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Must-know: The consequences of imprudent risk-taking by banks
By Saul Perez Sep 1, 2014 11:37 am EDT

Overview
We stated earlier that most banks are highly leveraged financial risk-takers.
When things go awry, the results can be catastrophic, leading to huge losses
or even to a bank closure. This is true for full-service banks like JPMorgan
(JPM), traditional banks like Wells Fargo (WFC), investment banks like
Goldman Sachs (GS) and Morgan Stanley (MS), or any other financials
included in an ETF like the Financial Select Sector SPDR Fund (XLF).
Lets look at a few instances from history to fully appreciate the type of
losses a bank can incur.
Enlarge Graph
Major losses due to risk-taking in 1980s
In 1987, Merrill Lynch lost $377 million through trading in innovative
mortgage-backed securities. In 1989, the junk bond market collapsed, and so
did the fortunes of Drexel Burnham Lambert, which had bet big on the junk
bond market. Also in 1989, in the United Kingdom, Midland Bank lost a
reported 116 million pounds by guessing wrong on the interest rate
movements.
Major losses due to risk-taking in the 1990s
In 1991, the Bank of New England made massive bad debt provisions,
suffered a run on deposits, and had to be supported by the government to
the tune of about $2 billion.
In 1992 in the United Kingdom, Barclays Bank provided 2.5 billion pounds for
bad and doubtful debts and declared its first loss in its history. In 1993, Credit
Lyonnais succumbed to similar troubles and registered a net loss of 6.9
billion French franc (~834 million pounds), leading to government
bailouts that year and then later in 1995.
In 1995, two dissatisfied customers sued Bankers Trust for sums totaling
$200 million. This was because of disastrous swap contracts, which the bank
had arranged for them. These claims were settled for lesser amounts out of
court.
In 1996, the major Japanese banks wrote off a total of about 6,000 billion yen
(~36.5 billion pounds) of bad debts accumulated from the preceding boom
years.
Major events during the subprime crisis
We all know what happened during the subprime crisis, which was quite
recent. Iconic institutions, such as Lehman Brothers, collapsed. Merrill Lynch
had to be bought by Bank of America to continue operations. The
government had to bail out Fannie Mae and Freddie Mac. Many other
financial institutions had to seek money from the government to stay afloat.
All this just reminds us of the importance of understanding risk better,
especially if you are an investor of the banking sector. This is what were
going to cover in the rest of this series partsthe various types of risks in
banking. Keep reading to know more about these types of risks.
Financials Performance
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GraphXLFMSJPMWFCGSJan 1nd00:00:00.001
An investor's guide to banking risks (Part 4 of 14)
Must-know: The 8 types of bank risks
Banks and risk
Banks have to take risks all the time. Any bank has to take on risk to make
money. This includes full-service banks like JPMorgan (JPM), traditional banks
like Wells Fargo (WFC), investment banks like Goldman Sachs (GS) and
Morgan Stanley (MS), or any other financials included in an ETF like the
Financial Select Sector SPDR Fund (XLF).
Enlarge Graph
How risk arises
The risk arises from the occurrence of some expected or unexpected events
in the economy or the financial markets. Risk can also arise from staff
oversight or mala fide intention, which causes erosion in asset values and,
consequently, reduces the banks intrinsic value.
The money lent to a customer may not be repaid due to the failure of a
business. Also, money may not be repaid because the market value of bonds
or equities may decline due to an adverse change in interest rates. Another
reason for no repayment is that a derivative contract to purchase foreign
currency may be defaulted by a counter party on the due date. These types
of risks are inherent in the banking business.
Eight types of bank risks
There are many types of risks that banks face. Well look at eight of the most
important risks.
1.
2.
3.
4.
5.
6.
7.
8.
Credit risk
Market risk
Operational risk
Liquidity risk
Business risk
Reputational risk
Systemic risk
Moral hazard
Out of these eight risks, credit risk, market risk, and operational risk are the
three major risks. The other important risks are liquidity risk, business risk,
and reputational risk. Systemic risk and moral hazard are unrelated to
routine banking operations, but they do have a big bearing on a
banks profitability and solvency.
All banks set up dedicated risk management departments to monitor,
manage, and measure these risks. The risk management department helps
the banks management by continuously measuring the risk of its current
portfolio of assets, or loans, liabilities, or deposits, and other exposures. The
department also communicates the banks risk profile to other bank
functions and takes steps, either directly or in collaboration with other bank
functions, to reduce the possibility of loss or to mitigate the size of the
potential loss.
GraphXLFMSJPMGSWFCJan 1nd00:00:00.001
Must-know: Understanding credit risk in the banking business
Credit risk
The Basel Committee on Banking Supervision (or BCBS) defines credit risk as
the potential that a bank borrower, or counter party, will fail to meet its
payment obligations regarding the terms agreed with the bank. It includes
both uncertainty involved in repayment of the banks dues and repayment of
dues on time.
Enlarge Graph
All banks face this type of risk. This includes full-service banks like JPMorgan
(JPM), traditional banks like Wells Fargo (WFC), investment banks like
Goldman Sachs (GS) and Morgan Stanley (MS), or any other financials
included in an ETF like the Financial Select Sector SPDR Fund (XLF).
Dimensions of credit risk
The default usually occurs because of inadequate income or business failure.
But often it may be willful because 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 individuals credit quality.
Credit risk also denotes the volatility of losses on credit exposures in two
formsthe loss in the credit assets value and the loss in the current and
future earnings from the credit.
Banks create provisions at the time of disbursing loan (see Wells Fargos
provision chart above). Net charge-off is the difference between the amount
of loan gone bad minus any recovery on the loan. An unpaid loan is a risk of
doing the 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.
An example of credit risk during recent times
During the subprime crisis, many banks made significant losses in the value
of loans made to high-risk borrowerssubprime mortgage borrowers. Many
high-risk borrowers couldnt 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 globe 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 U.S. dollars.
GraphWFCMSJPMGSXLF (Financial Select Sector SPDR (ETF))Jan '15May
'15Sep '15Jan '16-20%-10%0%+ 10%+ 20%
Must-know: Why market risk is important to banks
Market risk
The Basel Committee on Banking Supervision defines market risk as the risk
of losses in on- or off-balance sheet positions that arise from movement in
market prices. Market risk is the most prominent for banks present in
investment banking. These investment banks include Goldman Sachs (GS),
Morgan Stanley (MS), JPMorgan (JPM), Bank of America (BAC), and other
investment banks in an ETF like the Financial Select Sector SPDR Fund (XLF).
This is because they are generally active in capital markets.
Enlarge Graph
Major components of market risks
The major components of market risk include:
Interest rate risk

