Understanding a Bank’s Operational and Business Risks

Two key risks that all banks face are operational risk and business risk. Every banking transaction involves a number of steps. Most of the time, we fail to appreciate the complex set of steps that goes into every transaction. This is because the transactions complete instantaneously. However, a lot goes on behind the scenes to make our banking transactions easy and quick. As with every process, banks’ operations may not complete as desired if they’re not executed properly.

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 reputational risk.”

Full-service banks like JPMorgan (JPM), traditional banks like Wells Fargo (WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS), or smaller, regional banks face operational risk.

Operational risk occurs in all day-to-day bank activities. Operational risk examples include a check incorrectly cleared, or a wrong order punched into a trading terminal. This risk arises in almost all bank departments—credit, investment, Treasury, and information technology.

There are many causes of operational risks. It’s difficult to prepare an exhaustive list of causes because operational risks may occur from unknown and unexpected sources. Broadly, most operational risks arise from one of three sources:

• People risk: Incompetency or wrong posting of personnel as well as misuse of power.
• Information technology risk: The failure of the information technology system, the hacking of the computer network by outsiders, and the programming errors that can take place any time and can cause loss to the bank.
• Process-related risks: Possibilities of errors in information processing, data transmission, data retrieval, and inaccuracy of result or output.

The closure of First NBC Bank in 2017 is an example of operational risk resulting in a bank’s failure. The regulators seized the bank’s assets after it failed to maintain sound accounting practices. It also fell short in fulfilling its regulatory capital requirements.

The bank grew tremendously using volatile funding sources and acquiring assets that weren’t liquid. It had deposits of around $3.5 billion and assets worth $4.7 billion at the time of failure. The bank’s failure cost the FDIC (Federal Deposit Insurance Corporation) approximately $1 billion.

Among others, one of the reasons behind First NBC’s failure was its founder and CEO Ashton Ryan Jr.’s dominant influence at the bank. Additionally, the bank’s board failed to exercise adequate oversight on the bank’s operations.

The 1995 fall of Barings, one of Britain’s oldest banks, is another well-known example of operational risk leading to a bank’s collapse. It was mainly due to the failure of its internal control processes. One of Barings’ traders in Singapore, Nick Leeson, was able to hide his trading losses for more than two years.

Leeson was able to authorize his own trades and enter them into the bank’s system without any supervision. This practice occurred due to weak and inefficient internal auditing and control measures. His supervisors were alerted after the losses became too big to ignore. By that time, it wasn’t possible to keep the trades and losses a secret. Let’s next discuss another risk faced by banks—business risk.

Unlike operational risk, 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. Business risk can also arise from a bank choosing the wrong strategy, which might lead to its failure.

In the heyday of cheap money in the 1990s and early 2000s, many banks were taking excessive leverage and earning supernormal profits. However, most of it was a mirage. When the situation turned for the worse in 2007–2008, many of the same banks that were on a roll fell flat on their institutional faces. Many of them had to take severe losses and bailouts from the government to keep afloat, while others were forced to close down.

The above table lists the banks that have closed down since 2015. Bank failures are more common than we think. From 2009 to the present, there have been 506 bank failures, an average of approximately four bank failures per month in nearly the last 11 years.

Most of the bank closures resulted from the inability of a bank to manage one or more of the main risks that we have discussed. Notably, the US banking sector has moved in the right direction in terms of prudently managing its risks since the subprime crisis. Not a single US bank failed in 2018, according to the FDIC. 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 three banks together had total assets worth $93.5 million. Ohio-based Resolute Bank and Louisa Community Bank in Kentucky were closed in October. Each had deposits of around $26 million.

All banks face trouble, big or small, at some point in the history of their operations. This includes JPMorgan Chase (JPM), Wells Fargo (WFC), Goldman Sachs (GS), and Morgan Stanley (MS), and other banks included in the Financial Select Sector SPDR Fund (XLF). These four banks together form approximately 22% of XLF. Overall, banks form roughly 43% of this financials ETF.

The banks that have a sound strategy come out of turbulent times stronger. Banks that want to grow too fast and too soon beyond their means grow at a rapid pace for some time. However, they can also meet their doom sooner rather than later.