| Banks are institutions wherein miracles | | | | the bank's main activities: deposit taking |
| happen regularly. We rarely entrust our money | | | | and loan making.Most banks deposit some of |
| to anyone but ourselves - and our banks. | | | | their assets with other banks. This is |
| Despite a very chequered history of | | | | normally considered to be a way of spreading |
| mismanagement, corruption, false promises and | | | | the risk. But in highly volatile economies |
| representations, delusions and behavioural | | | | with sickly, underdeveloped financial |
| inconsistency - banks still succeed to | | | | sectors, all the institutions in the sector |
| motivate us to give them our money. Partly it | | | | are likely to move in tandem (a highly |
| is the feeling that there is safety in | | | | correlated market). Cross deposits among |
| numbers. The fashionable term today is "moral | | | | banks only serve to increase the risk of the |
| hazard". The implicit guarantees of the state | | | | depositing bank (as the recent affair with |
| and of other financial institutions moves us | | | | Toko Bank in Russia and the banking crisis in |
| to take risks which we would, otherwise, have | | | | South Korea have demonstrated).Further closer |
| avoided. Partly it is the sophistication of | | | | to the bottom line are the bank's operating |
| the banks in marketing and promoting | | | | expenses: salaries, depreciation, fixed or |
| themselves and their products. Glossy | | | | capital assets (real estate and equipment) |
| brochures, professional computer and video | | | | and administrative expenses. The rule of |
| presentations and vast, shrine-like, real | | | | thumb is: the higher these expenses, the |
| estate complexes all serve to enhance the | | | | worse. The great historian Toynbee once said |
| image of the banks as the temples of the new | | | | that great civilizations collapse immediately |
| religion of money.But what is behind all | | | | after they bequeath to us the most impressive |
| this? How can we judge the soundness of our | | | | buildings. This is doubly true with banks. If |
| banks? In other words, how can we tell if our | | | | you see a bank fervently engaged in the |
| money is safely tucked away in a safe | | | | construction of palatial branches - stay away |
| haven?The reflex is to go to the bank's | | | | from it.All considered, banks are risk |
| balance sheets. Banks and balance sheets have | | | | traders. They live off the mismatch between |
| been both invented in their modern form in | | | | assets and liabilities. To the best of their |
| the 15th century. A balance sheet, coupled | | | | ability, they try to second guess the markets |
| with other financial statements is supposed | | | | and reduce such a mismatch by assuming part |
| to provide us with a true and full picture of | | | | of the risks and by engaging in proper |
| the health of the bank, its past and its | | | | portfolio management. For this they charge |
| long-term prospects. The surprising thing is | | | | fees and commissions, interest and profits - |
| that - despite common opinion - it does. The | | | | which constitute their sources of income. If |
| less surprising element is that it is rather | | | | any expertise is attributed to the banking |
| useless unless you know how to read | | | | system, it is risk management. Banks are |
| it.Financial Statements (Income - aka Profit | | | | supposed to adequately assess, control and |
| and Loss - Statement, Cash Flow Statement and | | | | minimize credit risks. They are required to |
| Balance Sheet) come in many forms. Sometimes | | | | implement credit rating mechanisms (credit |
| they conform to Western accounting standards | | | | analysis), efficient and exclusive |
| (the Generally Accepted Accounting | | | | information-gathering systems, and to put in |
| Principles, GAAP, or the less rigorous and | | | | place the right lending policies and |
| more fuzzily worded International Accounting | | | | procedures. Just in case they misread the |
| Standards, IAS). Otherwise, they conform to | | | | market risks and these turned into credit |
| local accounting standards, which often leave | | | | risks (which happens only too often), banks |
| a lot to be desired. Still, you should look | | | | are supposed to put aside amounts of money |
| for banks, which make their updated financial | | | | which could realistically offset loans gone |
| reports available to you. The best choice | | | | sour or non-performing in the future. These |
| would be a bank that is audited by one of the | | | | are the loan loss reserves and provisions. |
| Big Six Western accounting firms and makes | | | | Loans are supposed to be constantly |
| its audit reports publicly available. Such | | | | monitored, reclassified and charges must be |
| audited financial statements should | | | | made against them as applicable. If you see a |
| consolidate the financial results of the bank | | | | bank with zero reclassifications, charge off |
| with the financial results of its | | | | and recoveries - either the bank is lying |
| subsidiaries or associated companies. A lot | | | | through its teeth, or it is not taking the |
| often hides in those corners of corporate | | | | business of banking too seriously, or its |
| ownership.Banks are rated by independent | | | | management is no less than divine in its |