Equity risk
Foreign exchange risk
Commodity risk
Interest rate risk
Its the potential loss due to movements in interest rates. This risk arises
because a banks assets usually have a significantly longer maturity than
its liabilities. In banking language, management of interest rate risk is also
called asset-liability management (or ALM).
Equity risk
Its the potential loss due to an adverse change in the stock price. Banks can
accept equity as collateral for loans and purchase ownership stakes in other
companies as investments from their free or investible cash. Any negative
change in stock price either leads to a loss or diminution in investments
value.
Foreign exchange risk
Its the potential loss due to change in value of the banks assets or liabilities
resulting from exchange rate fluctuations. Banks transact in foreign
exchange for their customers or for the banks own accounts. Any adverse
movement can diminish the value of the foreign currency and cause a loss to
the bank.
Commodity risk
Its the potential loss due to an adverse change in commodity prices. These
commodities include agricultural commodities (like wheat, livestock, and
corn), industrial commodities (like iron, copper, and zinc), and energy
commodities (like crude oil, shale gas, and natural gas). The commodities
values fluctuate a great deal due to changes in demand and supply. Any
bank holding them as part of an investment is exposed to commodity risk.
Market risk is measured by various techniques such as value at risk and
sensitivity analysis. Value at risk is the maximum loss not exceeded with a
given probability over a given period of time. Sensitivity analysis is how
different values of an independent variable will impact a particular
dependent variable.
The chart above shows how Goldman Sachs measures its various market
risk. In the next part of the series, well look at what is probably the most
important day-to-day risk for a bankoperational risk.
GraphBACGSMSJPMXLF (Financial Select Sector SPDR (ETF))Jan '15May
'15Sep '15Jan '16-20%-10%0%+ 10%+ 20%

