Classification of risks in corporate banking
Category: Corporate Banking
1. Credit Risks: Only one Category of Risks a Bank has to cope with
All this shows that commercial banking is much more than «only» taking deposits and handing out loans. In view of the enormous financing needs of the banks target groups, however, lending will remain one of the most important business sectors of a commercial bank. Even more, the professional management of the risks associated with lending has become a key competence that is crucial for a bank’s very survival. Whereas, in former times (which ended in the early nineties), loan loss provisions were widely considered as hidden reserves whose book value was less than their actual realizable value, today many loan loss provisions result in write-offs, i.e. real losses to the bank.
Credit risk is inherent to lending. Taking calculable risks is the very nature of lending. Although its importance has grown during recent years, there are still a number of other types of risk that can represent far greater threats to a bank’s business:
2. Electronic Systems and Networks
Astonishingly, leading international banks don’t consider credit risks the most threatening factor to their stability. Far more important is the reliability and security of their computer based data processing and clearing systems which worries e.g. the US investment bank J. P. Morgan more than bad loans, market risks or even derivatives. According to the US Comptroller of the Currency, a failure of a bank’s electronic systems over only one to two days can get this bank into serious trouble. Annual reports in the recent year have therefore stated for the first time that comprehensive electronic backup systems have been established to counter the threat of computer failure. But, meanwhile, an even greater danger may be about to arise. Ever more companies, individuals and government agencies are electronically linked via information highways — a trend that is certain to continue as demonstrated by the spectacular rise of the Internet giving 35 to 40 million people access to the so called information super highways. Although the Internet opens up whole new dimensions for business, anyone doing any transactions on such an open unsecured electronic network should be aware of its dangers, such as the uncontrolled spread of viruses, logic bombs and other devices that can totally cripple computer systems — for example those of a bank.
3. Derivatives
Next come risks associated with derivatives. For many, these highly complex financial innovations are still difficult to assess. Generally accepted accounting and auditing principles are still being developed. Derivatives are still not explicitly shown in a bank’s balance sheet itself, but only in the appendices. The notional volume of derivatives often exceeds a bank’s total assets. So, Deutsche Bank in 1993 had derivatives totaling 1341 billion DM and total assets of 557 billion DM. A study conducted by Germany’s Federal Bank revealed that in Germany derivatives accounted for 83 percent of total bank assets at year-end 1992. In 1993, derivatives totaled for more than 14000 billion US dollars. Since these enormous amounts are concentrated in the hands of only a few international banks, experts fear that the collapse of one of these global players could lead to the breakdown of the whole banking system. Although the collapse of the British bank Barings has proved that a bank can fail because of the risks inherent in derivatives, the rest of the banking system remained mainly unaffected.
Bank regulators view derivatives from different perspectives. Some board members of Germany’s Federal Bank compare derivatives with gambling. The American Securities and Exchange Commission, however, concedes that derivatives can indeed moderate the effects of dramatically changing foreign exchange rates or stock or bond prices. Thus, they can help to prevent a crash in the markets. This applies when derivatives are not — as often happens — used for speculative reasons but for hedging risks deriving from another transaction. To correctly assess the risk posed by a derivative transaction, banks use the so called credit equivalent. This indicates the amount of money the bank is going to loose if its counterparty becomes unable to meet its obligations. This credit equivalent amounted to 2.15 percent of the nominal volume traded in derivatives, a number much more manageable than the 14000 billion US dollars mentioned before.
4. Credit Risks
Finally, corporate credit risks have to be taken into consideration. And here, the risks derived from mortgages account for a disproportionately large amount of all corporate loans that turned bad. This is highlighted by some spectacular real estate crashes, such as the failure of real estate developer Olympia & York which built much of London’s modern skyline. In Germany, the bankruptcy of the union-owned housing society «Neue Heimat» became infamous. Neue Heimats financing bank was left bankrupt in the wake of the company’s disaster.
Risks arising from lending to corporations, however, are the very nature of a corporate bank’s business. There is no such thing as lending without taking risks. So, a commercial bank must focus its activities on:
— acquiring clients with good creditworthiness and enhancing their proportion of the bank’s loan portfolio
— properly assessing the risks associated with lending to its corporate clients
— managing the bank’s overall exposure to corporate credit risks as represented in the loan portfolio
— setting up clear guidelines on what to do in case of a clients bankruptcy
— achieving a price for its loans that is adequate for the risk the bank is exposed to by the individual loan.