Major risks for banks include credit, operational, market, and liquidity risk. Since banks are exposed to a variety of risks, they have well-constructed risk management infrastructures and are required to follow government regulations. Government agencies, such as the Office of Superintendent of Financial Institutions (OSFI) in Canada, set the regulations to counteract risks and protect depositors.
Why Do the Risks for Banks Matter?
Due to the large size of some banks, overexposure to risk can cause bank failure and impact millions of people. By understanding the risks posed to banks, governments can set better regulations to encourage prudent management and decision-making.
The ability of a bank to manage risk also affects investors’ decisions. Even if a bank can generate large revenues, lack of risk management can lower profits due to losses on loans. Value investors are more likely to invest in a bank that is able to provide profits and is not at an excessive risk of losing money.
The major risks faced by banks include credit, operational, market, and liquidity risks.
Prudent risk management can help banks improve profits as they sustain fewer losses on loans and investments.
Ways to decrease risks include diversifying assets, using prudent practices when underwriting, and improving operating systems.
Credit risk is the biggest risk for banks. It occurs when borrowers or counterparties fail to meet contractual obligations. An example is when borrowers default on a principal or interest payment of a loan. Defaults can occur on mortgages, credit cards, and fixed income securities. Failure to meet obligational contracts can also occur in areas such as derivatives and guarantees provided.
While banks cannot be fully protected from credit risk due to the nature of their business model, they can lower their exposure in several ways. Since deterioration in an industry or issuer is often unpredictable, banks lower their exposure through diversification.
By doing so, during a credit downturn, banks are less likely to be overexposed to a category with large losses. To lower their risk exposure, they can loan money to people with good credit histories, transact with high-quality counterparties, or own collateral to back up the loans.
Operational risk is the risk of loss due to errors, interruptions, or damages caused by people, systems, or processes. The operational type of risk is low for simple business operations such as retail banking and asset management, and higher for operations such as sales and trading. Losses that occur due to human error include internal fraud or mistakes made during transactions. An example is when a teller accidentally gives an extra $50 bill to a customer.
On a larger scale, fraud can occur through breaching a bank’s cybersecurity. It allows hackers to steal customer information and money from the bank, and blackmail the institutions for additional money. In such a situation, banks lose capital and trust from customers. Damage to the bank’s reputation can make it more difficult to attract deposits or business in the future.
Market risk mostly occurs from a bank’s activities in capital markets. It is due to the unpredictability of equity markets, commodity prices, interest rates, and credit spreads. Banks are more exposed if they are heavily involved in investing in capital markets or sales and trading.
Commodity prices also play a role because a bank may be invested in companies that produce commodities. As the value of the commodity changes, so does the value of the company and the value of the investment. Changes in commodity prices are caused by supply and demand shifts that are often hard to predict. So, to decrease market risk, diversification of investments is important. Other ways banks reduce their investment include hedging their investments with other, inversely related investments.
Liquidity risk refers to the ability of a bank to access cash to meet funding obligations. Obligations include allowing customers to take out their deposits. The inability to provide cash in a timely manner to customers can result in a snowball effect. If a bank delays providing cash for a few of their customer for a day, other depositors may rush to take out their deposits as they lose confidence in the bank. This further lowers the bank’s ability to provide funds and leads to a bank run.
Reasons that banks face liquidity problems include over-reliance on short-term sources of funds, having a balance sheet concentrated in illiquid assets, and loss of confidence in the bank on the part of customers. Mismanagement of asset-liability duration can also cause funding difficulties. This occurs when a bank has many short term liabilities and not enough short-term assets.
Short-term liabilities are customer deposits or short-term guaranteed investment contracts (GICs) that the bank needs to pay out to customers. If all or most of a bank’s assets are tied up in long-term loans or investments, the bank may face a mismatch in asset-liability duration.
Regulations exist to lessen liquidity problems. They include a requirement for banks to hold enough liquid assets to survive for a period of time even without the inflow of outside funds.
This has been CFI’s guide to the Major Risks Faced by Banks. To keep advancing your career, the additional CFI resources below will be useful: