Chalking it up
04 September 2013
Priyanka Birla, senior research analyst covering financial risk at Beroe, discusses the processes behind analysing bank risk
Image: Shutterstock
A bank’s financial statements represent a set of unique risk factors, which change with varying policies, practices and perceptions in the banking system. This calls for an analysis procedure that is markedly different from assessing the manufacturing or service sectors.
Risk in banking systems
The six most common risks the banking system suffers from which can be classified as i) financial risks; and ii) non-financial risks. Financial risks can further be classified into three main sub headings:
Credit risk:
The credit risk or default risk can be defined as the potential loss that can be incurred due to failure of the bank’s counterparty to meet its obligations as per the terms of the contract. For example: a homeowner stops making monthly mortgage payments.
Liquidity risk:
Liquidity risk arises when a bank is unable to raise funds to meet the expected or unexpected obligations of collateral or cash without adversely impacting the bank’s financial conditions (funding liquidity risk) or when a bank is not able to write off its position in some financial instruments due to inadequate market depth or market inefficiencies (market liquidity risk).
Market risk:
Market risk arises due to movement in various market policies. The market risk management of a bank involves assessment of sensitivity of a bank’s earning to various factors like foreign exchange rates, interest rates, commodity prices and equity prices.
Non-financial risks can be further classified into following three types:
Operational risk:
The risk to bank’s current income and prospective income due to failed internal processes, systems, people or from any other external event is called operating risk.
Strategic risk:
The risk to bank’s current or prospective earnings due to poor business decisions, ineffective implementation of the business decisions or due to lack of responsiveness or compatibility to changing external and internal business environment is called strategic risk.
Compliance risk
The risk to current and potential earnings due to non-compliance to or violations of various laws, rules regulations, prescribed practices, agreements or ethical standards is called the compliance risk.
Ratio analysis using
CAMELS framework
CAMEL rating was adopted as a common financial institution rating system by the Federal Financial Institution Examination Council in the US in 1979. Later, in 1987, it was adopted by the National Credit Union Administration in the US.
The acronym represents the following five parameters of a bank’s financial health:
Capital adequacy;
Asset quality;
Management quality;
Earning ability;
Liquidity; and
Sensitivity to market risk
Each of the above components would be rated on a scale of 1 to 5:
1= Strong
2= Satisfactory
3= Fair
4= Marginal
5= Unsatisfactory
Capital adequacy
Maintaining an adequate level of capital to align with the various risk exposures like market risk, credit risk, operational risk is a critical element to measure a banking institution’s financial performance and is measured in terms of statutory minimum capital standards prescribed in Basel III guidelines.
Asset quality
Losses due to delinquent loans in the loans portfolio of the bank is the greatest risk a bank faces. The provisions made against potential loan losses not only impact the loan portfolio value, but also the underlying capital of a bank.
Loans for which the debtor does not make scheduled payments for at least 90 days will be classified as a non-performing loan. The loan is defaulted or close to being defaulted as the probability of it being paid out becomes significantly low.
Management quality
This parameter is used to assess the ability of a bank management to efficiently generate revenues and profitability and to identify, to measure and to control risk factors in order to ensure smooth and safe functioning of an institution that is in compliance with laws and regulations applicable to the institution.
Earnings quality
Good earnings quality is a safeguard against depletion of capital due to shrinking asset values. Effective credit analysis prior to granting loans will lead to higher recovery rates and thus inflate the ratio above industry ratios.
Liquidity
Adequate liquid assets should be available with a bank that can be easily converted to cash with minimal loss to fund short-term obligation. Thus, the risk of maturity mismatch between the assets and liabilities is high among banks.
Banks can face unforeseen demand from customers to withdraw from their deposits. At any time, the bank should have enough short-term assets which are easily convertible to cash as and when liquidity is required to meet the customers’ demands.
Findings
By conducting the CAMEL analysis on top 20 banks worldwide, ranked according to their asset base, we have given the banks ratings between 1 and 5 (1 being the best and 5 being the worst). The result of our analysis is summarised in the table to the right
Risk in banking systems
The six most common risks the banking system suffers from which can be classified as i) financial risks; and ii) non-financial risks. Financial risks can further be classified into three main sub headings:
Credit risk:
The credit risk or default risk can be defined as the potential loss that can be incurred due to failure of the bank’s counterparty to meet its obligations as per the terms of the contract. For example: a homeowner stops making monthly mortgage payments.
Liquidity risk:
Liquidity risk arises when a bank is unable to raise funds to meet the expected or unexpected obligations of collateral or cash without adversely impacting the bank’s financial conditions (funding liquidity risk) or when a bank is not able to write off its position in some financial instruments due to inadequate market depth or market inefficiencies (market liquidity risk).
Market risk:
Market risk arises due to movement in various market policies. The market risk management of a bank involves assessment of sensitivity of a bank’s earning to various factors like foreign exchange rates, interest rates, commodity prices and equity prices.
Non-financial risks can be further classified into following three types:
Operational risk:
The risk to bank’s current income and prospective income due to failed internal processes, systems, people or from any other external event is called operating risk.
Strategic risk:
The risk to bank’s current or prospective earnings due to poor business decisions, ineffective implementation of the business decisions or due to lack of responsiveness or compatibility to changing external and internal business environment is called strategic risk.
Compliance risk
The risk to current and potential earnings due to non-compliance to or violations of various laws, rules regulations, prescribed practices, agreements or ethical standards is called the compliance risk.
Ratio analysis using
CAMELS framework
CAMEL rating was adopted as a common financial institution rating system by the Federal Financial Institution Examination Council in the US in 1979. Later, in 1987, it was adopted by the National Credit Union Administration in the US.
The acronym represents the following five parameters of a bank’s financial health:
Capital adequacy;
Asset quality;
Management quality;
Earning ability;
Liquidity; and
Sensitivity to market risk
Each of the above components would be rated on a scale of 1 to 5:
1= Strong
2= Satisfactory
3= Fair
4= Marginal
5= Unsatisfactory
Capital adequacy
Maintaining an adequate level of capital to align with the various risk exposures like market risk, credit risk, operational risk is a critical element to measure a banking institution’s financial performance and is measured in terms of statutory minimum capital standards prescribed in Basel III guidelines.
Asset quality
Losses due to delinquent loans in the loans portfolio of the bank is the greatest risk a bank faces. The provisions made against potential loan losses not only impact the loan portfolio value, but also the underlying capital of a bank.
Loans for which the debtor does not make scheduled payments for at least 90 days will be classified as a non-performing loan. The loan is defaulted or close to being defaulted as the probability of it being paid out becomes significantly low.
Management quality
This parameter is used to assess the ability of a bank management to efficiently generate revenues and profitability and to identify, to measure and to control risk factors in order to ensure smooth and safe functioning of an institution that is in compliance with laws and regulations applicable to the institution.
Earnings quality
Good earnings quality is a safeguard against depletion of capital due to shrinking asset values. Effective credit analysis prior to granting loans will lead to higher recovery rates and thus inflate the ratio above industry ratios.
Liquidity
Adequate liquid assets should be available with a bank that can be easily converted to cash with minimal loss to fund short-term obligation. Thus, the risk of maturity mismatch between the assets and liabilities is high among banks.
Banks can face unforeseen demand from customers to withdraw from their deposits. At any time, the bank should have enough short-term assets which are easily convertible to cash as and when liquidity is required to meet the customers’ demands.
Findings
By conducting the CAMEL analysis on top 20 banks worldwide, ranked according to their asset base, we have given the banks ratings between 1 and 5 (1 being the best and 5 being the worst). The result of our analysis is summarised in the table to the right
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