Defences against bank risks

Banks are an essential part of a nation's economy. They facilitate the flow of funds from surplus units (depositors) to deficit units (borrowers) to fuel the growth of the economy.

The main objective of a bank is to maximise its shareholders' wealth by increasing the current share price. To do so, the bank has to ensure that its cash flows are sizeable and regular. But the sizable and regular cash flows are interrupted by various risks such as credit risk, liquidity risk, interest rate risk, operational risk and exchange risk. These risks, if not managed properly, can make banks susceptible to failure.

Banks have some defences to protect their financial position. The first defence is quality management, which is essential to supervise banking activities to attain the expected goal.

The next defence is diversification, both portfolio and geographic.

Portfolio diversification is spreading loans and deposits among a wide range of customers.

Geographic diversification is finding out customers located in various regions to take the advantage of different economic conditions. This will help offset the loss from one geographic location with the gain from another location.

Deposit insurance can work as a defence against risks. Under this system, depositors are protected from the loss caused by a bank's inability to pay its debts. The protection may be in full or in part. This system tries to promote financial stability.

Here, a bank takes an overall insurance policy and pays a certain premium to the central bank against the policy. If the bank fails, the central bank comes forward to pay a particular amount of money to its customers before the final settlement by the court.

The final defence is owners' capital provided by the owners of a bank. More importantly, owners' capital can absorb losses from bad loans and poor investments.

Banks have to be sufficiently capitalised so that depositors may not suffer from possible losses.

According to Basel III, a bank's capital must be at least 12.5 percent of its risk-weighted assets. But with the growth of a bank's risk-weighted assets, its capital requirement also increases.

Banks with higher capital have higher loss absorbency. Suppose Alpha Bank has assets of Tk 100 financed by debt capital of Tk 85 and equity capital (owners' capital) of Tk 15. Beta Bank has assets of Tk 100 financed by debt capital of Tk 80 and equity capital of Tk 20.

If Alpha lends out Tk 100 and ends up with a 15 percent loss, the whole amount of its capital will be wiped out because the loss is first compensated by capital. If the loss is more than 15 percent, the bank will be insolvent.

If Beta lends out Tk 100 and ends up with a 15 percent loss, the bank will still be left with an equity capital of Tk 5. The bank will be insolvent if the loss exceeds 20 percent of its assets.

Quality management and diversification play a crucial role to avoid bank failure by keeping the loss minimum. If they fail to minimise the loss, owners' capital comes as the last line of defence against bank failure.

A higher amount of capital indicates that a bank has more capacity to pay off the loss. Thus, the greater the risk of loss, the more capital a bank should hold. However, if the loss is unusual, capital is not enough to protect a bank from failure. In that case, the deposit insurance scheme comes into operation.

The author is a professor of the banking and insurance department at the University of Dhaka