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Lately, with the frequent headlines about large banks getting into trouble, the question that many ask but few answer is: Just how safe is a bank? As an ex-banker, here is my answer.
It is a fallacy to think that banking is a very safe business. It is not.
While banks may make reassuring noises and present a face of strength and stability, in truth, banking has inherent risks that are unique and often over and above risks faced by other businesses. Just ask the shareholders and depositors of banks who have lost money. Or those who bit their nails while waiting for a rescue package.
Here are the four riskier aspects of banking that are not commonly known or talked about (except regurgitated in IPO small print that only insomniacs or the pointedly meticulous read):
1. Credit risk
2. Liquidity risk
3. Market risk
4. Operational risk
Credit risk
This is an inherent risk of all businesses that provide credit to their customers. But in the banking business, the risk is magnified.
How so?
In a trading business, the trader may buy and sell goods at a gross profit (revenue less cost) of say 25%. If the trader provides credit to his customer, and his customer fails to pay him, he would have to sell four times that amount of sale to cover his loss.
In a banking business, the bank takes on liabilities in the form of savings/deposits and gives out loans. One can say the bank buys and sells cash (with promise to repay at fixed future date/s).
Let us say the bank earns a margin of 2%. That in effect is the bank’s gross profit. Should its customer fail to pay, it would have to make fifty fresh loans of equivalent value and margin to cover the loss.
That is why good credit risk management is so critical for a bank.
Liquidity risk
Lending on a margin is not usually sufficient to achieve the kind of return that shareholders expect because the margin is slim (unless lending to customers that have what the financial world terms a low credit rating, i.e. those who tend to delay or default in repayments). So banks invariably ‘mismatch’ by borrowing short to lend long – meaning they borrow with maturity dates that on average reflect a shorter tenor than that of their loans.
To provide a simple illustration, a bank may accept savings and deposits that are due for renewal on a daily, weekly, monthly, yearly or longer tenor such that the average maturity is say 1 year. (Mind you, maturity of deposits can be accelerated provided the depositors are willing to forgo interest.) While a bank may set aside a certain portion of savings and deposits collected to be held as liquidity (the proportion varies but would generally not be above 1/3rd), the rest would be lent to be repaid on longer tenors that average out to be much higher than 1 year. 25 year housing loans for example.
Thus, when there is a liquidity squeeze, a bank may find that it has insufficient short term assets to meet the demand for cash. In liquidating its assets at short notice, it suffers a loss in value. Or, worse, finds that the cash raised is insufficient to meet deposit withdrawals. In such a situation, it would either close its doors or run to the central bank for help.
Market risk
Just as any investor is exposed to the risk of market fluctuations, a banking institution faces such risks on a daily basis. In fact, its business is to undertake risks and earn income from them.
In return for an anticipated revenue (a fee or a trading gain), the bank bears the risk of loss due to market price movements out of underwriting of shares, exposure to foreign currencies, derivatives, etc. The idea, as in insurance, is to spread the risk through diversity and volume in numbers so that the income more than covers losses.
Usually, a bank covers the risk of market fluctuations by ‘matching’. This is when the bank matches a market trade with an opposite one. Then it only has to worry about counterparty risk (failure of the other party to perform).
However, it may take an open position (meaning an unmatched position) intentionally or due to lack of market or extreme volatility.
One of the most common exposures a bank takes on is the exposure to interest rate fluctuations. If a bank is aggressive in building up a mortgage portfolio, it may be earning interest based mostly on a fixed rate while paying interest that fluctuates. Let us say a bank is lending on average at 6% p.a. and bearing interest cost at 3.5% p.a. It will suffer a significant loss should the interest rate level move up to say 7% p.a.
That is market risk.
Operational risk
There are in reality many operational risks but the one that bothers banks most is fidelity risk because their business is, in essence, the manipulation of data.
