The Arab Investment & Export Credit Guarantee Corporation“DHAMAN” Bank’s Risk Assessment AMAN UNION 5th April 2011 Dubai – U.A.E.
Introduction to Banks’ Risk Assessment WORKSHOP OUTLINE • What is a bank? • Sources of information • Types of banks (Function) • Practical steps to Bank Assessment • Matters to Keep in mind • Bank’s Balance Sheet & Income Statement • CAMELS framework
What Does Bank Mean? In simple terms, • A bank is a commercial institution • Licensed as a receiver of deposits • Mainly concerned with making and receiving payments • Supplying financing to individuals & corporate
Sources of Information on Banks Financial Information may be obtained through: • Bank’s Web Page • Annual Report (Hard Copy) • Bankers Almanac database (fee based – by subscription) • Bankscope database (fee based – by subscription) • Fitch rating • CI Rating • Others
Types of Banks (Function) Banks can be both private or public in nature. The most common forms / types are: • Retail banks • Commercial banks • Investment banks • Specialized banks • Savings & Loans • Development banks • Central Banks – Regulators • Online banks
Retail Bank • A bank that works with consumers, otherwise known as 'retail customers'. • Provides basic banking services to the general public, including: • Checking and savings accounts • CDs • Safe deposit boxes • Mortgages and second mortgages • Auto loans • Unsecured and revolving loans such as credit cards • Payment and Collection processing
Commercial Banks • A bank that works with businesses. • Handles banking needs for large and small businesses, including: • Basic accounts such as savings and checking • Lending money for real and capital purchases • Lines of credit • Trade Finance / Letters of credit & Letters of guarantee • Collection Services services • Payment and transaction processing • Foreign exchange
Investment Banks • Some large investment banks serve as commercial banks or retail banks • Work primarily in the investment markets • Help organizations use investment markets through raising money by issuing stocks or bonds • Consult on mergers and acquisitions • Specialized investment banks usually do not take customer deposits
Specialized Banks • Usually owned by the State • Established for economic development of the country, with a focus on certain sectors • Operate like commercial banks • Rely on the State for funding rather than on deposits • Target specific sectors, such as: • Agriculture • Industrial • Real Estate • Others
Savings & Loans (S&L’s) • Specialized banks created to promote affordable homeownership. • Encouraged people to save their money • Capitalization & deposit funds are used by S&L’s to lend through long term mortgages • Affordable monthly payment.
Development Banks • Multilateral institutions / supranational institutions. • Provide financing for development needs of a regional group of countries. • Rely on capital contributions from member countries • Examples include: • The World Bank / IMF • Islamic Development Bank • African Development Bank • Asian Development Bank • American Development Bank • European Bank for Reconstruction & Development
Online Banks • Primary or exclusive use on the Internet • Allow to have more choice and flexibility • Direct use of own computer\ • Often get more competitive rates • Online banks allow you to do everything online, including • Open accounts • Fund accounts • Transfer money between accounts • Use online bill pay services • Buy CDs • Get loans • Access overdraft lines of credit • Access cash in the real world with a debit card
Central Banks Main Characteristics: • Public institution / government authority • Named either as central bank, reserve bank, or monetary authority. • Usually independent, operating under rules usually free from political interference. • Roles are similar in different countries, but they may have different objectives. • Enjoy supervisory powers • Regulatory body for the banking sector in the country
Central Banks • They usually have three primary goals: • Conduct monetary policy • Issue currency • Regulate the money/credit supply • Control the interest rates in a country • Supervise and regulate financial Institutions • Provide financial services • Act as a lender of last resort to the banking sector during times of financial crisis. • Hold the reserves of other banks • Sell new issues of securities for the government
Banking Regulations Bank regulations are a set of certain requirements, restrictions and guidelines imposed by the financial regulatory authority within a country usually in view of international banking regulations set forward by recognized regulatory bodies.
