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.
