Functions and forms of
Banking
Introduction to banks and the banking system: their roles in
facilitating economic activity and the relevant risks banks face.
LUISS Guido Carli
Daniele Penza – dpenza@luiss.it
Agenda
Banks and Banking
Core Bank Services and additional financial
services.
Bank’s role in the economy
Financial intermediation, asset
transformation, money creation
Different Bank Types
Retail, Wholesale, Central banks…
Banking Risks
Credit Risk, Market Risk, Operational Risk,
Liquidity Risk, Systemic Risk, Other Risks
that Banks face
Forces Shaping and Threating the
Banking Industry
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Banks and banking
Understanding banks and the three core banking functions
What is a bank

A bank is a financial institution
licensed to receive deposits
and make loans and subject to
regulation and supervision.

Most banks can be categorized
as retail, commercial or
corporate,
or
investment
banks. The big global banks
often operate separate arms
for each of these categories.
Banks can provide many financial services, but they are defined by regulators in relation to
an official authorization (“the Banking license”). You cannot call yourself a bank unless you
are a licensed deposit taker.
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How do Banks Make Money?
1.
2.
3.
Interest Income. The primary source of revenue.

The difference between the interest the Bank receives from the borrowers and the
interest it pays to the depositors.

It generates mainly interest rate risk, credit risk and liquidity risk.
Fee-based income. Non-interest fees for their services.

Credit card fees, checking accounts, savings accounts, mutual fund revenue,
Investment management fees, custodian fees….

Fee-based income sources are very attractive for Banks since they are relatively stable
over time and do not fluctuate. It is beneficial, especially during economic downturns,
where interest rates may be artificially low and capital markets activity slows down.

It generates mainly operational risk.
Capital Market Income. Managing financial products for trading or investment purposes.

Investing Bank’s capital in stock, bonds, and financial derivatives, sales and trading
services, advisory M&A,…

It is a very volatile source of income for Banks (when not fee-based) and may fluctuate
significantly.

It generates mainly Market & Counterparty risk.
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Core Banks services (1/2)
To understand banking risk and regulation, it is essential to understand the range of services
banks provide and the key role that banks play in a modern economy.
The core services Banks traditionally provide are:
1)
Deposit collection: accepting cash or money (deposits) from individuals and businesses
(depositors) for safekeeping in a bank account, available for future use.
2)
Payment services: the process of accepting and making payments on behalf of customers
using their bank accounts.
3)
Loan underwriting: evaluating and deciding whether a customer (borrower) is eligible to
receive credit and then extending a loan or credit to the customer.
Services
Deposit Collection
Examples of Bank products
■
■
■
■
Payment Services
■
■
■
■
Underwriting Loans
■
■
■
Checking/current accounts
Certificates of deposit
Savings accounts
Debit cards
Electronic banking
Foreign exchange
Checking accounts
Commercial and industrial loans
Consumer loans
Real estate/mortgage loans
Credit cards
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Core Banks services (2/2)
Deposits
When a bank accepts deposits, the depositor, in effect, lends money to the
bank. In Exchange, the depositor receives interest payments on the
deposits. The bank then uses the deposits to finance loans to borrowers
and generates income by charging interest on the loans. The difference
between the interest the bank receives from the borrowers and the interest
it pays to the depositors is the bank's primary source of revenue and profit
(called Net Interest Margin or NII).
(True/False): “You put your money in a Bank, and they look after it for you”
FALSE. Depositors lend money. It’s not your money in a safe. Banks can do whatever they want with that money.
Loans
When underwriting a loan, a bank evaluates the borrower’s credit quality
(the likelihood that the borrower will repay the loan). However, depositors,
who lend money to the bank in the form of deposits, typically do not
evaluate the bank’s credit quality or ability to repay the demand deposits.
Depositors assume their deposits with the bank are safe and will be
returned in full by the bank “on demand.” Banks occasionally fail and cannot
repay deposits fully. To protect depositors against bank failures,
governments have created safety nets such as deposit insurance.
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Banks’ role in the
economy
Understanding banks’ role in the economy and the mechanism of
money creation through fractional reserve banking
Banks’ role in the economy
Through the core bank services mentioned, banks are critical facilitators of economic activity.
Financial Intermediation
Banks channel savings
from depositors to
borrowers, an activity
known as financial
intermediation.
Asset Transformation
2
1
Banks create loans from
deposits through asset
transformation.
Money Creation
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(True/False): “Banks invest in the real economy”
Banks, through
financial
intermediation and
asset transformation,
engage in money
creation.
FALSE. Banks provide credit services to borrowers for a fixed or floating interest rate rather than sharing in the risk and actual
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returns on an investment.
Banks’ role in the economy
FINANCIAL INTERMEDIATION




