Is My Money Safe - How Sound are Banks
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Banks are institutions where miracles happen regularly. We rarely entrust our
money to anyone but ourselves – and our banks. Despite a very chequered history
of mismanagement, corruption, false promises and representations, delusions and
behavioural inconsistency – banks still succeed to motivate us to give them our
money. Partly it is the feeling that there is safety in numbers. The fashionable
term today is "moral hazard". The implicit guarantees of the state and of other
financial institutions move us to take risks which we would, otherwise, have
avoided. Partly it is the sophistication of the banks in marketing and promoting
themselves and their products. Glossy brochures, professional computer and video
presentations and vast, shrine-like, real estate complexes all serve to enhance
the image of the banks as the temples of the new religion of money.
But what is behind all this? How can we judge the soundness of our banks? In
other words, how can we tell if our money is safely tucked away in a safe haven?
The reflex is to go to the bank's balance sheets. Banks and balance sheets have
been both invented in their modern form in the 15th century. A
balance sheet, coupled with other financial statements is supposed to provide us
with a true and full picture of the health of the bank, its past and its
long-term prospects. The surprising thing is that – despite common opinion – it
does.
But it is rather useless unless you know how to read it.
Financial statements (Income – or Profit and Loss - Statement, Cash Flow
Statement and Balance Sheet) come in many forms. Sometimes they conform to
Western accounting standards (the Generally Accepted Accounting Principles, GAAP,
or the less rigorous and more fuzzily worded International Accounting Standards,
IAS). Otherwise, they conform to local accounting standards, which often leave a
lot to be desired. Still, you should look for banks, which make their updated
financial reports available to you. The best choice would be a bank that is
audited by one of the Big Four Western accounting firms and makes its audit
reports publicly available. Such audited financial statements should consolidate
the financial results of the bank with the financial results of its subsidiaries
or associated companies. A lot often hides in those corners of corporate
holdings.
Banks are rated by independent agencies. The most famous and most reliable of
the lot is Fitch Ratings. Another one is Moody’s. These agencies assign letter
and number combinations to the banks that reflect their stability. Most agencies
differentiate the short term from the long term prospects of the banking
institution rated. Some of them even study (and rate) issues, such as the
legality of the operations of the bank (legal rating). Ostensibly, all a
concerned person has to do, therefore, is to step up to the bank manager, muster
courage and ask for the bank's rating. Unfortunately, life is more complicated
than rating agencies would have us believe.
They base themselves mostly on the financial results of the bank rated as a
reliable gauge of its financial strength or financial profile. Nothing is
further from the truth.
Admittedly, the financial results do contain a few important facts. But one has
to look beyond the naked figures to get the real – often much less encouraging –
picture.
Consider the thorny issue of exchange rates. Financial statements are calculated
(sometimes stated in USD in addition to the local currency) using the exchange
rate prevailing on the 31st of December of the fiscal year (to which
the statements refer). In a country with a volatile domestic currency this would
tend to completely distort the true picture. This is especially true if a big
chunk of the activity preceded this arbitrary date. The same applies to
financial statements, which were not inflation-adjusted in high inflation
countries. The statements will look inflated and even reflect profits where
heavy losses were incurred. "Average amounts" accounting (which makes use of
average exchange rates throughout the year) is even more misleading. The only
way to truly reflect reality is if the bank were to keep two sets of accounts:
one in the local currency and one in USD (or in some other currency of
reference). Otherwise, fictitious growth in the asset base (due to inflation or
currency fluctuations) could result.
Another example: in many countries, changes in regulations can greatly effect
the financial statements of a bank. In 1996, in Russia, for example, the Bank of
Russia changed the algorithm for calculating an important banking ratio (the
capital to risk weighted assets ratio).
Unless a Russian bank restated its previous financial statements accordingly, a
sharp change in profitability appeared from nowhere.