| agencies. The most famous and most reliable | | | | prescience. What is important to look at is |
| of the lot is Fitch-IBCA. Another one is | | | | the rate of provision for loan losses as a |
| Thomson BankWatch-BREE. These agencies assign | | | | percentage of the loans outstanding. Then it |
| letter and number combinations to the banks, | | | | should be compared to the percentage of |
| that reflect their stability. Most agencies | | | | non-performing loans out of the loans |
| differentiate the short term from the long | | | | outstanding. If the two figures are out of |
| term prospects of the banking institution | | | | kilter, either someone is pulling your leg - |
| rated. Some of them even study (and rate) | | | | or the management is incompetent or lying to |
| issues, such as the legality of the | | | | you. The first thing new owners of a bank do |
| operations of the bank (legal rating). | | | | is, usually, improve the placed asset quality |
| Ostensibly, all a concerned person has to do, | | | | (a polite way of saying that they get rid of |
| therefore, is to step up to the bank manager, | | | | bad, non-performing loans, whether declared |
| muster courage and ask for the bank's rating. | | | | as such or not). They do this by classifying |
| Unfortunately, life is more complicated than | | | | the loans. Most central banks in the world |
| rating agencies would like us to believe. | | | | have in place regulations for loan |
| They base themselves mostly on the financial | | | | classification and if acted upon, these yield |
| results of the bank rated, as a reliable | | | | rather more reliable results than any |
| gauge of its financial strength or financial | | | | management's "appraisal", no matter how well |
| profile. Nothing is further from the | | | | intentioned. In some countries in the world, |
| truth.Admittedly, the financial results do | | | | the Central Bank (or the Supervision of the |
| contain a few important facts. But one has to | | | | Banks) forces banks to set aside provisions |
| look beyond the naked figures to get the real | | | | against loans of the highest risk categories, |
| - often much less encouraging - | | | | even if they are performing. This, by far, |
| picture.Consider the thorny issue of exchange | | | | should be the preferable method.Of the two |
| rates. Financial statements are calculated | | | | sides of the balance sheet, the assets side |
| (sometimes stated in USD in addition to the | | | | should earn the most attention. Within it, |
| local currency) using the exchange rate | | | | the interest earning assets deserve the |
| prevailing on the 31st of December of the | | | | greatest dedication of time. What percentage |
| fiscal year (to which the statements refer). | | | | of the loans is commercial and what |
| In a country with a volatile domestic | | | | percentage given to individuals? How many |
| currency this would tend to completely | | | | lenders are there (risk diversification is |
| distort the true picture. This is especially | | | | inversely proportional to exposure to single |
| true if a big chunk of the activity preceded | | | | borrowers)? How many of the transactions are |
| this arbitrary date. The same applies to | | | | with "related parties"? How much is in local |
| financial statements, which were not | | | | currency and how much in foreign currencies |
| inflation-adjusted in high inflation | | | | (and in which)? A large exposure to foreign |
| countries. The statements will look inflated | | | | currency lending is not necessarily healthy. |
| and even reflect profits where heavy losses | | | | A sharp, unexpected devaluation could move a |
| were incurred. "Average amounts" accounting | | | | lot of the borrowers into non-performance and |
| (which makes use of average exchange rates | | | | default and, thus, adversely affect the |
| throughout the year) is even more misleading. | | | | quality of the asset base. In which financial |
| The only way to truly reflect reality is if | | | | vehicles and instruments is the bank |
| the bank were to keep two sets of accounts: | | | | invested? How risky are they? And so on.No |
| one in the local currency and one in USD (or | | | | less important is the maturity structure of |
| in some other currency of reference). | | | | the assets. It is an integral part of the |
| Otherwise, fictitious growth in the asset | | | | liquidity (risk) management of the bank. The |
| base (due to inflation or currency | | | | crucial question is: what are the cash flows |
| fluctuations) could result.Another example: | | | | projected from the maturity dates of the |
| in many countries, changes in regulations can | | | | different assets and liabilities - and how |
| greatly effect the financial statements of a | | | | likely are they to materialize. A rough |
| bank. In 1996, in Russia, to take an example, | | | | matching has to exist between the various |
| the Bank of Russia changed the algorithm for | | | | maturities of the assets and the liabilities. |
| calculating an important banking ratio (the | | | | The cash flows generated by the assets of the |
| capital to risk weighted assets ratio). | | | | bank must be used to finance the cash flows |
| Unless a Russian bank restated its previous | | | | resulting from the banks' liabilities. A |
| financial statements accordingly, a sharp | | | | distinction has to be made between stable and |
| change in profitability appeared from | | | | hot funds (the latter in constant pursuit of |