Banks engage in financial intermediation by collecting funds in the form of deposits and then
loaning these funds out.
It bridges the gap between the deficit borrowers and the surplus payers.
Throughout the world, bank loans are the predominant source of financing for individuals
and companies. Other financial intermediaries, such as finance companies and the financial
markets (such as stock or bond markets), also channel savings and investments.
Unlike other financial intermediaries, though, banks alone channel deposits from
depositors to borrowers. Hence, banks are also called “depository financial
intermediaries/institutions”
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Banks’ role in the economy
ASSET TRANSFORMATION
The process of creating a new asset (loan) from liabilities (deposits) with different
characteristics is called asset transformation.
Financial intermediation emphasizes the differences between bank deposits and bank loans.
 Bank deposits (e.g., savings accounts, checking accounts) are typically relatively small,
consisting of money entrusted to the bank by individuals, companies, and other
organizations for safekeeping. Deposits are also comparatively safe and can normally be
withdrawn at any time or have relatively short maturities.
 By contrast, bank loans (e.g., home mortgage loans, car loans, corporate loans) are generally
larger and riskier and have repayment schedules typically extending over several years.
Assets
Large Loans / High-Risk
Long Maturity
BANK LENDS
Bank
Liabilities
Small Deposits / Low-Risk
Short maturity
BANK BORROWS
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Banks’ role in the economy
MONEY CREATION
Money creation is the process of generating additional money
by repeatedly lending.
Banks earn revenues from the financial intermediation/asset
transformation process by converting customer deposits into
loans.
To be profitable, the bank’s interest rates on its loans must be
greater than the rate it pays on the deposits that finance
them.
Since most deposits can be withdrawn at any time, banks
must balance the goal of higher revenues with the need to
have cash on hand to meet the withdrawal requests of
depositors.
To do this, Banks “reserve” a relatively small fraction of their
deposit funds to meet depositor demand. Banking regulators
determine the reserve requirements and the proportion of
deposits a bank must keep as reserves in the vault.
Keeping only a small fraction of the depositors’ funds
available for withdrawal is called “fractional reserve banking.”
This system allows banks to create money.
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Banks’ role in the economy
MONEY CREATION
As this process continues, more deposits are loaned out and spent, and more money is
deposited; at each turn, more and more money is made available through the lending
process.
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Banks’ role in the economy
MONEY CREATION
In the previous example, the amount of money created at each deposit is 90% of the last step
(100% less the 10% held in reserve). Reserve requirements limit how much money an initial
deposit can create in the fractional reserve banking system. The money multiplier, the inverse
of the reserve requirement, is a formula used to determine how much new money each unit of
currency can create.

With a reserve requirement of 10%, the money multiplier is 10 (1/10% = 10). Thus, the amount of money
that can be created on a USD 100 deposit is USD 1,000. Out of USD 1,000, USD 900 (or 90%) is new
money and USD 100 (or 10%) is the original deposit.

With a reserve requirement of 20%, the money multiplier falls to 5 (1/20% = 5). Thus, the amount of
money that can be created on a USD 100 deposit would be USD 500. ff this USD 500, USD 400 (or 80%) is
new money, and USD 100 (or 20%) is the original deposit.
(True/False): “Banks take savings and lend them to borrowers”
Partially true. Much of the money lent comes from the money creation mechanism.
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Banks’ role in the economy
MANDATORY CASH RESERVES
In Europe, today, the Eurosystem requires banks to hold a proportion of their liabilities in the
form of deposits on accounts with their national central bank: These are called "minimum" or
"required" reserves (MRR). These are calculated by applying different reserve ratios to specific
liability categories.
Minimum cash reserves have been a long-established form of bank regulation.
The requirement that each bank maintains a minimum reserve of base money has been justified
on the grounds that:
1)
it reduces the bank’s exposure to liquidity risk (insolvency)
2)
aids the central bank’s efforts to maintain control over national money stocks (by preserving
a more stable relationship between the outstanding quantity of base money, which central
banks are able directly to regulate, and the outstanding quantity of bank money);
3)
It secures government revenue. The higher the minimum legal reserve ratio, the greater the
proportion of savings transferred to the public sector.
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Banks’ role in the economy
MONEY CREATION
OFFICIAL RATES IN THE EUROSYSTEM (https://www.ecb.europa.eu/stats/policy_and_exchange_rates/key_ecb_interest_rates/html/index.en.html)
The Governing Council of the ECB sets three official interest rates on Eurosystem operations
every six weeks as part of its monetary policy and its work to keep prices stable in the euro area.
1) the main refinancing operations rate: the interest rate banks pay when they borrow
money from the ECB for one week. When they do this, they have to provide collateral
to guarantee that the money will be paid back (1,25%)
2) the marginal lending facility rate: the interest rate Banks pay when they borrow from
the ECB overnight (currently 1,50%, this costs them more than if they borrow for one
KEY ECB RATES
week). When they do this, they have to provide collateral, for example, securities, to
guarantee that the money will be paid back.
3) The deposit facility rate: it defines the interest Banks receive (or have to pay in times
of negative interest rates) for depositing money with the central bank overnight
(currently 0,75%)
4)
Are this rates continuously compounded? Or normal? ….
The minimum reserve earns interest at the average of the 'marginal allotment rate' in the
main refinancing operations during the maintenance period, weighted according to the
number of calendar days.
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Banks’ role in the economy
In Europe, the Eurosystem's regular open market operations consist of liquidity-providing
operations with a weekly frequency/maturity (MROs, Main Refinancing Operations) and
liquidity-providing operations with a duration of three years (LTROs, Longer-Term Refinancing
Operations):
 MROs serve to guide short-term interest rates, determine liquidity conditions in the market
and signal the stance of monetary policy in the Euro area;
 LTROs, on the other hand, provide the financial sector with additional longer-term
refinancing.
Other non-conventional measures of monetary policy:
 Three-year LTRO: In recent years, regular operations have been complemented by two longterm refinancing operations in the euro with a three-year maturity and liquidity-providing
operations in US dollars.
 PELTRO: Longer-term refinancing operations for the pandemic emergency.
 TLTRO: Targeted longer-term refinancing operations (TLTROs) are Eurosystem operations
that provide credit institutions with maturities of up to four years. TLTROs offer long-term
financing on favorable terms for banks to further facilitate credit conditions in the private
sector and support the provision of bank credit to the real economy.
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Other Banking Services
Fee income is the second main source of revenue for banks after the interest the bank
receives from its borrowers.
Other banking services may include:


