Risks of Bank Loans

There are many risks associated with bank loans, both for the bank and for those who receive the loans. A close analysis of risk in bank loans requires understanding what risk means. Risk is a concept which denotes the probability of certain outcomes--or the uncertainty of them--especially an existing negative threat for trying to achieve a current monetary objective. Risk in bank loans can include: credit risk, the risk that the loan won't be paid back on time or at all; interest rate risk, the risk that the interest rates priced on bank loans will be too low to earn the bank enough money; and liquidity risk, the risk that too many deposits will be withdrawn too quickly, leaving the bank short on immediate cash.

Much of the economy can be characterized by a trade-off between risk and return. There are risks associated with all actions. "Risk" here means the chance that your investment, your time, effort or money, will go wasted rather than be used productively. You risk dropping your ice cream cone every time you have one in your hand, if you want to think about it like that. Generally, the more return something has the potential for, the more risky it might be--economists call this an inverse relationship. For example, it's relatively easy to obtain a fair return on a Treasury bill, although the rate of return will be less than 5 percent yearly. T-bills are reliable but not highly profitable. However, the stock market is a higher-risk vehicle that can make higher returns (around 11 percent a year is considered the historical nominal return of the stock market) or result in losses. Different investments are going to be good for different people, but with most investments, the two things that will be analyzed are the risks associated with that investment and the potential return of that investment.

The point of taking on risk in the first place is to get a chance for a greater return, and when banks make loans, they are undertaking several types of risk in the hope of making a return. Theoretically at least, banks make money when they combine small savings deposits of individuals and put those funds together into loans, which they loan out to creditworthy borrowers. These borrowers pay back more in interest than the bank pays the depositors, making the bank profitable. When a bank makes a loan, though, there are several ways in which the profit-making model could fall on its face.

When a banker makes a loan, he is taking a risk that the borrower will pay the loan back (credit risk), and also taking the risk that the funds loaned out won't be needed to pay out withdrawals or to take care of regular bank business, thereby preventing bank runs (liquidity risk). Further, the banker is undertaking "interest rate risk," which is more subtle but still present. Interest rate risk represents the possibility that the bank has somehow priced its loan and deposit interest rates incorrectly, be it the bank's fault or the fault of an ever-changing marketplace. If it turns out that the loan payments aren't high enough to cover deposit costs (or, if the bank's profit on loans is less than its losses on deposits), the bank will fail to be profitable.

Depositors to banks have their own sets of risks. Most significantly, the depositor is worried about credit risk--if the bank fails, the depositor wonders if he will be able to get back the money he put in. However, depositors don't really have a comparable number of risks as bankers, because safeguards are in place. Most banks are unlikely to refuse to give depositors back their deposits, and the FDIC insures bank deposits up to a set amount, so this risk is relatively low. Other risks that depositors worry about (like the risk that banks won't pay out interest, or won't pay out high enough interest rates), are incidental compared to getting back their deposits.

Risks are relative to each person, so it is hardly surprising that the borrower has his own sets of risks that he cares about. Firstly, the borrower got a loan for a reason, and if she borrowed logically, she borrowed such that the returns on the investment that she is going to use the loan for are higher than the loan costs, putting her ahead in the long run. This means that the borrower has risk: risk that the return on the investment will be too low and the costs of the loan too high, making his endeavor a financial failure. This is a form of interest risk. The borrower faces other risks (credit risk associated with the investment, for instance), but these other forms of risk reflect on the investment, not on the loan. The biggest risk for a borrower, then, is that something will go wrong with the investment and he won't be able to pay back the loan.