The net assets themselves are always misstated: the figure refers to the
situation on 31/12. A 48-hour loan given to a collaborating client can inflate
the asset base on the crucial date. This misrepresentation is only mildly
ameliorated by the introduction of an "average assets" calculus. Moreover, some
of the assets can be interest earning and performing – others, non-performing.
The maturity distribution of the assets is also of prime importance. If most of
the bank's assets can be withdrawn by its clients on a very short notice (on
demand) – it can swiftly find itself in trouble with a run on its assets leading
to insolvency.
Another oft-used figure is the net income of the bank. It is important to
distinguish interest income from non-interest income. In an open, sophisticated
credit market, the income from interest differentials should be minimal and
reflect the risk plus a reasonable component of income to the bank. But in many
countries (Japan, Russia) the government subsidizes banks by lending to them
money cheaply (through the Central Bank or through bonds). The banks then
proceed to lend the cheap funds at exorbitant rates to their customers, thus
reaping enormous interest income. In many countries the income from government
securities is tax free, which represents another form of subsidy. A high income
from interest is a sign of weakness, not of health, here today, gone tomorrow.
The preferred indicator should be income from operations (fees, commissions and
other charges).
There are a few key ratios to observe. A relevant question is whether the bank
is accredited with international banking agencies. These issue regulatory
capital requirements and other mandatory ratios. Compliance with these demands
is a minimum in the absence of which, the bank should be regarded as positively
dangerous.
The return on the bank's equity (ROE) is the net income divided by its average
equity. The return on the bank's assets (ROA) is its net income divided by its
average assets. The (tier 1 or total) capital divided by the bank's risk
weighted assets – a measure of the bank's capital adequacy. Most banks follow
the provisions of the Basel Accord as set by the Basel Committee of Bank
Supervision (also known as the G10). This could be misleading because the Accord
is ill equipped to deal with risks associated with emerging markets, where
default rates of 33% and more are the norm. Finally, there is the common stock
to total assets ratio. But ratios are not cure-alls. Inasmuch as the quantities
that comprise them can be toyed with – they can be subject to manipulation and
distortion. It is true that it is better to have high ratios than low ones. High
ratios are indicative of a bank's underlying strength, reserves, and provisions
and, therefore, of its ability to expand its business. A strong bank can also
participate in various programs, offerings and auctions of the Central Bank or
of the Ministry of Finance. The larger the share of the bank's earnings that is
retained in the bank and not distributed as profits to its shareholders – the
better these ratios and the bank's resilience to credit risks.
Still, these ratios should be taken with more than a grain of salt. Not even the
bank's profit margin (the ratio of net income to total income) or its asset
utilization coefficient (the ratio of income to average assets) should be relied
upon. They could be the result of hidden subsidies by the government and
management misjudgement or understatement of credit risks.
To elaborate on the last two points:
A bank can borrow cheap money from the Central Bank (or pay low interest to its
depositors and savers) and invest it in secure government bonds, earning a much
higher interest income from the bonds' coupon payments. The end result: a rise
in the bank's income and profitability due to a non-productive, non-lasting
arbitrage operation. Otherwise, the bank's management can understate the amounts
of bad loans carried on the bank's books, thus decreasing the necessary
set-asides and increasing profitability. The financial statements of banks
largely reflect the management's appraisal of the business. This has proven to
be a poor guide.
In the main financial results page of a bank's books, special attention should
be paid to provisions for the devaluation of securities and to the unrealized
difference in the currency position. This is especially true if the bank is
holding a major part of the assets (in the form of financial investments or of
loans) and the equity is invested in securities or in foreign exchange
denominated instruments.
Separately, a bank can be trading for its own position (the Nostro), either as a
market maker or as a trader. The profit (or loss) on securities trading has to
be discounted because it is conjectural and incidental to the bank's main
activities: deposit taking and loan making.
