Evaluating Banking Risks

Objectives Students will be able to explain different types of Banking Risk Students will be able to calculate ratios which are commonly used to measure exposure Students will be able to conduct peer or trend analysis of credit risk exposure

Types of Risk 1.Credit Risk 2.Liquidity Risk 3.Market Risk Interest Rate Risk Foreign Exchange Risk 4.Operational Risk 5.Reputation Risk 6.Legal Risk

Credit Risk: the risk that a borrower will not pay back interest or principal on a loan. A key comparative advantage of banks is analyzing and monitoring the behavior of borrowers. Banks may enhance their advantage by specialization in loans to certain regions, industries or types of borrowers. Such a strategy exposes the banks to systemic risk.

Measuring a Banks Credit Risk/Key Ratios Loans are assets with the most credit risk (also the most profitable). Other types of assets are typically more transparent and have less risk of default. Large quantities of loans make banks riskier. Higher Loans to Assets means higher risk. Rapid expansion of credit means banks may not be discriminating Higher Loan Growth Rate means higher risk

Credit Risk Notes Compare loan to asset ratio of US banks to Hang Seng Compare loan growth. Compare charge-off ratios. (p 33). Compare the allocations of loans between various types.

Comparison

Stages of Bad Loans Past Due Loans: Loans for which contracted payments have not been made, but which still are accruing interest. –More than 90 days past due is Nonperforming Loans Nonaccrual Loans: Loans that are habitually past due and no longer accruing interest. Total Noncurrent = Past Due + Nonaccrual Charge-offs: Loans written off as uncollectable Recoveries: Sums later collected on loans written off. Net Chargoffs = Charge-offs - Recoveries

Measures of Bad Debt We can also measure banks credit risk by their past performance. –Net Charge offs to Loans, Net Charge Offs to Assets –Noncurrent Assets to Loans tend to lead Chargeoffs US Commercial Bank FDIC Statistics on Banking

Composition of a Banks Loan Portfolio Some loans are riskier than others, so a high share of loans in risky categories involves higher risk. –Banks concentrate on real estate lending which tends to have very low default rates. An undiversified portfolio also exposes a bank to risk. Concentration in the property market exposes the bank to systematic risk of property collapse.

Net Chargeoff Rates by Loan Type Source: FDIC Statistics on Banking

Protection Banks protect themselves from credit risk with reserves allocated to loan losses. Measures of these reserves measure banks protection against credit risk Loan Loss Allowance/Loans Loan Loss Allowance/Net Chargeoffs Banks earnings are also a protection against losses Earnings Coverage = (NI-Burden)/Net Chargeoffs

Protection from Bad Loans US Commercial Banks, 2004

Liquidity Risk Banks liabilities are available to depositors on demand. Banks must wait long time for repayment for their loans. Banks face risk that many depositors will withdraw funds at the same time forcing the bank to liquidate assets at high cost. Banks also keep some liquid assets such as cash, short-term deposits, or government bonds but these earn low interest.

Measuring Liquidity Risk Asset Indicators Loans are the least liquidity type of asset. Banks with relatively high amounts of loans are illiquid. –Net Loans to Assets, –Net Loans to Deposits. Banks facing a liquidity shortfall sell short-term securites for cash. Firms with lots of such securities are relatively liquid. –Short-Term Investments to Assets.

Liquidity Risk Liabilities Indicators Deposits/Liabilities are divided into two types 1.Core Deposits Checking & Savings Accounts, MMDA, Small Time Deposit 2.Volatile/Purchased Liabilities, Large Time Deposit/Jumbo CDs, Fed Funds, Commercial Paper, etc. Core deposits are thought to be more stable and unlikely to be withdrawn quickly.

Liability Meaure of Dependence Noncore Dependence is a key indicator of potential liquidity problems. Noncore Dependence =

All Insured Commercial Banks UBPR Peer Group 1

Market Risk Market risk is the risk that banks are exposed to through changes in asset market prices. –Interest Rate Risk –Foreign Exchange Rate Risk

Interest Risk: Risk that market interest rates might fluctuate Banks typically have long-term assets (mortgages, etc.) and have short-term liabilities (checking, savings deposits). When interest rates rise, they will have to pay more on deposits while facing the possibility that they would not increase income on liabilities. This would reduce NIM.

Measuring Interest Rate Risk Measure the interest sensitive assets for which the interest rate can be raised by a given time horizon (say 1 year) if the interest rate rises. At the same horizon, measure the interest sensitive liabilities for which a higher interest must be paid if the interest rate rises. Refinancing Gap = IS Assets – IS Liabilities

Example: Bank

Example: Hang Seng Bank, 2004 Most mortgage loans in HK are floating rate, so most assets are interest sensitive

Exchange Rate Risk Balance sheets are kept in a single currency. If bank assets or liabilities are denominated in currencies other than the balance sheet currency, fluctuations in currency values will require a revaluation of the assets. Exchange rate risk is the risk that a currency fluctuation would negatively impact balance sheets. –US banks do business almost entirely in US$. Exchange rate risk is not a big issue. –This is not true in HK which is why banks try to keep currency liabilities and assets roughly matched.

Comprehensive Risk Management Modern banks use computer models to measure market risk. Based on historical data on correlations between asset prices and assumptions about the distribution of shocks (i.e. assume shocks are normally distributed) the models will generate a distribution of returns over any horizon. Value at Risk models will predict some possible loss which will be the maximum possible loss with some percentage chance over some forecast horizon.

Problems with VAR’s Normal distributions assess a very low likelihood of extreme, crisis events. –HKMA recommends balance sheets should be “stress-tested” against some Historical time series models are subject to unexpected structural change. Less good at evaluating losses from infrequently traded assets like loans.

Other Risks Operational Risk Risk that operating expenses may vary significantly. –Crime & terrorism –Employee error or fraud Legal Risk Risk that lawsuits or unenforcable contracts might affect profitability or solvency Reputation Risk Risk that negative publicity may affect customer base or business opportunities.

Off Balance Sheet Analysis A number of bank activities are not in the traditional lending categories but which may expose the bank to some risk. –Contingent liabilities. Banks make promises to lend under some set of circumstances. Loan Commitments – Promise to lend some money to firm if they so desire. Letters of Credit – Promise to lend money to trader if their customer defaults on a purchase order.

Contingent Liabilities in comparison

Off Balance Sheet Analysis, cont. A number of bank activities are not in the traditional lending categories but which may expose the bank to some risk. –Derivatives. Financial Securities or instruments that will earn some future payment contingent on some market outcome (Futures, Forwards, Options). Interest Rate Derivates. Exchange Rate Derivatives Credit Derivatives

Regulatory Analysis Regulators use a 6 tier standard to measures called CAMELS C = Capital Adequacy A = Asset Adequacy M = Management Quality E = Earnings L = Liquidity S = Sensitivity to Market Risk

CAMELS Ratings Regulators in HK & US give all banks a rating from 1 to 5 in all CAMELS categories with 1 being best and 4-5 worst. A combined ranking is constructed with a combined score of 4-5 indicating a high likelihood of near term failure.

Market Measures of Bank Performance Financial markets may be a measure of bank performance. Equity Markets: Common stock Book-to-Market ratio measures markets perception of growth potential and risk of assets. Preferred stock and subordinated debt holders are exposed to downside risk but not upside gains from risky activities. Price of these assets may help measure riskiness of activities.