Types of Risks in Commercial Banking

Banking activity is generally considered to be risky. Banks earn money by borrowing money from people and then lending them to other people at a higher rate of interest. However, commercial banking activity is considered to be even riskier. This is generally because of the huge dollar value of the transactions in commercial banking.

Hence, commercial banks are required to create a system to manage the risk in a more appropriate manner.

In this article, we will have a closer look at some of the risk factors which are associated with commercial banking.

Why is Commercial Banking Considered Riskier?

A commercial bank is considered to be riskier as compared to other lending institutions. This is because of the various risk factors which are associated with it. Some of the important ones have been listed below:

1. Higher Ticket Size: Retail loans given by banks such as mortgage loans, education loans, automobile loans, and even personal loans have a very small ticket size. On the other hand, commercial loans can have a large ticket size.

   It is common for commercial banks to lend out millions of dollars to corporations. Since the ticket size is larger, there are fewer counterparties in a commercial bank’s portfolio. A default by any single counterparty has a larger impact on the workings of a commercial bank.

2. Limited Liability Structure: When an individual takes a loan, their individual credit is associated with the loan. This means that they are personally liable to pay the loan. On the other hand, corporate entities are limited liability structures. This means that they are an artificial person created in the eyes of the law. The shareholders are only liable for the amount of money that they have already invested in the firm. Hence, there is always a chance that the bank may not be able to recover its dues in the event of bankruptcy.

3. Contagion Effect: Corporations tend to be linked to one another. This is truer for big corporations which operate within the same sector.

   For instance, many auto ancillary companies might be selling to the same automobile company. Since the business of all these companies is related so closely, there is a possibility of a contagion effect. This means that the failure of one company has an impact on another company and can induce the failure of that company. This makes lending to corporates riskier.

4. Close Banking Relationships: Also, commercial banks have close relationships with their corporate partners. This means that the management of the company to whom money is being lent out can have very good relations with the management at the commercial bank. Hence, there is a possibility that they may influence the lending decision. However, with the introduction of technology, this risk is becoming redundant since lending decisions are made by the system and not by humans.

Types of Risks Faced by Commercial Banks

Now, since we know that commercial banks face higher lending risks as compared to other lenders, let’s have a closer look at some of the risks which are faced by commercial banks.

1. Operational Risks (System): A lot of the lending process has now become automated. There is a lot of emphasis on straight-through processing. This means that commercial banks try to give out loans without any human intervention. The systems are thoroughly tested. However, there is always a chance that a technical error takes place and a loan is processed incorrectly. The costs of this can be very high.

2. Operational Risks (Collusion): In many commercial banks, the lending process is not fully automated. This means that the lending decision is not completely driven by the system. Instead, it is controlled by humans to a large extent. As a result, it is possible for corporate lenders to collude with the bank’s internal staff and bribe them not to follow certain procedures. Since the dollar value of commercial loans is so large, such bribing begins to make economic sense.

3. Credit Risks: Commercial banking also has a large number of credit risks. Retail banks lend a small amount of money to many different borrowers. However, commercial banks lend a large amount to fewer borrowers. Hence, their risks are more concentrated. Also, there is always a chance that some of these borrowers may default on large sums of money.

   There have been many cases in commercial banking history where bank officials have colluded with large corporations in order to defraud the shareholders of the bank. Commercial banks need to take such risks into account.

4. Regulatory Risks: Commercial banks are one of the most regulated entities all across the world. This means that commercial banks have to comply with a large number of rules. If they fail to do so, then they may have to face financial fines and penalties.

   In some extreme cases, commercial banks may also face temporary suspension of their license. Hence, commercial banks need to be cognizant of these regulatory risks and have procedures in place to control them.

5. Market Risks: Last but not the least, commercial banks interact with financial markets on a large scale. Hence, these banks also face market risks. Commercial banks interact with the market when they borrow money from depositors or lend to lenders.

   Commercial banks also interact with the markets if they securitize their long-term loans. An adverse movement in the markets exposes commercial banks to a lot of risks. It is important for commercial banks to plan for such risks and also use derivative instruments in order to manage them.

The fact of the matter is that commercial banking is an extremely risky operation. Banks are exposed to a wide variety of risks. However, over the years, banks have developed risk management systems that are quite effective.