UBFB3023 Commercial

Bank Management

Lecture 3: Banking
Performance Analysis
and Bank Risks
Learning Goals

• Various types of bank risks

• Managing risk and returns
• Fundamental of bank risks
• Financial statement manipulation
Managing risk and returns

• Fundamental objective of bank management is to

maximize shareholder’s wealth.

• Require managers to evaluate the present

value of cash flows under uncertainty, when
evaluated on a risk-adjusted basis.
Managing risk and returns

• To obtain higher yields, a bank must either take

on increased risk or lower operating cost.

• A bank’s profitability will generally vary directly

with the riskiness of its portfolio and operations.
Bank Risks

• Risk to the manager of a financial institution or to

a regulator supervising a financial institution
means the perceived uncertainty associated
with a particular event.
Bank Risks

• Will customer renew loan?

• Will customer service their loan payment?
• Will deposits and other sources of funds grow
next month?
• Will the financial firm’s stock price rise and its
earnings increase?
• Are interest rates going to rise or fall next week,
and will a financial institution lose income or
value if they do?
Fundamental of Bank Risks

1. Credit risk
2. Liquidity risk
3. Market risk
4. Operational risk
Fundamental of Bank Risks

5. Legal risk
6. Capital risk
7. Reputational risk
8. Strategic risk
9. Off balance sheet risk
Fundamental of Bank Risks

1. Credit risk
• Potential loss in net income and market value of
equity resulting from non-payment or delayed
payment on loans and securities.
• Three questions need to be addressed:
1. What has been the loss experience?
2. What amount of losses do we expect?
3. How prepared is the bank?
Fundamental of Bank Risks

1. Credit risk
• Most widely used indicators of credit risk
• Non-Performing Loans / Total Loans
• Net Loan Charge-Offs / Total Loans
• Provision for Loan Losses / Total Loans
Fundamental of Bank Risks

1. Credit risk
• Non-performing loans are income-generating loans
that are past due for 90 days or more
• Charge-offs are loans that have been declared
worthless and written off the lender’s books. If
some of these loans ultimately generate income, the
amounts recovered are deducted from gross charge-
offs to yield net charge-offs
Fundamental of Bank Risks

1. Credit risk
• Provision for loan losses are the estimation of
potential loan default as and assessment of the
bank’s financial health
• As these ratios rise, exposure to credit risk grows,
and failure of a lending institution may be just around
the corner
Fundamental of Bank Risks

2. Liquidity risk
• Probability the financial firm will not have sufficient
cash and borrowing capacity to meet deposit
withdrawals, loan demand, and other cash needs
• Variation in net income and market value of equity
caused by a bank's difficulty in obtaining cash at a
reasonable cost from either the sale of assets or
new borrowings
Fundamental of Bank Risks

2. Liquidity risk
• Banks can acquire liquidity in two distinct ways:
1. By liquidation of assets
• Composition of loans & investments
• Maturity of loans & investments
• Percent of loans and investments pledged as collateral
2. By borrowing
• Core deposits (fixed deposits)
• Volatile deposits (saving and current account)
• Issue REPO, CP, bonds, Interbank, Central Bank, etc
Fundamental of Bank Risks

2. Liquidity risk
• Indicators of exposure to liquidity risk include:
• Cash and Due from Balances Held at Other Depository
Institutions / Total Assets
• Purchased Funds (Eurodollars, federal funds, RPs, CDs,
CP) / Total Assets
• Cash Assets and Government Securities / Total Assets
• Heavier use of purchased funds increases the
chances of a liquidity crunch (a critical situation that
arises because of shortage in money) in the event
deposit withdrawals rise or loan quality declines
Fundamental of Bank Risks

3. Market risk
• Probability of the market value of the financial firm’s
investment portfolio declining in value due to a
change in:
• Interest rates
• Foreign exchange rates
• Security prices (Equity and commodity)
• It can be measured by:
• Book Value of Assets / Market Value of Assets
Fundamental of Bank Risks

3. Market risk
• Interest rate risk
• Potential loss in bank’s net value income and market
value of its equity resulting from any changes in the
market interest rates
• Banks have to compare the sensitivity of their interest
income with the sensitivity of their income expenses
• For example, if the increase in interest income falls more
than increase in interest expenses, the net interest
income will decline and so will the value of the bank
Fundamental of Bank Risks

3. Market risk
• Interest rate risk
• Among the most widely used measures of interest-rate risk
exposures are these:
• Interest Sensitive Assets / Interest Sensitive Liabilities
• Uninsured Deposits* / Total Deposits

*Uninsured deposits are usually government and corporate

deposits that exceed the amount covered by insurance and are
usually so highly sensitive to changing interest rates that they will
be withdrawn if yields offered by competitors rise even slightly
Fundamental of Bank Risks

3. Market risk
• Foreign exchange risk
• Is a financial risk that exists when a financial transaction
is denominated in a currency other than that of the base
currency
• The risk to a financial institution’s condition resulting from
adverse movements in foreign exchange rates that affect
the values of assets, liabilities, and off-balance sheet
activities (LC, BG, forward exchange foreign currency)
denominated in currencies different from the bank’s
domestic (home) currency
Fundamental of Bank Risks

