But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.
Must-know: 2 broad categories of controlling bank risks
So far in this series, we’ve learned all about banking risks. Now let’s turn our attention to ways of controlling risks. There are many ways risks can be controlled.
There are some other minor types of risks that a bank carries. These aren’t as important as the previous risks discussed, but we’ll mention them in this article.
Moral hazard is the most interesting risk that we’ll cover. You must have read or heard in that media the phrase “too-big-to-fail.” Too-big-to-fail is nothing but moral hazard in a sense.
Systemic risk is the name of the most nightmarish scenario you can think of. This type of scenario happened in 2008 across the world.
Business risk is the risk arising from a bank’s long-term business strategy. It deals with a bank not being able to keep up with changing competition dynamics, losing market share over time, and being closed or acquired.
Reputational risk is the risk of damage to a bank’s image and public standing that occurs due to some dubious actions taken by the bank. Sometimes reputational risk can be due to perception or negative publicity against the bank and without any solid evidence of wrongdoing.
Liquidity by definition means a bank has the ability to meet payment obligations primarily from its depositors and has enough money to give loans. So liquidity risk is the risk of a bank not being able to have enough cash to carry out its day-to-day operations.
The Basel Committee on Banking Supervision defines operational risk “as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputation risk.”
The Basel Committee on Banking Supervision defines market risk as the risk of losses in on- or off-balance sheet positions that arise from movement in market prices. Market risk is the most prominent for banks present in investment banking.
The Basel Committee on Banking Supervision (or BCBS) defines credit risk as the potential that a bank borrower, or counter party, will fail to meet its payment obligations regarding the terms agreed with the bank.
There are many types of risks that banks face. We’ll look at eight of the most important risks. Out of these eight risks, credit risk, market risk, and operational risk are the three major risks.
We stated earlier that most banks are highly leveraged financial risk-takers. When things go awry, the results can be catastrophic, leading to huge losses or even to a bank closure.
Banking risk can be defined as exposure to 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).
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 explored the most commonly used valuation metric for financial companies—the price-book value. We also understood the relation between price-book value and return on equity.
Nothing is perfect. Although the price-book value ratio method looks robust, it has a few disadvantages that you should avoid.
So now that we know about the price-book value (or P/BV) ratio, let’s use our learning to apply this ratio to select stocks. The first step is to check for the average P/BV ratio for an industry and compare it with a company’s P/BV ratio and return on equity.
Historical analysis has shown that return on equity has a strong impact on banks’ value creation in the long run. So financials that have high price-book value ratios should also have high returns on equity.
Let’s say you are the owner of your own bank. You accept deposits from your relatives, and then you lend out cash to your friends. The deposits from your relatives are short-term loans and show up on the balance sheet as liabilities (after all, the money is not yours).
The price-book value ratio is the ratio of the market value of equity to the book value of equity. Price stands for the current market price of a stock. Book value is the total assets minus liabilities, or net worth, which is the accounting measure of shareholders’ equity in the balance sheet.