Most banks deposit some of their assets with other banks. This is normally
considered to be a way of spreading the risk. But in highly volatile economies
with sickly, underdeveloped financial sectors, all the institutions in the
sector are likely to move in tandem (a highly correlated market). Cross deposits
among banks only serve to increase the risk of the depositing bank (as the
recent affair with Toko Bank in Russia and the banking crisis in South Korea
have demonstrated).
Further closer to the bottom line are the bank's operating expenses: salaries,
depreciation, fixed or capital assets (real estate and equipment) and
administrative expenses. The rule of thumb is: the higher these expenses, the
weaker the bank. The great historian Toynbee once said that great civilizations
collapse immediately after they bequeath to us the most impressive buildings.
This is doubly true with banks. If you see a bank fervently engaged in the
construction of palatial branches – stay away from it.
Banks are risk arbitrageurs. They live off the mismatch between assets and
liabilities. To the best of their ability, they try to second guess the markets
and reduce such a mismatch by assuming part of the risks and by engaging in
portfolio management. For this they charge fees and commissions, interest and
profits – which constitute their sources of income.
If any expertise is imputed to the banking system, it is risk management. Banks
are supposed to adequately assess, control and minimize credit risks. They are
required to implement credit rating mechanisms (credit analysis and value at
risk – VAR - models), efficient and exclusive information-gathering systems, and
to put in place the right lending policies and procedures.
Just in case they misread the market risks and these turned into credit risks
(which happens only too often), banks are supposed to put aside amounts of money
which could realistically offset loans gone sour or future non-performing
assets. These are the loan loss reserves and provisions. Loans are supposed to
be constantly monitored, reclassified and charges made against them as
applicable. If you see a bank with zero reclassifications, charge offs and
recoveries – either the bank is lying through its teeth, or it is not taking the
business of banking too seriously, or its management is no less than divine in
its prescience. What is important to look at is the rate of provision for loan
losses as a percentage of the loans outstanding. Then it should be compared to
the percentage of non-performing loans out of the loans outstanding. If the two
figures are out of kilter, either someone is pulling your leg – or the
management is incompetent or lying to you. The first thing new owners of a bank
do is, usually, improve the placed asset quality (a polite way of saying that
they get rid of bad, non-performing loans, whether declared as such or not).
They do this by classifying the loans. Most central banks in the world have in
place regulations for loan classification and if acted upon, these yield rather
more reliable results than any management's "appraisal", no matter how well
intentioned.
In some countries the Central Bank (or the Supervision of the Banks) forces
banks to set aside provisions against loans at the highest risk categories, even
if they are performing. This, by far, should be the preferable method.
Of the two sides of the balance sheet, the assets side is the more critical.
Within it, the interest earning assets deserve the greatest attention. What
percentage of the loans is commercial and what percentage given to individuals?
How many borrowers are there (risk diversification is inversely proportional to
exposure to single or large borrowers)? How many of the transactions are with
"related parties"? How much is in local currency and how much in foreign
currencies (and in which)? A large exposure to foreign currency lending is not
necessarily healthy. A sharp, unexpected devaluation could move a lot of the
borrowers into non-performance and default and, thus, adversely affect the
quality of the asset base. In which financial vehicles and instruments is the
bank invested? How risky are they? And so on.
No less important is the maturity structure of the assets. It is an integral
part of the liquidity (risk) management of the bank. The crucial question is:
what are the cash flows projected from the maturity dates of the different
assets and liabilities – and how likely are they to materialize. A rough
matching has to exist between the various maturities of the assets and the
liabilities. The cash flows generated by the assets of the bank must be used to
finance the cash flows resulting from the banks' liabilities. A distinction has
to be made between stable and hot funds (the latter in constant pursuit of
higher yields). Liquidity indicators and alerts have to be set in place and
calculated a few times daily.
