Must-know: The consequences of imprudent risk-taking by banks

Market Realist

An investor's guide to banking risks (Part 3 of 14)

(Continued from Part 2)

Overview

We stated earlier that most banks are highly leveraged financial risk-takers. When things go awry, the results can be catastrophic, leading to huge losses or even to a bank closure. This is true for full-service banks like JPMorgan (JPM), traditional banks like Wells Fargo (WFC), investment banks like Goldman Sachs (GS) and Morgan Stanley (MS), or any other financials included in an ETF like the Financial Select Sector SPDR Fund (XLF).

Let’s look at a few instances from history to fully appreciate the type of losses a bank can incur.

Major losses due to risk-taking in 1980s

In 1987, Merrill Lynch lost $377 million through trading in innovative mortgage-backed securities. In 1989, the junk bond market collapsed, and so did the fortunes of Drexel Burnham Lambert, which had bet big on the junk bond market. Also in 1989, in the United Kingdom, Midland Bank lost a reported 116 million pounds by guessing wrong on the interest rate movements.

Major losses due to risk-taking in the 1990s

In 1991, the Bank of New England made massive bad debt provisions, suffered a run on deposits, and had to be supported by the government to the tune of about $2 billion.

In 1992 in the United Kingdom, Barclays Bank provided 2.5 billion pounds for bad and doubtful debts and declared its first loss in its history. In 1993, Credit Lyonnais succumbed to similar troubles and registered a net loss of 6.9 billion French franc (~834 million pounds), leading to government bailouts that year and then later in 1995.

In 1995, two dissatisfied customers sued Bankers Trust for sums totaling $200 million. This was because of disastrous swap contracts, which the bank had arranged for them. These claims were settled for lesser amounts out of court.

In 1996, the major Japanese banks wrote off a total of about 6,000 billion yen (~36.5 billion pounds) of bad debts accumulated from the preceding boom years.

Major events during the subprime crisis

We all know what happened during the subprime crisis, which was quite recent. Iconic institutions, such as Lehman Brothers, collapsed. Merrill Lynch had to be bought by Bank of America to continue operations. The government had to bail out Fannie Mae and Freddie Mac. Many other financial institutions had to seek money from the government to stay afloat.

All this just reminds us of the importance of understanding risk better, especially if you are an investor of the banking sector. This is what we’re going to cover in the rest of this series’ parts—the various types of risks in banking. Keep reading to know more about these types of risks.

Continue to Part 4

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