Risk in Banking
The practice of lending money is itself a risk, and lending borrowed money puts the bank in a precarious position of remaining liable to its own depositors/creditors regardless of the behavior of its own debtors. Exposure to these risks makes banking a delicate operation, and has given rise to a great deal of regulation: banks are the most regulated and monitored financial institution, and may be the most rightly regulated industry.
But back to the point, banking is heavily influenced by risk, and in this chapter the author means to discuss the concept of risk and explore the various kinds of risks that banks face.
The Concept of Risk
Risk reflects the inaccuracy of human prediction: it is the chance that the outcome of an action will be something other than what was intended or imagined before taking it. In some instances risk means incurring damage to the status quo, leaving the person worse off than he was before. In other instances, it means getting less benefit than was expected. No harm is done, but the individual is displeased with the lack of results. So long as humans are unable to perfectly predict the future, there will be risk. It is inevitable.
Psychologically, people are happiest when outcomes meet or exceed their expectations, and hope and fear drive them to seek the assistance of others in guaranteeing that they will get the outcome they expect. They wish to be protected from loss, even if the loss ins inevitable or the consequence of their own poor choices, and they will pay a premium to any person or institution that will provide that protection. Hence politics, hence insurance, hence any service that mitigates risk.
Banking gives individuals a degree of financial security: it will guarantee a specific rate of return on deposits, regardless of what happens with the investment of that money. Banks provide a similar service to their borrowers, guaranteeing that the interest rate on a loan will not change for the duration of the contract, regardless of what occurs in the overall economy.
The profit or loss of a bank depends on its own ability to predict risk. If the bank can make more than the expected amount by investing depositors' funds, it keeps the change; or if it makes less, it bears the loss. If interest rates fall after a loan contract is signed, the bank continues to collect more interest than it could earn by lending the same funds at the increased market rate; and if interest rates fall, the bank will collect less than it could. Being sustainable and profitable requires a bank to be good at predicting risks.
It's noted that all financial services organizations must face risk, but most of them pass this risk along to their customers. A stockbroker or mutual fund manager is paid commissions regardless of whether the assets he obtains for his clients are profitable, so the customer bears the entire risk. For that reason, these other servants are largely indifferent to risk whereas banks must be cautious because the risk is their own - hence banks tend to be among the most skittish and conservative of investors in avoiding or mitigating risk.
Interest Rate Risk
Interest rate risk considers whether earnings will meet expectations as a result of interest rates in the market. When entering into a long-term contract, the lender cannot recall his capital but must wait for the borrower to repay him per the terms of the contract (though the borrower may usually opt to repay sooner). Hence if interest rates rise, the lender regrets that he could have made more interest if he had waited to loan the money.
When entering into a loan contract, the lender (bank) considers the return it wishes to earn, it considers its own cost of capital (the interest due depositors), its operating expenses in servicing the loan, and its desired rate of profit. The loan contract guarantees the lender's revenue (so long as it is repaid) but his costs may vary for factors other than the behavior of the borrower (there are usually fines and penalties to compensate the lender for the buyer's behavior).
There is a brief mention of floating rate loans, in which both the lender and borrower expect to benefit from future changes in the interest rate. The borrower hopes for a decrease in the rate to lower his payments and the lender hopes for an increase in rates so he can earn more revenue. In this sense, the interest rate risk is shared between borrower and lender. There's some finicky detail about the mechanism by which the rate on the contract changes, which is generally limited.
Because the rate of interest cannot be accurately predicted, banks maintain a portfolio of loans at various rates, taking into account the automatic variations of its variable-rate lending and the understanding that some customers (though not all) will refinance loans when the interest rate falls. IT must be remembered that the banks' actions are generally dependent on the cooperation of others: there must be borrowers willing to loan at the rate the bank demands,
Banks also attempt to control the cost they pay for capital by adjusting the rate they pay for various deposit accounts, thereby giving encouragement to depositors to keep more or less funds in the bank's custody. Banks have better control over their borrowings (from other banks, the central bank, and issuing securities to be repaid in future) and can issue new securities and pay off outstanding ones to the degree permitted by the specific vehicles as well as selling or buying debt to other banks and investors.
The author provides a number of details and scenarios that pertain to specific situations and kinds of transactions, but this adds nothing to the basics described above.
Market Risk
Market risk considers the change in the market value of financial securities that have already been purchased. To the long-term investor, the market risk generally results in paper losses, as the value of securities fluctuates and a temporary loss will be recovered in time, and does not become realized until the securities are sold. To the short-term investor, market risk can be significant simply because he will not hold securities for long enough for the market fluctuations to recover short-term losses.
Because banks tend to hold many short-term investments (which can be bought and sold to manage their cash reserves as depositors withdraw funds unpredictably), they are particularly susceptible to market risk. The recent collapse of banks during the financial crisis of the early twenty-first century was largely caused by risky investment choices and the realization of market risk, the result of which was additional legislation and regulatory vigilance of the market investments of banks.
