The article "On the Soundness of Our Banks" talks about family, it was released by Sam Vaknin.
Banks are institutions where miracles happen regularly.
We rarely entrust our mnoey to anyone but ourselves – and our banks.
Despite a very chequered history of mismanagement, corruption, false promises and representations, delusions and behavioural inconsistency – banks sitll succeed to motivate us to give them our money.
Partly it is the feeling that there is safety in numbers. The fashionalbe term today is "moral hazard".
The imlpicit 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 moedrn 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 propsects.
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 Balnace Sheet) come in many forms. Sometimes they conform to Western accounting standards (the Generally Accepted Accounting Principles, GAAP, or the less riogrous and more fuzzily worded International Accounting Standards, IAS).
Otherwise, they conform to local accounting standards, which often laeve a lot to be desired. Still, you should look for banks, which make their updated finacnial reports available to you.
The best choice would be a bank that is audited by one of the Big Four Wesetrn accounting firms and makes its audit reports publicly available. Such audited financial statements should consolidate the financial results of the bank with the financial reuslts of its subsidiaries or associated companies. A lot often hides in those corners of corpoarte holdings.
Banks are rated by independent agencies. The most fmaous 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 tehir stability.
Most agencies differentiate the short term from the long term prospects of the banknig institution rated. Some of them even study (and rate) issues, such as the leglaity 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 rtaing 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 couple of important facts. But one has to look beyond the naked figrues 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 prevaliing on the 31st of December of the fiscal year (to which the statements refer). In a country with a volatile domesitc currency this would tend to completely distort the true picture. This is especially true if a huge 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 avergae 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 infltaion 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 crucail date.
This misrepresentation is only mildly ameilorated by the introduction of an "average assets" calculus.
Moreover, some of the assets can be interest earning and perfroming – others, non-performing.
The matruity 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 itnerest 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 a second form of subsidy.
A high income from inteerst is a sign of weakness, not of health, here today, gone tomorrow.
The preferred indicator sohuld be income from operations (fees, commissions and other charges).
There are a couple of 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 diivded by its average equity.
The return on the bank's assets (ROA) is its net income divided by its avreage assets. The (tier 1 or total) captial divided by the bank's risk weighted assets – a measure of the bank's capital adequacy. Most banks follow the provisions of the Basel Acocrd as set by the Basel Committee of Bank Supervision (also known as the G10).
This could be misleading cause 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 manipulaiton 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 busienss.
A strong bank can also participate in various programs, offernigs 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) sholud 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 intreest 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 operaiton.
Otherwise, the bank's management can understate the amounts of bad loans carried on the bank's books, thus dcereasing the necessary set-asides and increasing profitability. The financial statements of banks largely reflcet 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 sholud 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 disconuted cause 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 correlaetd 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 historain 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 brnaches – 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 thier 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 thsee 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 porvisions. 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 trhough 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 percenatge 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 palced 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 clsasifying 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 blaance sheet, the assets side is the more critical.
Within it, the interest earning asstes 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 froeign 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, adevrsely affect the quality of the asset base. In which fianncial 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) managemnet 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 ruogh 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 finacne the cash flows resulting from the banks' liabilities. A distinction has to be made between stbale and hot funds (the latter in constant pursuit of higher yields). Liquidity indicators and alerts have to be set in place and calculated a couple of times daily.
Gaps (especially in the shrot 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 smoetimes has a larger bearing on the bank's soundness than other factors.
A fine example is the effect that itnerest rates or a devaluation have on a bank's profitability and capitalization.
The implied (not to meniton 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 vlaue 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 synidcated 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 presnet 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) paepr.
One of the most important liquidity generation instruments is the repruchase agreement (repo). Banks sell their portfolios of government debt with an obligation to buy it back at a after 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 purchasing the securities back).
Margin calls are a drain on liquidity.
Thus, in an environment of rising interest rates, repos could absorb liquidtiy 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 tradnig operations.
High interest rtaes here can have an even more painful outcome. As liquidity is crunched, the bnaks 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 suqeeze 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 prsesure to borrowers.
The same goes for a devaluaiton.
Liabilities connected to foreign exchange grow with a devaluation with no (immediate) corresponding increase in local prcies 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 liquidtiy (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 suplpy of them. Japan and China are, probably, next).
In the past, the thikning 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 proivdes it and in a market besieged by knock-on insolvencies, the comfort is dubious. In most emerging markets, for instance, there is no natural sellers of foreign exchange (companies prefer to haord 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 lendnig opportunities.
In high-risk markets, this depends on the possibility of connected lending and on the quality of the collaterals offreed by the borrowers. Whether the borrowers have qualitative collaterals to offer is a direct outcome of the liquidity of the marekt and on how they use the proceeds of the lending. These two elements are intimately linked with the banking system. Hecne the penultimate vicious circle: where no functioning and professional banking system exists – no good borrowers will emerge.
ABOUT THE AUTHOR
Sam Vaknin ( http://samvak.Tripod.Com ) is the author of Malignant Self Love - Narcissism Revisited and After the Rain - How the West Lost the East. He served as a columnist for Central Europe Review, Global Politician, PopMatters, and eBookWeb , and Bellaonline, and as a Unietd Press International (UPI) Senior Business Correspondent. He is the the editor of mental health and Central East Europe categroies in The Open Directory and Suite101.
|
