It’s been a decade since the global financial crisis of 2008-2009, but has it taught us anything? Doesn’t seem like it, given that banks are still considered by many as a stable, if somewhat boring, way to save and invest their funds. However, if the collapse of Lehman Brothers and even before that, Barings Bank, can teach us anything, it is that banks are exposed to some inherent risks. Here’s what you should know.
1. Operational Risk
The Bank of International Settlements (BIS) defines operational risk as “the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.” Banks are exposed to this type of risk, for a large part, due to human error. For example, incorrectly filled information or leaked sensitive information, as a result of system failure. Inaccurate data processing or programming errors and instances of hacking can also lead to this type of risk. This is the risk that led to the collapse of one of the oldest banks of the UK, Barings Bank. And, given that banking institutions are increasingly digitising their processes, operational risk is only likely to be present.
2. Credit Risk
BIS defines credit risk as “the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms.” So, this type of risk is the result of loans, interbank transactions, forex transactions, trade financing, financial futures, options, swaps, and even extension of guarantees or commitments. Simply put, this is what the subprime crisis in the US was all about. Borrowers defaulted on loans, leading to banks facing severe credit risk. Even defaulting on credit card bills can lead to this type of risk. One of the ways banks can protect themselves against credit risk is to hike interest rates on loans, which in turn makes it difficult for borrowers to repay. When it comes to interbank transactions, loss can occur when the transaction is unsuccessful or delayed at one end.
3. Liquidity Risk
Staying with the BIS definitions, banks face liquidity risk due to their role in the “maturity transformation of short-term deposits into long-term loans… both of an institution-specific nature and that which affects markets as a whole.” So when an investment fails to be marketable, which means that it cannot be bought or sold quickly, so that loss is either prevented or minimised, banks face liquidity risks. It can go so far as to come in the way of banks being able to conduct day-to-day transactions. Imagine a situation where you go to the bank to withdraw money that is rightfully yours, only to realise that the bank cannot fulfill its commitment to you. This is what happened to some banks during the 2008-2009 crisis.
4. Market Risk
Changes in central bank interest rates, stock prices, credit spreads, forex rates and more can lead to losses in a bank’s trading book, exposing the institution to market risk. BIS defines market risk as “as the risk of losses in on-balance or off-balance sheet positions that arise from movement in market prices.” Banks that are active in the capital markets are at higher market risk. And, some of the biggest names in the banking world, such as Bank of America, Goldman Sachs and JPMorgan, are exposed to market risk due to their market participation. Market risks can be of various types, including interest rate risk, equity risk, commodity risk and currency risk.
5. Business Risk
This occurs at times when the institution witnesses lower than expected profits or experiences a loss in its business. The best way to minimise business risk is to be flexible with business strategies and quickly adapted to changing market conditions. However, banks have never been known to be agile or flexible. The banks that collapsed during the 2008-2009 crisis were ones that didn’t have adequate risk management measures in place.
6. Systematic Risk
This is the risk that impacts the entire financial industry, rather than just a single financial institution. Systemic risks arise out of cascading failures, where a large financial institution crashes, affecting all other institutions in the industry.
Along with all these risks, having money in low-interest bank accounts is a risk in itself. The risk of devaluation, where the interest earned is less than the inflation rate. So what is the solution for the common investor? This is where multi-strategy funds can prove to be very useful. Some of the best managed multi-strategy funds have given their investors double-digit returns, even during the global financial crisis of 2008-2009. This is because investments are chosen and monitored using cutting-edge technology, to ensure the best possible returns, as well as minimizing risk.