Evaluating Banking Risks

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Evaluating Banking Risks
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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

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Types of Risk

• Credit Risk
• Liquidity Risk
• Market Risk
• Interest Rate Risk
• Foreign Exchange Risk
• Operational Risk
• Reputation Risk
• Legal Risk

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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.

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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

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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.

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Comparison
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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

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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

US Commercial Bank FDIC Statistics on Banking
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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.

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Net Chargeoff Rates by Loan TypeSource FDIC
Statistics on Banking
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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

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Protection from Bad LoansUS Commercial Banks,
2004
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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.

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Measuring Liquidity RiskAsset 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.

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Liquidity RiskLiabilities Indicators

• Deposits/Liabilities are divided into two types
• Core Deposits Checking Savings Accounts, MMDA,
  Small Time Deposit
• 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.

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Liability Meaure of Dependence

• Noncore Dependence is a key indicator of
  potential liquidity problems.
• Noncore Dependence

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All Insured Commercial BanksUBPR Peer Group 1
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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

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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.

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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

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Example Bank
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Example Hang Seng Bank, 2004Most mortgage loans
in HK are floating rate, so most assets are
interest sensitive
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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.

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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.

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Problems with VARs

• 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.

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Other Risks

• Operational Risk
• Risk that operating expenses may vary
  significantly.
• Crime terrorism
• Employee error or fraud

• Legal Risk
• Risk that lawsuits or unenforcable contracts
  might affect profitability or solvency
• Reputation Risk
• Risk that negative publicity may affect customer
  base or business opportunities.

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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.

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Contingent Liabilities in comparison
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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

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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

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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.

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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.