Reinvestment risk arises when a bank has fixed rate interest-earning assets, such as housing loans, where the borrower has the right to repay those loans early. If interest rates fall and borrowers repay their loans the bank will have to reinvest the proceeds received at the then prevailing lower rates.
Operational risk is a catchall category for other things that could go wrong. It includes potentially catastrophic events such as earthquakes, flooding and fire and other more mundane factors such as power, computer or telecommunications failures.
The balance sheet, prepared as of a specific date, records the categories and amounts of assets employed by the business (i.e., the resources committed) and the offsetting liabilities incurred to lenders and owners (i.e., the funds obtained). Also called the statement of financial condition or statement of financial position, it must always balance. By definition, the recorded value of the total assets in- vested in the business at any point in time must be matched precisely by the recorded liabilities and owners’ equity supporting these assets. Liabilities are specific obligations that represent claims against the assets of the business, ranking ahead of the owners in repayment priority. In contrast, the recorded shareholders’ equity in effect represents a residual claim of the owners on the remaining assets after all liabilities have been subtracted.
The major categories of assets, or resources committed, are:
• Current assets (items that turn over in the normal course of business within a relatively short period of time, such as cash, marketable securities, accounts receivable, and inventories).
• Fixed assets (such as land, mineral resources, buildings, equipment, machinery, and vehicles), all of which are used over a longer time frame.
• Other assets, such as deposits, patents, and various intangibles, including goodwill that arose from an acquisition.
Major sources of the funds obtained are:
• Current liabilities, which are obligations to vendors, tax authorities, employees, and lenders due within one year or less.
• Long-term liabilities, which are a variety of debt instruments repayable beyond one year, such as bonds, loans, and mortgages.
• Owners’ (shareholders’) equity, which represents the recorded net amount of funds contributed by various classes of owners of the business as well as the accumulated earnings retained in the business after payment of dividends.
Balance sheets are static in that, like snapshots, they reflect conditions on the date of their preparation. They’re also cumulative because they represent the effects of all decisions and transactions that have taken place since the inception of the business and have been accounted for up to the date of preparation.
As we indicated earlier, financial accounting rules require that all transactions be recorded at costs and values as incurred at the time, and retroactive adjustments to recorded values are made only under very limited circumstances. As a consequence, balance sheets (being cumulative) display assets and liabilities acquired or incurred at different times. Because the current economic value of assets can change, particularly in the case of longer-lived items (such as buildings and machinery) or basic resources (such as land and minerals), the costs stated on the balance sheet are not likely to reflect true economic values. Moreover, changes in the value of the currency in which the transactions are recorded can, over time, distort the balance sheet.
Ultimately, the recorded book value of owners’ equity is affected by all of these value differentials. There generally is quite a divergence between this residual accounting value and the current economic value of the business as reflected in share prices or in valuations for acquisition. In fact, the shares of successful companies are usually traded at price levels far above their recorded book value.
Finally, a number of relatively recent accounting rules require the estimation and recording of contingent liabilities arising from a variety of future obligations, such as pension and health-care costs, further introducing a series of value judgments. These are frequently shown as “other liabilities,” listed just ahead of shareholders’ equity, and, in effect, amount to a reclassification from being part of the owners’ residual claims, to a special form of long-term liability.
The accounting profession’s FASB is expending a great deal of effort to re- solve these and other issues affecting the meaning of the balance sheet, but only with partial success. Accounting standards continue to evolve, and a manager or analyst must be aware of the underlying issues and processes when reviewing and analyzing this statement.
Insurance companies sell policies that pay out in the event of death or disability. The premiums charged on these policies are based on actuarial assumptions about factors such as mortality rates. If those assumptions prove to be incorrect such policies may be loss making.
Financial contracts are frequently complex and banks are exposed to the risk that their understanding of an agreement differs from that of a court. Legal disputes between American commercial banks and a number of insurance companies on credit derivative contracts written by the latter on failed energy trading companies around the turn of the century involved billions of dollars in disputed claims.
Banks are at risk from fraud and other criminal behavior by their staff, customers and counterparties. In some cases these actions may involve actual theft but in other cases it may simply involve the concealment of losses that do not become apparent until a later date.
A US bank with operations in a foreign country is, for example, at risk from the imposition of capital controls preventing it from remitting any profits or other funds it has in that country. In extreme cases foreign banks may even have their assets appropriated.