Risks Faced By Banks

It is often said that profit is a reward for risk bearing. Nowhere is this truer than in the case of banking industry. Banks are literally exposed to many different types of risks. A successful banker is one that can mitigate these risks and create significant returns for the shareholders on a consistent basis. Mitigation of risks begins by first correctly identifying the risks, why they arise and what damage can they cause. In this article, we have listed the major types of risks that are faced by every bank. They are as follows:

Credit Risks

Credit risk is the risk that arises from the possibility of non-payment of loans by the borrowers. Although credit risk is largely defined as risk of not receiving payments, banks also include the risk of delayed payments within this category.

Often times these cash flow risks are caused by the borrower becoming insolvent. Hence, such risk can be avoided if the bank conducts a thorough check and sanctions loans only to individuals and businesses that are not likely to run out of income over the period of the loan. Credit rating agencies provide adequate information to enable the banks to make informed decisions in this regard.

The profitability of a bank is extremely sensitive to credit risks. Hence, even if credit risk rises by a small amount, the profitability of the bank can get extremely impacted. Therefore, to deal with such risks banks have come up with a wide variety of measures. For instance, banks always hold a certain amount of funds in reserves to mitigate such risks.

The moment a loan is made, a certain amount of money is appropriated to the provision account. Also, banks have started utilizing tools like structured finance to mitigate such risks. Securitization helps remove the concentrated risk from the bank’s books and diffuse it amongst the various investors in the capital markets. Credit derivatives like credit default swap have also come into existence to help banks survive in the event of a credit default.

Unpaid loans were, are and will always be a byproduct of conducting the banking business. Modern banks have realized this and are prepared to handle the situation without becoming insolvent until a catastrophic loss occurs.

Market Risks

Apart from making loans, banks also hold a significant portion of securities. Some of these securities are held because of the treasury operations of the bank i.e. as a means to park money for the short term. However, many securities are also held as collateral based on which banks have given loans to their customers. The business of banking is therefore intertwined with the business of capital markets.

Banks face market risks in various forms. For instance if they are holding a large amount of equity then they are exposed to equity risk. Also, banks by definition have to hold foreign exchange exposing them to Forex risks. Similarly banks lend against commodities like gold, silver and real estate which exposes them to commodity risks as well.

In order to be able to mitigate such risks banks simply use hedging contracts. They use financial derivatives which are freely available for sale in any financial market. Using contracts like forwards, options and swaps, banks are able to almost eliminate market risks from their balance sheet.

Operational Risks

Banks have to conduct massive operations in order to be profitable. Economies of scale work in the favor of larger banks. Hence, maintaining consistent internal processes on such a large scale is an extremely difficult task.

Operational risk occurs as the result of a failed business processes in the bank’s day to day activities. Examples of operational risk would include payments credited to the wrong account or executing an incorrect order while dealing in the markets. None of the departments in a bank are immune from operational risks.

Operational risks arise mainly because of hiring the wrong people or alternatively they could also occur if there is a breakdown of the information technology systems. A lapse in the internal processes being followed could also lead to catastrophic errors. For instance, Barings Bank ended up bankrupt because of its failure to implement appropriate internal controls. One trader was able to bet so much in the derivatives market that the equity of Barings Bank was wiped out and the bank simply ceased to exist.

Moral Hazard

The recent bailout of banks by many countries has created another kind of risk called the moral hazard. This risk is not faced by the bank or its shareholders. Instead, this risk is faced by the taxpayers of the country in which banks operate. Banks have become accustomed to taking excessive risk. If their risk pays off, they get to keep the returns. However, if their risk backfires, then the losses are borne by taxpayers in the form of bailouts. This too big to fail model has caused banks to become reckless in their pursuit of profit. Although central banks are using audits to ensure that safe business practices are followed, banks nowadays indulge in risky business the moment they are not under regulatory oversight.

Liquidity Risk

Liquidity risk is another kind of risk that is inherent in the banking business. Liquidity risk is the risk that the bank will not be able to meet its obligations if the depositors come in to withdraw their money. This risk is inherent in the fractional reserve banking system. Therefore, in this system, only a percentage of the deposits received are held back as reserves, the rest are used to create loans. Therefore, if all the depositors of the institution came in to withdraw their money all at once, the bank would not have enough money. This situation is called a bank run. This has happened countless times over the history of modern banking.

Modern day banks are not very concerned about liquidity risk. This is because they have the backing of the central bank. In case there is a run on a particular bank, the central bank diverts all its resources to the affected bank. Therefore, the depositors can be paid back when they demand their deposits. This restores depositor’s confidence in the banks finances and the run on the bank is averted.

Many modern day banks have faced bank runs. However, none of them have become insolvent due to a bank run post the establishment of central banks.

Business Risk

The banking industry today is considerably advanced and diversified. Banks today have a wide variety of strategies from which they have to choose. Once such strategy is chosen, banks need to focus their resources on obtaining their strategic goals in the long run.

Hence, there is always a risk that a given bank may choose the wrong strategy. As a result of this wrong choice, the bank may suffer losses and end up being acquired or may simply collapse. Consider the case of banks such as Washington Mutual and Lehman Brothers. These banks chose the subprime route to growth. Their strategy was to be the preferred lender to people who have less than perfect credit scores. However, the whole area of subprime lending went bust and since these banks had heavy exposures to such loans, they suffered dire consequences too.

Banks have no possible way to mitigate the risks that are created by following inappropriate business objectives. Which objectives were right and which were wrong? This question can only be answered in hindsight. When Lehman Brothers was focusing their resources on subprime lending, it must have seemed like the strategically right thing to do!

Reputational Risk

Reputation is an extremely important intangible asset in the banking business. Banks like JP Morgan bank, Chase bank, Citibank, Bank of America etc have all been in the business for hundreds of years and have stellar reputations. These reputations enable them to generate more business more profitably.

Customers like their money to be deposited at places which they believe follow safe and sound business practices. Hence, if there is any news in the media which projects a given bank in a negative light, such news negatively impacts the banks business. For instance Citibank was recently viewed as manipulating the Forex rates via conducting false trades with its own trading partners. When regulators found out about Citibank’s predatory tactics, they levied huge fines on the bank.

Apart from the fines Citibank also lost reputation as a bank that follows fair trade practices when the customers found out that they tend to resort to market manipulation. Many prospective customers may have shifted their business away from Citibank as a result of this discovery causing monetary loss as a result of reputation loss.

Banks can save their reputation by ensuring that they never participate in any unfair or manipulative business practices. Also, banks need to continuously ensure that their public relations efforts project them as a friendly and honest bank.

Systemic Risk

Systemic risk arises because of the fact that the financial system is one intricate and connected network. Hence, the failure of one bank has the possibility to cause the failure of many other banks as well. This is because banks are counterparties to each other in a lot of transactions. Hence, if one bank fails, the credit risk event for the other banks becomes a reality.

They have to write off certain assets as a result of the failure of their counterparty. This writing off often leads to the bankruptcy of other banks and an unstoppable domino seems to take over. Systemic risk is an extremely bad scenario to be in. For instance when the subprime crisis happened in 2008, it seemed like the entire global financial system would collapse.

The very nature of banking system therefore makes them prone to systemic risks. Systemic risks do not affect an individual bank rather they affect the entire system. Hence, there is very little that an individual bank can do to protect itself in the event that such a risk materializes.

Thus, the management of banks requires a lot of skill since multiple types of risks need to be mitigated. Some of these risks can be avoided whereas for the others the best that banks can do is to minimize their damage.