The three largest risks banks take are credit risk, market risk and operational risk.
This page was last updated on 19 May 2020
When handling our money, the three largest risks banks take are credit risk, market risk and operational risk.
Sound like jargon? Think of it this way: you have £100 pounds. You lend £20 to a friend, invest £50 in Bitcoin and leave the rest in your pocket.
What is credit risk?
Remember your friend who 'forgot' to pay you back… two years ago?
People and companies who fail to pay back their debts pose the largest risk to banks. When lending money to someone, there’s always a chance they won’t pay you back. This is credit risk.
Banks have ways of reducing this risk. When you apply for a loan, the lender will look at what’s known as the five C’s: credit history, capacity, collateral, capital and conditions.
- Credit history, also known as character, is basically your track record for repaying debts.
- Capacity refers to your ability to repay a loan by looking at your job stability and your debt compared to your income, known as the debt-to-income ratio.
- If you can’t pay back your secured loan, the lender will seize an asset such as your house or car as collateral.
- Would you still be able to pay your loan if you lost your job? To know, the lender looks at any savings, investments and other assets you might own to determine how much capital you have.
- Finally, the purpose – or conditions – of the loan can affect whether someone wants to lend you money or not.
The bank’s assessment determines how much interest they’ll charge you. If you are seen as a risky customer, for example by having a bad credit history, your loan will be more expensive.
What is market risk?
You invested £50 in Bitcoin. What happens next? The price could drop and leave your investment worthless. This is market risk.
Investment banks are particularly exposed to risks from changes in financial markets. This is because they hold more financial assets such as shares and bonds for themselves and their customers.
Market risk can for example come from a change in interest rates, the price of a good or the exchange rate of a currency. Banks that have bought shares in an oil company will for example lose money, if global oil prices suddenly go down.
What is operational risk?
The last £30? Turns out you should probably have fixed that hole in your pocket.
All banks are to an extent vulnerable to human errors or mistakes. In business terms, this is called operational risk. It comes from the losses a bank might make from bad internal processes, people or external events. This could for example be confidential information getting leaked or a badly judged decision by an employee.
The losses from operational risk can be huge. British banks have had to pay around £30 billion for mis-selling payment protection insurance (PPI) over the last decade. Customers were sold the insurance despite in many cases not being eligible for or needing it. It was designed to cover debt repayments in certain circ*mstances when the customer was unable to pay, for example because of illness, losing their job or death.
Of course then Arnold Schwarzenegger came along.
Bank of England's explainer on what risks do banks take?
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Male voice: Get to the crunch, make a decision. Surprise! Just pick one and roll with it. Come on!
You, sniffy man make your decision! Do it now!
That’s a good boy you’ve at least made a decision about the PPI, right? Come on!
Female voice: After the 29 August 2019, you will no longer be able to make a PPI complaint.
Male voice: Bye byes for the PPIs.
Female voice: Quite. So you need to decide. Yes I want to make a PPI complaint or no I don’t.
Male voice: Make a decision. Do it now!
Female voice: Visit the Financial Conduct Authority at www.fca.org.uk/ppi or call 0800 101 8800.
See AlsoFDIC: Failed Bank ListMale Voice: Come on!
How do banks reduce the impact of losses?
To tackle all kinds of risk, banks hold capital to cushion the blowfrom losses. Bank capitalis the difference between what a bank owns and owes, meaning its net worth. The largest banks are now required to have as much as ten times more capital than before the 2008 financial crisis.
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As a seasoned expert in banking and financial risk management, I bring a wealth of knowledge and experience to shed light on the intricacies of the three primary risks that banks navigate daily: credit risk, market risk, and operational risk.
Credit Risk: When banks engage in lending, the specter of credit risk looms large. Simply put, this is the risk associated with borrowers failing to repay their debts. The article aptly draws a parallel by envisioning a scenario where you lend £20 to a forgetful friend. Banks employ a comprehensive approach to mitigate credit risk, evaluating the borrower through the lens of the five C's: credit history, capacity, collateral, capital, and conditions. This meticulous assessment allows banks to gauge the borrower's track record, financial stability, assets, and the purpose of the loan. The article rightly emphasizes that a borrower's perceived riskiness influences the interest rates applied to the loan.
Market Risk: The mention of investing £50 in Bitcoin vividly illustrates market risk. Banks, particularly investment banks, are exposed to the volatilities of financial markets. Changes in interest rates, commodity prices, or currency exchange rates can impact the value of financial assets held by banks. For instance, if a bank invests in shares of an oil company, a sudden drop in global oil prices can lead to significant losses. Market risk underscores the dynamic nature of the financial landscape and the need for banks to navigate these fluctuations strategically.
Operational Risk: The final piece of the risk puzzle is operational risk, exemplified by the metaphorical £30 in your pocket with an unnoticed hole. In the banking realm, operational risk stems from internal errors, human mistakes, or external events that can lead to substantial losses. The article highlights real-world instances, such as the mis-selling of payment protection insurance (PPI) by British banks, resulting in hefty financial penalties. Operational risk emphasizes the importance of robust internal processes, risk management protocols, and employee decision-making to safeguard against unforeseen events.
Mitigating Losses: To cushion the impact of potential losses across these risk categories, banks maintain capital. Bank capital, defined as the difference between what a bank owns and owes, acts as a financial buffer. In the aftermath of the 2008 financial crisis, regulations now mandate larger banks to hold significantly more capital, providing a safety net to weather turbulent economic conditions. The article wisely points out that the accumulation of capital is a proactive measure aimed at preventing catastrophic losses and ensuring the stability of the banking system.
In conclusion, understanding these risks and the measures banks employ to manage them is crucial in comprehending the intricacies of the financial sector. It underscores the delicate balance banks must strike between facilitating economic activities through lending and investments while safeguarding against potential pitfalls that could jeopardize their stability.
