Figure 1.2. Bank Goals and Constraints

Goal

Amount of Cash Flow

Maximize Shareholder Wealth

Timing of Cash Flow

¹— Risk of Cash Flow

Credit Risk

Interest Rate Risk

Liquidity Risk

Operational Risk

Capital Fraud Risk Risk

Constraints

Market Competition

Social Legal/Regulatory

Risk management

As mentioned by Alan Greenspan in the quote at the beginning of this chapter, bank management is risk management. Banks accept risk in order to earn profits. They must balance the various alternative strategies in terms of their risk/return characteristics with the goal of maximizing shareholder wealth. In doing so, banks must recognize that there are different types of risk and that the impact of a particular investment strategy on shareholders depends on the impact on the total risk of the organization. That total risk is composed of six components:

1. Credit risk: The risk that the bank will not get its money back (or that payment will be delayed) from a loan or investment. This is what caused most bank failures in recent years.

2. Interest rate risk: The risk that the market value of a bank asset (i.e., loans and securities) will fall with increases in interest rates. For a commercial bank that promises to pay a fixed amount to depositors, any decline in the value of assets due to interest rate increases could have serious implications for the solvency of the organization.

3. Liquidity risk: The risk of being unable to meet the needs of depositors and borrowers by turning assets into cash (or being unable to borrow funds when needed) quickly with minimal loss. Given the large amount of bank deposits that must be paid on demand or within a very short period, liquidity risk is of crucial importance in banking.

4. Operational risk: The risk that operating expenses, especially noninterest expenses such as salaries and wages, might be higher than expected. Banks that lack the ability to control their expenses are more likely to have unpleasant earnings surprises. Over an extended time in a competitive market enviroment, banks with excessively high operating costs will have difficulty surviving.

5. Capital risk: The risk of having inadequate equity capital to continue to operate. This may be viewed either from an economic perspective so that inadequate equity capital occurs when customers refuse to leave their funds with the bank (causing a liquidity crisis) or from a regulatory perspective (where the bank regulatory authorities close the bank because of capital below regulatory minimums),

6. Fraud risk: The risk that officers, employees, or outsiders will steal from the bank by falsifying records, self-dealing, or other devices. Fraud risk is associated with unsound banking practices that could result in bank failure.

The principal risk that has caused problems for bank management is credit or default risk. Although banks fail for many reasons, the principal one is bad loans. Banks, of course, don't make "bad" loans. They make loans that go bad. At the time the loans were made the decisions seemed correct. However, changes in oil prices, real estate prices, crop prices, and other factors that were not foreseen resulted in credit problems. Recent problems with energy loans, agricultural loans, and loans to less-developed countries certainly illustrate this point. The crucial importance of credit risk in the loan portfolio has contributed to the extensive treatment of loans and the loan portfolio in this book.

Bank management must carefully balance risk and return in seeking to maximize shareholder wealth. However, such decisions are constrained by a number of factors. Of course, all businesses face constraints in their decision making, but the constraints under which banks operate are particularly important. These constraints may be classified into three separate though overlapping areas:

1. Market constraints: Banks face considerable market constraints as they attempt to manage risk in order to maximize shareholder values. These market constraints take the form of competition from other banks, from nonbank providers of financial services, and from the capital market. For example, if management believes that it must charge 8% on a loan in order to be fully compensated for credit risk, but if other lenders will provide credit to the borrower at 7%, this is a market constraint that has a potentially serious impact on the bank.

2. Social constraints: Social constraints stem from the historical position of the commercial bank at the core of the financial system. As such, banks often become the lender of next to last resort in times of financial crisis (the Federal Reserve is, of course, the lender of last resort) in providing credit to distressed institutions and in providing deposit and credit services to their customers. Because the financial performance of a bank is intimately linked with the economic health of the community it serves, banks often perform numerous social functions (and are expected to do so) despite, in many cases, being unable to determine the contributions of such activities to shareholder wealth.

3. Legal/regulatory constraints; Perhaps more significant is the enormous variety of legal and regulatory constraints on the portfolio management (i.e., its risk/return position) of a commercial bank.