Major Risks for Banks

Liquidity risk, operational risk, credit risk, market risk, and capital risk.

The major risks for a bank are liquidity risk, operational risk, credit risk, market risk, and capital risk.

The main objective of bank management is to maximize value, which means increasing shareholders' wealth and optimizing the price of its common stock

This goal is usually achieved through investing in assets that generate the highest gross yield suitable to their risk profile and keep costs down. 

A bank must either take on increased risk or lower operating costs to obtain a higher yield. A bank's profitability will generally vary directly with the riskiness of its portfolio and operations. 

Additionally, government regulations like reserve requirements and investment restrictions are critical indicators of a bank's risk management framework. 

As such, understanding a bank's significant risks helps us look at how these large financial institutions handle our money. 

Key insights : 

  • Banks have 5 main major risks: liquidity, operational, credit, market, and capital risk. 
  • Each factor plays a crucial role in the likelihood that recent or impending events will harm an institution's profitability and the market value of its assets, liabilities, and stockholder's equity.
  • The impact of adverse risk events can be absorbed by sufficient bank capital so that the institution remains solvent. 

Why are these risks important? 

It's almost accurate to say that taking risks is what bank management is all about.

Under the tenet of "avoiding all risks," financial institutions will stagnate and fall short in meeting the community's legitimate credit demands. 

However, a bank that takes on too many risks is sure to have problems. 

There are numerous methods to describe and categorize banking vulnerabilities, and it is feasible to compile a lengthy list of the dangers to which banks are exposed. We will look at the 5 major risks that banks face. 

Credit risk 

Credit risk is the most evident risk in banking, which may also be the most significant in terms of possible losses.

Credit risk is associated with the quality of individual assets and the likelihood of default. It is the potential variation in net income and market value of equity resulting from the nonpayment of funds. 

Credit risk includes not just the possibility that borrowers won't be able to make payments; it also consists of the chance that prices will be delayed, which could result in issues for the bank. 

Higher interest rates on a company's debt obligations, a drop in the share price, and/or a downgrading of the evaluation of its debt quality are some ways that the capital markets respond to a deterioration in a company's credit standing.

Due to the sheer volume of data, evaluating the quality of a single asset is extremely challenging. In addition, whenever a bank acquires an earning asset, it assumes the risk that the borrower will default and not repay the principal and interest on a timely basis. 

The cash flow for debt services changes as general economic conditions and a firm's operational environment do.

Similarly, employment and personal net worth changes affect a person's ability to pay back debt. To determine a borrower's ability to repay, banks do a credit analysis on each loan request.

Investment securities often have lower credit risk. The bank makes various investments, including investment-grade corporate and government debt, hybrid products, and equity. Loans, on the other hand, exhibit the most significant credit risk. 

Liquidity Risk 

Another constant concern in banking is the possibility that the need for money will require the forced sale of or collection of assets at a loss. 

Liquidity refers to an owner's ability to convert the asset to cash with minimal loss from depreciation. It is necessary for banks for four main reasons:

  • As a safety net to replace net cash outflows
  • To make up for the lack of expected cash inflows
  • As a source of funds when future obligations are due
  • As a source of cash to initiate new transactions when it's needed

If one or more of these needs cannot be met, there is a threat to liquidity. Therefore, banks must ensure a suitable balance of different assets and liabilities to meet their liquidity requirements.

1. Holding liquid assets 

  •  Most banks hold some assets that can be readily sold to meet liquidity needs. These assets provide immediate access to cash but are costly for the bank to hold. 
  • Cash assets are held to satisfy customer withdrawal needs, meet legal reserve requirements, or purchase services from other financial institutions but do not pay interest. Hence banks attempt to minimize cash holdings due to the cost of holding them. 
  • Liquid assets, therefore, consist of unpledged, marketable short-term securities that are classified as available for sale. 

2. Ability to borrow for liquidity 

  • If two banks hold similar assets, the one with the more significant total equity or lowest financial leverage can take on more debt with less chance of becoming insolvent. 
  • The lower the bank's borrowing capacity and the higher its borrowing costs 
  • Core deposits are stable deposits that are not highly interest-rate sensitive. These types of deposits are less sensitive to the interest rate paid. 

The greater the core deposits in the funding mix, the lower the unexpected deposit withdrawals and potential new funding requirements; hence, the greater the bank's liquidity.

Market Risk 

It is the current and potential risk to earnings and stockholders' equity resulting from adverse market rates or price movements. 

There are three major areas of market risk:

1) Interest rate risk or reinvestment rate risk 

The exposure of bank profits to changes in interest rates, which have varied effects on assets and liabilities, is known as interest rate risk. The fact that banks operate with mismatched balance sheets makes them susceptible to interest rate risk. 

Bankers have a solid incentive to position the bank accordingly if they strongly believe that interest rates will move in a particular direction. 

