Is My Money Safe? On The Soundness Of Our Banks

But what is behind all this? How can we judge the soundness of our banks? In different 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 several fancied in their modern form in the Ordinal century. A balance sheet, coupled with different business statements is supposed to provide us with a true and full image of the health of the bank, its past and its long-term prospects. The astonishing thing is that – despite common opinion – it does. The less astonishing element is that it is rather useless unless you cognize how to see it.

Financial Statements (Income – aka Profit and Loss - Statement, Cash Flow Statement and Balance Sheet) come in many a forms. Sometimes they adapt to Western accounting standards (the Generally Accepted Accounting Principles, GAAP, or the less rigorous and more fuzzily worded International Accounting Standards, IAS). Otherwise, they adapt to local accounting standards, which often leave a lot to be desired. Still, you should look for banks, which do their updated business reports accessible to you. The better select would-be be a bank that is audited by one of the Big Six Western accounting firms and does its audit reports in public available. Such audited business statements should consolidate the business results of the bank with the business results of its subsidiaries or associated companies. A lot often hides in those corners of corporate ownership.

Banks are rated by independent agencies. The most famed and most reliable of the lot is Fitch-IBCA. Another one is Thomson BankWatch-BREE. These agencies assign letter and number combinations to the banks, that reflect their stability. Most agencies differentiate the short term from the long term prospects of the banking institution rated. Several of them even as study (and rate) issues, such as the lawfulness 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 bravery and ask for the bank's rating. Unfortunately, life is more complex than rank agencies would-be like us to believe. They base themselves mostly on the business results of the bank rated, as a reliable gauge of its business strength or business profile. Nothing is further from the truth.

Admittedly, the business results do contain a few important facts. But one has to look on the far side the naked figures to get the real – often more less encouraging – picture.

Consider the thorny issue of exchange rates. Business statements are calculated (sometimes explicit in USD in addition to the local currency) mistreatment the exchange rate prevailing on the Ordinal of Gregorian calendar month of the business year (to which the statements refer). In a country with a volatile domestic currency this would-be tend to all distort the true picture. This is especially true if a big chunk of the work preceded this capricious date. The same applies to business statements, which were not inflation-adjusted in high inflation countries. The statements wish look inflated and even as reflect profits wherever heavy losses were incurred. "Average amounts" accounting (which does use of average exchange rates throughout the year) is even as 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 several different currency of reference). Otherwise, fictitious growth in the quality base (due to inflation or currency fluctuations) could result.

Another example: in many a countries, changes in regulations can greatly effect the business statements of a bank. In 1996, in Russia, to take an example, the Bank of Russia changed the algorithmic program for conniving an important banking quantitative relation (the capital to risk weighted assets ratio). Unless a Russian bank restated its previous business statements accordingly, a sharp change in gain appeared from nowhere.

The net assets themselves are always misstated: the amount refers to the situation on 31/12. A 48-hour loan given to a collaborating firm can inflate the quality base on the crucial date. This deception is only gently ameliorated by the introduction of an "average assets" calculus. Moreover, several of the assets can be interest earning and activity – others, non-performing. The maturity distribution of the assets is as well of prime importance. If most of the bank's assets can be withdrawn by its clients on a really short notice (on demand) – it can fleetly find itself in trouble with a run on its assets leading to insolvency.

Another oft-used amount is the net financial gain of the bank. It is important to distinguish interest financial gain from non-interest income. In an open, sophisticated credit market, the financial gain from interest differentials should be bottom and reflect the risk plus a reasonable component of financial gain to the bank. But in many a countries (Japan, Russia) the government subsidizes banks by disposal to them money cheaply (through the Central Bank or through bonds). The banks then proceed to lend the cheap funds at immoderate rates to their customers, thus reaping large interest income. In many a countries the financial gain from government securities is tax free, which represents another form of subsidy. A high financial gain from interest is a sign of weakness, not of health, here today, there tomorrow. The preferred indicator should be financial gain from operations (fees, commissions and different charges).

