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Evaluating Banking Risks

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					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

               Loan Growth


11.20%

11.00%

10.80%

10.60%
10.40%

10.20%
                                         Loan Growth
10.00%

9.80%

9.60%

9.40%
9.20%

9.00%
         USA                 Hang Seng
          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
                  2.00%
                  1.80%
US Commercial     1.60%
Bank              1.40%
                  1.20%
FDIC Statistics   1.00%
                  0.80%
on Banking
                  0.60%
                  0.40%
                  0.20%
                  0.00%
                              2001        2002        2003         2004

                          Noncurrent/Assets      Net Chargeoffs to Assets
    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

4.00%

3.50%

3.00%

2.50%                                                                                       2004
                                                                                            2003
2.00%
                                                                                            2002

1.50%                                                                                       2001


1.00%

0.50%

0.00%
        Total loans & Total real estate Commercial &         Loans to     All other loans
         leases            loans        industrial loans   individuals       & leases
                                                                         (including farm)
                 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
7


6


5


4


3


2


1


0
       2004                      2003                  2002                   2001

     Loan Loss/Net Charge Offs    Earnings/Net Charge Offs    Loan Loss/Gross Loans (%)
               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 =
 Noncore Liabilities - Short - term Investments
             Long - term Assets
    All Insured Commercial Banks
          UBPR Peer Group 1
                       Noncore Dependence


    14


    12


    10


    8
%




    6


    4


    2


    0
         2004   2003             2002       2001   2000
              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
Bank Balance Sheets

Assets
Loans Due in More than 1 Year             80   5%
Short-term Securities                     20   4%

Liabilities
Short-term Deposits                       90   4%
Equity                                    10

NIM =      (80*.05)+(20*.04)   - (90*0.04)
                         4.8            3.6    1.2


Repricing Gap                   (90-20)        -70

Interest Rate rises 1%
           (80*.05)+(20*.05)   - (90*0.05)
                           5            4.5    0.5

Change in NIM = Repricing Gap*Change in Interest Rate
Example: Hang Seng Bank, 2004
Most mortgage loans in HK are floating rate, so most
           assets are interest sensitive
                                Cumulative Gap



       60000


       40000


       20000


HK$m       0


       -20000


       -40000


       -60000
                Up to 3   Up to 6      Up to 12   More than 12   Total
                months    months       Months       Months
          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               Legal Risk
• Risk that operating          • Risk that lawsuits or
  expenses may vary              unenforcable contracts
  significantly.                 might affect profitability or
   – Crime & terrorism           solvency
   – Employee error or fraud   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
                    Commitments (% of Assets)


90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
              USA                               Hang Seng
 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.

				
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