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

OverviewWe 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).Let’s 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 1980sIn 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 1990sIn 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 we’re going to cover in the rest of this series’ parts—the various types of risks in banking. Keep reading to know more about these types of risks.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphXLFMSJPMWFCGSJan 1nd00:00:00.001

An investor's guide to banking risks (Part 4 of 14)

Must-know: The 8 types of bank risksBy Saul Perez • Sep 1, 2014 11:37 am EDT

Banks and riskBanks 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 arisesThe 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 bank’s 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 risksThere are many types of risks that banks face. We’ll look at eight of the most important risks.

1. Credit risk2. Market risk3. Operational risk4. Liquidity risk5. Business risk6. Reputational risk7. Systemic risk8. Moral hazardOut 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 bank’s profitability and solvency.

All banks set up dedicated risk management departments to monitor, manage, and measure these risks. The risk management department helps the bank’s 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 bank’s 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.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphXLFMSJPMGSWFCJan 1nd00:00:00.001

An investor's guide to banking risks (Part 5 of 14)

Must-know: Understanding credit risk in the banking businessBy Saul Perez • Sep 1, 2014 11:37 am EDT

Credit riskThe 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 bank’s 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 riskThe 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 individual’s credit quality. Credit risk also denotes the volatility of losses on credit exposures in two forms—the loss in the credit asset’s value and the loss in the current and future earnings from the credit.

Banks create provisions at the time of disbursing loan (see Wells Fargo’s 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 timesDuring the subprime crisis, many banks made significant losses in the value of loans made to high-risk borrowers—subprime mortgage borrowers. Many high-risk borrowers couldn’t 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.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphWFCMSJPMGSXLF (Financial Select Sector SPDR (ETF))Jan '15May '15Sep '15Jan '16-20%-10%0%+ 10%+ 20%

An investor's guide to banking risks (Part 6 of 14)

Must-know: Why market risk is important to banksBy Saul Perez • Sep 1, 2014 11:37 am EDT

Market riskThe 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 risksThe major components of market risk include:

Interest rate risk Equity risk Foreign exchange risk Commodity riskInterest rate riskIt’s the potential loss due to movements in interest rates. This risk arises because a bank’s 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 riskIt’s 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 riskIt’s the potential loss due to change in value of the bank’s 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 riskIt’s 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, we’ll look at what is probably the most important day-to-day risk for a bank—operational risk.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphBACGSMSJPMXLF (Financial Select Sector SPDR (ETF))Jan '15May '15Sep '15Jan '16-20%-10%0%+ 10%+ 20%

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

Operational risk—the risk in all banking transactionsBy Saul Perez • Sep 1, 2014 11:37 am EDT

Operational riskThe 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 departments—credit, investment, treasury, and information technology.

Causes of operational risksThere are many causes of operational risks. It’s 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 bank’s collapseThe fall of one of Britain’s oldest banks, Barings, in 1995, is an example of operational risk leading to a bank’s 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 bank’s 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 wasn’t possible to keep the trades and the losses a secret.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphXLFMSJPMGSWFCJan 1nd00:00:00.001

An investor's guide to banking risks (Part 8 of 14)

Must-know: Liquidity risk—when banks have too little cashBy Saul Perez • Sep 1, 2014 11:37 am EDT

Liquidity riskLiquidity 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 bank’s reputation and the bank’s 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 2008–2009.

Liquidity risk can ruin banksA 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 didn’t 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 factors—demand 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 2007–2008, the bank wasn’t able to sell the loans it had originated. At the same time, it also wasn’t 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, we’ll look into a bank’s reputational risk.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphXLFMSJPMGSWFCJan 1nd00:00:00.001

An investor's guide to banking risks (Part 9 of 14)

Must-know: Reputational risk—when banks lose the public’s trustBy Saul Perez • Sep 1, 2014 11:37 am EDT

Reputational riskReputational risk is the risk of damage to a bank’s 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 public’s 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 bank’s failure to honor commitments to the government, regulators, and the public at large lowers a bank’s reputation. It can arise from any type of situation relating to mismanagement of the bank’s 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 riskIn 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.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphXLFCJPMSTTWFCJan 1nd00:00:00.001

An investor's guide to banking risks (Part 10 of 14)

Must-know: Business risks—it’s all about a bank’s strategy

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

Business risk Business risk is the risk arising from a bank’s 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 2007–2008, 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.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphCJPMSTTWFCXLF (Financial Select Sector SPDR (ETF))Jan '15May '15Sep '15Jan '16-20%-10%0%+ 10%+ 20%

Must-know: Systemic risk—the economy affecting banksBy Saul Perez • Sep 1, 2014 11:38 am EDT

Overview

Until now, we’ve looked at risks arising from banking activities, decisions, and strategies. But the last two types of risks that we’ll discuss are quite unrelated. Out of these two, we’ll first look at systemic risk.

Systemic riskSystemic 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 IndexThe table above shows the Chicago Board Options Exchange (or CBOE) Volatility Index (or VIX) for last ten years. It’s a good proxy for systemic risk. High values of VIX show periods of high systemic risk. Systemic risk by itself doesn’t lead to losses. But in an environment where systemic risk is high, many other risk factors—especially market risk—rise 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, we’ll look at a different type of risk that is also the most recently talked about—moral hazard.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on 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 banksBy Saul Perez • Sep 1, 2014 11:38 am EDT

Moral hazard

Moral hazard is the most interesting risk that we’ll 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 it’s economically unsound. The reasoning is that the person, group, or organization knows that the costs of such risk-taking, if it materializes, won’t 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 risk-taking. Executives would think that even if they took very high risks—gambling on money provided by depositors—they 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 wouldn’t 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 hazardMoral 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).Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphXLFMSJPMGSWFCJan 1nd00:00:00.001

An investor's guide to banking risks (Part 13 of 14)

Overview: Other risks, such as legal and country, that banks faceBy Saul Perez • Sep 1, 2014 11:38 am EDT

RecapIn this series, we’ve 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 risksThere are some other minor types of risks that a bank carries. These aren’t as important as the previous risks discussed, but we’ll mention them in this article.

Legal riskA 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 riskA bank that operates in many countries also faces country risk when there’s a localized economic problem in a certain country. In such a scenario, the bank’s 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 that’s able to manage various risks successfully and continuously evolve with the changing needs in the banking landscape.

Financials Performance

1M3M6MYTD1Y3Y5YClick Ticker Above to Show/Hide on GraphXLFMSCJPMGSJan 1nd00:00:00.001

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

Must-know: 2 broad categories of controlling bank risksBy Saul Perez • Sep 1, 2014 11:38 am EDT

Controlling risksSo far in this series, we’ve learned all about banking risks. Now let’s 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 level—having binding regulations Control at the bank levelAt 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 branch’s 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 levelTo 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. It’ll help you understand the sector better and help you analyze and select the correct stocks to invest in.

We’ll 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.