Practical steps to Bank Assessment Practical steps to Bank Assessment: • Get the correct name of the bank • Look at the Economic performance & major economic indicators • Look at the banking sector in the country • Check out the bank’s ranking in the country in terms of asset size, equity size and deposit base size. • Check bank’s history (date established, mergers & acquisitions) • Check ownership • Define bank’s Activities • Start reading the bank’s balance sheet & Income statement • Start looking at the ratios • Write down the analysis
Practical steps to Bank Assessment • Get the correct name of the bank • Names can be confusing, specially when translated. • Examples: • National Bank of Egypt vs. Alwatany Bank • National Bank of Kuwait vs. Al Ahli Bank
Practical steps to Bank Assessment • Look at the economic performance & major economic indicators • How well is the economy performing • Economic & political reforms • Impact of macro economic variables on performance • Sources for generating foreign currency (Exports) • Trade Balance • Foreign Direct Investments (FDÍ) • Foreign Currency Reserves • Foreign Currency Debt
Practical steps to Bank Assessment 3. Look at the banking sector in the country • How well is the banking sector regulated • Competitive and structural issues of the banking system. • Banking sector reforms • Foreign banks operating in the country • Foreign ownership • Central Bank acting as a lender of last resort • Historical performance
Practical steps to Bank Assessment • Check out the bank’s ranking & rating • Country Ranking in terms of total assets, equity and deposit base. • World Ranking • Bank Rating if available in terms of financial strength & foreign currency • Local rating • International Rating
Practical steps to Bank Assessment • Check bank’s history/Profile • Date established • Mergers & acquisitions • What went on • Undergoing & Future plans
Practical steps to Bank Assessment • Check ownership • Change in ownership • Full government ownership • Part government ownership • Semi government ownership (through • Privately owned • Listed • Closed • Major business groups vs. individuals
Practical steps to Bank Assessment • Define bank’s activities/type • Specialized sector • Trade finance • Regular commercial • Etc..
Practical steps to Bank Assessment • Start reading the bank’s figures • Latest figures – interim & year-end, not exceeding 15 months • Audited figures – Audit Report • Trend between 3 to 5 years • Check movements up/down more than 5% • Stable growth vs. abrupt jumps • Capital injections vs. Diminishing Equity • Loan portfolio break-down (Short vs. Long term; Provisions) • Deposit base break-down (Current, Savings & Term) • Asset Mix / Asset distribution
Practical steps to Bank Assessment • Start looking at the ratios • Asset Quality • Capital Adequacy • Profitability / Performance • Liquidity
The Analysis • Backstage preparation is done • Proceed with the story.
Keep in Mind • There is no one mold for banks’ financial statements • Diverse financial reporting • Different disclosures & terminology • Know what's behind the numbers (in terms of bank type/specialization, Islamic vs. conventional, etc.) • Notes to the Financial Statements are essential and are integral part of the financial statements. Take these notes seriously. • Auditor's Report • Clean opinion/green light • Qualified Opinion – red flag
Keep in Mind • Look for Consolidated Financial Statements (parent & majority-owned subsidiaries (50%+ or "effective control") • Evaluations differ significantly by country, bank size, stage of development, economic conditions, etc.. • Look at Non-Financial Statement Information, i.e. Information on the state of the economy, industry and competitive considerations, market forces, technological change, and the quality of management.
Bank’s Balance Sheet Assets Earning Assets • Net Loans • Other Earning Assets Non-Earning Assets Total Assets Liabilities • Deposits & Short term Funding • L.T. Funding • Other Liabilities Total Liabilities Total Equity
Assets – Earning Assets Earning Assets • Net Loans • Gross Loans • Consumer/Retail Loans • Corporate & Commercial Loans • Provisions Other Earning Assets • Loans & Advances to banks • Trading securities • Other Investments / Other earning assets
Assets – Non-Earning Assets Non-Earning Assets • Cash & Due from bank • Fixed Assets • Other Assets • Intangibles
Liabilities • Total Customer Deposits • Current Deposits • Savings Deposits • Term Deposits • Deposits from Banks • Short term Funding • Long Term Funding • Other Liabilities
Equity • Share Capital/Common Equity • Statutory Reserves • Revaluation Reserves • Retained Earnings (Loss) • Intangibles
Income Statement • Net Interest Income (Loss) • Interest Income • Interest Expense (Cost of Funds) • Non-Interest Income (Loss) • Fees & Commissions • Foreign Exchange • Other Operating Income (Loss) • Operating Expenses • Provisions on Impaired Loans • Net Operating Income (Loss) • Net Income (Loss)
Off Balance Sheet Items • Obligations that are contingent liabilities of a bank • Do not appear on bank’s balance sheet • Items include the following: • Standby letters of credit • Letters of credit • Risk participations in bankers' acceptances • Sale and repurchase agreements • Asset sales with recourse against the seller • Interest rate swaps • Interest rate options & currency options
CAMELS Framework • CAMELS is an international bank-rating system where bank supervisory authorities rate institutions according to six factors. • The six factors are represented by the acronym "CAMELS" • C - Capital adequacy • A - Asset quality • M - Management quality • E – Earnings • L – Liquidity • S - Sensitivity to Market Risk
CAMELS Rating System • Bank supervisory authorities assign each bank a score on a scale of one (best) to five (worst) for each factor. • Banks achieving an average score less than two it is considered to be a high-quality institution • Banks with scores greater than three are considered to be less-than-satisfactory establishments. • The system helps the supervisory authority identify banks that are in need of attention.
Capital Adequacy • Key drivers of capital: • Earnings • Asset Valuation • Capital injection • Risk weighted assets. Weight is defined and allocated to different assets based on Basel I vs. Basel II approach / Basel III • Key ratios • Tier One • Total Capital ratio • Leverage (Equity to Total Assets) • Local and international benchmarks • Internationally set at a Minimum of 8% (capital to equal at least 8% of its risk-weighted assets.)
Capital Adequacy • The capital requirement is a bank regulation, which sets a framework on how banks must handle their capital. • The categorization of assets and capital is highly standardized so that it can be risk weighted. • Internationally, the Basel Committee on Banking Supervision influence each country's banking capital requirements. • The current framework is a complex capital adequacy framework commonly known as Basel II. • After 2012 it will be replaced by Basel III.
Capital Adequacy • The capital ratio is the percentage of a bank's capital to its risk-weighted assets. • Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord. • Each national regulator normally has a very slightly different way of calculating bank capital, designed to meet the common requirements within their individual national legal framework. • Most developed countries implement Basel I and II, stipulate lending limits as a multiple of a banks capital eroded by the yearly inflation rate.
Capital Adequacy • Risk-weighted asset is a bank's assets weighted according to credit risk. • Some assets are assigned a higher risk than others, such as cash or government securities/bonds. • Since different types of assets have different risk profiles, weighing assets based on the level of risk associated with them primarily adjusts for assets that are less risky by allowing banks to "discount" lower-risk assets. • In the most basic application, government debt is allowed a 0% "risk weighting" - that is, they are subtracted from total assets for purposes of calculating the ratio.
Asset Quality • Assessment of the credit risk associated with a particular asset. • These assets are earning assets • Effective Risk Management Policies & Controls • Loan portfolio analysis: uncovering the risk profile of the loan portfolio; key differences between types of bank • Loan quality: impaired loans and reserve adequacy • Off balance sheet exposures: lending commitments and other special purpose vehicles
Asset Quality • Factors pertaining to asset quality: • Asset portfolio is appropriately diversified • Bank Policies in place to limit Credit Risks • How efficiently operations are being utilized. • Loan quality • Portfolio analysis • Impaired loans • Provisioning levels, charge offs and recoveries
Asset Quality • Placements & Advances to banks • Trading and investments • Assessing Securities and Derivatives portfolios (use of value at risk (VaR) models) • Government bonds and T-bills • Investment risk: valuation and accounting policies, hidden reserve or black hole.
Management Quality • An act of getting self & people together to accomplish desired goals and objectives using available resources efficiently and effectively. • Comprises planning, organizing, staffing, leading/directing, and controlling an organization or effort for the purpose of accomplishing a goal. • Resourcing encompasses the deployment & manipulation of human resources, financial resources, technological resources, and natural resources.
Management Quality • Bank management components are: • Asset management • Liquidity management • Liability management • Capital adequacy management • Risk management
Earnings • Types of income and expense, impact of earnings accrual and asset impairment policies, core and non core earnings • Key drivers of earnings • Net interest margin • Fees and commissions • Trading • Measure quality and diversity of income, cost control, provision burden • Major Ratios: • Return on Equity (ROE) = Net Income / Equity • Return on Assets (ROA) = Net Income / Total Assets
Liquidity • The degree to which an asset can be converted into cash quickly and with minimal impact to the price received. • Liquidity is characterized by a high level of trading activity. • The ability to convert an asset to cash quickly “marketability". • Assets that can by easily bought or sold, are known as liquid assets. • Liquid assets need an established market with enough participants to absorb the selling without materially impacting the price of asset.
Liquidity • Relative ease in transfer of ownership and movement of asset • Relative ease in transfer of ownership and movement of asset • Easily converted into cash: deposits, commercial paper, repos, inter-bank lines/ money market instruments, government bonds. senior and subordinated bonds, common and preferred stock, also include blue chip securities • Funding stability and liquidity for a bank
Major Liquidity Ratios • Key drivers of liquidity • Volatility of Liabilities • Quality and Liquidity of Assets • Contingency Funding Needs • Net Loans / Deposits & Short Term Funding Ratio. • Should Ideally be at a maximum of 80% for banks. • Liquid Assets / Deposits & Short Term Funding Ratio • Should ideally be At 20%