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Banking Risk

A bank's core business, credit activity, is centered on borrowing and lending, thus mainly dealing with two components: money and risks.

The first component, money, seems to be the simplest to measure, as all balance sheets and income statements report only money values. In fact, the different contracts, timing, and liquidity require much more attention than expected.

Every economic activity implicitly includes risk, as the economic framework always includes uncertainty. But a bank's activity is centered on risk, as its core business is in borrowing money, and lending it, bearing all risks of counterpart: default, maturity transformation, market values variation, liquidity, and so on.

Diverse layers of bank activity are cross-linked, and take part in maintaining the equilibriums in terms of revenue, economic stability, and operational activity. As a consequence, the bank's activity analysis is always complex.

The ways for analyzing credit activity are multiple.

On one hand, the banking activity is a specification of firms management, so it can be analyzed with the same attitude in terms of internal processes, costs and income, business models, personnel management, and so on.

Another possibility is to evaluate the activity results of banks from the outside, by means of regression analyses, so as to find a posteriori a description of their actual activity, results, and business models distribution and evolution.

Banks play a key role in financing the real economy, thereby sustaining and promoting the economic growth; their activity is often considered to be of national interest, and in some countries it is directly held by public companies.

In fact, the credit support of a firm or sector can substantially change its evolution and growth; choosing which firm to finance or which sector to support can be in some cases more effective than some public policy interventions.

Other fundamental aspects of banks activity are related to the volume of money managed in stock exchange and bonds markets, where the buying and selling activity can significantly affect values. Even when considering issuers of large dimensions, as in the case of sovereign bonds, the bank's attitude to buying or holding bonds to maturity can be of fundamental importance, and often the interest of governments in keeping the availability of banks in this can sometimes affect the government policy toward the banking sector.

This key role in sustaining the economic growth and the fact that banks are typically large firms induces specific attention toward the bank's activity, as the banks' default not only stops the support of economic growth but also can induce huge effects of market instability, lack of confidence in banks and in savings, bank runs, and disruptive effects on the real economy.

Thus, the analysis of a bank's activity, and of its different layers and interconnections, and the supervision and regulation of banks, are of fundamental importance for preserving savers' confidence in banks, the bank's action in channeling savings to firms, thus sustaining economic growth and preserving economic and financial stability.

The credit activity also carries a specific characteristic, as it involves buying and selling money-different maturity, contracts, risks, but always money. There is no actual goods production or transformation. This simplifies some aspects, but also induces a greater interrelationship between the different activity layers; so, as an example, there can be no strict separation, as it happens in industrial or commercial activities, between real goods or services production, and financial activities.

At a first glance, a bank's balance sheet seems to be quite similar to any other firm's balance sheet: The assets side mainly includes customer loans, bonds, interbank credits, and some other assets such as cash, buildings, and so on. As banks do not buy, transform, or sell goods, there is no motivation for quantifying the values of goods at the beginning and end of each year. The liabilities side includes deposits, interbank debts, issued bonds, and capital.

A more significant difference with respect to nonfinancial activities, such as the industrial activity, appears when comparing the assets side with the income statement: For banks, the total revenue is only a fraction of total assets, while industries typically register sales revenues in value closer to the total assets.

As an example, the FCA 2015 group's consolidated balance sheet1 reports total assets of ?105,040 million, equity of 16,255 (15.5% of TA), and net revenues of ?110,595 million (105% of TA), while the Deutsche Bank 2015 balance sheet2 reports total assets of ?1,436,029 million, capital of 45,828 (3.2% of TA), and main income values (interest income, current income, commission income, and other operating income) summing up to a total of ?31,086 million, around 2% of total assets.

It is evident that when analyzing a bank's activity, our attention is more on the assets volume than on income. It is worth noting that Germany's GDP for 2015 was estimated to be ?3,025,900 million,3 while Deutsche Bank's total assets in 2015 were about 47% of its home country's GDP.

This assets dimension also explains why risks are so significant in banking activity. Referring to the values above, a reduction of 3.5% in value for FCA assets will reduce the equity value from 15.5 to 12.4% of total assets, while in the case of Deutsche Bank the capital will be completely wiped out.

Another signal of banks' central role is shown by the number of governments' interventions in rescuing banks during financial crises: Interventions on capital are absolutely fundamental when a large bank is likely to fail, and the cost of nonintervention is typically much higher than the cost of capital injection needed for rescuing the bank.

In fact, not only can the effects of uncertainty in assets and liabilities deeply affect income, and thus banking stability, but also dealing with risks is the basis of the banking activity.

So, even if the primary focus with respect to a bank's activity is toward their assets value, the uncertainty of values intrinsically inherent in the lending activity is the key reference for understanding why banking is almost a synonym for risk management.

1.1 Single Bank Risk

The first reference for analyzing a bank's activity is in considering its balance sheet main values.

(JPMorgan Chase & Co./2015 Consolidated Annual Report)

Starting from the assets side (Table 1.1), the most important exposure of banks is for customer financing, by means of loans.

Table 1.1 Bank balance sheet: assets.

Loans are the traditional banks' core business, which brings a fundamental part of revenues and carries the most significant risks.

In fact, the main activity of banks consists in evaluating whom to lend money, how, and how much to lend. Analyzing a firm's balance sheets, cash flows, and tendencies (hard information), or verifying the firm's reputation, management capabilities, and reference market stability (soft information) are some of the important ways of evaluating the firm's credibility: that is, if there is a strong probability that the firm will meet its obligations and pay back the debts as scheduled.

It is evident that this evaluation cannot be exact. On one hand, it depends on future events that are not possible to forecast exactly, and moreover speculating the reactions of the firm management on these unforeseeable events will be even more difficult. On the other hand, it is not possible to analyze in depth all the firm's aspects and details, and this intrinsically results in widening the confidence intervals of the creditworthiness estimation.

As a consequence, it is fundamental for banks to use all possible strategies to reduce the total risk of the lending activity.

The traditional, and still fundamental, strategy is based on diversification. In fact, if the exposures are affected by different risk sources, the total risk is lower than the sum of individual risks. In practice, this means that it is unlikely that all exposures will...