There are a few key ratios to observe. A relevant question is whether the bank is authorised with international banking agencies. The latter issue restrictive capital requirements and different defined 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 financial gain divided by its average equity. The return on the bank's assets (ROA) is its net financial gain divided by its average assets. The (tier 1 or total) capital divided by the bank's risk weighted assets – a measure of the bank's capital adequacy. Most banks follow the provisions of the Basle Accord as set by the Basle Committee of Bank Direction (also best-known as the G10). This could be dishonest because the Accord is ill equipped to deal with risks associated with emerging markets, wherever 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 manipulation 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 of reserves and provisions and, thereby, of its ability to expand its business. A strong bank can as well participate in various programs, offerings and auctions of the Central Bank or of the Ministry of Finance. The more of the bank's earnings are preserved 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 as the bank's profit margin (the quantitative relation of net financial gain to total income) or its quality utilization constant (the quantitative relation of financial gain to average assets) should be relied upon. They could be the result of hidden subsidies by the government and management misjudgement or statement 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 more higher interest financial gain from the bonds' coupon payments. The end result: a rise in the bank's financial gain and gain due to a non-productive, non-lasting arbitrage operation. Otherwise, the bank's management can downplay the amounts of bad loans carried on the bank's books, thus decreasing the necessary set-asides and increasing profitability. The business statements of banks for the most part reflect the management's appraisal of the business. This is a poor manual to go by.

In the main business results' page of a bank's books, special attention should be paid to provisions for the devaluation of securities and to the unrealised difference in the currency position. This is especially true if the bank is holding a major part of the assets (in the form of business investments or of loans) and the equity is endowed in securities or in foreign exchange denominated instruments. Separately, a bank can be commercialism for its own position (the Nostro), either as a market maker or as a trader. The profit (or loss) on securities commercialism has to be discounted because it is supposed and incidental to the bank's main activities: deposit taking and loan making.

Most banks deposit several of their assets with different banks. This is commonly considered to be a way of spreading the risk. But in extremely volatile economies with sickly, underdeveloped business sectors, all the institutions in the sector are likely to come in bicycle (a extremely correlate 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 Korean peninsula have demonstrated).

Further closer to the bottom line are the bank's in operation expenses: salaries, depreciation, fixed or capital assets (real estate and equipment) and body expenses. The rule of thumb is: the higher these expenses, the worse. The great scholar Arnold toynbee once aforementioned that great civilizations collapse at once after they gift to us the most impressive buildings. This is doubly true with banks. If you see a bank fervidly engaged in the construction of palatial branches – stay away from it.

All considered, banks are risk traders. They live off the couple between assets and liabilities. To the better of their ability, they try to second guess the markets and reduce such a couple by forward part of the risks and by attractive in proper portfolio management. For this they charge fees and commissions, interest and profits – which constitute their sources of income. If any skillfulness is attributed 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 rank mechanisms (credit analysis), efficient and exclusive information-gathering systems, and to put in place the right disposal policies and procedures. Simply in case they misread the market risks and these 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 non-performing in the future. These are the loan loss reserves and provisions. Loans are supposed to be perpetually monitored, reclassified and charges must be ready-made against them as applicable. If you see a bank with zero reclassifications, charge off and recoveries – either the bank is lying through 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 percentage of non-performing loans out of the loans outstanding. If the two figures are out of kilter, either being is actuation your leg – or the management is incompetent or lying to you. The 1st thing new owners of a bank do is, usually, improve the placed quality quality (a polite way of language that they get rid of bad, non-performing loans, whether declared as such or not). They do this by classifying the loans. Most central banks in the earth 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 several countries in the world, the Central Bank (or the Direction of the Banks) forces banks to set aside provisions against loans of the highest risk categories, even as if they are performing. This, by far, should be the desirable method.