Operational riskthe risk in all banking transactions
Operational risk
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 reputation risk.
Enlarge Graph
Full-service banks like JPMorgan (JPM), traditional banks like Wells Fargo
(WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS),
or any other banks included in an ETF like the Financial Select Sector SPDR
Fund (XLF) 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 departmentscredit,
investment, treasury, and information technology.
Causes of operational risks
There are many causes of operational risks. Its 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.
1.
People risk: Incompetency or wrong posting of personnel and misuse of

powers
2.
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
3.
Process-related risks: Possibilities of errors in information processing,
data transmission, data retrieval, and inaccuracy of result or output
Operational risk can lead to a banks collapse
The fall of one of Britains oldest banks, Barings, in 1995, is an example of
operational risk leading to a banks collapse. It was mainly due to 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.
Nick was able to authorize his own trades and enter them into the banks
system without any supervision due to weak and inefficient internal auditing
and control measures. His supervisors were alerted after the losses became
too huge. By that time, it wasnt possible to keep the trades and the losses a
secret.
Must-know: Liquidity riskwhen banks have too little cash

Liquidity risk
Liquidity by definition 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 banks reputation and the banks bond
prices in the money market.
Enlarge Graph
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 full-service banks like JPMorgan (JPM), traditional banks like Wells Fargo
(WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS),
and any other bank included in an ETF like the Financial Select Sector SPDR
Fund (XLF) have to proactively manage their liquidity risk to stay healthy.
In conditions of tight liquidity, the banks generally turn to the Fed. Look at
the chart above to see how financial institutions borrowed massively from
the Fed during the subprime crisis of 20082009.
Liquidity risk can ruin banks
A very recent 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 didnt 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 factorsdemand 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 20072008, the bank wasnt able to
sell the loans it had originated. At the same time, it also wasnt 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. In
the next part of our series, well look into a banks reputational risk.
Must-know: Reputational riskwhen banks lose the publics trust
Reputational risk
Reputational risk is the risk of damage to a banks image and public standing
that occurs due to some dubious actions taken by the bank. Sometimes
reputational risk can be due to perception or negative publicity against the
bank and without any solid evidence of wrongdoing. Reputational risk leads
to the publics loss of confidence in a bank.
Enlarge Graph
Reputational risk sometimes creates other problems that a bank could have
avoided. Look at the table above to know about the top ten banking brands.
Most brand values stem from the reputation enjoyed by a bank.
All banks take utmost care to maintain and enhance their reputation. This
includes multinational banks like Citigroup (C) and JPMorgan (JPM), traditional
banks like Wells Fargo (WFC), asset managers like State Street (STT), and
other financials that are part of an ETF like the Financial Select Sector SPDR
Fund (XLF). Many bank advertisements are built around trust. This might give
you an indication of how important reputation is for a bank.
The banks failure to honor commitments to the government, regulators, and
the public at large lowers a banks reputation. It can arise from any type of
situation relating to mismanagement of the banks affairs or non-observance
of the codes of conduct under corporate governance.
Risks emerging from suppression of facts and manipulation of records and
accounts are also instances of reputational risk. Bad customer service,
inappropriate staff behavior, and delay in decisions create a bad bank image
among the public and hamper business development.
An example of reputational risk
In the 1990s, Salomon Brothers was the the fifth largest investment bank in
the U.S. All banks are allowed to buy government securities up to a specified
limit at auctions. Salomon falsified records to buy government securities in
quantities much larger than it was allowed.
By buying such large quantities, the bank was able to control the price that
investors paid for these securities. In 1991, the government caught the bank
in its act. Salomon Brothers suffered considerable loss of reputation. The U.S.
government fined Salomon Brothers to a tune of $290 million, the largest
fine ever levied on an investment bank at the time.
GraphXLFCJPMSTTWFCJan 1nd00:00:00.001
Must-know: Business risksits all about a banks strategy
Business risk
Business risk is the risk arising from a banks 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.
Enlarge Graph
In the heyday of cheap money in the 1990s and early 2000s, many banks
were taking excessive leverage and earning supernormal profits. But most of
it was a mirage. When the situation turned for worse from 20072008, many
of the same banks that were on a roll fell flat on their face. Many of them had
to take severe losses and bailouts from the government to keep afloat, while
some were forced to close down.
The above table lists the banks that closed down in 2014. Bank failures are
more common than we think. Since 2009 to now, there have been 478 bank
failures, an average of approximately six bank failures per month in the last
six and a half years. Most of these closures resulted from the inability of a
bank to manage one or more of the main risks that we have already
discussed.
All banks with a long history have faced trouble at some point. This includes
multinational banks like Citigroup (C) and JPMorgan (JPM), traditional banks
like Wells Fargo (WFC), asset managers like State Street (STT), and other
financials that are part of an ETF like the Financial Select Sector SPDR
Fund (XLF).
The banks that have a sound strategy come out of the trouble stronger.
Banks that want to grow too fast and too soon beyond their means grow at a
rapid pace for some time but meet their doom sooner, rather than later.
GraphCJPMSTTWFCXLF (Financial Select Sector SPDR (ETF))Jan '15May
'15Sep '15Jan '16-20%-10%0%+ 10%+ 20%
Must-know: Systemic riskthe economy affecting banks

