Major Risks Faced by Banks
The major risks faced by a bank include the following:
- Credit risk from defaults on loans or by counterparties.
- Market risk from declines in the value of trading book assets.
- Operational risk from external events or failure of internal controls.
Capital Requirements For Banks
To mitigate the risk of bank failures caused by losses on loans or trading assets, banks must be funded by adequate sources of capital. Banks and their regulators may have different views about how much capital is sufficient in light of the risks a bank faces.
Economic Capital vs. Regulatory Capital
Regulatory capital is the amount of capital that regulators require a bank to hold. This may include equity, or Tier 1 capital, and long-term subordinated debt, or Tier 2 capital.
Economic capital is the amount of capital a bank believes it needs to hold based on its own models. Regulatory capital is typically greater than economic capital.
Deposit Insurance and Moral Hazard
Deposit insurance exists to increase public trust in the banking system. However, it gives rise to moral hazard by decreasing the attention depositors pay to a bank’s financial health and increasing the level of risk a bank is willing to take when its depositors are insured.
Investment Banking Financing Arrangements
In a private placement, securities are sold directly to qualified investors. In a public offering, securities are sold to the investing public.
When assisting a securities issuer on a best efforts basis, an investment bank sells as much of the issue to the public as it can. In a firm commitment, an investment bank buys an entire issue of securities from the issuer for one price and resells the securities to the public for a higher price. A Dutch auction process may be used to determine a price for an initial public offering.
Potential Conflicts of Interest
Within a firm that provides commercial banking, investment banking, and securities services, inherent conflicts of interest exist. Information may be acquired in a commercial banking or investment banking transaction that would give the other units an unfair advantage. An investment bank’s task of selling newly issued stocks and bonds may conflict with a securities unit’s duties to act in the best interests of its clients and recommend trading actions independently.
Bank regulators generally require commercial banking, investment banking, and securities activities to be kept separate, either by preventing firms from engaging in more than one of these activities or by requiring Chinese walls between these units of a bank.
Banking Book vs. Trading Book
The banking book refers to loans made by a bank. The balance sheet value of a loan includes the principal amount to be repaid and accrued interest, unless the loan becomes nonperforming, in which case the value does not include accrued interest.
The trading book refers to assets and liabilities related to a bank’s trading activities. Trading book items are marked to market daily based on actual market prices when they exist or on estimated prices when necessary.
The Originate-to-Distribute Model
The originate-to-distribute model involves banks making loans and selling them to other parties, many of which pool the loans and issue securities backed by their cash flows. This model frees up capital for the originating banks and may increase liquidity in sectors of the loan market. However, it has also led to decreased lending standards and lower credit quality of the loans sold.