Cash management. Banks provide cash or treasury management services to large corporations, i.e., the
Bank agrees to handle cash and payments for a company and invest any temporary cash surplus.
Investment and security-related activities. Many Bank customers demand investment products with
higher returns and associated risks than bank deposits. Banks also offer other securities-related activities,
including brokerage and investment banking services:








Brokerage Services involve the buying and selling of securities (e.g., stocks and bonds) on behalf of customers.
Investment services include advising commercial customers on mergers and acquisitions and offering a broad range
of financing options, including direct investment in the companies.
Derivatives trading. Derivatives such as swaps, options, forwards, and futures are financial instruments
whose value is “derived” from the intrinsic value and/or change in the value of another financial or
physical asset, such as bonds, stocks, or commodities such as gold or oil. Derivative transactions help
institutions manage various risks, such as foreign exchange, interest rate, commodity price, equity price,
and credit default risks.
Loan commitments. Banks receive a flat fee for extending a loan commitment of a certain amount of
funds for some time.
Letters of credit. Guarantees a payment
Insurance services.
Trust services. The Bank professionally manages customers’ assets.
Risk management services. For a fee, banks now offer their customers the same risk management skills
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and tools they use internally.
Different bank types
Illustrating different types of banks by focusing on the types of
customers served and the range of services offered
Different Bank Types
RETAIL BANKS
Retail Banks’ (also known as Consumer Banks) primary customers are individuals, or
“consumers”. It is intended to give them access to basic banking services (saving accounts,
mortgages, credit cards, personal loans, foreign currency,…) and financial advice.
Many retail banks also offer services to small and medium enterprises (SMEs) even if it is
typically mass-market banking.
Although retail banks can come in many forms, most have a network of local branches that
enable them to focus on retail consumers in one specific geographic area, such as a city or a
region of a country. However, there are several very large retail banks that have extensive
branch networks that cover entire countries or portions of countries.
Retail banks may have different specializations:

Retail and consumer banks, savings and loans companies, cooperatives. These offer loans primarily to
individuals to finance houses, cars, or other purchases.

Private Banking firms. These provide wealth management services, including tax and investment advice,
typically to rich individuals.

Postal Banks. These offer banking services to customers in post offices. This structure, where the postal
service owns or collaborates with a bank, is widely used worldwide.
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Different Bank Types
WHOLESALE BANKS (1/2)
Wholesale banks’ customers are primarily corporate and noncorporate businesses.
Although the range of business customers varies, it usually includes larger domestic and
international companies. Many wholesale banks finance international trade and often operate in
several countries through representative offices or smaller branches. These banks are known as
international, multinational, or global banks. Banks that offer financial services, including
insurance and core banking functions, are called universal banks.
Wholesale banks also offer advisory services tailored to the specific needs of large businesses.
Types of wholesale banks include:

Commercial banks. These offer a wide range of highly specialized loans to large businesses, act as
intermediaries in raising funds, and provide specialized financial services, such as payment and risk
management services.

Correspondent banks. These offer banking services to other banks, often in another country, including
loans and various investment alternatives.

Investment (sometimes called “merchant banks”). These offer professional advice to corporations and
governments about raising funds in the capital markets, such as the stock, bond or credit markets. In the
case of companies, they also provide advice on buying or selling companies as a whole or in part. In the
case of governments, they will advise on privatizing public assets. They may also serve as underwriters
and investors in these activities.
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Different Bank Types
WHOLESALE BANKS (2/2)
The number of investment banks has diminished since 2008 due to the GFC.

In 2008, in the wake of the subprime mortgage market’s collapse, investment banks Bear Stearns
and Lehman Brothers went out of business. Bear Stearns was sold to JPMorgan Chase and Lehman
Brothers declared bankruptcy.

Merrill Lynch, the third largest investment bank in the U.S., merged with Bank of America.

