Bank Risks: Everything You Need to Know

Like any business, the banking sector faces several risks. However, given the sector’s systemic importance, it’s important that bank risks are properly understood and addressed. Since banks are custodians of public money, governments also have a stake in keeping bank risks in check.

Bank risks can be broadly divided into two categories. One is macro level, or systemic, risk, which happens when the entire banking system faces trouble. A perfect example would be the 2008 financial crisis. The other is a bank-specific issue. Here, we can cite Wells Fargo’s example. The bank recently came under scrutiny for some of its business practices. Deutsche Bank has also been facing trouble.

Systemic risks could arise from the occurrence of some expected or unexpected events in the economy or the financial markets. Micro risks could arise from staff oversight or mala fide intention, causing erosion in asset values and, consequently, reducing the bank’s intrinsic value.

The money a bank lends to a customer may not be repaid due to the failure of a business. It may also not be repaid because the market value of bonds or equities may decline due to an adverse change in interest rates or a downturn in the economy. Another reason for non-repayment is that the counterparty may default on the derivative contract. These types of risks are inherent in the banking business.

There are many types of risks that banks face:

• Credit risk.
• Market risk.
• Operational risk.
• Liquidity risk.
• Business risk.
• Reputational risk.
• Systemic risk.
• Moral hazard.

Systemic risk is the most nightmarish scenario for a bank. This type of scenario happened across the world in 2008. Broadly, it refers to a scenario in which the entire financial system might come to a standstill. The default or failure of one financial institution can cause a domino effect, threatening the stability of the entire system. For instance, in 2008, the Lehman Brothers’ collapse triggered a massive sell-off in the banking sector.

An analogy of systemic risk would be an epidemic that required large-scale safeguards for public health. It’s a critical risk, as it’s generally not limited to a single bank but rather to the broader banking and financial sector. Smaller banks are more affected by systemic risk because they generally have weaker capital bases and less access to money markets. The only things a bank can do to avoid such risks are to have a strong capital base and best-in-class processes and internal checks.

Moral hazard is the most interesting bank risk. You’ve likely read or heard the phrase “too big to fail.” Too big to fail is nothing but moral hazard, in a sense. Moral hazard refers to a situation in which a person, a group, or an organization is likely to have a tendency or a willingness to take high-level risk, even if it’s economically unsound. The reasoning is that the person, group, or organization knows that the costs of such risk-taking, if they materialize, won’t be borne by the person, group, or organization taking that risk.

Economists describe moral hazard as any situation in which one person makes the decision about how much risk to take, while another bears the costs if things go bad. A very succinct example of moral hazard was the 2008 subprime crisis. After the meltdown precipitated by the crisis, taxpayers’ money was used to bail companies out.

This type of situation would likely alter executives’ behavior toward risk-taking. Executives would think that even if they took very high risks, they wouldn’t have to bear the costs of such behavior. A good organizational culture and giving credence to high ethical standards can help address this kind of risk-taking. A bank must also have a strong board of directors to oversee management and take remedial measures when necessary. A well-crafted compensation policy to avoid reckless risk-taking would also help reduce this bank risk.

Finally, strong corporate governance and regulations would also help control the moral hazard. A bank can exercise a large degree of control over operational risk by having strong systems and processes in place. A bank can also control risk by ensuring stringent audits and compliance.

There are some other minor types of bank risk. These aren’t as important as the previous risks discussed, but they still deserve attention.

A bank also faces legal risks. Legal risks can come in the form of financial loss arising from legal suits filed against a bank. A bank that operates in many countries also faces country risk if there’s a localized economic problem in a certain country. In such a scenario, the bank’s holding company may need to bear the losses. In certain cases, the holding company may also need to provide capital.

Now let’s turn our attention to ways of managing bank risks. There are many ways to do so, but there are two broad categories:

• At the bank level.
• At the government level (having binding regulations).

Risks can be controlled by having rules, systems, and processes in place that enable prudent banking and are difficult to circumvent. These rules, systems, and processes can be at the branch level, the regional or zone level, and the top management level. All banks use such systems and processes.

All banks have dedicated risk-management departments that monitor, measure, and manage these risks. The risk-management department helps the bank’s management by continuously measuring the risk of its current portfolio of assets, liabilities, and other exposures. The department regularly communicates with other bank functions. It takes steps, either directly or in collaboration with other bank functions, to reduce the possibility of loss or to mitigate the size of a potential loss.

Banks standardize their processes to avoid ambiguous interpretations by staff. For example, a check’s clearance might require authorization from the branch’s bank manager. But no matter how robust its rules, systems, and processes may be, a bank is still open to risks. Risks can quickly become contagions and lead to a collapse in financial markets. Such situations affect the entire economy of a country, and in many large cases, the reverberations are felt across the world.

Governments and central banks also strive to control bank risks. To reduce the chances of such occurrences and to limit their fallout, governments and central banks regulate the banking sector. In the US, the Federal Reserve is the main body that regulates banks. Such regulations aim to strengthen banks’ abilities to survive shocks and reduce the risk of large-scale flare-ups in the banking, capital, and financial markets. The Fed regularly conducts stress tests to determine banks’ abilities to cope with financial turmoil.

After the 2008 financial crisis, the Fed decided to tighten banking regulations. The Volcker Rule is the commonly used phrase for Section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The rule was proposed after the crisis but came into effect only in 2015. Broadly speaking, the Volcker Rule is meant to prevent excessive risk-taking by banks.

With that said, the Volcker Rule has been slightly relaxed. The easing of rules is generally welcome news for banks, as businesses tend to favor fewer regulations. Some of the big banks lobbied for the easing of the Volcker Rule.

Such regulations might look like stumbling blocks in good times, but they can turn out to be saviors when the tide turns. With the longest economic expansion in history currently showing signs of stress, the need of the hour should be to strengthen—not relax—the rules related to bank risk controls.

Pundits are divided as to whether a recession is imminent. However, if we consider the data points, we’ll find that an economic slowdown is almost certainly on the horizon. Meanwhile, Berkshire Hathaway Chair Warren Buffett seems optimistic about banks. Berkshire added some banking shares in the second quarter. The company is also reportedly planning to add more Bank of America shares.