Banks are institutions where miracles happen regularly. We rarely entrust our money to anyone but ourselves – and our banks. Despite a very checkered history of mismanagement, corruption, false promises and representations, delusions, and behavioral inconsistency – banks still succeed in motivating us to give them our money. Partly it is the feeling that there is safety in numbers. The fashionable term today is "moral hazard." The implicit guarantees of the state and other financial institutions move us to take risks that we would otherwise have avoided. Partly it is the sophistication of the banks in marketing and promoting themselves and their products. Glossy brochures, professional computer and video presentations, and vast, shrine-like real estate complexes enhance the banks' image as the temples of the new religion of money.
But what is behind all this? How can we judge the soundness of our banks? In other words, how can we tell if our money is safely tucked away in a haven?
The reflex is to go to the bank's balance sheets. A balance sheet should provide an accurate and complete picture of the bank's health, past, and long-term prospects. The surprising thing is that – despite common opinion – it does. Banks and balance sheets were invented in their modern form in the 15th century.
But it is rather useless unless you know how to read it.
Financial statements (Income – or Profit and Loss - Statement, Cash Flow Statement, and Balance Sheet) come in many forms. Sometimes they conform to Western accounting standards (the Generally Accepted Accounting Principles, GAAP, or the less rigorous and more fuzzily worded International Accounting Standards, IAS). Otherwise, they conform to local accounting standards, often leaving a lot desired. Still, it would be best to look for banks that make their updated financial reports available to you. The best choice would be a bank audited by one of the Big Four Western accounting firms and publicly available its audit reports. Such audited financial statements should consolidate the bank's financial results with the economic consequences of its subsidiaries or associated companies. A lot often hides in those corners of corporate holdings.
Independent agencies rate banks. The most famous and most reliable of the lot is Fitch Ratings. Another one is Moody's. 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. Some even study (and rate) issues, such as the legality of the bank's operations (legal rating). Ostensibly, all a concerned person has to do is step up to the bank manager, muster the courage, and ask for the bank's rating. Unfortunately, life is more complicated than rating agencies would have us believe.
They base themselves mainly on the bank's financial results, rated as a reliable gauge of its financial strength or financial profile. Nothing is further from the truth.
Admittedly, the financial results do contain a few essential facts. But one has to look beyond the naked figures to get an honest – often much less encouraging – picture.
Consider the thorny issue of exchange rates. Financial statements are calculated (sometimes stated in USD in addition to the local currency) using the exchange rate prevailing on the 31st of December of the fiscal year (to which the statements refer). In a country with a volatile domestic currency, this would completely distort the accurate picture. This is especially true if a big chunk of the activity preceded this arbitrary date. The same applies to financial statements, which were not inflation-adjusted in high inflation countries. The reports will look inflated and even reflect profits incurred by heavy losses. "Average amounts" accounting (which uses average exchange rates throughout the year) is even 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 some other money of reference). Otherwise, fictitious growth in the asset base (due to inflation or currency fluctuations) could result.
Another example: in many countries, changes in regulations can vastly affect financial statements. In 1996, in Russia, for example, the Bank of Russia changed the algorithm for calculating an important banking ratio (the capital to risk-weighted assets ratio).
Unless a Russian bank restated its previous financial statements accordingly, a sharp change in profitability appeared from nowhere.
The net assets themselves have consistently been misstated: the figure refers to the situation on 31/12. A 48-hour loan to a collaborating client can inflate the asset base on the crucial date. This misrepresentation is only mildly ameliorated by introducing an "average assets" calculus. Moreover, some assets can be interest earning and performing – others, non-performing. The maturity distribution of the assets is also of prime importance. If most of the bank's assets can be withdrawn by its clients on concise notice (on demand) – it can swiftly find itself in trouble with a run on its assets leading to insolvency.
Another oft-used figure is the net income of the bank. It is important to distinguish interest income from non-interest income. In an open, sophisticated credit market, the payment from interest differentials should be minimal and reflect the risk plus a reasonable revenue component to the bank. But in many countries (Japan, Russia), the government subsidizes banks by lending them money cheaply (through the Central Bank or bonds). The banks then lend the cheap funds at exorbitant rates to their customers, thus reaping enormous interest income. In many countries, the income from government securities is tax-free, which represents another form of subsidy. A high income from interest is a sign of weakness, not health, here today, gone tomorrow. The preferred indicator should be income from operations (fees, commissions, and other charges).
