Financial institution risk assessment and management

Banking Risk

The Office of the Comptroller of the Currency (OCC) has argued that there is the possibility that financial institutions are taking disproportionate risks to improve their profitability. This paper will discuss these different risks and present some evidence to surrounding the idea that banks are taking on excessive risk in the quest for improved profitability.

Arguments and Evidence

The OCC's Semi-Annual Risk Perspective (2012) highlights the following areas of concern with respect to these risks. Underwriting standards are under pressure as banks compete for higher earning assets to improve profitability. Higher yields come from riskier investments, and the OCC believes banks are pursuing riskier investments in order to earn yield. Persistent low interest rates -- below inflation levels -- compel banks to increase risk in order to earn positive real returns.

New product risk occurs when banks seek out new or unfamiliar markets in order to "offset declines in revenues from core lines of business." In part, these declines relate to the current interest rate environment, but can also relate to ongoing weakness in the mortgage sector. Banks are forced to seek out new opportunities outside of mortgages to fuel growth.

The OCC also argues that banks are seeking to increase efficiency, and that at times led to the use of third-party products or distribution systems to capture economies of scale. Unfortunately, third-party products and systems are riskier than in-house ones. The OCC is worried that banks are trying too hard to squeeze out efficiencies in its systems.

These risks are especially critical given the environment at present, with ongoing weakness in economic growth and vulnerability to shocks. The report specifically mentions the threat of rate shocks from the low interest rate environment. There are also risks associated with changes in the regulatory environment, which the report hyperbolically describes as "unprecedented' in volume and scope.

Despite these concerns, the report also noted that the "primary driver of earnings over the past year was lower provisioning expense as gross revenues in all three income categories remained relatively flat. Earning flatness does not suggest that banks are taking on undue risk. Certainly a category such as realized securities gains or losses should have made a dramatic change if there was increased risk (volatility) in the banking system. Provisioning expenses were reduced at all banks, which can either be seen as risky behavior or a reflection of higher quality credit portfolios. The reduction in expenses is cited in the report as one of the risks, as banks seek better efficiency but take on more risk to achieve it. Another potentially risky revenue stream comes from trading. Trading income increased but the report notes that the European economic issues have reduced the risk appetite of many banks, again refuting the idea that banks are taking on excess risk in search of higher profits. The one big example at J.P. Morgan of excess risk-taking (Henry & Viswanatha, 2012) does not appear to be indicative of an industry-wide trend.