Bank Risk Assessment Methodology

Bank Risk Assessment Methodology
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Bank Risk Assessment Methodology
Introduction:
The development of a bank assessment methodology is crucial for any investing financial institution. It sets the standards and basis for the evaluation of the targeted bank. For the development of a bank assessment methodology for our investment company we will focus on a complete range of factors that can affect the creditworthiness of a bank. It is important to point out that though the bank risk assessment is dependent on its own factors, it is also highly influenced by the local factors prevailing in the macro environment such as economic, regulatory and political environment. This enforces that the country with weak financial position is likely to own financially unstable banks which have high credit risk.
Sources of Information:
In order to evaluate the key considerations above, wide variety of information is required. This information can be obtained from direct or indirect and primary or secondary resources which are all easily publicly available. Such information can be obtained from four broad categories which would include the first information published by the banks which are likely to include sources like audited annual and interim financial reports, economic publications, prospectus of a bank etc. The second information published externally which is likely to include newspaper, magazine and journal articles, and reports from brokers, directories, chamber of commerce etc. The third information published by the rating agencies which include rating reports from Standard and Poor’s, Moody, Fitch and Capital Intelligence. The fourth information sources are other miscellaneous sources like meetings, share price etc. These all sources of information can provide a detailed qualitative and quantitative analysis of the risk assessment; however we will mainly focus on the ratios and information that can be easily obtained from the published financial statements.
Basic Methodology
In order to conduct a successful analysis few basic steps need to be followed. Firstly the bank should be first viewed with its fit in its operating regulatory and country’s environment which means that the factors that can influence a bank from external sources should be taken into account first. Then the bank’s performance over the past years and with that of its competitors should be analyzed, that is what level of performance the bank has delivered over time. The changes in the performance should be analyzed that whether they were caused by factors in control of bank or outside its control. Then a careful consideration of ratios is required; ratios evolve over time and are subject to changes in the market conditions and regulatory environment therefore should be analyzed properly. A good analysis will take into account of all the qualitative and quantitative factors. The sole financial statement analysis for risk assessment might not give a very fair idea and can be misleading as the financial statements are based on historical data and can’t predict future and changes accurately.
The Approach
The determination of financial soundness is an important aspect of risk assessment while making investment decisions. Investment in banks with low ability and potential to earn, inadequate capital and inability to give returns will result in risky investments with low abilities to produce required returns and vice versa. The key considerations while evaluating and assessing risk for a bank need to be given to the capital adequacy of a bank including the quality of its assets, liabilities and investments, the earning potential that is the quality, sustainability and sources, the effectiveness and role of management, the vulnerability of earnings and economic capital on the market variables like forex, interest rates and commodity process. In our methodology we will focus on factors that involve the quantitative ratio analysis and results can be easily obtained from the published financial statements of any bank.
Capital Adequacy:
Capital adequacy is a term that is used for the amount of shareholder’s funds that is readily available for running the business of a bank. Capital adequacy is essential for a bank for mainly three reasons that is it can be used to absorb losses, provide safety to depositors and creditors and to satisfy the regulatory authorities for the concerns of security of depositors and creditors. The capital adequacy is a key pre-requisite for high return and high risk investments. Banks with ample capital enable the management to invest in high risk projects yielding high returns for e.g. investment in unsecured loans to small entrepreneurs and commercial property developers. On the other hand, low risk projects like purchasing government securities and granting secure loans doesn’t require large amount of capital to cover unexpected losses.
The ratios that can be used to determine the capital adequacy along with each ratios importance and the means to calculate it are given as follows:
Basic Capital Ratio and Equity multiplier:
The basic capital ratio is calculated as the equity/total assets, where the equity includes common stock, non-redeemable and preferred stocks, capital surplus, retained earnings and other reserves. This ratio is an indicator of the amount of equity available in relation to the total assets of the bank. This ratio can be easily calculated by a glance at the balance sheet and is easy to understand. The ratio from 5% to 8% is usually for a well-capitalized bank. (Grier, 2001)
The reciprocal of the basic capital ratio results in the equity multiplier, which is total assets/equity. For a well-capitalized bank this ratio can range from 20% and below. (Grier, 2001) The information for total assets could be obtained from balance sheet and equity from balance sheet and statement of changes in equity.
Dividend Payout Ratio:
Dividend payout ratio can be calculated as dividend/net income. This ratio could be an indicator of the excess income left that was available to be distributed in shareholders in form of dividends. A high dividend payout ratio can also result in shortage of sources of investment as the bank usually reinvest from its retained profits. The ideal ratio is considered to range below 50%. (Grier, 2001) The information for dividends paid during the year is available in cashflow statement and net income in income statement.
Capital Adequacy Ratio:
This ratio is calculated as primary capital/total assets, where primary capital is referred to as all equity including certain qualifying subordinated debt, reserve for loan losses and redeemable stock. The ratio signifies the importance of market approach to capital adequacy and takes into account of further areas like reserve for loan losses. The information for total assets could be obtained from balance sheet and equity from balance sheet and statement of changes in equity.
Basel Ratio:
The Basel ratio is a regulatory ratio for capital adequacy. It is calculated as Capital (Tier1+ Tier 2+ Tier3)/ Credit Risk+ Market Risk+ Operational Risk, where the definition of capital remains the same further categorized into three tiers. Tier 1 includes preferred and common stock, capital surplus, permanent reserves less good will. Tier 2 includes subordinated debt, hybrid instruments, revaluation reserves, provision and loan loss reserves. Tier 3 capital is a shot term subordinated debt that is acquired as part of the market risk requirements resulting from trading portfolio. This ratio incorporates the assessed risk faced by the bank and defines a minimum capital requirement of banks with different sizes and capital structures. In an adequate Basel ratio the total capital ratio should be 8% and above, tier1 capital must be 50% of the total capital, tier 2 capital is limited to 100% of that of Tier 1 and Tier 3 capital is limited to 250% of that of Tier 1 capital. (Grier, 2001) The data for the analysis of Basel Ratio can be obtained from the Basel Disclosures made by the bank in each financial year.
Asset Quality:
Asset quality management has been often identified as the reason for bank failures. The problem roots from the inadequate lending policies adopted by the bank which results in difficulty in funding for the short term finances that ultimately results in the financial crisis for a bank. The asset quality of a bank can be determined by two ways; firstly by analyzing the credit and lending policies along with the credit risk management process and secondly by evaluating the lending portfolio and asset quality in comparison with past years and industry benchmarks.
Credit risk management policy of a bank is the indicator of asset quality. Despite of the availability of many collaterals, guarantees, hedges and credit derivatives there is still a chance of default caused by the changes in the financial position of an issuer, counterparty or borrower’s which is mitigated by the credit risk policies. On the other hand banks these days act as financial intermediately and in that role the most important a...