WHAT ARE RISKS FACING COMMERCIAL BANKING INSTITUTION SECTOR AND HOW TO OVERCOME

Introduction

Whenever we analyze any banking company, we’re looking at two main variables—the return a bank earns and the amount of risk.

v What does “risk” mean?

Risk is generally understood as “the possibility that something bad or unpleasant (such as an injury or a loss) will happen.” Risk is pervasive in most things that we do. When you drive, there’s a risk of getting into an accident. When you play, there’s a risk of getting injured. However, we often fail to recognize the importance of understanding risks to civilization.

Introduction to banking risk

Banking risk can be defined as exposure to the uncertainty of outcome. It’s applicable to full-service banks like JPMorgan (JPM), traditional banks like Wells Fargo (WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS), or any other financials included in an ETF like the Financial Select Sector SPDR Fund (XLF). Let’s look at the definition in some detail to understand its importance.

Defining “exposure”

Exposure denotes a position or stake in an outcome. Exposure is important because if a bank has no exposure to a risk, it would be safe. In such a scenario, a bank would be like a bystander who hasn’t placed any bet in a casino, and the outcome will have no financial impact on the bystander.

Defining “outcome”

An outcome is the consequence of a particular course of action. How and when this outcome is recognised will become clearer as we look in detail at the various categories of banking risk later in this series.

Defining “uncertainty”

Uncertainty is not knowing exactly what the potential outcome will be. At best, you can make an estimate about the number of possible outcomes. One of these many possible outcomes will be the most probable. This most probable outcome is known as the “base case” scenario. The greater the difference from the base case scenario, the greater the risk, and vice-versa.

What to do when faced with risks?

All banks have different choices when faced with a transaction involving risk. These choices include:

   Avoiding the risk if it’s economically unenviable Accepting and retaining risk on an economically justifiable basis

Increasing, reducing, or eliminating risk, according to one’s expectation of a return Reducing risk by diversifying a bank’s portfolio of risks

Hedging risk, to a degree, by using financial instruments Liquidating risk by transferring to another party

Banking can’t run without taking risks. Most banks are highly leveraged financial risk-takers

Eight types of bank risks

There are many types of risks that banks face. We’ll look at eight of the most important risks.

1.    Credit risk,

2.    Market risk.

3.    Operational risk,

4.    Liquidity risk,

5.    Business risk,

6.    Representational risk,

7.    Systemic risk, and

8.    Moral hazard

Credit risk

 The Basel Committee on Banking Supervision (or BCBS) defines credit risk as the potential that a bank borrower, or counter party, will fail to meet its payment obligations regarding the terms agreed with the bank. It includes both uncertainty involved in repayment of the bank’s dues and repayment of dues on time.

Dimensions of credit risk

The default usually occurs because of inadequate income or business failure. But often it may be willful because the borrower is unwilling to meet its obligations despite having adequate income.

Credit risk signifies a decline in the credit assets’ values before default that arises from the deterioration in a portfolio or an individual’s credit quality. Credit risk also denotes the volatility of losses on credit exposures in two forms—the loss in the credit asset’s value and the loss in the current and future earnings from the credit.

Banks create provisions at the time of disbursing loan). Net charge-off is the difference between the amounts of loan gone bad minus any recovery on the loan. An unpaid loan is a risk of doing the business. The bank should position itself to accommodate the expected outcome within profits and provisions, leaving equity capital as the final cushion for the unforeseen catastrophe. An example of credit risk during recent times

During the subprime crisis, many banks made significant losses in the value of loans made to high-risk borrowers—subprime mortgage borrowers. Many high-risk borrowers couldn’t repay their loans. Also, the complex models used to predict the likelihood of credit losses turned out to be incorrect.

Major Banks all over the globe suffered similar losses due to incorrectly assessing the likelihood of default on mortgage payments. This inability to assess or respond correctly to credit risk resulted in companies and individuals around the world losing many billions of U.S. dollars.

Market risk

The Basel Committee on Banking Supervision defines market risk as the risk of losses in on- or off-balance sheet positions that arise from movement in market prices. Market risk is the most prominent for banks present in investment banking.

