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Measuring Risk in Banking

Risk to a banker means the perceived uncertainty connected with some event.

Bankers are concerned with six main types of risk:

1. Credit risk

2. Liquidity risk

3. Market risk

4. Interest rate risk

5. Earnings risk

6. Solvency risk

Credit risk

The danger of default by a borrower to whom a bank has extended credit.

The following are four of the most widely used indicators of bank credit risk:

The ratio of nonperforming assets to total loans and leases.

The ratio of net charge offs of loans to total loans and leases.

The ratio of the annual provision or loan losses to total loans and leases or to

equity capital.

The ratio of allowance for loan losses to total loans and leases or to equity capital.

Liquidity risk

The danger of having insufficient cash to meet a banks obligations when due.

Other indicators of a banks exposure to liquidity risk include the ratios of:

Net loans to total assets.

Cash and due from deposit balance held at other banks to total assets.

Cash assets and government securities to total assets.

Market risk

The danger of changing market values of bank assets, liabilities, and equity that may

bring about loss.

The ratio of a banks book value assets to the estimated market value of those

same assets.

The ratio of book- value equity capital to the market value of a banks equity

capital.

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The market value of a banks bonds and other fixed- income assets relative to

their value as recorded on the banks books.

The market value of a banks common and preferred stock per share, reflecting

investor perceptions of the banks risk exposure and its earnings potential.

Interest rate risk

The danger that shifting interest rates may adversely affect a banks net income, the value

of its assets, or equity.

The ratio of interest- sensitive assets to interest- sensitive liabilities: when

interest-sensitive assets exceed interest sensitive liabilities in a particular maturity

range, a bank is vulnerable to losses from falling interest rates. In contrast, when

rate-sensitive liabilities exceed rate-sensitive assets, losses are likely to be

incurred if market interest rates rise.

The ratio of uninsured deposits to total deposits, where uninsured deposits are

usually government and corporate deposits that exceed the amount covered by

insurance and are usually so highly sensitive to changing interest rates that they

will be withdrawn if yields offered by competitors rise even slightly higher.

Earnings risk

The danger that a banks rate of return on assets or equity or its net earnings may fall.

Standard deviation () or variance (2 ) of after- tax net income.

Standard deviation or variance of the banks return on equity (ROE) and

return on assets (ROA)

Solvency (or Default) Risk.

Solvency risk the danger that a bank may fail due to negative profitability and erosion of

its capital.

The interest rate spread between market yields on bank debt issues (such as

capital notes and CDs) and the market yields on government securities of thesame maturity. A widening in that spread indicates that investors in the market

expect increased risk of loss from purchasing the banks securities.

The ratio of a bank's stock price to its annual earnings per share. This ratio

often falls if investors come to believe that a bank is undercapitalized relative to the

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risks it has taken on.

The ratio of equity capital (net worth) to total assets held by the bank, where

a decline in equity funding relative to assets may indicate increased risk

exposure for the bank's shareholders and debtholders.

The ratio of purchased funds to total liabilities. Purchased funds usually

include uninsured deposits and borrowings in the money market from other banks,

corporations, and governmental units that fall due within one year.

The ratio of equity capital to risk assets held by the bank, reflecting how

well current hank capital covers potential losses from those assets most likely to

decline in value.

Other Forms of Risk in Banking

Inflation riskthe probability that an increasing price level for goods

and services (inflation) will unexpectedly erode the purchasing power of

bank earnings and the return to shareholders.

Currency or exchange rate riskthe probability that fluctuations in

the market value of foreign currencies (the dollar, pound, yen, etc.) will

create losses for the bank by altering the market values of its assets and

liabilities.

Political riskthe probability that changes in government laws or

regulations, at home or abroad, will adversely affect the bank's

earnings, operations, and future prospects.

Crime riskthe possibility that bank owners, employees, or customers

may choose to violate the law and subject the bank to loss from fraud,

embezzlement, theft, or other illegal acts.