What Are the Main Risks Faced by Banks and How Do They Attempt to Mitigate Them?

Following the 2008 financial crisis banking institutions have become more risk adverse and in fact invest regularly in their risk management departments. Risk can be defined as an ‘exposure to uncertainty of outcome’ measured by the volatility (standard deviation) of net cash flow within the firm. Within the banking industry firms face multiple risks but in the following essay, I will specifically identify three potential risks and how they are managed. My 3 chosen risks are; credit risk, liquidity risk and business risk.

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Credit risk is the risk that arises from the possibility of non-payment of loans by the borrowers. Even though credit risk mainly refers to risk of non-payment, banks also include the risk of delayed payments under this category. Credit risk is the biggest determining factor on a bank’s financial success. Currently within a bank 50% of its employee’s job duties are based on risk management, and this is projected to increase to 65% by 2025 (Samandari, Havas and Härle, 2019). Internally banks try to mitigate credit risk by ensuring thorough background checks are conducted to determine the ability of the borrower to fulfil their commitment to repay the loan, and also rely upon the help of credit rating agencies. In addition, securities are taken against a loan so in case of default the bank can recover the secured good and incur no loss. Interest rates are also used adjusted to the deemed risk, and so the riskier the loan the higher the premium. This ensures those that take out the loan at a higher rate are more inclined to be on time with payments as the cost of borrowing is higher, thus reducing the moral hazard. All these different areas are regularly monitored by banks as a small rise in credit risk can amount to the profitability of banks being extremely impacted (UKEssays.com, 2019).

Externally, regulators over the years have improved regulations set upon these institutions to make sure they are risk adverse and capital management is properly accounted for. The Basel accords are the main point of reference for risk management for firms. Basel ACCORD 1998 required banks had a minimum capital requirement of 8% * sum of risk weighted assets. Corporate loans were weighted at 100% whereas mortgages were weighted at 50%. Regardless of the profile of the borrower all mortgages were weighted at 50%. This accord came under criticism as it was considered too simple and encouraged banks to have higher risk weighted assets to maximise profits. Basel II then followed and split risk rating into either a standardised approach or internal rating based. Standardised approach was the non-requirement to consider actual credit risk but simply categorise obligors.  Internal ratings based allowed banks to utilise internal systems to calculate requirement for credit risk. Basel II divided the eligible regulatory capital of a bank into three tiers. Basel III the most recent accord but it didn’t change the minimum capital requirement but enforced stricter rules to ensure the quality of capital.  Basel III increased minimum Common Equity Tier 1 capital from 4% to 4.5%, and minimum Tier 1 capital from 4% to 6%. The overall regulatory capital was left unchanged at 8% (Chatterjee, 2019)

Liquidity Risk can be defined as the risk that a bank will have insufficient liquid assets on its balance sheets and is therefore unbale to fulfil its financial commitments without the sale of assets. This occurs due to liabilities being greater than assets due to loan defaults with a surge of depositor demands. Usually a bank operates by holding vast amounts cash deposits by customers and they then use this deposited money to make long term credit available to larger customers who require much greater capital. As cash deposits are a short-term liability on the banks financial statement, banks must always be ready to meet immediate demand from depositors as they can be demanded at any time. Moreover, sensitivity to interest rates can impact a banks liquidity.

As seen from the diagram a lower interest will lead to an increase in the demand for money (I**->I*), (M** -> M*). This is because customers who take out loans are always looking to minimise the cost of borrowing and will try take out loans with the lowest interest rate. But also, a higher interest rate will reduce the demand for money as seen in the diagram as (I*->I**), (M* -> M**). This is because customers who are depositors will look to deposit their capital in a bank where the reward for saving is the highest. Thus, changing interest rates will impact both the demand for deposits and for loans impacting the banks liquidity position. This is because if capital is demanded by all customers at same time the bank maybe unable to meet its commitments and the varying interest rates also impact the value of assets which a bank may rely upon to meet its financial requirements. These factors mean that liquidity managers must the circumstances of their largest depositors and holders of credit and be able to accurately determine if withdrawals will be demanded in the immediate time period. It’s important for a bank to remain liquid because if customers are unable to withdraw their funds it will lead to an erosion of trust which is the biggest foundation in the working banking system. An inability to provide funds when demanded will lead to panic amongst customers and a run on the bank as customers want to withdraw their capital to ‘keep it safe’. If a run on a bank occurs the banks future is almost certainly untenable so at all costs institutions most seek to avoid illiquidity.