When a rise in interest rates is anticipated, they will increase the interest sensitivity of assets relative to liabilities and do the opposite when a fall is expected.

Combining assets and liabilities can increase or decrease exposures, and methods like interest-margin variance analysis (IMVA) are used to assess existing exposures and predict future directions.

2) Equity and security price risk 

The risk to earnings or capital resulting from changes in the value of financial instrument portfolios is known as price risk.

Market values of securities, including stocks, fixed-income investments, foreign currency holdings, and related derivative and off-balance sheet contracts, are impacted by market prices, interest rates, and exchange rates.

A bank can mitigate equity and security price risk through portfolio diversification by eliminating unsystematic risk. Alternatively, it can purchase derivatives contracts such as futures and options to hedge the equity price risk. 

3) Foreign exchange risk 

Changes in foreign exchange rates affect the value of assets, liabilities, and off-balance sheet activities denominated in foreign currencies. This risk exists because some banks hold assets and issue liabilities denominated in different currencies. 

When the number of assets differs from the number of liabilities in a currency, any change in exchange rates produces a gain or loss that affects the bank's stockholders' equity market value.

Foreign exchange risk is also found in off-balance sheet loan commitments and guarantees denominated in foreign currencies. 

Operational risk 

The Basel committee defines operational risk as: "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. "

In other words, operational risk refers to the possibility that operating expenses might vary significantly from expected, producing a decline in net income and bank value. 

Operational risks can be found at a technical level, specifically in a bank's information system or risk measures. Alternatively, these risks can be manifested at an organizational level, such as in a bank's internal reporting, monitoring, and control systems. 

Separating risk-takers from risk controllers is a crucial aspect of operational risk management at the organizational level. This was a fundamental weakness in the Barings Bank system that was memorably exploited by one of its derivatives traders, leading to the bank's demise (the movie).

Operational risk is difficult to measure directly but is likely greater the higher the numbers of divisions or subsidiaries, employees and loans to insiders. 

Capital Or Solvency Risk 

Since all of the previously stated risks would, in one way or another, influence a bank's capital and solvency, the capital risk is not considered a specific risk. It is technically insolvent when a bank has a negative net worth or shareholders' equity.

The difference between a company's assets and liabilities measured by the market value represents its economic net worth. Therefore, the capital risk is the possibility that the market value of assets will fall below the market value of liabilities.

If such a bank were to liquidate its assets, it would not be able to pay all creditors and would be bankrupt. In short, the greater the equity is to assets, the greater the number of assets that can default without the bank becoming insolvent. 

Suppose management does not have a good asset management strategy and does not allocate funds to revenue-generating investments. In that case, the capital risk may, in some situations, pose a significant issue for banks.

Lehman Brothers is a good illustration of how banks mismanage their assets and heavily rely on risky investments.

Due to bad lending policy, low-interest rates, tax regulations, and toxic subprime mortgages, Lehman Brothers eventually became insolvent. They filed for bankruptcy in 2008, correlated with one of the worst economic downturns in US history.

Regulations For major risks for banks

Bank regulators help managers keep their firms operating by regulating allowable activities. However, they are mainly responsible for limiting risk-taking by banks. 

To assess bank risk, regulators routinely examine the quality of assets, mismatching maturities of assets and liabilities, and internal operating controls. 

If they determine that a bank has assumed too much risk, they require additional equity capital. 

Regulators use a CAMELS Rating System to access the banks' earnings and risk management. 

Here is an overview of the CAMELS Rating System : 

  • Capital Adequacy: The capacity of management to recognize, quantify, monitor, and manage risks, as well as the institution's capacity to retain capital commensurate with the nature and magnitude of all forms of risk

  • Asset Quality: Indicates the degree of current credit risk connected to the loan and investment portfolio and off-balance sheet activity.

  • Management of Quality: Demonstrates how well the board of directors and senior management have identified, measured, monitored, and controlled risks. The employment of rules and procedures by regulators to control risks within targets is emphasized.

  • Earnings: Reflects elements that might impact the sustainability or quality of earnings in addition to earnings quantity and trend.

  • Liquidity: Demonstrates the suitability of the institution's existing and future sources of liquidity and its methods for managing money.

  • Sensitivity To Market Risk: Reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, and equity prices can adversely affect earnings or economic capital.

Regulators numerically rate each bank in six categories, ranging from the highest or best (1) to the worst rating (5). They also assign a composite rating for the bank's overall operation. 

  • A composite rating of 1 or 2 shows a fundamentally sound bank. 
  • A rating of 3 indicates that the bank shows some underlying weakness that should be corrected. 
  • A rating of 4 or 5 indicates a problem bank with some near-term potential for failure.
Financial Statement Modeling Course

Everything You Need To Master Financial Statement Modeling

To Help You Thrive in the Most Prestigious Jobs on Wall Street.

Learn More

Researched and Authored by Mahdi Naouar LinkedIn

Reviewed and Edited by Aditya Salunke | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources: