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