Bank Capital and Risk ~ Bank capital and risk are intimately related to each other. Capital itself is mainly the funds contributed by the owners of a bank that have been placed there at the owners" risk—the risk that the bank will earn a less-than-satisfactory return on the owners’ funds or may even fail, with the stockholders recovering little or nothing. And the s‘sks facing the own- ers of a bank are substantial. They include credit risk, liquidity risk, interest rate risk, oper- ing risk, exchange risk, and crime risk. in Banking Credit Risk. There is, first of all, credit risk. Banks make loans and take on securities that are nothing more than promises to pay. When borrowing customérs fail to make some or all of their promised interest and principal payments, these defaulted loans and securities result in losses that can eventually erode the bank's capital. Because owners’ capital is usu- ally no more than 10 percent of the volume of bank loans and risky securities (and often much less than that), it doesn’t take too many defaults on loans and securities before bank capital simply becomes inadequate to ubsorb further losses. At this point, the bank fails and will close unless the regulatory authorities elect to keep it afloat until a buyer can be found. Liquidity Risk. Banking also entails substantial liquidity risk, the danger of running out * of cash when cash is needed to cover deposit withdrawals and to meet the credit requests of good customers. If a bank cannot raise cash in timely fashion, it is likely to lose many478 will suffer deficiencies in quality control in. the production and delivery of services, managerial errors in judgment, of fluctuations in ‘economic conditions that could adversely affect the bank's performance. Exchange risk ‘The danger that a bank will suffer losses due to adverse movements in currency prices while the bank is trading for itself or for iteeuistomers, Crime risk ‘The danger that a bank will lose funds as a result of robbery or other crimes committed by its customers or ‘employees. Part IV Managing Bank Sources of Funds of its customers and suffer a loss in earnings for its owners. If the cash shortage persist, this may lead to runs on the bank and ultimate collapse. The inability of a bank to meet iis liquidity needs at reasonable cost is often a prime signal that it is in serious trouble. Interest Rate Risk. Banks also encounter risk to their spread—that is, the danger that revenues from earning assets will decline or that interest expenses will rise significantly, squeezing’ the spread between revenues and, expenses, thereby reducing net income. Changes in the spread between bank revenues and expenses are usually related to either portfolio management decisions (j.¢., changes in the composition of bank assets and lit bilities) or interést rate risk—the probability that fluctuating interest rates will result in significant appreciation or depreciation in the value of and the return from the bank's assets. In recent years, banks have found ways to reduce their interest rate risk exposure, but such risks have not been completely eliminated—nor can they be. Operating Risk. Banks also face significant operating risk due to possible breakdowns in quality control, inefficiencies in producing and delivering services, simple errors ia judgment by management, fluctuations in the economy that impact the demand for each individual bank's services, and shifts in competition as new suppliers of financial ~ ~ices enter or leave a particular bank’s market area. These changes can adversely affect a oank’s revenue flows, its operating costs, and the value of the owner’s investment in the bank (eg. its stock price).. Exchange Risk.’ Larger banks face exchange risk from their dealings in foreign cur rency. The world’s most tradable currencies float with changing market conditions today. Banks trading in these currencies for themselves and their customers continually run the tisk of adverse price movements on both the buying and selling sides of this market. Crime Risk. Finally, banks encounter significant crime risk. Fraud or embezzlement by bank employees or directors can weaken a bank severely and, in some instances, lead to its failure. In fact, the Federal Deposit Insurance Corporation lists fraud and embezzlement from insiders as one of the prime causes of recent bank closings. Moreover, the large . amounts of money that banks keep in their vaults often proves to be an irresistible attrac- tion to outsiders. As the famous outlaw Jesse James was reputed to have said when asked why he robbed banks, “because that’s where the money is.” Bank robberies approached record levels during the 1970s and 1980s. Ther hefis were frequently a by-product of bankers’ efforts to make their lobbies, drive-in windows, and teller miachines more-accessible to the public. While the 1990s brought a decline in the daily rate at which bank robberies were occurring, the extent and intensity of bank crime remain high by historical standards, The focus of bank robberies has shifted somewhat with changes in banking technology; theft from ATMs and from patrons using electronic networks has become one of the most problematic aspects of bank crime risk today.