A Bank is a financial intermediary that acts as an economic firm producing goods and services. With this view in mind it’s easy to see that a bank exists to make a profit. In order for a bank to be successful and make a profit, it has to take risk. A bank that is averse to risk will be a stagnant institution unable to adequately serve its customers effectively and produce a profit. However, a banking institution that takes excessive or unnecessary risk is also likely to run into trouble. All risk is uncertain but with bounds the probability of an outcome can be predicted using expectation. A bank can also run into trouble if it decides to take a risk but incorrectly fails to calculate the expectation and probability of that risk, if it fails to correctly price this risk, or even both of these, as was the case in the current financial crisis.
Banks are faced with a number of different risks. The first of these is the Credit Risk. The Basel Committee on Banking Supervision defined credit risk as, ‘the potential that a bank borrower or counter party will fail to meet its obligations in accordance with agreed terms’. This is the risk that a borrower, someone who has taken out a consumer credit product with the bank, will not be able to repay the debt under the terms of the original loan agreement (Bad debts). Obviously this is a problem for the bank, as it will result in a fall in the expected assets of that bank, therefore possibly meaning that the bank has a greater level of liability than assets.
To manage credit risk banks can employ various strategies. To start with they try to predict the consumers’ behaviour before the loan agreement is made. By using stringent vetting processes to sort out and deny borrowing to those most likely to default on their loan they can protect themselves from the majority of credit risk. This process is done in the form of credit scoring. The bank will often then further vet the potential borrower using the well-known lending acronym CAMPARI (Character, Ability, Means, Purpose, Amount, Repayment and Insurance). A well-run bank will then continue to further monitor the borrowers behaviour once the loan has been made; this is referred to as the ‘going concern’ approach. The idea of this is to tackle the issue banks face risking of moral hazard. The risk, in this case the potential to default, may change once the loan has been made, either due to external factors or through the deliberate actions of the consumer to gain a financial advantage.
The bank can also improve its ability to predict the possibility of default by spreading its loan portfolio over a large number of borrowers. This is the tactic of making a large number of small loans as opposed to a small number of larger loans. By doing this the bank is able to rely more closely on the law of large numbers. The law of large numbers states that a group behaves more predictably than an individual. This means that the number of consumers that default on their repayments is far closer to the average expected amount. To make this method work effectively though, the bank needs to make sure that the default risk of each loan customer is independent. To do this the bank will diversify the loans it gives out over a large number of different types of borrower. The bank will then use its calculated risk to estimate the level of loss it will receive from consumers defaulting and add a risk premium to the cost of the consumers’ loan. This risk is calculated predominantly considering three general factors: the historical loss rate on loans and investments, the expected loss rates in the future and finally the banks stance on how to weather the loss. These factors contribute to calculating the risk premium that needs to be added. If calculated and priced correctly this risk premium should ensure that the bank doesn’t make a loss at all even if...