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GamblingIs Our Money Safe? - Part II
by:
Sam Vaknin
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 Bale Accord as set by the Bale Committee of Bank Supervising (also acknowledged as the G10). This could be deceptive 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, reserves, and provisions and, therefore, of its ability to expand its business. A strong bank can besides participate in various programs, offerings and auctions of the Central Bank or of the Ministry of Finance. The larger the share of the bank's earnings that is maintained 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 magnitude relation of net financial gain
to total income) or its plus utilization constant
(the magnitude 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 profitableness due to a non-productive, non-lasting arbitrage operation. Otherwise, the bank's management can minimize the amounts of bad loans carried on the bank's books, thus decreasing the necessary set-asides and increasing profitability. The fiscal statements of banks mostly reflect the management's appraisal of the business. This has proved to be a poor guide.
In the main fiscal results page of a bank's books, special attention should be paid to provisions for the devaluation of securities and to the unfulfilled difference in the currency position. This is especially true if the bank is holding a major part of the assets (in the form of fiscal investments or of loans) and the equity is invested with in securities or in foreign exchange denominated instruments.
Separately, a bank can be commerce for its own position (the Nostro), either as a market maker or as a trader. The profit (or loss) on securities commerce has to be discounted because it is divinatory and incidental to the bank's main activities: deposit taking and loan making.
Most banks deposit several of their assets with another banks. This is normally considered to be a way of spreading the risk. But in extremely
volatile economies with sickly, underdeveloped fiscal sectors, all the institutions in the sector are likely to come in bicycle-built-for-two (a extremely
correlative 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 Choson have demonstrated).
Further closer to the bottom line are the bank's operational expenses: salaries, depreciation, fixed or capital assets (real estate and equipment) and body
expenses. The rule of thumb is: the higher these expenses, the weaker the bank. The great historiographer Arnold joseph toynbee once aforesaid that great civilizations collapse instantly after they wish to us the most impressive buildings. This is doubly true with banks. If you see a bank fierily engaged in the construction of palatial branches – stay away from it.
Banks are risk arbitrageurs. They live off the match between assets and liabilities. To the better of their ability, they try to second guess the markets and reduce such a match by assumptive part of the risks and by piquant in portfolio management. For this they charge fees and commissions, interest and profits – which constitute their sources of income.
If any expertness is imputed 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 and value at risk – VAR - models), efficient and exclusive information-gathering systems, and to put in place the right loaning policies and procedures.
Just 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 futurity non-performing assets. These are the loan loss reserves and provisions. Loans are supposed to be perpetually
monitored, reclassified and charges ready-made against them as applicable. If you see a bank with zero reclassifications, charge offs 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 person is pull 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 plus quality (a polite way of expression 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 the Central Bank (or the Supervising of the Banks) forces banks to set aside provisions against loans at the highest risk categories, even as if they are performing. This, by far, should be the preferred method.
Of the two sides of the balance sheet, the assets side is the more critical. Inside
it, the interest earning assets merit the greatest attention. What percentage of the loans is commercial and what percentage given to individuals? How galore borrowers are there (risk diversification is reciprocally
proportional to exposure to single or large borrowers)? How galore 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 loaning 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 plus base. In which fiscal 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 consequent 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 economics environment is as important to the determination of its fiscal health and of its trustworthiness as any magnitude relation or micro-analysis. The state of the fiscal markets sometimes has a larger bearing on the bank's soundness than another factors. A fine example is the effect that interest rates or a devaluation have on a bank's profitableness and capitalization. The silent (not to mention the explicit) keep of the authorities, of another 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 fiscal environment, knock-on effects are more likely. Banks deposit money with another 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 commerce losses and loss of financial gain
from commerce 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 accomplished and unfulfilled 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 fiscal 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 instantly pay the losses or else happen them by purchasing 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 commerce operations. High interest rates here can have an even as more painful outcome. As liquidity is crunched, the banks are forced to happen their commerce losses. This is bound to put accessorial pressure on the prices of fiscal 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, besides strain the plus 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 quickly changed
to credit risk. Borrowers default on their obligations. Loan loss provisions need to be increased, feeding 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 according 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 normally 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 merchandising 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 loaning for their survival. The loaning base, in turn, depends on the quality of loaning opportunities. In high-risk markets, this depends on the possibility of connected loaning 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 return of the lending. These two elements are intimately coupled with the banking system. Therefore the penultimate vicious circle: wherever
no functioning and professional banking system exists – no nice borrowers wish emerge.
Simply about the Author
Sam Vaknin is the author of Malignant Self Love - Self-love Revisited and After the Rain - How the West Lost the East. He is a editorialist for Central Europe Review, United Press International (UPI) and eBookWeb and the editor of mental health and Central East Europe categories in The Open Directory and Suite101.
Web site:
http://samvak.tripod.com/
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