Interest rate risk

It’s the potential loss due to movements in interest rates. This risk arises because a bank’s assets usually have a significantly longer maturity than its liabilities. In banking language, management of interest rate risk is also called asset-liability management (or ALM).

Equity risk

It’s the potential loss due to an adverse change in the stock price. Banks can accept equity as collateral for loans and purchase ownership stakes in other companies as investments from their free or investible cash. Any negative change in stock price either leads to a loss or diminution in investments’ value.

Foreign exchange risk

It’s the potential loss due to change in value of the bank’s assets or liabilities resulting from exchange rate fluctuations. Banks transact in foreign exchange for their customers or for the banks’ own accounts. Any adverse movement can diminish the value of the foreign currency and cause a loss to the bank.

Operational risk

The Basel Committee on Banking Supervision defines operational risk “as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk.

Operational risk occurs in all day-to-day bank activities. Operational risk examples include a check incorrectly cleared or a wrong order punched into a trading terminal. This risk arises in almost all bank departments—credit, investment, treasury, and information technology.

Causes of operational risks

There are many causes of operational risks. It’s difficult to prepare an exhaustive list of causes because operational risks may occur from unknown and unexpected sources. Broadly, most operational risks arise from one of three sources.

People risk: Incompetency or wrong posting of personnel and misuse of powers

Information technology risk: The failure of the information technology system, the hacking of the computer network by outsiders, and the programming errors that can take place any time and can cause loss to the bankProcess-related risks: Possibilities of errors in information processing, data transmission, data retrieval, and inaccuracy of result or output

Operational risk can lead to a bank’s collapse

The fall of one of Britain’s oldest banks, Barings, in 1995, is an example of operational risk leading to a bank’s collapse. It was mainly due to failure of its internal control processes. One of Barings’ traders in Singapore, Nick Leeson, was able to hide his trading losses for more than two years.

Liquidity risk

Liquidity by definition means a bank has the ability to meet payment obligations primarily from its depositors and has enough money to give loans. So liquidity risk is the risk of a bank not being able to have enough cash to carry out its day-to-day operations.

Provision for adequate liquidity in a bank is crucial because a liquidity shortfall in meeting commitments to other banks and financial institutions can have serious repercussions on the bank’s reputation and the bank’s bond prices in the money market.

Reputational risk

Reputational risk is the risk of damage to a bank’s image and public standing that occurs due to some dubious actions taken by the bank. Sometimes reputational risk can be due to perception or negative publicity against the bank and without any solid evidence of wrongdoing. Reputational risk leads to the public’s loss of confidence in a bank.

Business risk

Business risk is the risk arising from a bank’s long-term business strategy. It deals with a bank not being able to keep up with changing competition dynamics, losing market share over time, and being closed or acquired. Business risk can also arise from a bank choosing the wrong strategy, which might lead to its failure.

Moral hazard

Moral hazard is the most interesting risk that we’ll cover. You must have read or heard the phrase “too-big-to-fail” in the media. Too-big-to-fail is nothing but moral hazard in a sense. Moral hazard refers to a situation where a person, a group (or persons), or an organization is likely to have a tendency or a willingness to take a high-level risk, even if it’s economically unsound. The reasoning is that the person, group, or organization knows that the costs of such risk-taking, if it materializes, won’t be borne by the person, group, or organization taking the risk.

Ways to control moral hazard

Moral hazard can be controlled through a good organizational culture, giving credence to high ethical standards. A bank must also have a strong board of directors to oversee management and to take remedial measures when needed. A well-crafted compensation policy to avoid reckless risk-taking would also help reduce this risk. Finally, strong regulations would also help control moral hazard.

Other risks

There are some other minor types of risks that a bank carries. These aren’t as important as the previous risks discussed, but we’ll mention them in this article.

Legal risk

A bank can be exposed to legal risk. Legal risk can be in the form of financial loss arising from legal suits filed against the bank or by a bank for applying a law wrongly.

Country risk

A bank that operates in many countries also faces country risk when there’s a localized economic problem in a certain country. In such a scenario, the bank’s holding company may need to bear losses in case it exceeds the capital of a subsidiary in a country. The holding company in certain cases may also need to provide capital.