Risk opacity: Why investing in a bank often takes nerves of steel

It's an inherently risky business which has more that could go against it than outsiders can detect

- DEVINA MEHRA

To those who ask me why my takiya kalam is "I am a nervous investor in banks and lenders," here's the answer. My refrain has nothing to do with poor quality bank management or anything of that kind. It's just that the structure of banking differs inherently from that of most other businesses.

One, it is in the nature of this business for negative surprises to outnumber positive surprises. The most recent being losses in the currency derivatives of a private sector bank that came to light a couple of months ago, with the result that its share price has halved from its highs even as the Nifty bank index has been doing very well.

Even on the lending side, when bank borrowers do very well, unlike equity investors, lenders do not get any extra income. However, when something goes wrong with a borrower, its lender has to take a hit.

So, where can the positive surprises come from? Credit growth? Unfortunately, higher-than-expected growth may not be a good thing at all for banks because problems in a lending book show up only some years later.

The financial crisis of 2008-09, for instance, was triggered by a hit on the home mortgage business of US banks where reckless lending resulted in way higher-than-expected defaults.