Big Banks Use Their Own Numbers to Evaluate Risk. Here's Why That's a Problem for You

Banks generally decide how much risk they want to take and what types of risks they're exposed to. While there are regulations currently in place to help ensure banks are financially sound, the recent collapse of Silicon Valley Bank and a few other banks just a few months ago proves that when some banks are willing to make riskier decisions, the rest of the industry -- and potentially the economy -- foot the bill.

The Federal Reserve wants to help mitigate some of this risk by having large banks shift toward a standardized way of evaluating credit, trading, and operational risks based on international standards.

And there are a few reasons why moving banks away from their own risk assessment standards could be a good thing for consumers.

Why bank risk can be a problem for consumers

First, when banks use their own formulas and data to determine if a certain investment or loan is risky, it sometimes leads to making big mistakes that potentially hurt individual customers.

In the case of SVB, the bank decided that buying lots of long-term bonds was a good investment decision. When interest rates rose quickly, the value of those bonds went down fast, and the bank couldn't sell them without significant losses.

SVB customers then got worried about their bank accounts and started pulling their money out, causing what's called a bank run. While not all of the factors in play could have been controlled by SVB, it's a recent example of how one bank's risk assessment caused panic among customers and led to other worries about the health of the banking industry in general.

The Federal Reserve's proposed standards aim to lessen some of this risk by not only requiring large banks to adhere to the same risk assessment standards but by also forcing the largest banks to set aside more capital to protect against rainy days -- $2 of capital for each $100 in risk-weighted assets, according to Bloomberg.

One additional benefit to more standardized rules could be more transparency for consumers. If all banks evaluate their investments and loans using the same system, consumers may be better able to compare one bank's services to another.

Bank regulations don't fix everything

It's impossible to regulate risk away completely. And just like individuals take on some risk to find financially rewarding investments, banks need to be able to do the same.

The average consumer can protect themselves by being in the best financial shape possible. That means storing money in FDIC-insured accounts, which protect up to $250,000 per depositor, per bank ($500,000 for joint accounts). Additionally, it may be a good time to evaluate your own potential risk taking. Early this year, personal loan balances were up 26% compared to last year, at the same time that interest rates were elevated.

Taking on too much risk, it seems, may be natural for both banks and individuals. And while bank regulations can help protect the economy, sound personal financial standards like paying off debt, saving money in an emergency fund, and building a retirement portfolio will significantly benefit your daily financial life.