The spate of bank failures over the past year and continuing volatility in the financial markets exacerbated by credit and housing woes have many individuals wondering about the safety of their money. Although, it is impossible to predict whether or not a particular bank will fail, for consumers, the turmoil within the financial sector amply illustrates the need to become more proactive and better informed in matters of finance and money management.
Banks can be subject a wide range of risks including but not limited to:
• Credit Risk: Loosely defined, banks incur credit risk when borrowers are unable to repay their loans. Excessive loan “charge-offs” can exert a serious negative impact on a bank’s financial health.
• Interest Rate Risk: Fluctuations in the interest rates can impact a bank’s assets and liabilities. Banks follow the usual old established rule: buy cheap, sell dear. For banks, this translates as borrow cheap and lend dear. The difference between borrowing and the lending rate is called the margin. The size of the margin is one factor that determines the profitability of the bank. When the rate of interest changes, banks have to adjust their borrowing and lending policies accordingly. The main objective is to ensure that lending is a profitable activity.
• Leverage Risk: Banks have two main sources of finance, i.e., equity (proceeds of shares bought by shareholders) and debt (borrowed funds). These borrowed funds constitute the leverage of the firm. Equity (paid-up shares) constitutes capital. The ratio of equity capital divided by the total assets shows the degree of risk that the bank carries. This ratio is called the leverage ratio and indicates the extent to which the bank is financed by equity compared to debt. The greater the use of debt to finance a bank (or, any business in general), the greater the risk because of the claims of the creditors.
• Trading Risk: Trading, in general, involves two activities, buying and selling of products. The products that banks buy and sell are called securities or financial instruments (e.g., bonds or “derivatives”). Since the prices of these securities fluctuate, the profits of the banks are influenced by the changes in the buying and selling prices of these securities. These trading activities, therefore, involve some informed (or misinformed!) speculation.
In conclusion, banking is a risky business and the management of financial institutions carries a heavy responsibility for ensuring their profitability. Clearly, bank failures can have significant, far-reaching consequences not only for the economy and financial markets but also for the population at large. Financial markets are like the life-line of the economy and exert a profound influence on key aspects such as the levels of employment, income and consumption.
For informational purposes only.