Two of the remaining major U.S. investment banks, Goldman Sachs and Morgan Stanley, legally
converted their operations to those of bank holding companies. This move allowed them to accept
deposits and raise funds through customer deposits to support their ongoing operations. It also
gave them access to emergency funding from their central banks, perhaps more important than
their new ability to collect deposits.

In Europe, some large banks, such as Barclays, reduced their investment banking activity. However,
because they had significant businesses in other areas (such as retail banking), they were better
able to survive than those banks that were wholly reliant on investment banking business.
Although the large investment banks in the United States have either converted to banks or
collapsed, there are still investment banks remaining; many are smaller, highly specialized
investment banks typically focused on providing advice to corporate customers about raising
money in the financial markets.
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Different Bank Types
HOLDING COMPANIES AND COOPERATIVE BANKS
Bank Holding companies
Bank holding companies own one or more banks but do not conduct banking business
themselves.
Bank holding companies often raise funding on behalf of their group and then “downstream” it
to their operating companies. They are able to service the interest on the debt from dividends
that are “upstreamed” from the operating companies.
Cooperative Banks
Cooperative banks are owned by their customers and usually have an extensive branch network
that covers small towns and villages as well as larger cities. Their core strength is often lending
to and taking deposits from individuals and small businesses.
For most banks, there is a distinction between shareholders, who invest in the bank and
therefore own it, and customers, who do business with the bank but have no ownership rights.
In contrast, someone who deposits money with a cooperative bank automatically becomes a
shareholder in that cooperative bank. In some cooperative banks, customers who receive loans
also become shareholders. Such customers are, in principle, entitled to vote and to control how
the local cooperative bank is run (e.g., Rabobank in The Netherlands)
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Different Bank Types
CENTRAL BANKS (1/2)
Central banks are the principal monetary
authority of a country (or, occasionally, a group
of countries like the ECB) and are crucial to the
functioning of all Banks, financial markets, and
the economy.
Central banks manage the amount of money
and credit in an economy usually in an effort to
contain inflation rates and/or to foster
economic growth through:





their daily activities of buying and selling
government debt;
determining and maintaining core interest
rates;
setting reserve requirement levels;
issuing currency;
arranging payments between Banks.
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Different Bank Types
CENTRAL BANKS (2/2)
Historically, central banks have usually combined this role as the principal monetary authority
with two other roles:
1)
oversight of the banking system as a whole (macroprudential supervision)
2)
the regulation and supervision of individual banks (microprudential supervision).
The body that is given responsibility for microprudential supervision usually has a responsibility
not only for bank regulation but also for bank supervision:
REGULATION
SUPERVISION
The process of writing
rules that govern how
banks operate and
behave: for example,
setting minimum levels
of capital, or requiring
banks to set aside a
proportion of their
deposits as a reserve.
The enforcement of
those rules: for
example, by
examining a bank’s
financial statements
or sending inspectors
to speak to a bank’s
management.
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Banking Risks
A helicopter view
Risk defined
If we look for the “risk” definition in the Oxford dictionary, we read “the possibility of something
bad happening at some time in the future.” Everyone is exposed to some type of risk every day,
whether driving, walking down the street, investing or something else.
There are multiple definitions of risk.
Everyone has a definition of what risk is, and everyone recognizes a wide range of risks. Some of
the more widely discussed definitions of risk include the following:

the likelihood an undesirable event will occur;

the magnitude of loss from an unexpected event;

the probability that “things won’t go well”;

the effects of an adverse outcome.
When dealing with business and finance, there is a distinct difference between risk and
uncertainty, although some tend to use these two terms interchangeably.
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Risk vs Uncertainty

Risk




Uncertainty


Risk is the chance that an investment’s actual outcome will differ from
the expected outcome. Risks can include the possibility of losing all or
some of the original investment in a business.
Risk can be calculated to some extent using historical data and models.
Risk can get minimized and controlled based on calculations and
mitigation techniques
Uncertainty refers to being unsure or not prepared for any results or
outcome.
Uncertainty implies an inability to predict outcomes due to a lack of
knowledge or data, making predictions impossible. There can be
multiple possible outcomes, but the possible outcomes are also not
sure. (e.g., first spread of COVID 19. There was no idea of what could
happen next).
Uncertainty gets beyond one’s control.
Uncertainty comes from an unknown source or probability.
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Risk vs Uncertainty
Parameters of
comparison
Risk
Uncertainty
Meaning
The chance that an investment’s actual
outcome will differ from the expected
outcome.
Uncertainty implies a situation where
the future events are not known.
Potential Outcomes
Potential outcomes are known.
Potential outcomes are unknown.
Measurement
Can be measured and quantified using
theoretical models.
Cannot be measured.
Control
Can be controlled if proper measures
are taken at the right time.
It is beyond our control.
Minimization
Probability
It can be minimized through preventive
measures.
Assigned.
No.
Not Assigned.
Risk describes a situation, in which there is a chance of loss or danger. Conversely, uncertainty
refers to a condition where you are not sure about future outcomes.
The other main difference between risk and uncertainty is that risk is measurable while
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uncertainty is not measurable or predictable.
Risk full definition
From the risk management perspective, we have a risk every time:
1)
We have a random variable: risk is about the future. The random variable is always a future
value of the target dimension.
2)
We know the probability associated to each outcome of the random variable: in other
words, we know or we can estimate the probability distribution function.
3)
We set the target variable as an economic or capital loss.
Let’s work with the following scenarios:



