Why do Banks take so much Risk?

Jul 14, 2012


- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
A number of banking scandals have surfaced in recent weeks, mainly involving large global investment banks. There was the Barclays LIBOR scandal, whereby they rigged their rate submissions in order to increase their immediate profits. There is also JP Morgan, who suffered nearly $6 billion in losses due a trade that went the wrong way.

One of the primary causes of the global crisis was banks taking on too much risk. Subprime mortgages are a good example of this; they involved lending to high-risk individuals with the potential to make high levels of profit. The downside is a much greater risk of losses. The explosion of various exotic derivatives and their high levels of associated risk further showcased the high risk taking behavior by many banks.

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It is clear that banks take on a lot more risk than they should. What is not so clear is why this occurs. Most companies and businesses do not take on nearly as much risk as banks do. But why is this the case? Why do banks take on so much risk, whereas most other companies do not?

The reason comes down to the special nature of banks in the economy. Banks cannot be allowed to go bust. Because most people have their money deposited and held in bank accounts, any bank that goes bust would cause a financial catastrophe. This doesn't apply to other companies and industries. If one shop goes bust, consumers can go to other shops.

Because a bank going bust would cause so many problems, the government usually bails them out whenever they are in trouble. Taxpayers as a whole end up absorbing the losses of a bank that goes bust and receives a bailout. Thus, the banks themselves do not suffer when they get into trouble.

The reason banks take a lot more risk than they should is that they don't suffer the negative consequences when something goes wrong. If they follow a risky strategy, they can keep all the profits when it goes well, but they don't suffer the losses when it goes wrong. In contrast, most other companies would have to suffer the losses themselves if things went wrong, so they will be much less likely to take too much risk.

This phenomenon is the socialization of losses and the privatization of profits. When banks make high profits, they can keep it for themselves. When they make losses, society bears the cost. As a result, there is a strong incentive for banks to take too much risk. Effective regulation is necessary to prevent banks from taking on too much risk, but of course this is easier said than done.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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5 Responses to "Why do Banks take so much Risk?"

Mihir Ashar

Jul 16, 2012

Regulations are the need of the hour! We are better off in India where traditional conservatism still exists largely in the banking sector.

Incentive linked bonuses at the highest levels should be abolished in case of banks.

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S.K.DAMANI

Jul 15, 2012

The one reason why Banks take so much risk is because, the statergy is always planned/noted down on a paper, where it looks good.But when imp[lemented many other reasons come into picture, which makes all calcuations on paper go for a toss. Planning on paper and implementing in actual practise, involves two different situations. And more particularly it is observed that whem planning many top bosses, miss out the small weeds and twigs, which later on become a hindrance and the plans come unstuck.
Possible reason!!!!!
Thanks Damani

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Harinder Bir Singh

Jul 15, 2012

The main reason is the turn over based bonus structure and the need/ greed of investment bankers to be one of the top producer.

The solution is to separate the retail and investment banking functions. If there are loses in the investment side that should be allowed to go bankrupt like any other business.

Iceland's example should have been followed by all the banks in trouble and the quantum of public suffering/ losses would have ring fenced.

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Kailash Nath Tandon.

Jul 15, 2012

No. Thanks.

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Kailash Nath Tandon.

Jul 15, 2012

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