Liquidity Risk
In general, liquidity risk is an opportunity cost faced by investors whose capital is tied up in investments. Liquidity risk represents the risk that they will not have liquid working capital available to take advantage of profitable opportunities. Banks also face an additional liquidity risk: that of not having the capital available to return deposits on demand. The consequence of a bank that "runs out of money" can be a significant panic among the general public (even if the bank has investments that can be liquidated), and when a bank must liquidate assets in a hurry, it generally does so at a loss.
The assumption on which most banks are founded is that the majority of funds will remain on deposit for an indefinite period of time, and only a faction will be withdrawn in the near term - this means that the bank can safely invest (and earn profit from) the majority of deposits as they are waiting to be withdrawn. No bank has the ability to repay all of its deposits immediately.
The first defense against liquidity risk is the bank's own cash reserves, which are kept liquid to repay depositors. Banks are encouraged (though not strictly required) to maintain a certain minimum reserve level to benefit from doing business with central bank and other banks, though this figure represents a minimum and banks may opt to keep more in reserve (though money held in reserve is dead and earns no interest).
A second defense is investment in short-term investments, which mature in thirty days or less. A constant churn of short-term investments keeps money passing constantly through the bank's accounts, and gives it the ability to have greater liquidity by investing more or less on any given day. However, as previously mentioned, short-term investments carry more significant market risk than long-term ones.
A third defense is investment in relatively stable securities that can be liquefied quickly - i.e. they can be bought or sold without penalty or loss, or with minimal penalty or loss. Most kinds of commercial investment (stocks and bonds) can be sold at will, as can some proportion of commercial paper, though all sales are dependent on the existence of a sufficient number of interested buyers.
The last line of defense is the central bank itself, a "lender of last resort" that can provide money on a moment's notice to any of its member banks. In general, the central bank loans and borrows money in order to stabilize the money supply, but it has the means to go into hero mode to rescue a given bank and, in most instances, can do so without doing harm to the money supply in general (simply by lending more of its pool to a specific bank).
There is some discussion of the various accounting and financial analyses that are used to measure and assess a bank's liquidity, which seem overly detailed.
There is then some considerations of the "bank run" in which large numbers of depositors rush to withdraw their deposits from a bank that seems to be at risk. Bank runs are often discussed as if they are mythical phenomenon or a theoretical bauble, but they routinely occur during major financial crises. The establishment of deposit insurance (the FDIC) to ensure depositors that their money is safe even if a bank fails has largely curtailed bank runs.
Credit Risk (Default Risk)
A bank depends on its borrowers to repay their loans per the terms of the loan agreement, and credit risk represents the chance that they may not. Unpaid loans are a total loss to the bank, because it is still beholden to return those funds to its depositors. Even if a loan is secured by capital, the cost of recovering the collateral represents a loss to the bank.
There's some mention of asymmetric information (the lender does not know things the borrower does) and moral hazard (the increased likelihood to behave irresponsibly when someone else will bear the loss), which are concerns for lenders, but which have been discussed ad nauseam in other sources. Banks are aware of these risks, and part of the interest rate charged to borrowers is meant to compensate for them.
There is then an enumeration of the various methods banks use to mitigate credit risk:
- Avoidance - The obvious way to mitigate risk is simply to avoid it by refusing to lend money to risky borrowers. There is political pressure for banks to lend to anyone, so the policies under which a bank can refuse a customer are limited, must be documented, and must be followed without prejudice or exception.
- Credit Rationing - Credit rationing is the practice of providing less credit than the borrower seeks. IT can be seen as being partial avoidance, as the bank limits its risk by limiting the amount loaned.
- Diversification - Diversification is simply the principle of not putting all of one's eggs in one basket, making many small loans instead of few large ones to mitigate risk. Diversification also is practiced in the type of loan that is issued and the type of borrower that is served.
- Specialization - Specialization is the practice of accepting only a certain kind of client (a bank that lends only to tobacco farmers or silver miners, for example), which is done because the bank develops a high level of familiarity with a given industry and can better assess the risk of an individual operation. This runs contrary to the principle of diversification
- Compensating Balances - Some loans are made with the commitment of the borrower maintaining some balance with the bank that can be seized if the loan is not repaid. (EN: The author does not explain the sense of this, as a person who has funds in the bank can use them rather than borrowing. Perhaps another source explores this better?)
- Screening - The screening process is designed to investigate whether the borrower has the means to repay a loan. For personal loans, an individual's salary, work history, credit report, and other factors are used to assure the bank they will meet their commitments. For businesses, banks often inspect their assets and review their business plans to assess the potential for the borrower to get the means to repay. Screening is often deferred to credit bureaus and independent agencies who rate borrowers.
- Monitoring - Monitoring enables the bank to observe the behavior of an individual after the loan has been made, to ensure the funds are being used responsibly, that collateral is not covertly sold, etc. Terms in the contract give the bank the right to take action to collect if certain activities are apparent.
