3 Types of Risk Facing Bank Stocks

By Markets Fool.com

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If you're going to invest in bank stocks, then you should do so with both eyes open. Even beyond the fact that most lenders are precariously leveraged by a factor of 10-to-1, a bank's business model is uniquely prone to three separate, but individually deadly, types of risk.

1. Interest-rate risk
A bank's fundamental business model is simple. It borrows money at low interest rates and then lends the proceeds out at higher rates.

For many years, this was referred to as the 3-6-3 rule. AsInvestopediaexplains:

The 3-6-3 rule describes how bankers would give 3% interest on depositors' accounts, lend the depositors' money at 6% interest, and then be playing golf at 3 p.m. This alludes to how a bank's only form of business is lending out money at a higher rate than what it is paying out to its depositors.

While this sounds great in theory, it has long since stopped explaining how banking works. The primary culprit for the change is so-called interest-rate risk. This comes about when it costs a bank more to borrow money than it can get from lending the same money out.

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The textbook example occurred in the 1970s and '80s. Thanks to double-digit inflation triggered by an unprecedented surge in energy prices, banks were forced to pay astronomical rates to borrow the money needed to fund their portfolios of lower-yielding but longer-term mortgages. Known in the industry as "mismatch," this contributed to hundreds of bank failures throughout the 1980s and rendered the savings-and-loan industry virtually obsolete.

2. Credit risk
While interest-rate risk has a long and distinguished history, most bankers will tell you that the biggest threat nowadays is the possibility that borrowers will default on their loans. Known as credit risk, this is one of the hardest risks for bankers and investors to proactively identify.

To be fair, there are countless metrics that investors can use to gauge a bank's current credit risk. There's the nonperforming-loans ratio, which shows what percentage of a bank's loan portfolio is behind on loan payments. There's the net charge-off ratio, which shows how much of a bank's total loans are recognized as a loss (after taking into account offsetting proceeds received from a seizure and sale of collateral). And you can look at how much of a bank's net revenue is set aside, or "provisioned," for loan losses in the future.

The problem is that all of these metrics are backward-looking. In the lead-up to the financial crisis, for instance, the nation's banks set aside an average of between 5% and 7% of their net revenue every quarter to cover future loan losses. This would lead an unsuspecting investor to conclude that there wasn't much to be concerned about. But less than two years later, the figure shot up to 51.7%.

Indeed, even for someone like me, who studies banks on a daily basis, credit risk is nearly impossible to accurately gauge at any particular moment. As a result, instead of basing an investment decision on current credit metrics, the best one can do is to go with a lender that has a long history of avoiding financial cataclysms by underwriting good loans. While past success doesn't guarantee future success, past failures make the latter pretty much impossible.

3. Liquidity risk
The final risk that banks face stems from the extreme leverage and fractional-reserve banking model they use to make money. Known as liquidity risk, this comes about when a bank's creditors -- namely, its depositors -- lose confidence in the institution and simultaneously withdraw their money. This creates problems, because banks keep only a sliver of these funds in their coffers, lending the lion's share of it out to businesses and homeowners.

Known as a bank run, this is what keeps bankers up at night. While bank runs were theoretically supposed to have been thwarted by the introduction of deposit insurance in the 1930s, we've seen multiple instances of them in the decades since then. It was a bank run that brought down Continental Illinois, the first "too big to fail" bank, in 1984. A more sophisticated version of the same phenomenon plagued Bear Stearns in March 2008. And a mass exodus of depositors led to the seizure and sale of the multibillion-dollar thrift Washington Mutual six months later.

Although it's hard to say exactly what causes bank runs to get out of hand, what isn't hard to say is that the first two risks I've discussed play a leading role. That is, if a bank's depositors are afraid that either interest-rate or credit risk threatens the solvency of the underlying institution, then the pump is primed, so to speak, for a mad dash for deposits. And once that happens, it's hard to put the genie back in the bottle.

The article 3 Types of Risk Facing Bank Stocks originally appeared on Fool.com.

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