What We Know, Don't Know and Can't Know About Bank Risks: A View from the Trenches

Abstract

This paper seeks to put forward a framework, from the perspective of practitioners and policymakers, for how the known, unknown, and unknowable vary by risk type within banking. We define total bank risk in terms of earnings volatility, which can be broken down into five major classes of risk: market, credit, asset/liability, operational, and business risks. For our purposes, risk is known (K) if it can be enumerated, in the sense of being identified, and quantified; it is unknown (U1) if the set of risks can be identified and enumerated but not meaningfully quantified; and it is unknowable (U2) if the existence of the risk or set of risks is not predictable ex ante, let alone quantifiable. Based on these definitions, we position the five sources of bank risk within the K, U1, U2 space based on evidence from industry practice and suggest that K decreases, and U1 and U2 increase, along a spectrum from market risk to credit risk, asset/liability risk, operational risk, and business risk. Using bank-level data we attempt to quantify or size both total bank risk and the contribution from each risk type based on a large sample of earnings volatility data for US bank holding companies over the 1986-2005 period. We find that a) total earnings volatility is protected by minimum regulatory capital requirements at implied credit rating levels ranging from about A- to BBB, depending on the sample; b) when allocating among the different risk types, market risk accounts for only about 5%, credit for almost half, structural interest rate risk for about 18%, and non-financial risks, including both operational and business risk, for about 30% of total risk; c) the diversification benefit, i.e., the difference between the whole and the sum of the parts, is about one-third. Not surprisingly, large banks also seem to experience fewer extreme adverse outcomes.