Must-know: Understanding credit risk in the banking business

Market Realist

An investor's guide to banking risks (Part 5 of 14)

(Continued from Part 4)

Credit risk

The Basel Committee on Banking Supervision (or BCBS) defines credit risk as the potential that a bank borrower, or counter party, will fail to meet its payment obligations regarding the terms agreed with the bank. It includes both uncertainty involved in repayment of the bank’s dues and repayment of dues on time.  

All banks face this type of risk. This includes 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).

Dimensions of credit risk

The default usually occurs because of inadequate income or business failure. But often it may be willful because the borrower is unwilling to meet its obligations despite having adequate income.

Credit risk signifies a decline in the credit assets’ values before default that arises from the deterioration in a portfolio or an individual’s credit quality. Credit risk also denotes the volatility of losses on credit exposures in two forms—the loss in the credit asset’s value and the loss in the current and future earnings from the credit.

Banks create provisions at the time of disbursing loan (see Wells Fargo’s provision chart above). Net charge-off is the difference between the amount of loan gone bad minus any recovery on the loan. An unpaid loan is a risk of doing the business. The bank should position itself to accommodate the expected outcome within profits and provisions, leaving equity capital as the final cushion for the unforeseen catastrophe.

An example of credit risk during recent times

During the subprime crisis, many banks made significant losses in the value of loans made to high-risk borrowers—subprime mortgage borrowers. Many high-risk borrowers couldn’t repay their loans. Also, the complex models used to predict the likelihood of credit losses turned out to be incorrect.

Major banks all over the globe suffered similar losses due to incorrectly assessing the likelihood of default on mortgage payments. This inability to assess or respond correctly to credit risk resulted in companies and individuals around the world losing many billions of U.S. dollars.

Continue to Part 6

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