| nowhere.The net assets themselves are always | | | | higher yields). Liquidity indicators and |
| misstated: the figure refers to the situation | | | | alerts have to be set in place and calculated |
| on 31/12. A 48-hour loan given to a | | | | a few times daily. Gaps (especially in the |
| collaborating firm can inflate the asset base | | | | short term category) between the bank's |
| on the crucial date. This misrepresentation | | | | assets and its liabilities are a very |
| is only mildly ameliorated by the | | | | worrisome sign.But the bank's macroeconomic |
| introduction of an "average assets" calculus. | | | | environment is as important to the |
| Moreover, some of the assets can be interest | | | | determination of its financial health and of |
| earning and performing - others, | | | | its creditworthiness as any ratio or |
| non-performing. The maturity distribution of | | | | micro-analysis. The state of the financial |
| the assets is also of prime importance. If | | | | markets sometimes has a larger bearing on the |
| most of the bank's assets can be withdrawn by | | | | bank's soundness than other factors. A fine |
| its clients on a very short notice (on | | | | example is the effect that interest rates or |
| demand) - it can swiftly find itself in | | | | a devaluation have on a bank's profitability |
| trouble with a run on its assets leading to | | | | and capitalization. The implied (not to |
| insolvency.Another oft-used figure is the net | | | | mention the explicit) support of the |
| income of the bank. It is important to | | | | authorities, of other banks and of investors |
| distinguish interest income from non-interest | | | | (domestic as well as international) sets the |
| income. In an open, sophisticated credit | | | | psychological background to any future |
| market, the income from interest | | | | developments. This is only too logical. In an |
| differentials should be minimal and reflect | | | | unstable financial environment, knock-on |
| the risk plus a reasonable component of | | | | effects are more likely. Banks deposit money |
| income to the bank. But in many countries | | | | with other banks on a security basis. Still, |
| (Japan, Russia) the government subsidizes | | | | the value of securities and collaterals is as |
| banks by lending to them money cheaply | | | | good as their liquidity and as the market |
| (through the Central Bank or through bonds). | | | | itself. The very ability to do business (for |
| The banks then proceed to lend the cheap | | | | instance, in the syndicated loan market) is |
| funds at exorbitant rates to their customers, | | | | influenced by the larger picture. Falling |
| thus reaping enormous interest income. In | | | | equity markets herald trading losses and loss |
| many countries the income from government | | | | of income from trading operations and so |
| securities is tax free, which represents | | | | on.Perhaps the single most important factor |
| another form of subsidy. A high income from | | | | is the general level of interest rates in the |
| interest is a sign of weakness, not of | | | | economy. It determines the present value of |
| health, here today, there tomorrow. The | | | | foreign exchange and local currency |
| preferred indicator should be income from | | | | denominated government debt. It influences |
| operations (fees, commissions and other | | | | the balance between realized and unrealized |
| charges).There are a few key ratios to | | | | losses on longer-term (commercial or other) |
| observe. A relevant question is whether the | | | | paper. One of the most important liquidity |
| bank is accredited with international banking | | | | generation instruments is the repurchase |
| agencies. The latter issue regulatory capital | | | | agreement (repo). Banks sell their portfolios |
| requirements and other defined ratios. | | | | of government debt with an obligation to buy |
| Compliance with these demands is a minimum in | | | | it back at a later date. If interest rates |
| the absence of which, the bank should be | | | | shoot up - the losses on these repos can |
| regarded as positively dangerous.The return | | | | trigger margin calls (demands to immediately |
| on the bank's equity (ROE) is the net income | | | | pay the losses or else materialize them by |
| divided by its average equity. The return on | | | | buying the securities back). Margin calls are |
| the bank's assets (ROA) is its net income | | | | a drain on liquidity. Thus, in an environment |
| divided by its average assets. The (tier 1 or | | | | of rising interest rates, repos could absorb |
| total) capital divided by the bank's risk | | | | liquidity from the banks, deflate rather than |
| weighted assets - a measure of the bank's | | | | inflate. The same principle applies to |
| capital adequacy. Most banks follow the | | | | leverage investment vehicles used by the bank |
| provisions of the Basel Accord as set by the | | | | to improve the returns of its securities |
| Basel Committee of Bank Supervision (also | | | | trading operations. High interest rates here |
| known as the G10). This could be misleading | | | | can have an even more painful outcome. As |
| because the Accord is ill equipped to deal | | | | liquidity is crunched, the banks are forced |
| with risks associated with emerging markets, | | | | to materialize their trading losses. This is |