Overview
Until now, weve looked at risks arising from banking activities, decisions,
and strategies. But the last two types of risks that well discuss are quite
unrelated. Out of these two, well first look at systemic risk.
Systemic risk
Systemic risk is the name of the most nightmarish scenario you can think of.
This type of scenario happened in 2008 across the world. Broadly, it refers to
the risk that the entire financial system might come to a standstill. It can also
be stated as the possibility that default or failure by one financial institution
can cause domino effects among its counter parties and others, threatening
the stability of the financial system as a whole.
The Chicago Board Options Exchange Volatility Index
The table above shows the Chicago Board Options Exchange (or CBOE)
Volatility Index (or VIX) for last ten years. Its a good proxy for systemic risk.
High values of VIX show periods of high systemic risk. Systemic risk by itself
doesnt lead to losses. But in an environment where systemic risk is high,
many other risk factorsespecially market riskrise to a very high level that
leads to losses.
An analogy to systemic risk would be like an epidemic or an anthrax attack
that would require large-scale safeguards for public health. Larger banks will
be the cause of high systemic risk because of their size and related counter
party dealings. Smaller banks will be more affected by systemic risk because
they generally have weaker capital bases and less access to money markets.
Systemic risk impacts traditional banks like Wells Fargo (WFC), investment
banks like Goldman Sachs (GS) and Morgan Stanley (MS), full-service banks
like JPMorgan (JPM), and any other banks included in an ETF like the Financial
Select Sector SPDR Fund (XLF).
In the next part of this series, well look at a different type of risk that is
also the most recently talked aboutmoral hazard.
GraphMSJPMGSWFCXLF (Financial Select Sector SPDR (ETF))Jan '15May
'15Sep '15Jan '16-20%-10%0%+ 10%+ 20%
Must-know: Why Too-big-to-fail is like moral hazard in banks
Moral hazard
Moral hazard is the most interesting risk that well cover. You must have read
or heard the phrase too-big-to-fail in the media. Too-big-to-fail is nothing
but moral hazard in a sense.
Moral hazard refers to a situation where a person, a group (or persons), or an
organization is likely to have a tendency or a willingness to take a high-level
risk, even if its economically unsound. The reasoning is that the person,
group, or organization knows that the costs of such risk-taking, if it
materializes, wont be borne by the person, group, or organization taking the
risk.
Enlarge Graph
Economists describe moral hazard as any situation in which one person
makes the decision about how much risk to take, while someone else bears
the costs if things go badly. A very succinct example of moral hazard was the
2008 subprime crisis. After the meltdown precipitated by the subprime crisis,
many banks were bailed out by using the taxpayers money.
This type of situation would likely alter executives behavior towards risktaking. Executives would think that even if they took very high risks
gambling on money provided by depositorsthey would have to bear no
costs of such behavior.
Notice how in the above graph the assets to equity in the banking sector
have fallen during the subprime crisis. This is because of the fall in assets
that lost value. This primarily happened due to the fall of banks having
exposure to subpar assets. Top management knew that it wouldnt lose
anything if the assets went bad, so it acquired riskier assets to increase
short-term bank performance, which increased its compensation.
Ways to control moral hazard
Moral hazard can be controlled through a good organizational culture, giving
credence to high ethical standards. A bank must also have a strong board of
directors to oversee management and to take remedial measures when
needed. A well-crafted compensation policy to avoid reckless risk-taking
would also help reduce this risk. Finally, strong regulations would also
help control moral hazard.
Top management of all banks can be prone to moral hazard. This includes
traditional banks like Wells Fargo (WFC), investment banks like Goldman
Sachs (GS) and Morgan Stanley (MS), full-service banks like JPMorgan (JPM),
and any other banks included in an ETF like the Financial Select Sector SPDR
Fund (XLF).
Overview: Other risks, such as legal and country, that banks face
Recap
In this series, weve learned about eight different types of risks that are
inherent in a banking system. A bank can exercise a large degree of control
over some types of risks like operational risk by having strong systems and
processes. A bank can also control risk by ensuring stringent audits and
compliance.
There are other types of risks that a bank has little control over, such as
systemic risk. The only things a bank can do to avoid such risks are to have a
strong capital base, to have the best-in-class processes, and to hope for the
best.
Other risks
There are some other minor types of risks that a bank carries. These arent
as important as the previous risks discussed, but well mention them in this
article.
Legal risk
A bank can be exposed to legal risk. Legal risk can be in the form of financial
loss arising from legal suits filed against the bank or by a bank for applying a
law wrongly.
Country risk
A bank that operates in many countries also faces country risk when theres
a localized economic problem in a certain country. In such a scenario, the
banks holding company may need to bear losses in case it exceeds the
capital of a subsidiary in an another country. The holding company in certain
cases may also need to provide capital.
All large banks that operate in many countries bear country risks. These
banks include JPMorgan (JPM), Citigroup (C), Goldman Sachs(GS), Morgan
Stanley (MS), and banks in an ETF like the Financial Select Sector SPDR
Fund (XLF).
Look at the above chart to see the results of uncontrolled risks for Lehman
Brothers. So we can say that a successful bank is one thats able to manage
various risks successfully and continuously evolve with the changing needs
in the banking landscape.
GraphXLFMSCJPMGSJan 1nd00:00:00.001
Must-know: 2 broad categories of controlling bank risks

