Talk to regulators and then to bankers about risk, and you will get two different stories. Regulators say a bank can never be too cautious. Bankers feel that if the yield is high enough to cover any loss, they can take a risk that others would avoid.
How else can you explain credit card issuers willing to push more plastic into circulation when the default rate on outstanding cards has reached as high as 5% or banks that are now making home loans for 125% of a property's value? No wonder regulators are warning that underwriting standards are being forgotten and that excess risk can kill not only earnings but also banks.
All involved in finance understand money risk and credit risk. Money risk, otherwise called interest rate risk, means that even with top- quality, fixed-income bonds or mortgages a lender can be killed by a rise in interest rates. Some banks that have had to be rescued by regulators had few if any bad loans on the books. They just were caught with exceedingly long-term government and municipal bonds as short-term interest rates rose.
Credit risk is, of course, the basic first lesson bankers learn. I know when I used to teach at Stonier I would start my lending discussion by explaining that it only takes five minutes to prepare and make a loan. The rest of the time is spent making it with a good prospect of getting the money back.
But today we face new types of risk.
The head of risk management for a major New England bank confided to me that the first and foremost risk he must watch for is reputational risk. "Anything that hurts our good name is far more damaging than a bad loan or investment," he explained.
Another risk we forget at our peril is covariant risk, meaning the risk that one bad event can bring others with it.
My best example is First National of Amarillo, Tex., which worried because neighboring banks were making so many agricultural and oil loans. Fearful of a decline in these two industries, First National diversified into mom and pop stores, auto dealers, and bank stock loans. But when oil and agriculture went under in the 1980s, they pulled these other borrowers down too.
Today we must also look at counterparty risk. If we try to hedge against risk but the party on the opposite side of the hedge goes under, that leaves us unprotected.
This helps explain why major money-center banks lost so much in Russia recently. They had made loans denominated in rubles with yields topping 30% in some instances. Then to protect themselves they sold the rubles to Russian banks in the forward market to get their dollars back.
This was a perfectly sound decision, but it later was found that the Russian banks were in deep trouble and had no way of obtaining the dollars they were committed to remit under their forward contracts. A deal is as good as the willingness and ability of the other side to keep its commitments.
So risk comes in various forms. But the key to most bankers should be the ultimate: career risk. In other words, will my decision jeopardize my career? Career risk causes many bankers to be too conservative at times.