Gaps (especially in the short term category) between the bank's assets and its
liabilities are a very worrisome sign. But the bank's macroeconomic environment
is as important to the determination of its financial health and of its
creditworthiness as any ratio or micro-analysis. The state of the financial
markets sometimes has a larger bearing on the bank's soundness than other
factors. A fine example is the effect that interest rates or a devaluation have
on a bank's profitability and capitalization. The implied (not to mention the
explicit) support of the authorities, of other banks and of investors (domestic
as well as international) sets the psychological background to any future
developments. This is only too logical. In an unstable financial environment,
knock-on effects are more likely. Banks deposit money with other banks on a
security basis. Still, the value of securities and collaterals is as good as
their liquidity and as the market itself. The very ability to do business (for
instance, in the syndicated loan market) is influenced by the larger picture.
Falling equity markets herald trading losses and loss of income from trading
operations and so on.
Perhaps the single most important factor is the general level of interest rates
in the economy. It determines the present value of foreign exchange and local
currency denominated government debt. It influences the balance between realized
and unrealized losses on longer-term (commercial or other) paper. One of the
most important liquidity generation instruments is the repurchase agreement (repo).
Banks sell their portfolios of government debt with an obligation to buy it back
at a later date. If interest rates shoot up – the losses on these repos can
trigger margin calls (demands to immediately pay the losses or else materialize
them by buying the securities back).
Margin calls are a drain on liquidity. Thus, in an environment of rising
interest rates, repos could absorb liquidity from the banks, deflate rather than
inflate. The same principle applies to leverage investment vehicles used by the
bank to improve the returns of its securities trading operations. High interest
rates here can have an even more painful outcome. As liquidity is crunched, the
banks are forced to materialize their trading losses. This is bound to put added
pressure on the prices of financial assets, trigger more margin calls and
squeeze liquidity further. It is a vicious circle of a monstrous momentum once
commenced.
But high interest rates, as we mentioned, also strain the asset side of the
balance sheet by applying pressure to borrowers. The same goes for a
devaluation. Liabilities connected to foreign exchange grow with a devaluation
with no (immediate) corresponding increase in local prices to compensate the
borrower. Market risk is thus rapidly transformed to credit risk. Borrowers
default on their obligations. Loan loss provisions need to be increased, eating
into the bank's liquidity (and profitability) even further. Banks are then
tempted to play with their reserve coverage levels in order to increase their
reported profits and this, in turn, raises a real concern regarding the adequacy
of the levels of loan loss reserves. Only an increase in the equity base can
then assuage the (justified) fears of the market but such an increase can come
only through foreign investment, in most cases. And foreign investment is
usually a last resort, pariah, solution (see Southeast Asia and the Czech
Republic for fresh examples in an endless supply of them. Japan and China are,
probably, next).
In the past, the thinking was that some of the risk could be ameliorated by
hedging in forward markets (=by selling it to willing risk buyers). But a hedge
is only as good as the counterparty that provides it and in a market besieged by
knock-on insolvencies, the comfort is dubious. In most emerging markets, for
instance, there are no natural sellers of foreign exchange (companies prefer to
hoard the stuff). So forwards are considered to be a variety of gambling with a
default in case of substantial losses a very plausible way out.
Banks depend on lending for their survival. The lending base, in turn, depends
on the quality of lending opportunities. In high-risk markets, this depends on
the possibility of connected lending and on the quality of the collaterals
offered by the borrowers. Whether the borrowers have qualitative collaterals to
offer is a direct outcome of the liquidity of the market and on how they use the
proceeds of the lending. These two elements are intimately linked with the
banking system. Hence the penultimate vicious circle: where no functioning and
professional banking system exists – no good borrowers will emerge.
About the Author
Sam Vaknin is the author of "Malignant Self Love - Narcissism Revisited" and
"After the Rain - How the West Lost the East". He is a columnist in "Central
Europe Review", United Press International (UPI) and ebookweb.org and the editor
of mental health and Central East Europe categories in The Open Directory,
Suite101 and searcheurope.com. Until recently, he served as the Economic Advisor
to the Government of Macedonia.
His web site:
http://samvak.tripod.com
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Article Published/Sorted/Amended on Scopulus 2007-11-03 23:11:24 in Economic Articles