Controlling risks
So far in this series, weve learned all about banking risks. Now lets turn our
attention to ways of controlling risks. There are many ways risks can be
controlled. There are two broad categories for controlling risks:
At the bank level

At the government levelhaving binding regulations
Control at the bank level
At the bank level, the risks are controlled by having rules, systems, and
processes that enable prudent banking and that 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, including JPMorgan (JPM), Wells Fargo (WFC), Citigroup (C),
Capital One (COF), and banks in an ETF like the Financial Select Sector SPDR
Fund (XLF).
The aim of such rules is to control risk. Banking processes, wherever
possible, are standardized to avoid ambiguous interpretation by staff. As an
example, a check clearance requires clearance from the branchs bank
manager.
But no matter how robust the rules, systems, and processes might be, they
leave a bank open to risk. Banking risks can quickly become a contagion and
lead to a collapse in financial markets. Such situations impact the whole
economy of a country, and in many large cases the reverberations are felt
across the globe.
Control at the government level
To reduce the chances of such occurrences and to control losses and impacts
on economies, governments, through their central banks and other bodies,
regulate the banking sector. In the U.S., the main body responsible for this is
the Federal Reserve (see the above chart for the structure of the Fed). Such
regulations aim to strengthen the banks abilities to survive shocks
and reduce the risk of large-scale flare-ups in the banking, capital, and
financial markets.
As an investor, you must know about these regulations in detail. Itll help you
understand the sector better and help you analyze and select the correct
stocks to invest in.
Well cover banking regulations in our next series. Keep watch of our website
to know more. In the meantime, to read about why the banking sector is
looking good, click here.

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Must-know: The consequences of imprudent risk-taking by banks

By Saul Perez Sep 1, 2014 11:37 am EDT

Interest rate risk

An investor's guide to banking risks (Part 7 of 14)

Operational risk occurs in all day-to-day bank activities. Operational risk

People risk: Incompetency or wrong posting of personnel and misuse of

Must-know: Liquidity riskwhen banks have too little cash

Must-know: Systemic riskthe economy affecting banks

By Saul Perez Sep 1, 2014 11:38 am EDT

At the bank level

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