Bank Risks and Risk Factors

Abstract

The Federal Reserve System has established a banking risk framework that consists of six risk factors: credit, market, operational, liquidity, legal and reputational risks. During examinations, institutions' risk management structures are reviewed using these risk categories.

The Federal Reserve Bank of Chicago (Seventh District) supervision group follows current and emerging risk trends on an on-going basis. This Risk Perspectives newsletter is designed to highlight a few current risk topics and some potential risk topics on the horizon for the Seventh District and its supervised financial institutions. The newsletter is not intended as an exhaustive list of the current or potential risk topics and should not be relied upon as such. We encourage each of our supervised financial institutions to remain informed about current and potential risks to its institution.

Credit Risk
The marketplace for C&I loans is highly competitive. Soft loan demand, the low interest rate environment, and strong market liquidity from banks and investors flush with cash has heightened the level of competition for C&I lending and will continue to make loan growth for our institutions very challenging into 2013.

Anecdotally, financial institutions have responded to these dynamics in a number of ways, including:
• Granting pricing and structural concessions in order to maintain or potentially grow market share
• Increasing leverage tolerance
• Entering into new lending areas and business lines
• Exploring mergers and acquisitions and other shareholder value maximization strategies.

While there appears to be increased appetite for additional credit risk exposure in some portfolios, corresponding levels of enhanced returns will likely be influenced by the due diligence and planning a management team conducts in advance of implementing any new business strategy.
In these situations there are a number of potential risks to consider.
First, aggressive growth targets may incent more aggressive terms or riskier borrowers. Also, new growth that occurs outside of a financial institution’s traditional geographic footprint presents the risk of unfamiliar markets that may differ from the traditional footprint. Finally, banks entering into new lending niches without lending staff possessing expertise in these sectors can pose a risk to appropriate due diligence and sound underwriting practices.

In this competitive environment, strategy development and execution are critical executive management and director responsibilities. An important component of the planning process is the assessment of potential changes in the financial institution’s risk profile, as well as ensuring that the risk management structure is appropriate for any new lending activities.

Liquidity Risk
Liquidity risk is the current and prospective risk to earnings or capital arising from a bank’s inability to meet its obligations when they come due without incurring unacceptable losses. Liquidity risk includes the inability to manage unplanned decreases or changes in funding sources. Liquidity risk also arises from the failure to recognize or address changes in market conditions that affect the ability to liquidate assets quickly and with minimal loss in value.
Quantity of Liquidity Risk Indicators
The following indicators, as appropriate, should be used when assessing the quantity of liquidity risk. It is not necessary to exhibit every characteristic, or a majority of the characteristic, to be accorded the rating.
Low
* Funding sources are abundant and provide a competitive cost advantage. * Funding is widely diversified. * There is little or no reliance on wholesale funding sources or other credit-sensitive funds providers. * Market alternatives exceed demand for liquidity, with no adverse changes expected. * Capacity to augment liquidity through asset sales and/or securitization is strong and the Bank has an established record in accessing these markets. * The volume of wholesale liabilities with embedded options is low. * The Bank is not vulnerable to funding difficulties should a material adverse change occur in market perception. * Support provided by the parent company is strong. * Earnings and capital exposure from the liquidity risk profile is negligible.
Moderate
* Sufficient funding sources are available which provide cost-effective liquidity. * Funding is generally diversified, with a few providers that may share common objectives and economic influences, but no significant concentrations. A modest reliance on wholesale funding may be evident. * Market alternatives are available to meet demand for liquidity at reasonable terms, costs, and tenors. * The liquidity position is not expected to deteriorate in the near term. * The Bank has the potential capacity to augment liquidity through asset sales and/or securitization, but has little experience in accessing these markets. * Some wholesale funds contain embedded options, but potential impact is not significant. * The Bank is not excessively vulnerable to funding difficulties should a material adverse change occur in market perception. * The parent company provides adequate support. Earnings or capital exposure from the liquidity risk profile is manageable.

High

* Funding sources and liability structures suggest current or potential difficulty in maintaining log-term and cost-effective liquidity. * Borrowing sources may be concentrated in a few providers or providers with common investment objectives or economic influences. * A significant reliance on wholesale funds is evident. * Liquidity needs are increasing, but sources of market alternatives at reasonable terms, costs, and tenors are declining. * The Bank exhibits little capacity or potential to augment liquidity through asset sales or securitization. * A lack of experience accessing these markets or unfavorable reputation may make this option questionable. * Material volumes of wholesale funds contain embedded options. The potential impact is significant. * The Bank’s liquidity profile makes it vulnerable to funding difficulties should a material adverse change occur. * There is little or unknown support provided by the parent company. Potential exposure to loss of earnings or capital due to high liability costs or unplanned asset reduction may be substantial.

Market Risk
Putting the key components together focuses on the market risk management for banks planning to set up a dedicated market risk management function or invest in the required tools. It provides a high-level summary of how each component can be put together for a risk management system, as well as how market risk management fits in. It is important to note that the summary is not intended to be prescriptive but is indicative only.

Risk management in the banking industry is a big topic that may be related to a wide spectrum of banking operation units and activities. The banking industry participants may use different categories of risks and at different granularity. For example, some banking supervisors consider eight inherent risks banks are exposed to, which are identified as credit, market, interest rate, liquidity, operational, reputational, legal and strategic risks.