| where default rates of 33% and more are the | | | | bound to put added pressure on the prices of |
| norm. Finally, there is the common stock to | | | | financial assets, trigger more margin calls |
| total assets ratio. But ratios are not | | | | and squeeze liquidity further. It is a |
| cure-alls. Inasmuch as the quantities that | | | | vicious circle of a monstrous momentum once |
| comprise them can be toyed with - they can be | | | | commenced.But high interest rates, as we |
| subject to manipulation and distortion. It is | | | | mentioned, also strain the asset side of the |
| true that it is better to have high ratios | | | | balance sheet by applying pressure to |
| than low ones. High ratios are indicative of | | | | borrowers. The same goes for a devaluation. |
| a bank's underlying strength of reserves and | | | | Liabilities connected to foreign exchange |
| provisions and, thereby, of its ability to | | | | grow with a devaluation with no (immediate) |
| expand its business. A strong bank can also | | | | corresponding increase in local prices to |
| participate in various programs, offerings | | | | compensate the borrower. Market risk is thus |
| and auctions of the Central Bank or of the | | | | rapidly transformed to credit risk. Borrowers |
| Ministry of Finance. The more of the bank's | | | | default on their obligations. Loan loss |
| earnings are retained in the bank and not | | | | provisions need to be increased, eating into |
| distributed as profits to its shareholders - | | | | the bank's liquidity (and profitability) even |
| the better these ratios and the bank's | | | | further. Banks are then tempted to play with |
| resilience to credit risks. Still, these | | | | their reserve coverage levels in order to |
| ratios should be taken with more than a grain | | | | increase their reported profits and this, in |
| of salt. Not even the bank's profit margin | | | | turn, raises a real concern regarding the |
| (the ratio of net income to total income) or | | | | adequacy of the levels of loan loss reserves. |
| its asset utilization coefficient (the ratio | | | | Only an increase in the equity base can then |
| of income to average assets) should be relied | | | | assuage the (justified) fears of the market |
| upon. They could be the result of hidden | | | | but such an increase can come only through |
| subsidies by the government and management | | | | foreign investment, in most cases. And |
| misjudgement or understatement of credit | | | | foreign investment is usually a last resort, |
| risks.To elaborate on the last two points: a | | | | pariah, solution (see Southeast Asia and the |
| bank can borrow cheap money from the Central | | | | Czech Republic for fresh examples in an |
| Bank (or pay low interest to its depositors | | | | endless supply of them. Japan and China are, |
| and savers) and invest it in secure | | | | probably, next).In the past, the thinking was |
| government bonds, earning a much higher | | | | that some of the risk could be ameliorated by |
| interest income from the bonds' coupon | | | | hedging in forward markets (=by selling it to |
| payments. The end result: a rise in the | | | | willing risk buyers). But a hedge is only as |
| bank's income and profitability due to a | | | | good as the counterparty that provides it and |
| non-productive, non-lasting arbitrage | | | | in a market besieged by knock-on |
| operation. Otherwise, the bank's management | | | | insolvencies, the comfort is dubious. In most |
| can understate the amounts of bad loans | | | | emerging markets, for instance, there are no |
| carried on the bank's books, thus decreasing | | | | natural sellers of foreign exchange |
| the necessary set-asides and increasing | | | | (companies prefer to hoard the stuff). So |
| profitability. The financial statements of | | | | forwards are considered to be a variety of |
| banks largely reflect the management's | | | | gambling with a default in case of |
| appraisal of the business. This is a poor | | | | substantial losses a very plausible way |
| guide to go by.In the main financial results' | | | | out.Banks depend on lending for their |
| page of a bank's books, special attention | | | | survival. The lending base, in turn, depends |
| should be paid to provisions for the | | | | on the quality of lending opportunities. In |
| devaluation of securities and to the | | | | high-risk markets, this depends on the |
| unrealized difference in the currency | | | | possibility of connected lending and on the |
| position. This is especially true if the bank | | | | quality of the collaterals offered by the |
| is holding a major part of the assets (in the | | | | borrowers. Whether the borrowers have |
| form of financial investments or of loans) | | | | qualitative collaterals to offer is a direct |
| and the equity is invested in securities or | | | | outcome of the liquidity of the market and on |
| in foreign exchange denominated instruments. | | | | how they use the proceeds of the lending. |
| Separately, a bank can be trading for its own | | | | These two elements are intimately linked with |
| position (the Nostro), either as a market | | | | the banking system. Hence the penultimate |
| maker or as a trader. The profit (or loss) on | | | | vicious circle: where no functioning and |
| securities trading has to be discounted | | | | professional banking system exists - no good |
| because it is conjectural and incidental to | | | | borrowers will emerge. |