Must-Know: Credit and Liquidity Risks in Banking

Banks face several types of risks in doing business. The top two kinds of risks that every bank faces are credit risk and liquidity risk. Let’s discuss what these risks are, how they affect banks, and what banks can do to mitigate these.

The Basel Committee on Banking Supervision (or BCBS) defines credit risk as “the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.” It includes both the uncertainty involved in repayment of the bank’s dues and repayment of dues on time.

All banks face this type of risk. This includes full-service banks like JPMorgan Chase (JPM), traditional banks like Wells Fargo (WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS), or other banks included in an ETF like the Financial Select Sector SPDR Fund (XLF).

Credit default usually occurs because of inadequate income or business failure. But often it may be willful, as the borrower is unwilling to meet its obligations despite having adequate income.

Credit risk signifies a decline in the credit assets’ values before default that arises from the deterioration in a portfolio or an individual’s credit quality. Credit risk also denotes the volatility of losses on credit exposures in two forms—the loss in the credit asset’s value and the loss in the current and future earnings from the credit.

Banks create provisions at the time of disbursing loans (see Wells Fargo’s provision chart above). A net charge-off is a difference between the amount of loan gone bad minus any recovery on the loan. An unpaid loan is a risk of doing business. The bank should position itself to accommodate the expected outcome within profits and provisions, leaving equity capital as the final cushion for the unforeseen catastrophe.

Banks manage credit risks by monitoring a number of factors including loan concentrations, credit risk by counterparties, country exposures, and economic and market conditions. Provisions and net charge-offs are indicators of banks’ asset quality. Improved asset quality results in lower charge-offs and higher profits for banks.

During the subprime crisis, many banks made significant losses in the value of loans made to high-risk borrowers—subprime mortgage borrowers. Many high-risk borrowers couldn’t repay their loans. Also, the complex models used to predict the likelihood of credit losses turned out to be incorrect.

Major banks all over the world suffered similar losses due to incorrectly assessing the likelihood of default on mortgage payments. This inability to assess or respond correctly to credit risk resulted in companies and individuals around the world losing many billions of dollars.

Notably, charge-off rates across banks have declined over the years after the crisis. There has been no significant rise in the rates for the sector as a whole recently. However, individual banks continue to face the effects of inadequate credit risk management. A recent example is Bank OZK (OZK). The bank’s stock tanked after the bank charged off $45.5 million on two real-estate loans in Q3 2018.

Let’s next discuss the other major risk faced by banks—liquidity risk.

Liquidity 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.

Provision for adequate liquidity in a bank is crucial because a liquidity shortfall in meeting commitments to other banks and financial institutions can have serious repercussions on the bank’s reputation and the bank’s bond prices in the money market.

Liquidity risk can sometimes lead to a bank run, where depositors rush to pull out their money from a bank, which further aggravates a situation. So, banks like JPMorgan Chase (JPM) and Wells Fargo (WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS), as well as other banks included in the Financial Select Sector SPDR Fund (XLF) must proactively manage their liquidity risk to stay healthy. These four major banks together form approximately 22% of XLF.

Overall, banks form roughly 43% of the ETF, with capital markets, insurance, and diversified financial companies forming the rest. In conditions of tight liquidity, these banks generally turn to the Fed.

An example of a bank being taken into state ownership due to its inability to manage liquidity risk was Northern Rock. Northern Rock was a small bank in Northern England and Ireland. Northern Rock didn’t have a large depositor base.

It was only able to fund a small part of its new loans from deposits. So, it financed new loans by selling the loans that it originated to other banks and investors. This process of selling loans is known as securitization.

Northern Rock would then take short-term loans to fund its new loans. So, the bank was dependent on two factors—demand for loans, which it sold to other banks, and availability of credit in financial markets to fund those loans. When markets were under pressure in 2007–2008, the bank was not able to sell the loans it had originated. At the same time, it also was not able to secure short-term credit.

Due to the financial crisis, a lot of investors took out their deposits, causing the bank to have a severe liquidity crisis. Northern Rock got a credit line from the government. But the problems persisted, and the government took over the bank. This shows us how important the role of liquidity management is in a bank.

It is worth mentioning that the US banking sector has moved in the right direction in terms of prudently managing its credit, liquidity, and other risks since the subprime crisis. One statistic to support this is the number of bank closures. Not a single US bank failed in 2018, according to the FDIC (Federal Deposit Insurance Corporation). In comparison, eight banks failed in 2017. The bank failures peaked in 2010 with 157 banks closing in that year.

In comparison, three banks have closed in 2019 so far. However, all three banks are very small. The first one is Enloe State Bank, which was reportedly closed due to fraud. It had deposits of around $31 million. The other two banks both closed in October, each with deposits of less than $30 million.  The two banks were Ohio-based Resolute Bank and Louisa Community Bank in Kentucky.