The Five Greatest Risks to Banks
Banks are typically thought of as stable, reliant and dull, or that’s what we would like them to be. Actually, banks are inherently risk managers, as we have now realized in the past five years.
Banks can be basket cases if they manage risk badly or high-return investment vehicles if they manage risk well, but in the end it’s all about risk management. That’s because banks make money out of lending and the art of lending is to ensure the customer will pay back and pay back at a profit with interest. This is the basics of banking and goes back to ancient times.
It all sounds so simple, and it is, but the complexity of the modern world is breaking down that simplicity. Just thirty years ago, the simplicity was there because we had just two types of risk to manage: market and credit. Credit risk speaks for itself: will the customer pay back? Market risk is also fairly obvious: are the markets good enough to support our position?
Then Barings Bank collapsed and another sort of risk appeared: operational risk, which is the risk of our own organization screwing itself up through inadequate internal controls. This one is also simple, although harder to manage because the bending of internal rules is all too easily achieved if the interests of the few dominate the survival of the many, especially if the interests of the few lie near the top of the tree.
Today, we think of Jerome Kerviel and Kweku Adoboli as illustrating operational risk in modern day organizations that got out of hand, but I would also place Fred Goodwin (RBS), James Crosby (HBOS) and Adam Applegarth (Northern Rock) in this space.
Now, that may be unfair as there is another form of risk that appeared in much more recent times, post-2008, that had gone under the radar before the financial crisis. That is the risk of not being able to keep ourselves funded. It is now called “liquidity risk” and it’s a good name, as I think of it as the ability for a bank to remain buoyant or to sink if its funds run out.
All four sorts of risk are interoperable, interdependent and inter-related but they have to be treated separately and in harmony to make sure that one does not explode at the expense of the others. RBS, HBOS and Northern Rock were all good banks that went bad because they had modeled and managed their market and credit risk analytics, but had not taken into account the risk of markets closing the doors to funds. It was when this liquidity risk exposure appeared that they also realized they had an operational risk: CEOs that had been overambitious and who had overleveraged the balance sheet because they believed markets would provide never-ending funding (liquidity).
I bring all this up because of the way these risks come into play at Co-operative Bank, the small UK ethical bank that has been a mutual but is now becoming a proprietary shareholder-owned bank. Why? Because it has a £1.5 billion capital shortfall under the new regulatory rules and has to fill that hole by converting bondholders into shareholders. The bondholders aren’t happy about it but, if they don’t accept the plan, they will probably become the holders of nothing as the bank will close.
How did the Co-operative get into such a mess? Because – like RBS, HBOS and Northern Rock – its executives over-stretched the balance sheet and created unmanageable liquidity risk. In this case, everyone is wondering how come a bank that the regulators and media all thought of as a decent, small, mutual bank has suddenly become a basket case. And the answer is the arrogance of management in stretching the bank’s balance sheet when buying a bad bank called Britannia Building Society, along with another form of risk.
Again, this other type of risk is wrapped into the other four (market, credit, liquidity and operational) but has its own designation today: compliance risk. The Co-operative had an 8.8% capital ratio – the amount they hold to cover a crisis – and this has been deemed unacceptable under the UK implementation of Basel III. Under this regulation, banks must achieve capital ratios of 10% or more and the Bank of England recently came out with an analysis saying the UK banks each had some form of shortfall.
For a big bank, such a shortfall can be covered by selling non-core assets (RBS, Lloyds) or via a rights issue (Barclays). But for a non-proprietary mutual, how do you find £1.5 billion you don’t have and find it fast? That is the challenge that Co-operative Bank faces and so they’re converting £1 billion of bond debt into shareholder equity and then selling a few other bits, like their insurance business, to survive. That’s the plan anyway.
One wonders what other types of risk need defending against. Perhaps environmental risk, technological risk, social risk, political risk, reputational risk … there are enough forms of risk out there to convince me that banks are not boring, dull, stable businesses at all; they are risk managers.