reliable funding when obligations fall due without paying a prohibitive price or disrupting the institution.
- Market liquidity
- The ability to transact an asset promptly and in meaningful size without causing a material adverse movement in its market price.
- Duration gap
- A measure of mismatch between the interest-rate sensitivity of assets and liabilities after allowing for their relative economic values.
Financial Risks and Institutions FAQ
Can a solvent institution still fail?
Yes. Assets may exceed liabilities while cash is unavailable at the required time. Forced sales can then realise discounts and convert liquidity pressure into a solvency problem.
Why use both gap and duration analysis?
Gap analysis focuses on near-term income as positions reprice. Duration focuses on economic-value sensitivity and cash-flow timing, so the measures answer related but different questions.
How can liquidity pressure create solvency loss?
An institution short of cash may sell assets quickly at depressed prices or borrow on expensive terms. Those actions realise valuation losses and reduce earnings or capital. The starting problem concerns timing, but its management can damage net worth, especially when markets are thin and many institutions attempt the same sale.
What does a positive repricing gap imply?
A positive gap means more rate-sensitive assets than liabilities reprice within the selected interval. Under a simplified parallel rate increase, net interest income tends to rise because asset income resets on a larger base. The conclusion depends on timing, pass-through, optionality and the assumption that other balance-sheet features remain unchanged.
Why are insurer and bank balance sheets exposed differently?
Banks commonly transform short or withdrawable funding into longer loans, making deposit behaviour and refinancing central. Insurers receive premiums before many claims but face uncertain claim timing and long liability durations. Both manage assets against obligations, yet contractual cash flows, policyholder options, regulation and the sources of liquidity demand differ.
How should a risk-transmission answer be structured?
Begin with the shock, name the first balance-sheet or cash-flow effect and trace each link to the threatened objective. Distinguish an accounting or market-value change from an immediate cash need. Then identify amplification through confidence, collateral, concentration or forced action, and finish with the control or buffer intended to break the chain.
What evidence distinguishes a temporary funding squeeze?
Start with a dated cash-flow forecast showing contractual inflows, outflows, collateral calls and the availability of committed facilities. Test whether assets can be monetised at credible stressed values and whether funding sources remain available when confidence weakens. A temporary mismatch has a plausible, documented route back to positive cash flow without destroying economic value.
By contrast, repeated dependence on emergency borrowing, forced sales or optimistic rollover assumptions can signal a deeper balance-sheet problem. Compare liquidity resources with the timing of obligations, then assess solvency separately using realistic asset values rather than assuming that eventual collection automatically supplies cash when required.
Exam move
Trace each scenario through cash flows and values. State the immediate risk, the balance-sheet effect, the objective threatened and the point where another risk category enters the chain. Redraw each institution as a two-sided balance sheet and annotate the timing, currency, repricing date and liquidity of major items.
For gap calculations, define the horizon before classifying positions and state the sign of the expected income effect before multiplying. For qualitative scenarios, use arrows to show how credit, market, liquidity and solvency channels interact. End by naming the buffer, limit or contingency action that interrupts the sequence.
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