Market risk and credit risk are different. The bank can offset market risk by purchasing interest rate swaps or other interest rate derivatives. 

By: Tom Hannagan In my past postings, we’ve discussed financial risk management, the role of risk-based capital, measuring profitability based on risk characteristics and the need for risk-based loan pricing (credit risk modeling). I thought it might be worthwhile to take one step back and explain what we mean by the term “risk.” “Risk” means unpredictable variability. Reliable predictions of an outcome tend to reduce the risk associated with that outcome. Similarly, low levels of variability also tend to reduce risk. People who are “set in their ways” tend to lead less risky lives than the more adventuresome types. Insurance companies love the former and charge additional premiums to the latter. This is a terrific example of risk-based pricing. Financial services involve risk. Banks have many of the same operational risks as other non-financial businesses. They additionally have a lot of credit risk associated with lending money to individuals and businesses. Further, banks are highly leveraged, borrowing funds from depositors and other sources to support their lending activities. Because banks are both collecting interest income and incurring interest expense, they are subject to market, or interest rate, risk. Banks create credit policies and processes to help them manage credit risk. They try to limit the level of risk and predict how much they are incurring so they can reserve some funds to offset losses. To the extent that banks don’t do this well, they are acting like insurance companies without good actuarial support. It results in a practice called “adverse selection” – incorrectly pricing risk and gathering many of the worst (riskiest) customers. Sufficiently good credit risk management practices control and predict most of the bad outcomes most of the time, at least at portfolio levels. Bad outcomes (losses) that are not well-predicted, and therefore mitigated with sufficient loan-loss reserves, will negatively impact the bank’s earnings and capital position. If the losses are large enough, they can wipe out capital and result in the bank’s failure.

Part 2 Reason one Unfortunately, there is a management issue regarding their transparency with the investment community and/or client base.  Regrettably for the managers and leaders choosing this approach, if this problem persists too long, the organization may choose to rectify with a change in the management and leadership Reason two The solution is both simple and complex.  In simplistic terms, the financial institution must evolve its portfolio risk management reduction techniques and take a more proactive stance.  Both internal and external data exists that can provide significant insight to the portfolio, its trends and potential future loss. Such data sources include: Internal behavioral characteristics (negative changes outside of just delinquencies) High line usage Non sufficient funds frequency & severity (for those borrowers who also have a deposit account with the institution) Deposit account closuresExternal data Regular rescore of the borrowers (both small business and consumer) Derogatory payment trends with other creditors (the borrower may be current with you but for how long?) Judgments or liens Such data can be used to create models for portfolio performance calculating: Delinquency trends by score (as the portfolio trends up or down in the score ranges we can adjust the expected loss rates, delinquency rates, etc.) Within score ranges and based upon other behavioral characteristics, what is the likelihood for charge-off or recovery. The biggest takeaway is that these portfolio management techniques are not new and untested.  Your data provider (such as Experian), has used these techniques and has the data to support the effectiveness.  While we are in trouble, we may find ourselves wanting to keep the “dirty secrets” to ourselves.  Too often such an approach leads to one’s demise.  Seek information, seek help, get control and truly start to move in a positive direction.