The Risky Business of Banking

The worst consequence of risk that a bank could face is going out of existence! Every time this happens more regulations are put in place. Banking business is all about risk taking. Every banking activity involves management of risk.

The risks banks face

The core business of a bank is to manage risk and provide a return to shareholders in line with the accepted risk profile. The credit crisis and the ensuing global recession seem to indicate that the banking sector has failed to tend to its core business. If it had done so effectively, then credit default swaps would not have been bought up with so much eagerness. If the banks had attended to risk management, then there would not have been a flood in the U.S. market of cheap short-term interest rate mortgages that led to the so-called housing bubble and the ultimate wave of personal bankruptcies and home foreclosures.

The most significant risk factors behind bank failures are 1: Liquidity risk, 2: Market risk, 3: Credit risk, 4: Operational risk and 5: Others

Liquidity risk involves the ability to fund increases in assets, manage unplanned changes in funding sources and to meet obligations when required, without incurring additional costs or inducing a cash flow crisis. In the context of the other key factors, risk may be defined as reductions in firm value due to changes in the business environment. Market risk (Trading risk) is the change in net asset value due to changes in underlying economic factors such as interest rates, exchange rates, and equity and commodity prices. Credit risk is the change in net asset value due to changes in the perceived ability of counterparties to meet their contractual obligations. Operational risk results from costs incurred through mistakes made in carrying out transactions such as settlement failures, failures to meet regulatory requirements, and untimely collections. Performance risk encompasses losses resulting from the failure to properly monitor employees or to use appropriate methods (including "model risk").

What happens when a bank fails?

In the US context: -

The bank's main regulator will declare bank's health as "unsafe or unsound." If the bank is state-chartered,the regulator is the state banking supervisor. With a national bank, it's the U.S. Office of the Comptroller of the Currency. The regulator will typically find that the bank's capital, needed to cushion against loan losses, is too low and the amount of loans in default too high.

The regulator appoints the Federal Deposit Insurance Corp. as receiver of the bank. This authorizes the FDIC to seize the bank's offices, vaults and records and sell its assets. The FDIC markets the failing bank to potential buyers. Interested buyers submit bids.

FDIC officials and staffers visit the bank, usually on a Friday after closing. Secrecy is maintained. Bank employees don't know that a shutdown is happening until the FDIC staffers arrive. The idea is to prevent a run on the bank by panicky depositors. The FDIC staffers spend much of the weekend reviewing the bank's books.

The FDIC announces the bank's closing and in most cases, the transfer of its deposits and the sale of its loans and other assets to a healthier bank. By Monday morning, the bank typically reopens under the acquiring bank's name. Customers' accounts and deposits are automatically transferred.

The FDIC uses the proceeds from selling the bank's assets to cover its liabilities, mainly customer deposits. The deposit insurance fund covers the rest. Accounts are insured up to $250,000 per depositor per bank. After the financial crisis hit, the amount insured was increased from $100,000 to the present level.

Banks fail primarily because of asset risk. Credit risk and liquidity risk are highly correlated: significant asset risk can lead to liquidity problems. Funding liquidity is important. Sometimes the line that separates credit risk, market risk, and liquidity risk can be vague, e.g. mortgage backed securities.

Now failed banks have asset quality problems because of 1: Poor underwriting standards 2: Poor risk management practices and 3: Poor management of the bank

A question arises why asset quality problems are not visible to bank’s Management/Board?

"If a bank is serious about risk management, then it will be serious from the top down” Before discussing this statement in more detail, let’s first look at the events that precipitated such a statement.

The chain of events that led to the global economic crisis is outlined in figure 1. The resulting global economic downturn led to a vicious cycle of companies failing or downsizing, thus leading to unemployment, which further reduced demand for goods and services. In addition, banks across the globe retrenched and in place of the liberal lending practices credit tightened across the board. Governments stepped in with fiscal support—the likes of which has never been seen in modern recorded history. And now, everyone waits to see what will happen with this never-before-tried experiment of flooding the world markets with government money.

Different people like to point fingers at different culprits. Some experts put the blame on credit default swap instruments that were sold worldwide with promises of high returns and low risk. Others blame those who promoted mortgage access to people who normally would not qualify for a housing loan. But perhaps the issue is more fundamental: The banks lost sight of the requirement to manage risk effectively and, in many cases; it is questionable if the basics of risk management were ever put in place