Whereas a normal business is mostly concerned with loss of stocks as its major risk, a bank has to be concerned with preventing the loss of cash (which is their stock). Not just physically but electronically. From external as well as internal parties. In incoming and outgoing flows. In both active and dormant accounts. In fact, in every aspect of operations.
This is why compliance, inspection, audit and various forms of checks and balances in a bank tend to be at a much higher level than those for normal businesses. Control systems in a bank must be well-designed and dynamic enough to keep up with innovative fraudsters.
Is big beautiful?
Many people think that banks are safe when they are big. Big is not necessarily beautiful. In a violent storm, big trees get uprooted too.
Over the years, we have witnessed the collapse or bail-outs of many banks, e.g. First Pensylvania, LTCB, Crédit Lyonnais, Barings, Société Générale and more recently Bear Stearns. Some of these were among the largest banks in the world. Each of the bank failures was caused by one or a combination of the risks mentioned above – bad credit, liquidity squeeze, market losses and control lapses.
Size does not ensure safety. In fact, size often exacerbates the problem when there is a risk of contagion.
What is contagion? Think dominoes, in a row, falling one by one. When a bank's environment is under stress and the adverse impact is large enough to affect it, other banks that are lending to the injured bank can be affected too and so the problem spreads, until the government steps in, if it chooses to and if it can afford to.
Wikipedia quotes 744 bank failures in the U.S. in the first 10 months of 1930 (the Great Depression period) rising to a total of 9,000 by the end of the 1930s, reflecting the contagion effect.
More recently, the subprime mortgage crisis has caused severe problems for several large financial institutions globally – in U.S., U.K., Germany, Switzerland, Australia, New Zealand and ripples in various other countries.
Banking is as safe as people perceive it to be. And if people perceive their savings with a bank are at risk, they can start a run on that bank. This is when the bank’s depositors panic and they all want to withdraw their money at the same time. As happened to several large financial institutions in the past.
Cash and liquidity are the life stream of banks, like blood to the body. When people think that a bank is in trouble, it gets into trouble. Confidence and perception towards a bank are paramount, regardless of the real situation or what its underlying assets are. Thus, a bank, no matter how big it is, cannot withstand a run unless rescued by government or collective efforts.
Wait, there’s more
Then there is gearing. Gearing refers to the extent to which an entity funds its business through borrowings as opposed to capital funds. For example, a gearing of 2 to 1 means for every RM 2 borrowing there is RM 1 capital acting as cushion. Shock absorber if you like. The higher the borrowings, the higher the gearing. Conversely, the more the capital funds, the lower the gearing and the better the capital ratio.
Because a bank earns a fine margin, it has to gear up to make money. And banks are among the most highly leveraged, compared to other businesses – their gearing generally ranges from 7 to 10 to 1. This means for every RM 1 borrowing, there is only a 10 to 15 sen cushion.
What can be done?
So what can be done to hedge your risks if you are a depositor or investor?
Diversify. As the saying goes, do not put all your eggs in one basket. More than one bank. More than one economic area. More than one sector. If you can.
Also, pick your banks carefully. The ones that have better capital ratios have better shock absorbers. So too the ones that have skilful drivers. They who know how to assess risk properly know how to avoid the big pot holes in finance.
Governance and ethical practices, regulations and compliance audit etc. do not seem to have any discernible improvement in reducing bank failures. They just get more spectacular.
Bigness is not relevant to safety nor is scale the main determinant of competitiveness. Mistakes are simply amplified in a big bank. Especially with egos that get carried away by some fixation on growth or other pet ideas.
Central banks are rethinking about how safe banking is. Since 1992, capital requirements for banks and risk activities have been redefined, first through the Basel Accord and then Basel II, which is currently under implementation. These measures will increase the need for capital funds for banks.
The roads are getting bumpier. Like the inclement weather these days, markets are getting more stormy and volatile. So banks will need better shock absorbers going forward.
From the recent debacles, people will look at banking in a new light. Investors will demand a higher risk premium, meaning they will ask for higher return on their risk capital for banking investments. They too will want better shock absorbers. By Joe Harry Low
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