Types of Risk Banks Address

How Credit Risk and Interest Rate Risk can Impact the Liquidity of a Bank
The banking industry is on the oldest in American history with origins dating back to 1784 with the founding of Bank of New York Mellon. The financial system, and in particular banks are a major component of a properly functioning economy. The banking system in general, is essentially a network of financial institutions that provide essential services to the economy. They are responsible for operating payments systems, providing loans, providing investment banking services, taking deposits, and so forth. From a consumer perspective, they are integral to the efficient movement of funds and capital from one entity to another. These are essential aspects to industry as well, due to their ability to help ensure efficient payments while also enabling business and household formation through credit services. As one of the most important industries in America, it is not without its inherent risks and subsequent regulations. Credit risk, Interest Rate Risk, and Liquidity Risk are some of the more common concerns for financial institutions. It is due to the mismanagement of these risks that banks occasions find themselves in financial difficulties and distress. In many instances, the mismanagement of these risks often have adverse impacts to not only the common shareholders of the bank, but to the overall economy as a whole. It is due to these systemic risks to the economy and the world at large, which requires banks to adequately safeguard themselves against these risks. In addition to internal controls being applied by banks themselves, external elements have now been put in place since the 2008 financial crisis to help mitigate the contagion caused by the mismanagement of risk. Although safer through the implementation of Basel III, annual stress tests, and more, the possibility that these risks could once again emerge to cause economic distress still abounds.
Aside from the payments system mentioned in the introduction, banks primary purpose is to function as a financial intermediary. By lending and investing money deposited by consumers to businesses, households and governments, the industry helps facilitate economic growth. This is particularly important as the technology sector is becoming more prominent around the world. In order to finance the growth of these highly risky technology ventures, capital from deposits and investors is needed. As the product grows and becomes successful, investors earn an adequate rate return on the money they invested, banks collect a fee through transaction costs, and consumers are able to consume the product and enhance their overall quality of life. This primary lending activity is how banks typically make money and works very well when conducted properly. To generate revenue, banks typically change consumers more for loans than they pay in deposits, keeping the difference as profit. Unfortunately, these transactions are not without their risks. The credit worthiness of the borrower will ultimately determine if the loan is paid back in full plus interest. A general economic decline can permanently reduce the value of the collateral used to back the original loan made by the bank. Business forecasts for IPOs or other capital raising activity can be incorrect causing massive losses to bondholders and shareholders. Pronounced job losses caused by a serve and unexpected decline in business activity can inhibit a person’s willingness to pay off the loan. These risk, among many others must all be taken into account within an inherently risky industry.
The first and often most cited risks imbedded in the banking industry is credit risk. Essentially, credit risk is defined as the likelihood that a borrower or counterparty will fail to meet the terms of the loan and stop payment. It is the risk of default, and can cripple banks if not accounted for properly. Credit risk can then be broken down further into three distinct sub-categories. These categories are outlined below in Chart 1. The bank can potentially mitigate this risk by requiring insurance in the case of mortgages or guarantees from high net individuals in the case of construction loans. Most banks have entire department dedicated to monitoring these risks.