Methods to mitigate liquidity risk vary. Asset liquid management is a commonly used method. This is where assets held are only highly liquid ones so large cash reserves and securities in which their value can be released very quickly. This method commonly used by both small and large entities as this method is seen as a more viable option than borrowing large amounts in the short term to cover liabilities. However, the biggest institutions may choose to borrow in the currency market to be more liquid. This is referred to borrowed liquidity risk management. Finally, a balance management strategy may be implemented, and this involves holding realisable securities and deposits at other banks. Unexpected cash needs are met by short term borrowing and long-term liquidity needs can be planned for (PAUL TSI, 2019).

Business risk is in the banking industry has been getting more severe in recent years especially the last decade. Risks have come in the form of competition from online banks challenging traditional banking ideas to the uncertainty of Brexit in recent years which has seen many large banks already prepare to relocate offices into cities like Frankfurt following an unfavourable Brexit outcome. Throughout history the biggest barrier to entry for firms into the banking industry was the foreseen high fixed costs and the amount of capital required to invest into physical branches. But recently online banks such as Monzo and Revolut have challenged this potentially outdated idea and are on course to treble their recorded number of customers at the end of the year 2019 where traditional banks are to grow its customer base by less than 1% (Thefintechtimes.com, 2019). As well as challenging the perceived non-negotiable fixed online banks have also benefitted from the high technical ability of employees and the absence of long existing systems. This is beneficial as its been easy for online banks to implement the latest systems whereas traditional banks have struggled to integrate new systems into all their branches as there are so many and changing systems is a costly process. Ashwell as it being costly it’s also time consuming as it can take up to 3-5 years to fully integrate a new system but in this time the new system maybe outdated. In addition, it’s a difficult task to even digitise systems but traditional banks have also struggled in the maintenance and quality of online services and have seen loss of customers only last year TSB had a failure with their IT migration (Wearden, 2019).

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Open banking has also posed a recent threat to the banking industry. Law and regulation have and will continue to greatly impact the landscape of the financial industry. With recent changes in the General Data protection Regulation and the EU’s revised Payment Services Directive (PSD2) these new regulations will lead to easier access for all stakeholders (Wilkinson, 2019). Banks will have to share previously proprietary data which with no doubt will increase competition in the industry but loosen the market power of these banks. By reducing information gaps, in the case competitors they will be able to interpret, analysis and evaluate customer data from other banks and gain knowledge of which customers to target. Extensive investment into research of understanding customer wants and needs will no longer be required. This may lead to a lower concentration ratio of firms in the banking industry as a few firms can no longer dominate the market as all have access to the same data.

To conclude, with no doubt the future of the banking industry is in s pivotal position and amidst an uncertain future. One out of three branches in the UK have been shut in the last five years. I believe the biggest determining factor in the changing landscape been the extraordinary advancements in technology which has seen customer needs and wants to change drastically. People demand a digital banking experience as its more convenient and especially for the new young generation who deem convenience everything. But with improved technology even though competition has caused problems for dominant firms, the improvement in technology has helped reduce costs by almost 39% (Phaneuf, 2019). In addition, technology has helped to create advanced systems in forecasting and limiting potential risks to banks. Compared to pre 2008 risk management the chance of credit and liquidity risk has vastly decreased but is still a threat, but I believe the change in culture to these risks has helped reduce the likely hood of another failure through incompetence. Organisations invest heavily into training and regular system checks to make sure process are in order. Before bankers were not held accountable and this saw triple AAA deemed subprime mortgages filled with bad credit which was the main cause of the financial crash. But with increased regulation and an importance of risk education emphasised it reduces the chances of an avoidable crisis. There are always booms and busts in an economy and another financial crisis is inevitable, but I believe banks are much more aware of these threats and so more prepared to reduce the potential impacts. But as recent trends have shown global economic, political and social opinions are changing. This is seen from the vote of Brexit, rise of nationalistic parties and increasing concern in regard to climate change. Barclays continued investment in fossil fuels has seen it gain huge criticism and lose customers. I believe the main threat to the banking industry in the coming years will be its ability to align its business objectives and services with the dynamic ever-changing customer demands. Customers now more than ever have more choice than ever and access to a lot more information to make informed decisions. If traditional banks are unable to adapt to new climate it could foreshadow a worrying future.

Bibliography

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