3.2.1 Banks

141. Gleeson1 described a prototypical bank, based on an analysis carried out by the Joint Forum,2 which can be used for this analysis. Although this is not intended to represent a specific bank, the prototypical bank does provide us with a starting point to identify the differences in balance sheets between banks and investment firms. The introduction to this Chapter explained that banks are usually identified by the activity of taking deposits and granting credits. Gleeson further elaborates on this by stating that “banks primarily engage in granting loans and extending credits […]. Assets are mainly funded by deposits collected from customers and from other banks (inter-bank deposits)”.3 Banks’ risks can therefore be seen, very broadly, as the result of the following: “a bank takes in money from one group of people (depositors) and lends it to another (borrowers). It is (almost) certain that it will have to repay depositors; it is not certain that it will be repaid by borrowers”.4 A bank therefore has to assess the credit and counterparty risk it is exposed to when granting loans to borrowers, but it is faced with a liquidity risk for the repayment obligations of its depositors (does the bank have enough liquid capital available at a certain point in time to fulfil all its repayment obligations?). Before continuing the discussion on the specific risks, it is useful to use the example of a prototypical bank (or stylised balance sheet) as drafted by the Joint Forum, included here in Table 1.

Table 1: Stylised balance sheet for a bank5

Notes to stylised balance sheet:

142. As this stylised example of a bank balance sheet shows, loans can make up “between 25 and 75 percent of total assets”.6 Therefore, the credit risk arising out of these loans will be the most significant risk borne by banks. Banks can also hold securities for their own account (see note 2 of the stylised example) and are therefore exposed to the market risk of these securities. A bank can also be exposed to foreign exchange risk for instance if it grants loans to clients in currencies other than those in which the deposit was taken. Furthermore, a bank is inherently exposed to interest rate risk, as there is usually not a perfect correlation between interest rate increases (or decreases) in the interest rate charged to clients for loans provided and the interest rate paid out to its clients on the deposits taken.

143. Given the nature of a bank’s activities, taking short-term deposits and granting long-term loans, a bank is also exposed to funding risk, given that deposits taken by a bank can be repayable in a short timeframe, whereas the loans it has granted will usually have a long time frame for the repayment of the loan. As such, a bank cannot predict its outgoing liquidity precisely and such liquidity outflows might be greater than the contractually agreed repayment scheme for the loans provided. This funding and liquidity risk are therefore essential risks that banks must manage.

144. Besides the risks described above, a bank is also exposed to operational risk. However, operational risk does not necessarily have an impact on the balance sheet of a bank. Failures in processes or people employed by the bank might impact the profitability of the bank but will usually not lead to a balance sheet item unless operational risk affects the value of an asset held.

145. This short description of the risks to which a bank is exposed does not purport to be exhaustive. As the focus of the study is on the risks of investment firms, this section is solely intended to highlight the differences between banks and investment firms.