3. Market risk
• Foreign exchange risk
• Measured by
• Assets denominated in a foreign currency minus liabilities
denominated in the same foreign currency
• High risk manifests itself when exchange rates change
adversely and the value of the bank’s net position of
assets versus liabilities denominated in a currency
changes sharply
Fundamental of Bank Risks

3. Market risk
• Security price risk
• Change in securities price will affect the values of
equities.
• Equity value risk: The financial risk involved in holding
equity in a particular investment. Often refers to equity in
companies through the purchase of stocks.
Fundamental of Bank Risks

4. Operational risk
• Uncertainty regarding a firm’s operations
• Failure in computer systems
• Errors, misconduct by employees
• Floods, lightning strikes, and similar events
• Risk of loss due to unexpected operating expenses
Fundamental of Bank Risks

5. Legal risk
• The potential that unenforceable contracts,
lawsuits, or adverse judgments can disrupt or
otherwise negatively affect the operations or
condition of the banking organisation
• Legal risk also includes compliance risk which
includes violations of rules and regulations. For
eg:
• Loans to a bankrupt/minor,
• AMLA - Anti-Money Laundering, Anti-Terrorism Financing
and Proceeds of Unlawful Activities Act
Fundamental of Bank Risks

6. Capital risk
• Closely tied to asset quality and a bank's overall
risk profile.
• The more risk taken, the greater is the amount of
capital required.
• Appropriate risk measures include all the risk
measures as well as ratios measuring the ratio of:
• Tier 1 Capital Ratio = Tier 1 Capital / Total risk weighted
assets (RWA) (>6%)
• Total Capital Ratio = Total Capital / Total RWA (>8%)
Fundamental of Bank Risks

6. Capital risk
• Tier 1 Capital Ratio = Tier 1 Capital / Total risk
weighted assets (RWA) (>6%)
• Tier 1 Capital (primary source of funding):
• Sum of common shares and stock surplus
• Retained earnings
• Other comprehensive income
• Qualifying minority interest and regulatory adjustments
Fundamental of Bank Risks

6. Capital risk
• Tier 1 Capital Ratio = Tier 1 Capital / Total risk
weighted assets (RWA) (>6%)
• Risk-weighted assets
• The total risk-adjusted assets where the risk weights are
based on four risk classes of assets (US) or five risk
classes of assets (Malaysia)
Fundamental of Bank Risks
Fundamental of Bank Risks

6. Capital risk
• Risk-weighted assets (Malaysia):
• 0% category
• zero credit risk): cash, MGS
• 10% category
• money market instruments: BA, NCD
• 20% category
• Loan guaranteed by financial institutions
• 50%
• Housing loans
• 100%
Fundamental of Bank Risks

7. Reputational risk
• Reputational risk is the potential that negative
publicity regarding an institution’s business practices,
whether true or not, will cause a decline in the
customer base, costly litigation, or revenue reductions.
• Reputational risk can also arise from the actions of
errant employees, such as the massive trading
losses disclosed by some of the world's biggest
financial institutions from time to time. In an
increasingly globalized environment, reputational risk
can arise even in a peripheral region.
Fundamental of Bank Risks

8. Strategic risk
• A possible source of loss that might arise from the
pursuit of an unsuccessful business plan.
• E.g. Inadequate resource allocation or from a failure
to respond well to change in the business
environment.
• Variations in earnings due to adverse business
decisions, improper implementation of decisions, or
lack of responsiveness to industry changes.
Financial Statement Manipulation

9. Off balance sheet risk

• The volatility in income and market value of bank
equity that may arise from unanticipated losses to
the off-balance sheet activities (LC, BG, FX).
• To account for the potential risk of off-balance sheet
activities, risk-based capital requirements oblige a
bank to convert off-balance sheet activities to
“on- balance sheet” equivalents (liabilities) and
hold capital against these activities.
Fundamental of Bank Risks
Fundamental of Bank Risks
Financial Statement Manipulation

• The usefulness of bank financial statements

depends on the quality and consistency of the
data.
• Ideally, banks would use the same accounting
rules in each period.
• Unfortunately, banks have wide discretion in
reporting certain items and can use extraordinary
transactions to disguise unfavourable events
or trends.
Financial Statement Manipulation

• Off-Balance sheet activities

• “Special-Purpose Vehicles” (SPV)
• Under some circumstances, it may be desirable to
remove liabilities from the balance sheet of the
company.
• For example: Bank A set up a subsidiary to acquire
deposits from customers & later Bank A acquire such
deposits from subsidiary as borrowing instead of
acquire deposits directly from customers - which
have to be classified as liability to the bank.
Financial Statement Manipulation

• Window dressing
• For example: Eliminate Fed (BNM) borrowing prior to
financial statement reporting date.
• Preferred stock
• Meets capital requirements but causes NIM, NI and
ROE to be overstated.
Financial Statement Manipulation

• Non-performing loans
• Banks may lend borrower funds to make
payments on past due loans, understating non-
performance status.
• Allowance for loan losses
• Management discretion and Internal Revenue
Service (IRS) regulations may be in conflict.
Financial Statement Manipulation

• Securities gains and losses

• Banks often classify all investment securities as
“available for sale,” overstating any true “gains or
losses”.
• Non-recurring sales of assets
• This type of transaction is not part of the bank’s
daily activities and typically cannot be repeated;
thus it overstates earnings (e.g. disposal of fixed
assets).