By Harrison Heaton
Risk is at the core of the entrepreneurial spirit and is what keeps investors in the pursuit of the highest returns available. However, when commercial banks get too ambitious, multiple risk factors come into play that have the potential to harm the financial institution and go on to put a dent in the whole economy in doing so. Interest rate risk, default risk, market risk, etc. all play a factor into the everyday danger that commercial banks have to deal with. However, When it comes to impacting the financial institution the most, and making them have some sweat on their eyebrows, it is credit and market risk.
When it comes to commercial banks, one of the biggest issues they face is issuing out credit to countless borrowers with the potential loss that comes from failure to repay the loan, mortgage, credit card balance, etc. The concept of the lender issuing out the capital to the borrower and not receiving their payments disrupts the cash flow coming into the lender. Obviously if you are issuing a loan to a borrower, you can't determine whether they will default on the loan payments or not but you put your trust in them based on factors such as the 5 “C’s” to determine higher or lower risk. These 5 “C’s” are Credit History, Capacity to Repay, Capital, the loan’s Condition, and associated Collateral. Technology and risk assessing departments have become more and more advanced, yet there is still a great deal of risk and uncertainty when it comes to loaning to numerous borrowers every day.
This is not a hypothetical. Credit risk has played huge parts in the decline of the entire United States financial system as we can see in the most recent example of the 2007-2008 financial crisis. In the previous years leading up to the financial crisis, banks and other lenders lent huge sums of capital in the method of subprime mortgages to very high risk borrowers with a much more lenient approach to assessing the risk, which led to much more payment default on loans and mortgages. When the economy slowed in 2006/2007, many of the borrowers that received these loans defaulted on their payment or couldn't repay a majority of the debt they acquired. This and a combination of the poor effort to account for risk wrecked the US economy and nearly made the entire global economy take a hit.
We have learned from the past however. Financial regulation has allowed financial institutions to take a much larger stance on their capital position, holdings, and higher tier 1 capital ratios. Yet in hindsight, it is 2021 and we just had one of the world’s deadliest pandemics to date and credit risk was underlying all the fear and uncertainty that came with it. In the first 3 months of the pandemic, banks have been adapting and adjusting to the changing times and exploring new approaches to the financial challenges that are inevitably going to happen and have already started snowballing into issues. It all depends on which sector you have business in and depending on the sector the changes in creditworthiness vary to a greater degree. Certain industries such as the food/beverage industry faced increased demand and therefore “did better” during the crises, but some industries got hit really hard. Travel, tourism, and hospitality were negatively affected and tanked immensely and faced financial hardship due to uncertainty.
In the depiction above, we can see a heat map that illustrates the intensity level of an income shock represented by the different color circles. Then further, each circle has a letter that corresponds to a sector within the market. The x axis has time to recover, and as we can see there are sectors that have had huge income intensity shocks and align over the slow section of the x axis meaning they got hit hard and it will be a while until they recover. You can see the sectors above, but the main point about how credit risk applies to these sectors. When businesses no longer have the same inflow of cash coming in, they need to resort to using other funds or applying cut backs on how they operate their business making it harder to pay the business loans and debt they took on. Small businesses took the roughest toll and default rate almost hit a record high of 5% in some states, meaning 1 out of every 20 business loans did not pay their debts in a timely manner.
With all this being said, credit risk is not the only potential downside that financial institutions/commercial banks have to meddle with. Market risk is also omnipresent and occurs when there are arising movements in prices or volatility within the market that affect the financial institutions holdings and investor portfolios. Market risk refers to the overall performance of the economy as a whole which contrasts sector or business specific risk such as credit risk above. Market risk is a very large umbrella that encompasses all different types of risk. Market conditions are conditional on numerous factors which include equity, commodity, interest, inflation and some other types of risk. Equity risk is the potential changes in share prices, commodity risk is when the price of a certain good that plays into the economy changes, interest rate risk being when the price to acquire debt through loans/mortgages go up, and inflation risk being where rises in the price of certain goods or services will undermine the value of money and adversely affect investments. All of these are considered branches underlying market risk and a combination of them can be very harmful to the well being of the entire free market.
However, with this being said and having numerous aspects that could bite you in the butt, market risk is actually not very prominent with adequate risk mitigation. Of course, in anything in life, it is impossible to eliminate all risk involved in something especially when it comes to the thing that motivates the free world I.E money. Yet, diversification is your best friend to lowering the likelihood of loss. With that being said, that is if you have a well balanced portfolio and time to plan ahead for financial declines, however some market risk you just can't avoid and it will affect the value of your investments in one way or another. Natural disasters, terrorist attacks, political polarization, recessions, foreign leader agendas, etc. all have a direct tie to your investment in some way or another.
Out of your hand risk is what I like to think of this type of risk. As much as you do to try and secure a proper risk management strategy such as diversification, which is always good to do, there are just some global and event and specific factors with the market that you can not avoid, which is encompassed in market risk. So for commercial banks, they have had huge losses on their investments and negative externalities on their equity, liquidity, credit, etc. that all result from an unexpected hardship and time of great distress such as the 2001 terrorist attack on the world trade center or twin towers. No one would have expected to wake up on September 11th, 2001 and view the horror that pursued on that day. Yet, sure enough this horror and tragedy compounded into more than just a terrorist attack, influencing the entire market negatively and causing an economic decline. Now, American were worried about terrorism and their finanical positions.
Again, risk and reward are two perfectly correlated concepts that are ever present in the field of investing and the market. Investors everyday are in the pursuit of higher than the average return, but risk keeps these investors humble. Credit risk and market risk are two huge motivators in the economy being sector specific with credit risk and overall economy specific with market risk. They are present and have a string attached to your money without you even knowing it, so do what you will with the information given to you, but always have the awareness that anything can happen which affects you and your life.
Work Cited
“What Is Market Risk? Definition and Meaning.” Market Business News, 23 Feb. 2019, https://marketbusinessnews.com/financial-glossary/market-risk/.
“Credit Risk Definition.” Bankrate, https://www.bankrate.com/glossary/c/credit-risk/.
“Principles for the Management of Credit Risk.” The Bank for International Settlements, 27 Sept. 2000, https://www.bis.org/publ/bcbs75.htm.
Nickolas, Steven. “What Are the Primary Sources of Market Risk?” Investopedia, Investopedia, 13 Sept. 2021, https://www.investopedia.com/ask/answers/042415/what-are-primary-sources-market-risk.asp.
“Market Risk.” Corporate Finance Institute, https://corporatefinanceinstitute.com/resources/knowledge/trading-investing/market-risk/.
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