Chart 1
Credit Risk
Subcategory
Definition
Credit Default Risk
The likelihood of loss due to the debtors inability to pay principle and interest for more than 90 days after the initial missed payment
Concentration Risk
The likelihood of a substantial loss due to a large exposure to a single asset class or industry (For example: Sub-Prime Mortgages in 2008)
Country Risk
The risk of loss associated with a state freezing currency payments, a country defaulting on its obligations, or political instability due to sever unrest ( i.e. Venezuela)
The 2008 financial crisis is a great illustration of many of the subcategories mentioned above. For one, many banks had large exposures to sub-prime mortgages through vehicles called collateralized debt obligations. Banks, such as Countrywide Financial has very large exposures to this subprime mortgages (Olster, 2010). As defaults started to rise, the bank was unable to mitigate the losses, as they were not properly diversified. As a result, the film lost substantial value and was later acquired by Bank of America (Rothacker, 2014). Countrywide also experience credit default risk as they risk management policies were very lax during this period of mass euphoria. Individuals were able to purchase homes with little money down or none at all. Individuals lied on their mortgage applications and even forged fake bank account information. Banks no managing risk properly ultimately signed off on these loans to individuals with a history of defaulting. Due to this poor risk management, the country entered into a deep recession with millions losing their jobs. The problem of interest rates is compounded by the fact that different purchases, securities, and investments all have varying durations. The varying durations could have a compound effect on a bank’s credit risk as it relates liquidity. For example, a typical mortgage may have a duration of 15 to 30 years, a checking treasury note may have a duration of 10 years, a treasury bill may have a duration of 3 months, while a certificate of deposit may have a duration of 5 years. As it relates to credit risk, a bank may have the unique problem of matching the duration of its assets with those of its liabilities (Goodhard, 2008). If not, a significant economic downtown could ultimately result in a liquidity crisis for the bank. This was one of the primary causes of the financial crisis, as banks could not access the short-term money as the markets froze. Meanwhile, they had lent money on subprime mortgages that were defaulting at record levels and had durations of 10 to 30 years. Another example relates to banks having large amounts of long-term assets such as mortgages funded in large part by short term liabilities such as deposits or certificates of deposit. In the event of a rise in short term interest rates, these liabilities become more expensive. The interest rates on the longer-term assets, which are often fixed remains unchanged. This is also known as interest rate risk and can be particularly devastating for banks that are not properly hedged. Interest rate risk is simply the probability of decline in values associated with unexpected rise or fall in interest rates. This risk is heavily associated with fixed income securities and investment products. As the interest rate is fixed, the rate is locked in for the duration of the obligation. Like the example above, if not matched properly, this can result in serve losses or gains depending on the direction of the change. In general, a risk in interest rates tend to correspond with a decline in asset value. Correspondingly, a decline in interest rates corresponds to an increase in asset value. For example, interest rate risk arises when a bank borrows at one rate such a variable rate but then lends money at a different rate that is fixed. Here too, a change in interest, particular is unexpected can have an adverse impact on the bank. In this case, the amount owed to bondholders would increase while fixed payments received remains unchanged. In the 2008 financial crisis, Bear Sterns, a very honored and established investment bank went bankrupt partly because of its inability to adhere to these principles. Here the bank financed itself through deposits, commercial paper and treasury bills. Although each has a very low interest rate, they are needed immediately. Customers for example expect to receive their deposits on demand. It then lent the money out long term to institutions, companies, and institutions, keeping the spread between the interest rates. However, as the financial collapse occurred, it could no longer tap into the short-term financing needed to run its business. The firm soon ran out of cash due to this mismatch of interest rates (Schularick, M, and A M Taylor, 2009).
The combination of credit risk and interest rates risk created a liquidity crisis for many banks in 2008. This is still relevant today as COVID 19 begins to heavily influence the world. As stimulus legislation begins to expire, and 11 million people are still unemployed, massive defaults could ensure. In particular, credit cards, student loans, mortgages and so forth are all at risk of non-payment. As individual borrowers are unable to make payments, foreclosures and defaults could begin. As more foreclosures begin, housing values could decline. As housing values decline the initial loan to value prospects used to initiate the loan are now no longer valid. This sequence of events could harm banks that have not properly reserved funds in the event of severe economic decline. Due in part to Basel III regulation and national stress tests, the banks appear to be insulated from contagion for now. Only time will tell if both interest rate risk and credit risk will rear their heads during this economic recession. If 2008 is any indication, let’s hope not.
References:
1. Goodhard, C and E Perotti, 2008 “Maturity mismatch stretching: Banking has taken a wrong turn”, CEPR Policy Insight 81, 6-July
2. Olster, Scott. “How the Roof Fell in on Countrywide.” Fortune, Fortune, 23 Dec. 2010, fortune.com/2010/12/23/how-the-roof-fell-in-on-countrywide/.
3. Rothacker, Rick, 2014 -. “The Deal That Cost Bank of America $50 Billion – and Counting.” Charlotteobserver, Charlotte Observer, 14 Aug. 2014, www.charlotteobserver.com/news/business/banking/article9151889.html.
4. Schularick, M, and A M Taylor, (2009), “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008”, NBER DP 15512