Whenever we analyze any banking company, we’re looking at two main variables—the return a bank earns and the amount of risk. To understand any bank, you need to understand these two parameters well. We discussed returns in our series on understanding price-to-book value here.
Now let’s understand risk. This is 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). The purpose of this series is to demystify banking risks and its jargon.
What does “risk” mean?
Risk is generally understood as “the possibility that something bad or unpleasant (such as an injury or a loss) will happen.” Risk is pervasive in most things that we do. When you drive, there’s a risk of getting into an accident. When you play, there’s a risk of getting injured. However, we often fail to recognize the importance of understanding risks to civilization.
In his seminal book, Against the Gods, Peter Bernstein states that the mastery over understanding risk is what defines the boundary between modern times and the past. By understanding and being able to measure risk with a good deal of confidence, we’ve been able to get insights into how the future will pan out. This concept of understanding and measuring risk is at the very heart of the modern market economy.
Look at above chart, it’s a graphic example of what excessive risk can do to an economy. Banks are one of the biggest facilitators of how this modern market economy functions. So it becomes even more imperative to know about banking risks as we shall see in the next part of this series.