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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.
