When handling our money, the three largest risks banks take are credit risk, market risk and operational risk.
Sound like jargon? Think of it this way: you have £100 pounds. You lend £20 to a friend, invest £50 in Bitcoin and leave the rest in your pocket.
What is credit risk?
Remember your friend who “forgot” to pay you back… two years ago?
People and companies who fail to pay back their debts pose the largest risk to banks. When lending money to someone, there’s always a chance they won’t pay you back. This is credit risk.
Banks have ways of reducing this risk. When you apply for a loan, the lender will look at what’s known as the five C’s: credit history, capacity, collateral, capital and conditions.
- Credit history, also known as character, is basically your track record for repaying debts.
- Capacity refers to your ability to repay a loan by looking at your job stability and your debt compared to your income, known as the debt-to-income ratio.
- If you can’t pay back your secured loan, the lender will seize an asset such as your house or car as collateral.
- Would you still be able to pay your loan if you lost your job? To know, the lender looks at any savings, investments and other assets you might own to determine how much capital you have.
- Finally, the purpose – or conditions – of the loan can affect whether someone wants to lend you money or not.
What is market risk?
You invested £50 in Bitcoin. What happens next? The price could drop and leave your investment worthless. This is market risk.
Investment banks are particularly exposed to risks from changes in financial markets. This is because they hold more financial assets such as shares and bonds for themselves and their customers.
Market risk can for example come from a change in interest rates, the price of a good or the exchange rate of a currency. Banks that have bought shares in an oil company will for example lose money, if global oil prices suddenly go down.
What is operational risk?
The last £30? Turns out you should probably have fixed that hole in your pocket.
All banks are to an extent vulnerable to human errors or mistakes. In business terms, this is called operational risk. It comes from the losses a bank might make from bad internal processes, people or external events. This could for example be confidential information getting leaked or a badly judged decision by an employee.
The losses from operational risk can be huge. British banks have had to pay around £30 billion for mis-selling payment protection insurance (PPI) over the last decade. Customers were sold the insurance despite in many cases not being eligible for or needing it. It was designed to cover debt repayments in certain circumstances when the customer was unable to pay, for example because of illness, losing their job or death.
Of course then Arnold Schwarzenegger came along.
Bank of England's KnowledgeBank guide on what risks do banks take.
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Male voice: Get to the crunch, make a decision. Surprise! Just pick one and roll with it. Come on!
You, sniffy man make your decision! Do it now!
That’s a good boy you’ve at least made a decision about the PPI, right? Come on!
Female voice: After the 29 August 2019, you will no longer be able to make a PPI complaint.
Male voice: Bye byes for the PPIs.
Female voice: Quite. So you need to decide. Yes I want to make a PPI complaint or no I don’t.
Male voice: Make a decision. Do it now!
Female voice: Visit the Financial Conduct Authority at www.fca.org.uk/ppi or call 0800 101 8800.
Male Voice: Come on!
How do banks reduce the impact of losses?
To tackle all kinds of risk, banks hold capital to cushion the blow from losses. Bank capital is the difference between what a bank owns and owes, meaning its net worth. The largest banks are now required to have as much as ten times more capital than before the 2008 financial crisis.
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