What is bulk risk?

Bulk risk occurs when a bank or other financial institution has too many eggs in one basket. It has given out too much money to one person or company. If that borrower has trouble paying the money back, it could spell big trouble for the bank.

Banks have special rules they need to follow so they don’t take on too much bulk risk. These rules are called “legal lending limits.” They cap how much a bank can lend to any one borrower. That way, if the borrower can’t repay the loan, the bank doesn’t go belly up.

Why bulk risk is bad news

When a bank has too much bulk risk, it’s walking on thin ice. Imagine if the bank loaned a huge change to a company that makes widgets. If people stop buying widgets and the company goes under, the bank could be left holding the bag on that giant loan.

Banks want to avoid situations like the plague. Having all their money tied up with one borrower is super risky. If something goes wrong with that one borrower, it could be curtains for the bank. The bank could lose a boatload of money in one fell swoop.

Concentration risk

Another word for bulk risk is “concentration risk.” Think about it like this: When you concentrate something, you end up with a lot of it in one place. For example, orange juice concentrate is a whole lot of OJ packed into one little can.

Concentration risk in lending means a bank has concentrated too much of its lending on one borrower or one industry. The bank has too many eggs in one basket. Diversification is the name of the game for banks. They want to spread their money around to minimize risk.

Limits keep things in check

That’s where legal lending limits come in. The government says, “Hold up now, banks. We can’t have y’all putting all your eggs in one borrower’s basket. You need to spread the love (and the risk) around.”

These limits draw a line in the sand. They tell banks the maximum amount they can lend to one person or company. It’s the lending limit line that banks shall not cross, lest they take on too much bulk risk.

Managing bulk risk

Banks have a few tricks up their sleeves to manage bulk risk and stay on the right side of those legal lending limits.

Loan syndication

One thing banks can do is team up with other banks to make a big loan. This is called “loan syndication.” It’s like a lending party where everyone chips in.

By syndicating the loan, each bank only has to cough up a portion of the money. So if the borrower goes belly up, no single bank is left holding the whole bag. They spread the risk around.

Loan sales

Another option for banks is to make a loan and then turn around and sell it to somebody else. This gets the loan off their books lickety-split.

When a bank sells a loan, they’re essentially saying, “I’m out. Somebody else can deal with this now.” They pass the risk on to the buyer of the loan. The bank gets their money back and can lend it out to somebody else.

Credit derivatives

Banks can also use something called “credit derivatives” to manage bulk risk. A derivative is a fancy financial instrument whose value is based on some underlying asset, like a loan.

With credit derivatives, banks can basically buy insurance on their loans. They pay a fee to somebody else who agrees to cover losses if the borrower doesn’t pay up. It’s like the bank is saying, “I’ll make this risky loan, but I’m gonna get somebody else to hold my hand in case things go south.”

The 2008 financial crisis

We saw what can happen when banks take on too much bulk risk during the 2008 financial crisis. It was a real doozy.

In the lead up to the crisis, banks were doling out mortgages left and right, even to folks who probably couldn’t afford them. They were also making big bets on complicated derivatives tied to those mortgages.

When the housing market went kerplunk and people started defaulting on their mortgages en masse, banks were left holding a whole lot of bad loans. Those fancy derivatives that were supposed to mitigate risk ended up magnifying it instead.

A bunch of banks went under and the whole economy was thrown for a loop. It was a painful lesson in what can happen when bulk risk gets out of hand.