This overview of banking risk is the first installment in a series of study guides for the International Certificate in Banking Risk and Regulation program, which is sponsored by the Global Association of Risk Professionals. The book’s structure, modeled loosely on that of the Basel II Accord, focuses on a bank’s credit, market, and operational risk. Credit risk derives primarily from a bank’s loan portfolio, otherwise known as its “banking book,” whereas a bank’s market risk derives primarily from its trading book.
The main virtue of Foundations of Banking Risk: An Overview of Banking, Banking Risks, and Risk-Based Banking Regulation is its clarity of exposition. Basic concepts are explained well. The text can be understood with little previous financial education. A list of summary statements precedes each chapter. Authors Richard Apostolik, Christopher Donohue, and Peter Went illustrate their main points with stylized fictional examples and a range of real-life case studies. The latter includes the collapse of Herstatt Bank and of Continental Illinois National Bank and Trust Company, the Swedish banking crisis of the early 1990s, the failure of Barings Bank, Peregrine, Parmalat, and Northern Rock, and the Icelandic banking crisis.
The authors instruct at a fairly fundamental level. They explain such elementary concepts as the main functions of banks (safekeeping of deposits, arranging payments, extending loans), the difference between a balance sheet and an income statement, and the multiplier of money creation under fractional reserve banking. CFA charterholders with generalist backgrounds who wish to get up to speed on analyzing banks for investment purposes are likely to want a more advanced text. For example, the section on credit analysis contains the classic mnemonic of the “five C’s of credit” (character, capital, conditions, capacity, and collateral) but makes no mention of something as basic as an interest coverage ratio. More important, in the chapters on credit risk, the emphasis is on the analysis that banks perform when they extend loans to retail or corporate borrowers, not on how to perform a credit analysis of debt securities issued by banks.
Other points in the book that illustrate the authors’ intention to keep it basic include the following:
- The book contains no mention of the Glass–Steagall Act or of the concept that banks are special.
- The authors explain that reserves can be used to smooth earnings over time. They could have noted, however, that earnings smoothing can make assessing a bank’s true financial condition more difficult for analysts.
- The book offers little discussion of the impact of the cyclicality of credit markets on asset prices and, therefore, on capital ratios and capital adequacy.
Apostolik, Donohue, and Went—all officials of the Global Association of Risk Professionals—say that the “‘acceptable’ range of inflation” is “usually considered” to be 2–3 percent a year. In the United States, it is closer to 1–2 percent, depending on which price index is being considered. The authors also contend that regulation of the banking industry is necessary because of the inherent instability of unregulated banks. They imply that this need is apparent from the fact that before the introduction of bank regulation, bank failures were “common.” Since the introduction of regulation, however, many banks have failed. In fact, many of them are discussed in the book.
Foundations of Banking Risk would be more informative if it were not largely a presentation of the Basel Accords or if it at least pointed out more of the weaknesses of those accords, beyond a few obvious ones that it does mention. For example, the authors explain that the calculation of operational risk capital under the basic indicator approach (15 percent of the average earnings of the past three years) is a rather unrefined method of measuring risk capital. They should also have noted that the advanced measurement approach, under which banks are permitted to use their own internally generated models to calculate operational risk capital, is subject to abuse.
The authors state that “prudently operated banks are characterized by higher capital ratios, take fewer risks, and suffer losses less frequently” than banks that are imprudently operated. That may be true, but elucidating the inherent trade-off between lower risk and higher earnings would have been more instructive in understanding why some banks maintain lower capital ratios and take greater risks than others. Similarly, a better explanation of the inherent tension between traders and risk management personnel would have been helpful.
As is often the case, the usefulness of Foundations of Banking Risk depends on the reader’s background and objective. Entry-level risk examiners will benefit from its focus on cornerstone issues. The book is less suitable for investors interested in valuing equity or debt instruments issued by banks.