LO 33.1: Analyze the credit risks and other risks generated by retail banking.
The retail banking industry revolves around receiving deposits from and lending money to consumers and small businesses. Loans can take the form of home mortgages, home equity lines of credit (HELOCs), installment loans (revolving loans covering automobiles, credit cards, etc.), and small business loans (SBLs). From the perspective of the lending institution, these individual loans constitute small pieces of large portfolios designed to reduce the incremental risk to any one exposure.
The biggest risk associated with retail banking is credit risk, which is the likelihood that a borrower will default on debt. Throughout the five years preceding the 2007 subprime mortgage crisis, banks offered customers products they could not afford with risks that were more than customers could bear. Loan-to-value (LTV) ratios on mortgaged properties were very high and borrowers with weaker credit were given mortgages. These strategies backfired when housing prices collapsed, which resulted in mortgages often exceeding the value of the properties themselves.
Although credit risk is the primary risk in retail banking, several other risks also impact the industry. These risks include:
Operational risks: day-to-day risks associated with running the business.
Business risks: strategic risks associated with new products or trends and volume risks associated with measures like mortgage volume when rates change.
Reputation risks: the banks reputation with customers and regulators.
2018 Kaplan, Inc.
Topic 33 Cross Reference to GARP Assigned Reading – Crouhy, Galai, and Mark, Chapter 9
Interest rate risks: the bank provides specific interest rates to its assets and liabilities and rates change in the marketplace.
Asset valuation risk: a form of market risk associated with the valuation of assets,
liabilities, and collateral classes. An example includes prepayment risk associated with mortgages in decreasing rate environments. Valuation risk also exists in situations when car dealers assume a residual value for a vehicle at the end of the life of a lease.
R e t a i l C r e d i t R i s k v s . C o r p o r a t e C r e d i t R i s k