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.
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