we cannot calculate any probability  we are under uncertainty.
we can associate a probability, but we can’t figure out any actual or significant loss  this is a risk
not to worry about.
We may have a significant loss, but the probability is negligible  again, this is a risk not to worry
about.
Even if the expected value of our random variable is a loss, this is not our “risk”. Risk is about
potential variability/dispersion around the expected value. Risk is always about “unexpected
loss”
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Risk vs Reward
A fundamental idea in finance is the relationship between risk and return: the greater the
amount of risk an investor is willing to take, the greater the potential return.
Risks can come in various ways, and investors need to be compensated for taking on additional
risks. Risk is usually assessed by considering historical behaviors and outcomes. In finance, the
standard deviation is a common metric associated with risk. Standard deviation provides a
measure of the volatility of a value in comparison to its historical average. A high standard
deviation indicates a lot of value volatility and, therefore, a high degree of risk.
The risk-return tradeoff is the balance between the desire for the lowest possible risk and the
highest possible returns. In general, low levels of risk are associated with low potential returns
and high levels of risk are associated with high potential returns.
“No risk, no gain” / “No free lunch”: taking
calculated risk is essential for gains.
None of the businesses or individuals can survive
without risk. While taking risks, it gets crucial to
understand the risk factors involved and take all the
necessary steps required to reduce risk using
diversification and hedging strategies while
preserving upside.
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Risk recap

Risk is the possibility of harm or loss. In Finance, we refer to the possibility of a monetary
loss associated with investments.

The most common measure of risk is simply the standard deviation of portfolio returns. The
higher this is, the more randomness in a portfolio, which is seen as bad.

When measuring risk, we often use probabilistic concepts. But this requires having a
distribution for the randomness in investments, a probability density function, for example.
With enough data or a decent enough model, we may have a good idea about the
distribution of returns. We can categorize these issues as follows.

For ‘risk,’ the probabilities that specified events will occur in the future are measurable and known,
i.e., there is randomness but with a known probability distribution. This can be further divided.



A priori risk, such as the outcome of the roll of a fair die
Estimable risk, where the probabilities can be estimated through statistical analysis of the past, for example,
the probability of a one-day fall of 10% in the S&P index
With ‘uncertainty,’ the probabilities of future events cannot be estimated or calculated.

In Finance we tend to concentrate on risk with probabilities we estimate, we then have all
the tools of statistics and probability for quantifying various aspects of that risk.

In some financial models, we do attempt to address the uncertainty. Instead of working with
probabilities, we now work with worst-case scenarios. Uncertainty is therefore more
associated with the idea of stress-testing portfolios.
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Banking Risks
Banks face several types of risk.
All the following are examples of the various risks banks encounter:

Borrowers may submit loan repayments late or fail to make repayments.

Depositors may demand the return of their money faster than the bank has reserved for.

Market interest rates may change and hurt the value of a bank’s loans.

Investments made by the bank in securities or private companies may lose value.

A bank may discover that it has acted in a way that is contrary to law or regulation and be fined by its
regulator or by a court of law.

Human input errors or fraud in computer systems can lead to losses.
To monitor, manage, and measure these risks, banks are actively engaged in risk management.
In a bank, the risk management function contributes to the management of the risks a bank
faces by continuously measuring the risk of its current portfolio of assets and other exposures;


by communicating the risk profile of the bank to others within the bank, to the bank’s regulators,
and to other relevant parties;
and by taking steps either directly or in collaboration with other bank functions to reduce the
possibility of loss or to mitigate the size of the potential loss.
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Typology of risk exposures
Risk factors can be broadly grouped together according to different criteria:
Market Risk
Basel
Risks
Credit Risk
Operational Risk
Other Risks
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Banking Risks
MARKET RISK
Market risk is the risk of losses to the bank arising from movements in market prices as a
result of changes in interest rates, foreign exchange rates, and equity and commodity prices.
The components of market risk are as follows:

(IR) - Interest rate risk is the potential loss in the trading portfolio due to movements in interest
rates or in inflation rates.

(EQ) - Equity risk is the potential loss due to an adverse change in the price of stock. Stock, also
referred to as shares or equity, represents an ownership interest in a company.

(FX) - Foreign exchange risk is the risk that the value of the bank’s assets or liabilities changes due
to currency exchange rate fluctuations.

(COM) - Commodity risk is the potential loss due to an adverse change in commodity prices. There
are different types of commodities, including agricultural commodities (e.g., wheat, corn,
soybeans), industrial commodities (e.g., metals), and energy commodities (e.g., natural gas, crude
oil). The value of commodities fluctuates a great deal due to changes in demand and supply.
Other Market Risk components are:

(INF) - Inflation risk is the potential loss due to movements in inflation rates. It is sometimes
considered a sub-category of Interest Rate Risk.

