Bank Business Risk

Understanding the risks on a bank’s asset side is fundamental to effective credit analysis. In this video, GICP trainer Jo Lock explores credit risk in loan books, market risk in trading portfolios, and the critical importance of proper risk management.

Read the transcript

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

To understand the exposures they produce and the results they drive, watch our videos on financial risk and performance risk.

Every bank’s balance sheet has two main sides: assets and liabilities. Today, we’ll look at the asset side, which includes the loan book, trading book, and investment portfolio. Understanding the risks in these areas is crucial for credit professionals, as problems here can lead to significant losses for banks.

Let’s start with the loan book. This is typically the largest asset for most banks and consists of loans made to individuals, businesses, governments and other institutions. The main risk in the loan book is credit risk – the risk that borrowers will not repay their loans in full and on time, as agreed. This could be due to financial difficulties such as cash flow problems, business failure, or economic downturns.

If borrowers default, the bank may lose both the interest income and all or part of the principal amount lent. If only one or two borrowers default, the loss may be manageable. However, if many borrowers default at the same time – for example, during a recession – the bank could face severe losses. If defaults happen on a large scale, the bank could lose a significant amount of money, both from unpaid loan amounts and lost interest income. These severe losses can impact the bank’s profits, reduce its ability to lend, and even threaten its stability.

Other risks in the loan portfolio include concentration risk, where the bank is exposed to a few large borrowers or industries, and collateral risk, if the assets securing the loans lose value, for example houses used as collateral for residential mortgage lending.

Next, let’s look at the trading book. This includes assets that are held for short-term trading, such as bonds, stocks and shares, or derivatives. The main risks here are market risk and liquidity risk.

• Market risk means that the value of these assets can fluctuate due to changes in interest rates, exchange rates, or market sentiment. For example, if the price of government bonds falls sharply, the bank may have to recognize trading losses.
• Liquidity risk arises if the bank cannot sell these assets quickly without taking a loss, particularly in stressed market conditions.
• There’s also counterparty risk – the risk that the other party in a trading transaction will not fulfill their obligations and may even default.

Finally, the investment portfolio consists of longer-term holdings, such as government securities, corporate bonds, and sometimes equities. These are generally considered safer than trading assets, but they still carry risks.

• Interest rate riskis key here; if interest rates rise, the value of existing fixed-rate investments falls.
• There’s also credit risk, if the issuer of a bond or security fails to pay interest or repay principal.
• Sometimes, banks invest in structured products or complex securities, which may look safe on the surface, but can carry hidden risks that may not be apparent until market conditions change.

In summary, the asset side of a bank’s balance sheet is exposed to various risks: credit risk in the loan book, market and liquidity risk in the trading book, and interest rate and credit risk in the investment portfolio.

Banks face several types of risks in their assets—such as credit risk in their loan book, market risk in their trading book, and interest rate risk in their investment portfolio.

Managing these risks means having processes and controls in place to understand, measure, and reduce the chance of losses. This could include careful lending standards, monitoring market movements, diversifying investments, and setting aside money to absorb potential losses.

If a bank does not manage these risks properly, problems can quickly grow. If losses are large, the bank might not have enough profits or reserves to cover them.

Significant losses can weaken the bank’s financial health by reducing its profits, eroding its capital base, and even making it difficult for the bank to continue its day-to-day operations. In extreme cases, poor risk management can lead to a bank failing or needing help from regulators to protect customers and the wider financial system.

In summary, without proper risk management, the risks on the asset side of the bank’s balance sheet can cause big losses that put the bank’s stability and future at risk.

Understanding these risks is a foundation for good credit analysis and risk management.