1 BFS Coursework Seminar Part Two: Measurements of Risk

2 Last Time… We examined the need to measure bank performance We decided that bank performance is dependant on risk exposure and profitability. We discussed how we can assess profitability through ratios (such as ROA and ROE).

3 Bank Risks Credit Risk Liquidity Risk Market Risk Interest Rate Risk Earnings Risk Solvency Risk

4 Credit Risk The Probability that Some of the Bank’s Assets Will Decline in Value and Perhaps Become Worthless

5 Credit Risk Measures Total Loans / Total Deposits Non-performing Loans / Total Loans Provision for Loan Losses / Total Loans

6 Credit Risk Measures Explained Total loans to total deposits: As this ratio grows, the bank may begin to endanger the interests of depositors. Non-performing loans to total loans and leases: The rise in this ratio signals that bank ’ s credit risk is increasing. If this ratio persistently rises, the bank may be heading for bank failure. Annual provision for loan losses / Total loans and leases: The increase in this ratio signals that the management is has more funds available to control bad loans. A higher value is considered ‘ better ’.

7 Liquidity Risk Probability the Bank Will Not Have Sufficient Cash and Borrowing Capacity to Meet Deposit Withdrawals and Other Cash Needs

8 Liquidity Risk Measures Net Loans / Total Assets Purchased Funds / Total Assets Cash assets and Government Securities / Total Assets

9 Liquidity Risk Measures Explained Net loans to total assets: Higher the value of the ratio, lower amounts of cash and reserves are available and the higher the chance of a liquidity crunch. Purchased funds (securities) to total assets: Higher use of purchased funds increases the chances of a liquidity crunch. Cash asset and government securities to total assets: Higher the value, more easily the bank can convert these securities into cash. A higher value is ‘better’.

10 Market Risk Probability of the Market Value of the Bank’s Investment Portfolio Declining in Value Due to a Rise in Interest Rates

11 Market Risk Measures Book-Value of Assets / Estimated Market Value of Assets Book-Value of Equity / Market Value of Equity Market Value of Bonds / Book-Value of Bonds

12 Market Risk Measures Explained Book / Market Value (of Assets, Equity and Bonds): This ratio shows the variation between accounting and market values of various assets. The higher the value, the greater the negative disparity between book and market values of assets. Higher value therefore means more risk.

13 Interest Rate Risk The Danger that Shifting Interest Rates May Adversely Affect a Bank’s Net Income, the Value of its Assets or Equity.

14 Interest Rate Risk Measures Interest Sensitive Assets / Interest Sensitive Liabilities

15 Interest Rate Risk Measures Explained Ratio of interest sensitive assets to interest sensitive liabilities: When interest sensitive assets exceed interest sensitive liabilities in a particular maturity range, a bank is vulnerable to falling interest rate. The same is the case for the opposite situation.

16 Earnings Risk The variation (Risk) inherent in the Bank’s Bottom Line – Its Net Income After All Expenses

17 Earnings Risk Measures Standard Deviation of Net Income Standard Deviation of ROE Standard Deviation of ROA

18 Earning Risk Measures Explained Standard Deviation: The higher the standard deviation or variance of bank income, the more risky is the banks earnings profile.

19 Solvency Risk Probability of the Value of the Bank’s Assets Declining Below the Level of its Total Liabilities. The Probability of the Bank’s Long Run Survival.

20 Solvency Risk Measures Stock Price / Earnings Per Share Equity Capital / Total Assets Equity Capital / Risk Assets

21 Solvency Risk Measures Explained P/E Ratio: This ratio often falls if investors come to believe that a bank is undercapitalised relative to the risks it has taken on. Ratio of equity capital to assets: A decline in equity funding relative to assets may indicate increased risk exposure for the banks shareholders and debt-holders. Ratio of equity capital to risk assets: It reflects how well current bank capital covers potential losses from these assets most likely to decline in value. A higher value is ‘better’.