(CR) – Credit Risk, in this context refers to the potential loss of value of credit derivatives products
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and the credit spread risk embedded in corporate bonds (also called “issuer risk”).
Banking Risks
CREDIT RISK
Credit risk is the risk that a bank borrower, also known as a counterparty, may fail to meet its
obligations (pay interest on the loan and repay the amount borrowed) in accordance with
agreed terms.
Credit risk is the largest risk most banks face and arises from the possibility that loans or bonds
held by a bank will not be repaid either partially or fully.
Credit risk is often synonymous with default risk.
In December 2007, the large Swiss bank UBS announced a loss of USD 10 billion due to the
significant loss in value of loans made to high-risk borrowers (subprime mortgage borrowers).
Many high-risk borrowers could not repay their loans, and the complex models used by UBS to
predict the likelihood of credit losses turned out to be incorrect.
Other major banks all over the world suffered similar losses due to incorrectly assessing the
likelihood of default on mortgage payments.
The inability to assess or respond correctly to this risk resulted in many billions of U.S. dollars in
losses to companies and individuals around the world.
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Banking Risks
OPERATIONAL RISK
Operational risk is the risk of loss resulting from inadequate or failed internal processes,
people, and systems or from external events. This definition includes legal risk, but excludes
strategic and reputational risk.
Compared to credit, market, and liquidity risk, operational risk is the least understood and most
challenging risk to measure, manage, and monitor.
In 1995, Baring Brothers and Co. Ltd. (Barings) collapsed after incurring losses of GBP 827 million
following the failure of its internal control processes and procedures. One of its traders in
Singapore hid trading losses for more than two years. Because of insufficient internal control
measures, the trader was able to authorize his own trades and book them into the bank’s systems
without any supervision. The trader’s supervisors were alerted after the trades started to lose
significant amounts of money and it was no longer possible for the trader to keep the trades and
the losses secret.
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Banking Risks
LIQUIDITY RISK
Liquidity risk is the risk that a bank may not be able to meet its obligations to repay deposits
and other funding, or to continue financing its assets.
There has been far greater focus on banks’ liquidity risk following the GFC of 2007–2009 when
several banks needed to be supported by their governments because they were unable to meet
their obligations to repay depositors and bondholders. The most recent Basel Accord includes
new standards on banks’ liquidity to complement its standards on banks’ capital levels: Basel I
and Basel II had provided standards only for capital levels.
In August 2007, Northern Rock, a bank focused on financing real estate in the United Kingdom,
received emergency funding from the Bank of England. The bank was relatively small and did
not have a sufficient depositor base to fund new loans from deposits. It financed new mortgages by selling the mortgages it had already originated to other banks and investors, and by
taking out short-term loans. When the credit markets came under pressure in 2007, the bank
found it increasingly difficult to sell the mortgages it had originated. At the same time, the
bank could not secure the short-term financing it required. Simply put, Northern Rock could
not finance its assets, was unable to raise new funds, ran out of money, and, notwithstanding
the emergency financing from the Bank of England, was ultimately taken over by the
government.
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Banking Risks
INTEREST RATE RISK IN THE BANKING BOOK
Interest rate risk in the banking book is the risk posed by adverse movements in interest rates
that cause a mismatch between the rates banks set on customer loans and on deposits.
For example, if rates were to increase and a bank’s deposits repriced sooner than its loans, it
could result in the bank paying out more interest on deposits than the interest it is receiving
from loans. The mismatch would subsequently bite into the bank’s net interest income (NII), as
well as affecting the economic value of its equity (EVE), which is derived by discounting future
cash inflows and outflows
American savings and loans (S&Ls), also called thrifts, are essentially mortgage lenders. They
collect deposits and underwrite mortgages. During the 1980s and early 1990s, the U.S. S&L
system underwent a major crisis in which several thousand thrifts failed as a result of interest
rate risk exposure. Many failed thrifts had underwritten longer-term (up to 30-year) fixed-rate
mortgages that were funded by variable-rate deposits. As market interest rates increased, the
deposit rates reset higher, and the interest payments the thrifts had to make began to exceed
the interest payments they were receiving on their portfolios of fixed-rate mortgages. This led
to increasingly large losses and eventually wiped out the equity of thousands of S&Ls and led
to their failures. As interest rates rose, the payments the S&Ls had to make on variable rate
deposits became larger than the payments received from the fixed-rate mortgage loans,