Of the two sides of the balance sheet, the assets side should earn the most attention. Inside it, the interest earning assets be the greatest dedication of time. What percentage of the loans is commercial and what percentage given to individuals? How many a lenders are there (risk diversification is reciprocally proportional to exposure to single borrowers)? How many a of the transactions are with "related parties"? How more is in local currency and how more in foreign currencies (and in which)? A large exposure to foreign currency disposal is not necessarily healthy. A sharp, unexpected devaluation could come a lot of the borrowers into non-performance and default and, thus, adversely affect the quality of the quality base. In which business 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) management of the bank. The crucial question is: what are the cash flows projected from the maturity dates of the several assets and liabilities – and how likely are they to materialize. A rough 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 finance the cash flows ensuant from the banks' liabilities. A distinction has to be ready-made between stable and hot funds (the latter in constant pursuit of higher yields). Liquidity indicators and alerts have to be set in place and calculated a few times daily. Gaps (especially in the short term category) between the bank's assets and its liabilities are a really worrisome sign.

But the bank's economic science environment is as important to the determination of its business health and of its trustiness as any quantitative relation or micro-analysis. The state of the business markets sometimes has a larger bearing on the bank's soundness than different factors. A fine example is the effect that interest rates or a devaluation have on a bank's gain and capitalization. The implicit (not to mention the explicit) keep of the authorities, of different banks and of investors (domestic as well as international) sets the psychological background to any futurity developments. This is only too logical. In an unstable business environment, knock-on effects are more likely. Banks deposit money with different banks on a safety basis. Still, the value of securities and collaterals is as nice as their liquidity and as the market itself. The really ability to do business (for instance, in the syndicated loan market) is influenced by the larger picture. Falling equity markets herald commercialism losses and loss of financial gain from commercialism operations and so on.

Perhaps the single most important factor is the general level of interest rates in the economy. It determines the present value of foreign exchange and local currency denominated government debt. It influences the balance between complete and unrealised losses on longer-term (commercial or other) paper. One of the most important liquidity generation instruments is the repurchase agreement (repo). Banks sell their portfolios of government business obligation with an obligation to buy it back at a later date. If interest rates shoot up – the losses on these repos can trigger margin calls (demands to at once pay the losses or else come about them by purchase the securities back). Margin calls are a drain on liquidity. Thus, in an environment of rising interest rates, repos could absorb liquidity 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 commercialism operations. High interest rates here can have an even as more painful outcome. As liquidity is crunched, the banks are forced to come about their commercialism losses. This is bound to put additional pressure on the prices of business assets, trigger more margin calls and squeeze liquidity further. It is a vicious circle of a monstrous momentum once commenced.

But high interest rates, as we mentioned, as well strain the quality side of the balance sheet by applying pressure to borrowers. The same goes for a devaluation. Liabilities connected to foreign exchange grow with a devaluation with no (immediate) corresponding increase in local prices to compensate the borrower. Market risk is thus apace changed to credit risk. Borrowers default on their obligations. Loan loss provisions need to be increased, consumption into the bank's liquidity (and profitability) even as further. Banks are then tempted to play with their reserve coverage levels in order to increase their reportable 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 commonly a last resort, pariah, resolution (see Southeast Asia and the Czech Republic for fresh examples in an endless supply of them. Japan and China are, probably, next).

In the past, the thinking was that several of the risk could be ameliorated by hedging in forward markets (=by commerce it to willing risk buyers). But a hedge is only as nice as the counterparty that provides it and in a market enclosed by knock-on insolvencies, the comfort is dubious. In most emerging markets, for instance, there are no natural sellers of foreign exchange (companies prefer to hoard the stuff). So forwards are considered to be a variety of gambling with a default in case of substantial losses a really plausible way out.

Banks depend on disposal for their survival. The disposal base, in turn, depends on the quality of disposal opportunities. In high-risk markets, this depends on the possibility of connected disposal and on the quality of the collaterals offered by the borrowers. Whether the borrowers have analysis collaterals to offer is a direct outcome of the liquidity of the market and on how they use the income of the lending. These two elements are intimately connected with the banking system. Thence the penultimate vicious circle: wherever no functioning and professional banking system exists – no nice borrowers wish emerge.

About The Author

Sam Vaknin is the author of "Malignant Self Love - Egocentrism Revisited" and "After the Rain - How the West Lost the East". He is a journalist in "Central Europe Review", United Press International (UPI) and ebookweb.org and the editor of mental health and Central East Europe categories in The Open Directory, Suite101 and searcheurope.com. Until recently, he served as the Economic Authority to the Government of Macedonia.

His web site: http://samvak.tripod.com