Bank Director's Training | Financial Report

Frequently, a single action, incident or event will trigger multiple portfolio risks. For example, when a bank makes a loan it is clear that it is taking on credit risk – the risk that it will not receive the principal and interest owed. However, making a loan can expose the bank to liquidity and market risk. To see this, let’s look at a bank’s balance sheet.

The assets on a bank’s balance sheet are prioritized according to how readily they can be converted to cash. Notice that loans appear towards the middle of the balance sheet, above items such as premises and fixed assets. This implies that loans are not a ready source of cash to meet liquidity needs.

Consolidated Report of Condition Schedule RC -- Balance Sheet Assets
	1. Cash and balances due	$10
	2. Securities	$250
	3. Federal funds sold	$5
	4. Loans and leases	$600
	5. Trading assets	$0
	6. Premises and fixed assets	$20
	7. Other assets	$1
	8. Total assets	$886

The reason for this is that making a loan takes time to gather information and to evaluate a borrower’s credit worthiness. Any attempt by the bank to sell the loan to raise funds requires the same due diligence by the prospective buyer as that performed initially by the selling bank. This increases the time needed to sell loans and associated costs, which affects liquidity risk due to their lower desirability as ready sources of liquidity.

Extending credit can also present a bank with market risk. Extending credit involves using deposits as a source of loan money for the bank. Among other things, the balances in these deposit accounts are influenced by the interest rate a bank offers its deposit customers. Since loans and deposit accounts are both affected by current interest rates, making a loan can cause an increase in market risk for a variety of reasons. One of the more common reasons is that the rates paid to depositors change more frequently than the loan rate. As market interest rates fluctuate, rates paid to depositors change more often than the rate on the loan. This results in a difference between what the bank pays depositors and what it receives on the loan, affecting net income and capital.

Here is an example of the effect market risk has on a bank's net interest income and profitability. Suppose a bank makes a five-year loan that pays 8 percent interest. The bank obtains the funds to make the loan from depositors who purchased one-year certificates of deposit (CDs). The bank pays these depositors 4 percent interest annually. This gives the bank a net interest income of 4 percent for the first year, the difference between the 8 percent the bank earns on the loan and the 4 percent it must pay depositors for the use of their money.

Changes in Market Interest Rates Affect Bank Income and Capital
Interest earned from government on five Year Note	+8.00
Interest paid to bank customer on one Year CD	-4.00
Net Interest Income	4.00

Suppose interest rates rise near the end of the first year when certificate holders are getting ready to renew their CDs. A bank competitor now pays 6 percent on one-year certificates of deposit. Our bank, which made the five-year loan, must also pay 6 percent to retain its CD depositors and stay competitive. Because our bank’s return on the loan is fixed at 8 percent for five years and the interest expense on the deposits it used to fund the loan increases to 6 percent, the net interest income for our bank for the next year falls from 4 to 2 percent. The rise in rates caused the bank’s income to fall.

Changes in Market Interest Rates Affect Bank Income and Capital
	Time Periods
	1	2
Interest earned from government on Five-Year Note	+8.00	+8.00
Interest paid to bank customer on One-Year CD	-4.00	-6.00
Net Interest Income	4.00	2.00

Since the bank’s income has fallen, it has less to add to its capital out of earnings than what it would have if its net interest income had remained constant. Thus, both the bank earnings and capital were harmed by the rise in interest rates.