Everything you need to know about bank risks

Like any business, the banking sector faces several risks. However, given the sector's systemic importance, it's important that bank risks are properly understood and addressed. Since banks are custodians of public money, governments also have a stake in keeping bank risks in check.

Bank risks can be broadly divided into two categories. One is macro level, or systemic, risk, which happens when the entire banking system faces trouble. A perfect example would be the 2008 financial crisis. The other is a bank-specific issue. Here, we can cite Wells Fargo's example. The bank recently came under scrutiny for some of its business practices. Deutsche Bank has also been facing trouble. Systemic risks could arise from the occurrence of some expected or unexpected events in the economy or the financial markets. Micro risks could arise from staff oversight or mala fide intention, causing erosion in asset values and, consequently, reducing the bank's intrinsic value.

The money a bank lends to a customer may not be repaid due to the failure of a business. It may also not be repaid because the market value of bonds or equities may decline due to an adverse change in interest rates or a downturn in the economy. Another reason for non-repayment is that the counterparty may default on the derivative contract. These types of risks are inherent in the banking business.

There are many types of risks that banks face:

Credit risk, Market risk, Operational risk, Liquidity risk, Business risk, Reputational risk, Systemic risk, Moral hazard. Systemic risk is the most nightmarish scenario for a bank. This type of scenario happened across the world in 2008. Broadly, it refers to a scenario in which the entire financial system might come to a standstill. The default or failure of one financial institution can cause a domino effect, threatening the stability of the entire system. For instance, in 2008, the Lehman Brothers' collapse triggered a massive sell-off in the banking sector.

An analogy of systemic risk would be an epidemic that required large-scale safeguards for public health. It's a critical risk, as it's generally not limited to a single bank but rather to the broader banking and financial sector. Smaller banks are more affected by systemic risk because they generally have weaker capital bases and less access to money markets. The only things a bank can do to avoid such risks are to have a strong capital base and best-in-class processes and internal checks.

Moral hazard is the most interesting bank risk. You've likely read or heard the phrase "too big to fail." Too big to fail is nothing but moral hazard, in a sense. Moral hazard refers to a situation in which a person, a group, or an organization is likely to have a tendency or a willingness to take high-level risk, even if it's economically unsound. The reasoning is that the person, group, or organization knows that the costs of such risk-taking, if they materialize, won't be borne by the person, group, or organization taking that risk.

Economists describe moral hazard as any situation in which one person makes the decision about how much risk to take, while another bears the costs if things go bad. A very succinct example of moral hazard was the 2008 subprime crisis. After the meltdown precipitated by the crisis, taxpayers' money was used to bail companies out.

This type of situation would likely alter executives' behavior toward risk-taking. Executives would think that even if they took very high risks, they wouldn't have to bear the costs of such behavior. A good organizational culture and giving credence to high ethical standards can help address this kind of risk-taking. A bank must also have a strong board of directors to oversee management and take remedial measures when necessary.