Must-know: A thorough look at defining banking risk
Introduction to banking risk
Banking risk can be defined as exposureto 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.
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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.
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.
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 unviable
- 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 transfering to another party
Banking can’t run without taking risks. Most banks are highly leveraged financial risk-takers. The picture above demonstrates the basic principles that Wells Fargo, one of the most successful U.S. banks, uses to manage risk.
How successfully a bank navigates through risk by choosing one or more courses of action as outlined above determines how successful a bank will be in the long run. Ignoring or not understanding risk well can have serious consequences as we shall see in the next part of this series.