leading to larger and larger losses.
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Banking Risks
SYSTEMIC RISK
Systemic risk refers to the possibility that an entire banking system may face losses or even
collapse, with all banks operating in that system being affected.
Systemic risk can arise due to macroeconomic or monetary events, such as a currency
devaluation, or it can result from the failure of a single “systemically important” financial
institution, whose problems cause difficulties for all other banks in the system.
In 1991, Argentina pegged its currency to the U.S. dollar, but over time people came to believe
that this relationship was not sustainable and that the Argentine government would be forced
to devalue the peso. In November 2001, interest rates rose dramatically in response to
expectations of a devaluation, and depositors began to withdraw funds from their banks. The
following day, the minister of the economy announced restrictions on banks’ ability to pay
clients and on customers’ ability to withdraw deposits. All banks in the system were affected by
these restrictions. Even banks that had been financially strong and conservatively managed
were not able to meet their obligations.
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Banking Risks
REPUTATIONAL RISK
Reputational risk is the potential loss resulting from a decrease in a bank’s standing in public
opinion. Recovering from a reputation problem, real or perceived, is not easy.
Organizations have lost considerable business for no other reason than loss of customer
confidence over a public relations problem, even with relatively solid systems, processes, and
finances in place.
In 2012, Standard Chartered reached an anti-money-laundering settlement with the New York
Department of Financial Services (NY DFS) for failures in its transaction surveillance systems.
The bank had to suspend dollar-clearing activity for high-risk business clients, mostly small and
medium enterprises (SMEs) in Hong Kong and the United Arab Emirates (UAE). It was also
barred from accepting new clients without prior approval from NY DFS. The regulator believed
that the bank allowed millions of suspicious payments to go unreported for several years.
The bank also agreed to pay a fine of USD 340 million to the regulator as part of an overall USD
667 million settlement in 2012. In addition to the financial losses, the bank closed much of its
SME business in the Middle East and received wide negative publicity.
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Banking Risks
COMPLIANCE RISK
Compliance risk is the risk that a bank may suffer losses as a result of its failure to comply with
laws and regulations or with internal policies and procedures that govern the way it operates.
This risk has been increasing in recent years, and oversight and scrutiny of banks have intensified
following the global financial crisis of 2007–2009. The result is that the number of laws and
regulations that a bank has to comply with has greatly increased, and so has the risk of noncompliance.
Furthermore, regulations on money laundering and financial crime (including tax evasion) have
become stricter in recent years, and governments and regulators are far less tolerant of any
breaches than they were in the past.
Wonga, a so-called payday consumer lender in the United Kingdom, also suffered significant
losses in 2014 when, under pressure from the Financial Conduct Authority, it had to write off
more than GBP 220 million of nonperforming loans (333,000 customers), as Wonga had not
followed underwriting due diligence with individual borrowers to ensure they were in a
position to repay the loans and pass an affordability test.
The firm suffered serious financial and reputational damage and had to rethink its business
model.
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Forces shaping and
threating the Banking
industry
Forces shaping the Banking
Industry
REGULATION, DEREGULATION, AND GLOBALIZATION
In the 1990s and the early years of the 21st century, deregulation led to a relaxing of restrictive
banking regulations in many countries around the globe.
The theory behind less oversight was that increased competition among banks would increase
their efficiency. Additionally, it was felt that banks would, in their own self-interest, effectively
regulate themselves with little need for heavy-handed oversight from government regulators.
However, as became apparent during the GFC of 2007–2009, banks were unable to police
themselves effectively. Their lack of discipline resulted in a virtual collapse of the global financial
system.
It has also become clear that many banks are now considered “too big to fail” due to their global
connectivity and importance to the worldwide financial system.
Since then, governments have introduced numerous banking regulation reforms. The trend
toward deregulation of financial markets that was seen in the years that preceded the global
financial crisis has now been put into reverse.
There has also been much more attention given to how banks conduct themselves and whether
they are treating customers fairly, regardless of whether they are operating in a financially
prudent manner.
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Forces shaping the Banking
Industry
COMPETITION
Banks are facing increasing competition from specialized financial services providers. Examples
of such non-depository financial intermediaries that now compete with banks include:

Retirement systems: pension plans and retirement funds.

Collective investment pools: mutual funds, unit trusts, and hedge funds.

Finance companies: leasing and equipment finance

Payment services

Insurance companies

Hedge funds

Private equity companies
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Forces shaping the Banking
Industry
OTHER FORCES

Securitization. Bundling together various debt capital assets, such as mortgages, credit cards,
and loans, and selling securities representing various types of ownership in the resulting
portfolio, is a relatively new financial product. Securitization is a threat to banks since it
enables non- banks to offer loans and financing at a lower cost than what banks historically
charge. Securitization, however, can also benefit banks by offering them a way to sell some
of the higher-risk assets they would pre- fer not to hold on their books.

Technological advances. Improvements in computing power, telecommunications, and
information technology have allowed banks to offer new ventures such as Internet-based
banking. Technological advances continue to reduce the cost of routine banking services,
such as payments and withdrawals.

Inflation and interest rate uncertainty. Both bank balance sheets and profits are highly
sensitive to changes in interest rates. When inflation increases, interest rates tend to
increase, and many banks suffer. When interest rates change considerably and frequently,
banks must focus on managing these risks.
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High-level threats to the future of
Banking
Even if the dragons of the past have been slain (or at least put to sleep for a while), new highlevel threats have emerged.
Without attempting to be comprehensive we might pack out three IT aspects:
1)
2)
3)
The risk of cyber-hacking is one of the most dangerous. It is well-known that there are daily,
routine attacks, by known actors, some of them state-sponsored, on many public institutions and
private companies in the West, including Banks. If the public came to believe that “their” money
was not safe, and trust in banks diminished, then the financial system could be put under huge
pressure once again.
Aspects of new technology (more computing power, the approach to big data, the distributed
ledger approach) means that the business model of traditional financial intermediaries are all
under threat. In response, many companies, including banks, now look like IT companies!
Finally, one might mention crypto-currencies and crypto-assets such as Bitcoin or Ethereum. I
don’t believe these to be a passing fad, but such assets are subject to many threats (inflation,
regulation,…) that could eventually cause a failure of trust in all such endeavors. If my view is
wrong, then it may lead to a significant leeching of deposits out of traditional banks
A second essential source of threat is climate change and the wider sustainability agenda.
Taking climate first, the risk to the financial sector have now been well documented. The
economy needs to transition to much lower (actually net negative) carbon emissions. That will
be driven and encouraged by public policy changes. Successful banks will be those who correctly
spot the emerging trends and shift financing towards it and those firms that choose to ignore it
will lose out.
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Current situation
THE PERFECT STORM

Global pandemic.

War in Europe.

Rise of commodity prices, inflation rates and interest rates.
All of these factors are actually interconnected pushing the western economies to a prolongated
period of recession.
Banks and regulators were all worried and focused to ensure that banks emerge from the
pandemic healthy when the situation has changed dramatically since Russia’s aggression
towards Ukraine. The war has led to deteriorating economic forecasts and unforeseen inflation
and has forced a total rethink of our energy supply.
Higher interest rates will hit indebted households particularly hard as they are already struggling
with the rise in prices. To add fuel to fire, the war has increased the threat of cyberattacks on
critical infrastructures, including in the financial sector. It has also increased the awareness
regarding the greening of our society, which (although as such a positive development) comes
with inherent transition risks.
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Current situation
THE EFFECTS OF COVID 19
The pandemic made certain risks to the European banking system all the more pressing, owing
to:



the lockdown measures and associated travel restrictions;
the closure of businesses deemed “non-essential”;
supply chain disruptions.
These challenges highlighted two key issues for banks:

the importance of adequate credit risk management as certain sectors were more vulnerable to
the fallout from the crisis (identification and classification of distressed borrowers, collateral
valuation, the adequacy of provisioning practices…)

and (for some banks) the need for further digitalization. Banks are facing increasing competition
from new market entrants such as fintech firms and big tech platforms. These new entrants are able
to provide services in an efficient and user-friendly manner, are less affected by regulatory burden
and the cost of office space, and can offer customers a wide range of choices, leveraging on their
customers’ data.
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Current situation
WAR IN UKRAINE
The challenges related to credit risk, are even more relevant today in the context of the war in
Ukraine.
But we have seen a shift in the drivers of credit risk from services-related sectors to commodity
trading, energy and raw material-intensive.
Although the full impact of the war is not yet known, it may further intensify the pressure on
asset quality in the coming quarters.




Drivers of a potential deterioration in asset quality include disruptions to supply chains and
increased costs for corporates for energy, commodities and other imports.
At the same time, the increase and volatility in commodity and energy prices, together with
ongoing global supply chain pressures, could prolong the period of elevated inflation.
Higher inflation combined with an increase in interest rates (which is generally positive for bank
profitability) could lead to defaults by borrowers.
The war has led to an increase in cyber risk, but it has also changed the nature of this risk. While
before the war, the motives of those behind cyberattacks seemed to be primarily financial in
nature, a new type of cyber threat seeks to focus on the destruction of critical infrastructure and
causing as much disruption as possible.
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Current situation
CLIMATE-RELATED AND ENVIRONMENTAL RISKS
The recent volatility in energy markets is a stark reminder of the need to speed up the energy
transition. This means that banks should also take action and increase their capacity to deal with
climate-related and environmental risks.
As the economy changes, banks will have to adjust how they operate and respond to these
developments. Addressing these risks will be one of the main challenges for banks in the years
ahead.
Considering the outcome of the self-assessments carried out in 2021: 90% of banks reported
that they are only partially aligned or not in line with the ECB’s supervisory expectations in this
area.
In this context, it is crucial that banks develop mitigation strategies to soften the long-term
impacts of climate-related and environmental risks and adjust their business strategies,
governance and risk management frameworks to adequately incorporate these risks. And banks
should have a clear overview on the “green” performance of their customers if they are to
manage their risks properly.
The ultimate aim is for climate-related and environmental risks to be managed like any other
risk and for banks’ transition plans to become part of their risk management practices.
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Learning Objectives
The three core services that banks provide, as
well as any additional financial services
The role banks play in facilitating economic activity
The roles different types of (retail, wholesale and central) banks play
within a financial system
The main risks that banks face, and the differences between credit,
market, operational, and liquidity risks, as well as other risks
The multiple forces that shape the banking industry and the main
threats the industry is facing.
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