Banks usually are encouraged by their banking supervisors to adopt an integrated firm-wide risk management framework. This is especially true after the financial crisis where risk management and control units are expected to work in a more integrated fashion but not in a silo.

Although sophistication and complexity of risk management systems vary among banks, due to their size, organizational structure, business focus or supervisory guidance, in general, the following components can be found:
• Board and senior management oversight
• Internal documentation such as organizational policies and procedures
• Risk measurement, monitoring and reporting systems and processes
• Internal controls, internal audits and compliance checkpoints

Interest Rate Risk
As the savings and loan crisis of the 1980s showed, taxpayers can end up paying when banks engage in excessive risk taking. And there are a large number of ways that banks can take on too much risk. They might make speculative loans, for example. The savings and loan industry engaged in speculative lending but also was exposed to risks by making long-term mortgages that were funded by short-term deposits. This creates what is called interest rate risk, which is discussed below in more detail. It is clear why taxpayers should care about bank risk taking, but why should the Federal Reserve?

As one of its duties, the Fed regulates the safety and soundness of certain banking organizations. This means the Fed monitors the riskiness of these banking organizations, examines them and takes steps to prevent them from taking risk in excessive levels. As a result, the Fed has a strong interest in topics such as interest rate risk. The Minneapolis Fed not only devotes considerable resources to regulating banks, but it also gives serious attention-in the fedgazette and other publications—to the effect of regulatory policy on bank risk taking.

All banks face interest rate risk (IRR) and recent indications suggest it is increasing at least modestly. Although IRR sounds arcane for the layperson, the extra taxes paid after the savings and loan crisis of the 1980s suggests there is good reason to learn at least a little about IRR.
Think of IRR as blood pressure for banks. It can increase or decrease without obvious outward signs, and such changes can cause failure. At the same time, regulators and banks can monitor it and detect changes. Finally, banks can take preventative steps to manage IRR but they do not want to eliminate it completely as it, like blood pressure itself, is vital for survival.

In general, IRR is the potential for changes in interest rates to reduce a bank's earnings and lower its net worth. IRR manifests in several different ways but we will provide a simplified example to illustrate the general issue. The most common manifestation of IRR occurs because the assets of the banks, such as the loans it holds, come due or mature at a different time than the liabilities of the bank, such as deposits.

Take, for example, a bank that funds itself only with certificates of deposit that have a maturity of two years. This bank also only makes mortgage loans with a maturity of 15 years. Should interest rates rise in the future, the bank would face a decline in its expected income. Why? The monthly inflow of cash to the bank from the mortgages are fixed for 15 years. When the certificates of deposit come due before the mortgages, the bank will have to pay more to receive funding so cash flows out of the bank will increase.

Clearly IRR holds the potential to have a negative impact on earnings and net worth of a bank. So why don't banks try to eliminate it by ensuring that all of its assets and liabilities have exactly the same maturities? Banks would earn less money without taking on this risk. By earning the difference between long-term and short-term rates, for example, banks are getting paid to assume IRR and meet the demands of customers for deposits and loans. The challenge for banks is to measure IRR and manage it such that the compensation they receive is adequate for the risks they incur.

Focusing on risk management of banks in this case is particularly important because, as has been pointed out in many Minneapolis Fed publications, some of the risk taking of banks is borne by the taxpayers who support the safety net for banks. These concerns are always heightened in periods such as the current one where IRR is on the rise.

Legal Risk
Legal risk is the risk of the Bank’s losses in cases of: * Incompliance of the Bank with the requirements of the legal regulations and concluded agreements * Making legal mistakes in carrying out activities (incorrect legal advice or incorrect drawing of documents, including that in consideration of disputes in courts); * Imperfection of the legal system (contradictory nature of the law, absence of legal regulations on certain issues arising in the course of the Bank’s activity); * Violation of legal regulations, terms and conditions of concluded agreements by the counterparties

The Bank’s activity is carried out according to the current legislations and Bank of Russia Regulations. The Bank observes all requirements and conditions of legislation and Regulations of the Bank of Russia related to licenses.
Thanks to Bank’s qualified employees it can react promptly and adequate on all changes in legislation including changes in Currency legislation, tax legislation and so on what permits to reduce the relevant risks significantly.

Capital Risk
Capital Risk applies the Generalized Method of Moments technique for dynamic panels using bank-level data for 42 Asian countries over the period 1994 to 2008 to investigate the impacts of bank capital on profitability and risk. Ignoring influence factors, the extant literature presents an ambiguous impact of bank capital on profitability (risk), however, when the effects from the influencing factors are taken into consideration, three conclusions are reached. First, along with the change in the categories of banks, investment banks have the lowest and positive capital effect on profitability, whereas commercial banks reveal the highest reverse capital effect on risk. Second, banks in low-income countries have a higher capital effect on profitability; banks in lower-middle income countries have the highest reverse capital effect on risk, while banks in high-income countries have the lowest values. Third, banks in Middle Eastern countries own the highest and positive capital effect on profitability. Far East & Central Asian banks have the largest reverse capital effect on risk, while the lowest value occurs in Middle Eastern countries' banks. Finally, our results also reveal that persistence of profit is greatly affected by different profitability variables, and all risk variables show persistence from one year to the next.