"Bank risk" may be defined as the risk that a bank, which has added its name to a transaction, will fail to honor its commitment.
A bank may "add its name to a transaction" by providing payment risk security in the form of a Guarantee or a Documentary Credit (LC), for example, or in various other ways.
In the case where a bank has provided security the "corporate risk of the buyer" is converted into "bank risk". However, the seller receives the bank's commitment to pay in addition to retaining the buyer's commitment to pay. Therefore, should the bank fail to honor its commitment, the seller still has the right to call upon the buyer to pay direct, in terms of the contract. This is true even if the buyer has already paid the bank and given the bank instructions to transfer such payment to the seller. The bank acts as "the buyer's agent" so, if the bank goes bankrupt while the payment is in process, this loss must be carried by the buyer. This means that a buyer whose bank fails may have to pay twice.
Nevertheless, bank security is usually only obtained when the buyer's financial condition is not known or it is financially weak, or when the buyer has exceeded its credit limit with the seller. Alternatively, bank security may be used as a means of transferring the country risk exposure of the transaction from the buyer's country to the bank's country. Therefore, it is important for a company to assess the financial strength and business ethics of a bank before it is accepted as a payment security provider.
The aim of such an assessment is to produce a list of acceptable banks, each assigned a monetary limit for exposure management purposes, confirmed by a senior company executive authorized by the Board of Directors.
Banks are generally highly leveraged entities. This means that they usually operate with a relatively small equity and reserves base compared to the debts and contingent liabilities, which they incur on an ongoing basis. They are therefore vulnerable and could easily fail should either a large debtor customer fail or should they incur a large loss trading financial instruments. Other dangers lurk with respect to fraud and country risk. The following examples will illustrate these points:
The British bank, Barings, failed in 1995 due to overwhelming financial instrument trading losses which were concealed from the supervisory authorities by fraud and alleged incompetence.
More than 11,000 banks operate in the United States. Over ten years, 1980 to 1989, 1,077 American banks failed or required rescue assistance from the federal authorities.
The Bank of Credit and Commerce International (BCCI), which operated branches and subsidiaries in many financial centers worldwide, failed spectacularly in 1991, mainly due to the dishonesty of several senior executives.
International Bank Supervision - A Background Note
In view of the key role which banks play in the economic fabric of every nation and the world, the Group of Ten (G-10) Central Bank Governors set up the Basel Committee of Supervisors, in 1974, to enhance bank supervisory systems and prudential standards. The G-10 consists of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. (Note: The list contains the names of 11 countries - perhaps Belgium and the Netherlands were counted as one with Luxembourg, which joined the G-10 later. Belgium, the Netherlands and Luxembourg are often referred to as the "Benelux" countries and have closely integrated many aspects of commerce and law amongst themselves.)
The Basel Committee of Supervisors was established initially to address issues raised by the Herstatt and Franklin National Bank crisis. The Committee's task is to agree upon broad principles that will guide banking safety, banking soundness and reasonable competition standards. It meets four times each year on the premises of the Bank for International Settlements (BIS) in Basel, Switzerland. …