The Banking System: Commercial Banking - Where Commercial Banks Are Vulnerable
ByStephen D. Simpson, CFA
Credit risk is arguably the most obvious risk to a bank. A bank's business model is basically predicated on the idea that the large majority of lenders will repay their loans on time, but a certain percentage will not. So long as the bank's estimates of repayment rates are accurate, or conservative, there are few problems. When a bank fails to adequately estimate and price the rate of losses, or when economic conditions change significantly, banks may face higher levels of bad which can shrink the bank's capital reserves to an unacceptable level. Taken to the extreme, if a bank underestimates the amount of credit losses it will incur, the bank can fail altogether.
Along with credit risk is concentration risk; the risk of having too much money lent out to certain categories of borrowers. If all of a bank's mortgage lending was confined to a particular neighborhood of a city, or a particular company's employees, there would be major risks to the bank's capital if some sort of disaster where to hit that neighborhood, or if that company ran into financial difficulties and laid-off many of those employees. More practically, concentration risk for most commercial banks is measured by the type of lending (residential mortgage, multifamily residential, construction, etc.) and the region of the borrowers.
Banks lend out the vast majority of the funds they receive as deposits, therefore, there is always a risk that the bank will face a sudden rush of withdrawals that it cannot meet, with the cash it has on hand. Banks cannot call in loans on demand and cannot legally forbid depositors from withdrawing funds.
In order to meet sudden liquidity needs, most banks can call upon lending facilities with other banks or the Federal Reserve. While capital is usually available for healthy banks, a sudden simultaneous rush from multiple banks can increase short-term borrowing costs significantly. The failure of a bank to properly administer its liquidity needs can significantly harm its profitability.
As banks frequently hold investment securities on their balance sheet, they are vulnerable to changes in the market value of those investments. As many banks hold significant percentages of their reserves in debt instruments widely thought of as "safe," (including U.S. government bonds), a sudden market decline in those securities could force banks to raise capital or pare back on lending, to say nothing of the loss in shareholder equity from the investment losses.
Banks are also vulnerable to the same sort of operating risk as any competitive enterprise. Management may make mistakes regarding acquisitions, expansion, marketing or other policies, and lose ground to rivals. In the case of banking, operating risk can have a longer tail than in other industries. Banks may be tempted to underprice loans to garner market share, but underpriced mortgage loans can hurt a bank for many years, and over-aggressive lending (lending to poor credit risks) can threaten the survival of the bank itself.
Interest Rate Risk
As so much of a bank's profitability is determined by the interest rates they charge and pay out, banks are highly exposed to changes in interest rates. Banks must always be making predictions and estimates of future interest rate movements and positioning their balance sheet, accordingly. Unexpected rate changes can significantly impair profitability, as the bank repositions its balance sheet. (Learn more in Managing Interest Rate Risk.)
The bank industry also faces certain legal risks that are not very common outside of the financial services industries. In addition to the aforementioned laws concerning fair and honest lending, banks are also compelled to play a role in monitoring potential illegal activities on the part of customers.
In particular, banks are required to be on the lookout for signs of money laundering. There are strict "know your customer" rules in place and banks must report transactions to the U.S. Treasury that exceed a certain dollar amount.
Banks are also subject to legal risks pertaining to their lending activities. Banks are required to be fair and unbiased in their lending, and are also required to disclose a range of information to prospective borrowers, including the annual percentage rates, terms and total costs to the borrower. Likewise, banks are subject to laws on usury and predatory lending. While the definitions of usury and predatory lending arguably seem fairly clear, in practice they can be subjective; what banks may consider a fair rate to compensate for the elevated risk of default, regulators or citizens groups may deem excessive and predatory.
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