Banking Risks – An overview and interrelationship

A bank uses its customers’ funds to earn a profit for itself by advancing, loaning monies for varying purposes to individuals, organizations, corporations etc. It may also invest in securities, bonds, facilities, people, mortgaged properties, technologies etc.  For a bank, its profit will depend on receiving money at low rates of interest and investing them at higher rates of interest. That is exactly where a bank takes almost all its risks.

 (a)  You can attract more depositors by paying high rates of interest; but then you need to target your sales (income earning activities) like making advances and loans and purchase of investments that yield still higher rates of interest, and are safe too. A bank may grant vastly different types of loans such as Import Loans, Export Loans, Student Education Loans, Housing Loans, Mortgage Loans etc.  This is one risk area.

(b)  On the other hand, you may minimize that type of risk by offering reduced rates of interest on deposits; but that will get you less deposits; and you are faced with the question as to whether that would be sufficient in volume and come fast enough to turn over to make adequate profits to give you a reasonable ROI. Herein lies another risk.

(c)  Following up on (a) and (b) above, it is obvious that you have to strike a balance between the two scenarios and go for the correct mix that would give you the best ROI. But how to find that correct mix? That is where ALM measurements come very handy.

(d)  With regard to making investments, some financial institutions like to play safe by investing in State securities and bonds; but they will give you a very low return compared to more lucrative commercial investments to be found in the market. Unfortunately, some parties offering these investments may not be reliable, and with regard to some others, very little may be known about their long standing reliability or integrity. Such investments pose risks, and lesser the information available, more, the risk will be. Further, some investment carry tags like re-pricing intervals, prepayment options etc. that add to the uncertainty. The deeper you tread into unknown territory, the deeper you will sink in risk.

(e)  ALCO  will analyze and take “measurements” of the bank’s deposit base and also its mix of investments to determine whether your mix of low interest yielding safe investments and higher interest yielding not so safe investments comprise an ideal mix, in addition carrying out many other tests on the bank’s other components of assets and liabilities before giving it a clean bill of health. Otherwise it will prescribe the correct medicine to get things under good control.

(f)   It is to be noted that times of falling prices, slumps and recession are especially difficult periods for a bank’s survival, when determination and control of ALM becomes very tricky and difficult. It is interesting to note that during the recession of 2008-2010, no less than 59 banks failed in US itself.

 Risk Factors for a Bank / Financial Institution:

Broadly, Risk is the possibility that events and/or actions may adversely affect the bank’s Capital Structure and/or its Earnings. We will discuss only 3 of the many known risks that are most relevant to a bank in its day-to-day activities under normal conditions.

      (i)      Credit Risk:

The risk that some loans/advances, investment may become unrecoverable (may not be repaid by some recipients). The bank’s assets mix, assets quality issues and the bank’s ability to leverage its capital would have implications on its credit risk. For a bank that extends to property developers, housing mortgages etc. may find themselves at considerable risk. We can take cue from the high number of foreclosures that occurred during the height of the recent recession during the 2007/2008 period, highly impacting several banks / financial institutions that eventually resulting in several crashes too

    (ii)      Liquidity Risk:

The risk that there won’t be enough liquid funds (cash) to turn around fast enough to meet the demands of the depositors for repayments / amortizations, and for making new loans to its potential borrowers. At its gravest levels of this type of risk, there could be a “run on the bank” by depositors and shareholders resulting in a “bank failure” as have happened to several financial institutions before.

  (iii)      Interest Rate Risk:

This risk may arise from 2 sources of IRR on earnings and IRR on capital.

(a)     IRR on Earnings:

This is the risk that could arise due to changes in prevailing rates of interest.  Depending on which direction the fluctuations are occurring (i.e., upward or downward), the change (if material) can adversely affect interest receivable and/or interest payable.

(b)     IRR on Capital: There are other terms by which this risk is referred to such as Market Risk, Valuation Risk and Price Risk. As in the case of IRR on Earnings, it reflects the effects the risk that could arise consequently to a change in the prevailing rates of interest; the difference being that it measures the effects on assets and liabilities instead of on earnings and disbursements. IRR on Capital can also be stated as the valuation effect on assets and liabilities in the balance sheet arising from changes in interest rates (both internal and external) taken together with some other market conditions.

 Strategic Risk, Operations Rick and Reputation Risk are a few other risks generally associated with the happening of events due to unforeseen and/or unexpected circumstances.

 Interrelationship between Risks:

I think the interrelationship that exists between the above described risk factors of a bank is best illustrated with an example.

 For instance, a bank intending to reduce its interest rate risk uses a strategy of converting as many types of its existing fixed interest bearing loans/ investments on one side and deposits on the other into new loans with variable interest rates. By taking this strategy to its extreme, the bank may succeed in making all its deposits and loans (issued) and investments (sold – if any) accounts to be variable interest bearing loans that rise or fall with the prevailing market rates. In adopting this strategy, the bank assumes that since all deposits / loans on both sides of the balance sheet rise or fall with the market interest rates, its margin will now stay constant. (By the way, if you can in reality maintain a constant margin, then you don’t have to worry about interest rate risk anymore.) Coming back to the example, the bank further argues that even the event of a rise or fall in deposits; it could always adjust the loan rates to its customers to turn around the situation back in their favor. So the bank is happy thinking it has resolved the issue of interest rate risk with by its new strategy.

 Again this brings us to the scenario we discussed elsewhere earlier too a very common mistake of concentrating on only one or a few variables in an equation without giving thought to all the variables involved. The bank in its euphoria has forgotten to take in to account that interest rates applicable to accounts on both sides of the balance sheet don’t necessarily rise or fall in equal increments and also the fact that they don’t necessarily happen simultaneously at the same time. In other words, it has totally missed the point that a one-to-one relationship does not exist between the loans/deposits accounts on either side of the balance sheet. Secondly, the bank made another wrong assumption in presuming that they could always re-price their loans (now converted to variable rate loans) to customers at a desirable higher rate. This thinking presupposes that its customers could absorb whatever the rate the bank dishes out to them. Well and good if they can, and do; otherwise you are heading for not only a cash flow crisis if the customers cannot pay up at the new rates and default on their repayments, but an unwanted credit risk too on your hands of your own creation!  It is opportune at this moment to reflect on what happened to certain top banks and financial institutions that re-priced their mortgage loans in keeping with the rising costs and interest rates that prevailed during the critical 2007 to 2010 period. The result in detail may be still fresh in the minds of quite a lot of us. The mortgage loan borrowers who were already up to their necks in hot water in a massive scale economic downturn could not absorb this additional burden too on their cash flow, and repayments started falling into arrears and finally complete default of the loans resulting in foreclosure of many mortgage properties all over the country. The banks and lending institutions were compelled to hold on to numerous foreclosed mortgage properties with no takers to sell them to, to recover their capital. Finally quite a number of these institutions also fell and crashed while some managed survive the crisis to live another day.

 Another important point that the bank appears to have overlooked or not attached much importance is the fact that working with higher rates of interest all round could lower the demand for your loans, while increasing inflows as deposits giving rise to a situation of excess liquidity, which is also a different type of liquidity risk. Further, carrying higher rates of interest has a tendency to create a general reduction in value of the bank’s investment portfolio (i.e. a decrease in the IRR on Capital).

 If we saw something in common in all the examples discussed, it is the fact that trying to control the risk of just one item of an asset or a liability in isolation of other surrounding factors results in the increase in the risk level of one or more other factors. The lesson to be learnt here is to try to maintain all risks at a controlled level instead of simply concentrating on one particular risk at a time.