Bank Financial Risk

Understanding how banks fund their operations is critical to assessing their stability. In this video GICP trainer Jo Lock explores the liability side of the balance sheet, examining liquidity risk in deposits, refinancing challenges in wholesale funding, capital adequacy requirements, and why balancing business and financial risk is essential for bank resilience.

Read the transcript

Hello, and welcome to this short learning video on bank financial risk, focusing on the liability side of the bank’s balance sheet.

To connect strategic choices to exposures and exposures to outcomes, watch our other short videos on business risk and performance risk.

While the asset side deals with loans, investments, and trading activities, the liability side shows how a bank funds these assets. The main components here include customer deposits, wholesale borrowings, and sometimes capital market instruments.

Understanding the risks in these areas is essential for credit professionals, because weaknesses here can threaten the bank’s ability to operate safely.

Let’s start with customer deposits. These are funds that individuals and businesses place with the bank, usually in the form of savings, current, or fixed deposit accounts. Deposits are typically the largest and most stable source of funding for banks. However, there is liquidity risk – if too many depositors want to withdraw their money at the same time, the bank may struggle to meet these demands, especially if it has invested in assets that cannot be sold quickly. This situation is known as a “bank run,” and it can happen if depositors lose confidence in the bank.

Next, we have wholesale borrowings. These are funds banks raise from other financial institutions, such as short-term loans or issuing bonds. The main risks here are refinancing risk and interest rate risk. Refinancing risk means the bank may not be able to roll over its borrowings when they come due, especially if market conditions are tight or the bank’s credit quality has deteriorated. Interest rate risk arises if the cost of borrowing goes up sharply—for example, if market interest rates rise—making it more expensive for the bank to fund its activities.

Banks may also use capital market instruments, such as bonds, subordinated debt or hybrid securities, to raise longer-term funds. While these can strengthen and diversify the bank’s funding mix, they also create capital risk. If the bank faces large losses from its assets, its ability to repay these capital market instruments or maintain required capital levels can be affected. Some capital market instruments may be ‘bailed in’ if a bank is failing or is close to failing and investors will lose their money. Regulators require banks to hold a minimum amount of capital to absorb losses and protect depositors, so falling below these levels can result in penalties or restrictions.

Another important risk on the liability side is concentration risk. If a bank relies too heavily on a few large sources of funding—such as major corporate depositors or a single market for raising funds—it can become vulnerable if these sources dry up or withdraw their money unexpectedly. This is what happened with Silicon Valley Bank in the US in 2023.

In summary, the liability side of a bank’s balance sheet is exposed to several key financial risks: liquidity risk if deposits are withdrawn quickly, refinancing and interest rate risk in wholesale funding, capital risk in maintaining regulatory standards, and concentration risk from over-reliance on specific funding sources. If these risks are not managed properly, the bank could face cash shortages, increased funding costs, or even regulatory intervention, threatening its financial health and stability.

Understanding and managing these financial risks is essential for credit professionals and vital for the safe operation of any bank.

So, combining what we have learnt today on financial risk, with our previous learning session on business risk, what is the optimum combination of these two risks for banks?

Balancing these risks involves maintaining a diversified revenue base and prudent cost management to mitigate business risk while adopting a conservative approach to capital, leverage and funding to manage financial risk. Excessive business risk, such as investing in risky assets or making too many bad loans can impair earnings and cause losses, while high financial risk, often due to heavy dependence on debt, inappropriate funding strategies or low capital levels, can strain liquidity and solvency during market downturns.

The optimal mix is achieved when a bank matches its risk appetite and strategic objectives with its ability to absorb losses. This means aligning risk-taking activities with robust risk management frameworks, maintaining adequate capital buffers, and ensuring access to stable funding. A bank should not have high business risk and high financial risk at the same time. One must balance out the other.

Ultimately, a prudent balance between business and financial risk supports resilience, investor confidence, and regulatory compliance, enabling the bank to withstand adverse conditions and capitalize on growth opportunities.