A:

A bank's primary exposure to any outside business or institution is constituted by the amount of capital it has invested in it. The more a bank invests within a specific industry, the greater the risk to it if a business or industry collapses. The main risks a bank is exposed to can fall under two primary categories: credit exposure and market risk.

Credit exposure is created through any form of lending in which a banking institution engages. If a bank lends a million dollars to a business, there is always a risk that the business might not repay the loan within the agreed terms of the contract. In order to measure credit risk, it is necessary to calculate the total credit exposure of the bank's loan portfolio relative to a particular industry or company.

Market risk occurs based upon movements in the markets in which a bank is engaged. There are generally considered to be four primary influences on market risk: foreign exchange, interest rates, equity and commodities.

Foreign-exchange risk is fairly straightforward. If a bank invests in a foreign company and the currency exchange rate then weakens by 25% compared to the bank's currency, this increases the amount of the foreign currency owed to the bank. This cuts into the company's profits and can potentially even cause a default if the drop in value is significant.

Interest risk is a bit more abstract. When a bank loans money to businesses, the interest rate determines how much profit the bank makes. Once a contract is signed on a long-term loan at a set interest rate, if interest rates in other markets rise, the bank's profit margin on the loan will be reduced as they are required to pay higher interest on deposit accounts the bank holds.

Should a bank decide to invest directly in a business and purchase stocks or secure real estate, it assumes an equity risk. In this situation, the bank's profits are directly related to the underlying value of the stock or real estate it owns.

Commodities risk may be assumed by directly purchasing a commodity or derivative. A bank can also indirectly assume this risk through investment in or lending to a company that deals in commodities.

The Federal Deposit Insurance Corporation (FDIC), reported the following aggregate commercial bank loan exposure as of December 2014:

- Real Estate: $3.707 trillion
- Construction & Development: $222.5 billion
- Non-farm Residential: $1.055 trillion
- Multi-family Residential: $232.7 billion
- Home Equity Loans: $456.8 billion
- Other 1-4 Family Residential: $1.591 trillion
- Commercial & Industrial Loans: $1.651 trillion
- Loans to Individuals: $1.298 trillion
- Credit Card Loans: $638.4 billion
- Other Loans to Individuals: $660 billion
- All Other Loans and Leases (including farms): $983 billion

Additionally, the FDIC reports that banks own more than $19.75 trillion in real estate, with $6 trillion in commercial and industrial properties, and $4.8 trillion in residential sites. Therefore, real estate is by far the largest holding for commercial banks in the U.S.

RELATED FAQS
  1. What factors are the primary drivers of banks' share prices?

    Find out which factors are most important when determining the share price of banks and other lending institutions in the ... Read Answer >>
  2. What's the difference between investment banks and commercial banks?

    Understand the principal differences between investment banks and commercial banks, and the areas of banking services that ... Read Answer >>
  3. What economic indicators are important to consider when investing in the banking ...

    Find out which economic indicators are most useful for investors in the banking sector, especially those influenced by central ... Read Answer >>
  4. How does the deposit multiplier affect a bank's profitability?

    Find out how a deposit multiplier affects bank profitability, how it increases the supply of money in the economy and why ... Read Answer >>
  5. What is the average profit margin for a company in the banking sector?

    Learn what the average profit margin is for companies in the banking sector, along with other evaluation metrics often used ... Read Answer >>
  6. What is the difference between an investment and a retail bank?

    Learn the primary differences between retail banks and investment banks by examining the business activities, type of clients ... Read Answer >>
Related Articles
  1. Investing

    What is a Bank?

    A bank is a financial institution licensed to receive deposits or issue new securities to the public.
  2. Personal Finance

    Retail Banking Vs. Corporate Banking

    Retail banking is the visible face of banking to the general public. Corporate banking, also known as business banking, refers to the aspect of banking that deals with corporate customers.
  3. Insights

    The World's Top 10 Banks

    Learn more about the world's largest banks and how more financial power shifts eastward as China is home to four of the world's largest banks.
  4. Investing

    Analyzing A Bank's Financial Statements

    A careful review of a bank's financial statements can help you identify key factors in a potential investment.
  5. Investing

    Bank of America's 3 Key Financial Ratios (BAC)

    Discover some of the key financial ratios that show the quality of Bank of America's loan portfolio and how profitable the bank has been.
  6. Investing

    Financial Institutions: Stretched Too Thin?

    Find out how to evaluate a firm's loan portfolio to determine its financial health.
  7. Personal Finance

    Getting a Loan Without Your Parents

    Use these five things to finance your dreams without banking on a second signature.
  8. Insights

    Understanding the Bank Rate

    Bank rate is a term describing the interest rate a country’s central bank charges its domestic banks on loans it makes to them.
RELATED TERMS
  1. Commercial Bank

    A commercial bank is a type of financial institution that accepts ...
  2. Commercial Loan

    A debt-based funding arrangement that a business can set up with ...
  3. Business Banking

    A company's financial dealings with an institution that provides ...
  4. Excess Loans

    A loan made by a state chartered or national bank to an individual ...
  5. Lending Freeze

    A period of time when banks either do not have excess money to ...
  6. Loan

    The act of giving money, property or other material goods to ...
Hot Definitions
  1. Efficiency Ratio

    Ratios that are typically used to analyze how well a company uses its assets and liabilities internally. Efficiency Ratios ...
  2. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  3. Maintenance Margin

    The minimum amount of equity that must be maintained in a margin account. In the context of the NYSE and FINRA, after an ...
  4. Salvage Value

    The estimated value that an asset will realize upon its sale at the end of its useful life. The value is used in accounting ...
  5. Cryptocurrency

    A digital or virtual currency that uses cryptography for security. A cryptocurrency is difficult to counterfeit because of ...
  6. Promissory Note

    A financial instrument that contains a written promise by one party to pay another party a definite sum of money either on ...
Trading Center