- Long-Term Relationships - In general, banks prefer to have long-term relationships with clients because their ongoing need for credit gives the borrower a solid credit history and their need for loans in the future encourages them to act responsibly for the present loan. Regular customers also save the bank the effort of seeking and screening new customers, and regular customers' need for credit is also predictable, enabling the bank to better manage its capital reserves.
- Loan Commitments - A loan commitment is an agreement by the bank to lend up to a specified amount to a borrower at any time. It is essentially an automatic approval for future loans to a given client. (EB: how this mitigates the bank's risk is not explained.)
- Collateral - Collateral is property that the bank is entitled to seize if the borrower defaults on his loan. It is common for auto and property loans to use the item in question as collateral (the car or real estate can be repossessed and sold by the bank). Collateral is generally worth less than the amount of the loan, so it is only partial insurance, but it remains one of the most common methods of security for banks.
- Credit Derivatives - Credit derivatives are forms of insurance: the bank pays a portion of the interest as a premium to a party that will reimburse it if the borrower defaults. The profit of the holder of a derivative is derived from the borrower's repayment activity.
There is a brief consideration of "sovereign risk," which pertains to banks that loan to governments, domestic or foreign. It is virtually impossible to bring a lawsuit against a sovereign government (it owns its courts, does not deign to obey the courts of other nations or even of various "world government" courts), so when a government declares that it will not make payments for a while, or will simply refuse to honor its agreement, there's nothing a bank can do to collect. Banks generally attempt to screen governments and assess their payment history, stability, and reliability of tax revenues in determining whether to loan to a foreign government.
Default risk is one of the primary factors in determining the rate at which a bank will lend to a specific individual. The cost of capital and operating expenses are the same for all borrowers and can be apportioned across the portfolio, but the risk of a specific borrower is often reflected in an increased rate offered to that borrower.
Currency Risk
Currency risk is visited on any bank that makes loans in more than one currency. Where a loan is denominated in foreign currency, the bank will lose or gain as that currency fluctuates against the domestic currency (in which the bank has to pay its depositors, employees, and other suppliers). The same is true when banks hold securities denominated in foreign currencies.
Banks that do business within a single nation (or economic bloc) are protected from this risk simply because they do not deal in foreign currencies at all. Those who borrow and invest across borders, or who have offices in foreign countries (and have to pay rent, salaries, and expenses in foreign currency) face this risk to the degree that they possess or must obtain foreign currency.
Currency risks are mitigated by swaps, forwards, and derivatives that essentially guarantee the bank a given rate of exchange. It is also possible for banks to purchase currency in advance of need when they expect that the fluctuation in value will be unfavorable in future. Some banks even use foreign currency exchange as an investment vehicle, which can be highly profitable or quite devastating.
Counterparty Risk
Counterparty risk is inherent in any contract that requires both parties to take actions that benefit the other: it is the risk that the other party will renege on the deal or behave in a fraudulent way. The author lists a number of examples of obvious fraud and misrepresentation, and suggests that even if the fraud is detected and the other party is compelled to make amends, the cost of detection and prosecution constitute a loss because they detract from the anticipated benefits.
There's also mention of regulators who act on behalf of both parties, though regulation tends to ebb and flow with the times. Whenever a scandal or misdeed is called to the attention of the public, politicians seek to curry favor by swiftly enacting legislation to prevent its recurrence.
Operational Risk
Operational risk pertains to the bank itself, though such risks can be caused or exacerbated by external agents. A few of the common operational risks are:
- Technology Risk - Banks rely heavily on information systems, and any breakdown or malfunction of their systems poses a significant risk to the stability of their operations. Business simply cannot move forward when the system is down, and any malfunction that loses or corrupts data can be harmful to the bank's performance.
- Human Resources Risk - The insufficiency or inadequacy of workers poses a risk to the bank's operations, but more significantly bank employees handle money and there is great temptation to misappropriate or embezzle the bank's funds, or to act in ways that are detrimental to the bank for personal profit.
- Reputation Risk - Because clients must trust a bank with their financial affairs, any damage to the bank's reputation harms the willingness of others (depositors, creditors, other banks) to do business with a bank whose reputation is in question. Reputation is highly subjective, so even the appearance of misconduct can be harmful to a bank.
- Compliance Risk - Compliance risk reflects the difficulty of doing business under the regulations of government on various levels. There are so many regulations from so many sources that it is difficult to comply with them all, and many are vague and contradict one another. A bank that is found out of compliance can be harshly penalized or even shut down by any of a pantheon of regulatory agencies.
- Legal Risk - Every bank transaction is the execution of a contract, and the precise wording of a contract may become a hindrance to the bank, causing it to have to fulfill liabilities it did not expect, forego benefits it expected, or to run afoul of regulations. Banks typically prefer standardized transactions whose contract wording has been worked out, but often engage in transactions that require amendments or additional documentation - and the latter is the source of many headaches.
- External Risk - This is a catch-all category for anything that may go wrong that is not covered by the previous categories: earthquakes, fires, robberies, locusts, etc. Given that businesses are interconnected, an event that affects one of the bank's vendors or partners is also a risk to the bank.