There are a few key ratios to observe. A relevant question is whether the bank is accredited with international banking agencies. These issue regulatory capital requirements and other mandatory ratios. Compliance with these demands is a minimum in the absence of which the bank should be regarded as positively dangerous.
The bank's equity (ROE) return is the net income divided by its average equity. The return on the bank's assets (ROA) is its net income divided by its average assets. The (tier 1 or total) capital is divided by the bank's risk-weighted assets – a measure of the bank's capital adequacy. Most banks follow the provisions of the Basel Accord as set by the Basel Committee of Bank Supervision (also known as the G10). This could be misleading because the Accord is ill-equipped to deal with risks associated with emerging markets, where 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. Since the quantities that comprise them can be toyed with – they can be subject to manipulation and distortion. It is indeed better to have high ratios than low ones. High ratios indicate a bank's underlying strength, reserves, and provisions and, therefore, its ability to expand its business. A strong bank can also participate in various programs, offerings, and auctions of the Central Bank or the Ministry of Finance. The larger the share of the bank's earnings that is retained 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 the bank's profit margin (the ratio of net income to total income) or its asset utilization coefficient (the percentage of revenue to average assets) should be relied upon. They could result from hidden subsidies by the government and management misjudgment or understatement 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 much higher interest income from the bonds' coupon payments. The result: a rise in the bank's revenue and profitability due to a non-productive, non-lasting arbitrage operation. Otherwise, the bank's management can understate the amounts of bad loans carried on the bank's books, thus decreasing the necessary set-asides and increasing profitability. The financial statements of banks largely reflect the management's appraisal of the business. This has proven to be a poor guide.
On the main financial results page of a bank's books, special attention should be paid to provisions for the devaluation of securities and the unrealized difference in the currency position. This is especially true if the bank holds a significant part of the assets (in financial investments or loans) and the equity is invested in securities or foreign exchange denominated instruments.
Separately, a bank can be trading for its position (the Nostro), either as a market maker or trader. The profit (or loss) on securities trading has to be discounted because it is conjectural and incidental to the bank's main activities: deposit-taking and loan-making.
Most banks deposit some of their assets with other banks. This is typically considered to be a way of spreading the risk. Cross deposits among banks only increase the risk of the depositing bank (as the recent affair with Toko Bank in Russia and the banking crisis in South Korea have demonstrated). But in highly volatile economies with sickly, underdeveloped financial sectors, all the institutions in the industry are likely to move in tandem (a highly correlated market).
The bank's operating expenses are closer to the bottom line: salaries, depreciation, fixed or capital assets (real estate and equipment), and administrative fees. The rule of thumb is that the higher these expenses, the weaker the bank. The great historian Toynbee once said that great civilizations collapse immediately after they bequeath us the most impressive buildings. This is doubly true with banks. Stay away from it if you see a bank fervently constructing palatial branches.
Banks are risk arbitrageurs. They live off the mismatch between assets and liabilities. To the best of their ability, they try to guess the markets second and reduce such a mismatch by assuming some risks and engaging in portfolio management. For this, they charge fees and commissions, interest, and profits – which constitute their sources of income.
If any expertise is imputed to the banking system, it is risk management. Banks are supposed to assess, control and minimize credit risks adequately. They are required to implement credit rating mechanisms (credit analysis and value at risk – VAR - models), efficient and exclusive information-gathering systems, and to put in place the right lending policies and procedures.
If they misread the market risks and these turn into credit risks (which happens only too often), banks are supposed to put aside money that could realistically offset loans gone sour or future non-performing assets. These are the loan loss reserves and provisions. Loans should be constantly monitored and reclassified, and charges against them as applicable. What is essential 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 someone is pulling your leg – or the management is incompetent or lying to you. The first thing new bank owners do is, usually, improve the placed asset quality (a polite way of saying that they get rid of evil, non-performing loans, whether declared as such or not). They do this by classifying the loans. If you see a bank with zero reclassifications, charge-offs, and recoveries – either the bank is lying through its teeth, not taking the business of banking too seriously, or its management is no less than divine in its prescience. Most central banks in the world have in place regulations for loan classification. If acted upon, this yields rather more reliable results than any management's "appraisal," no matter how well-intentioned.
In some countries, the Central Bank (or the Supervision of the Banks) forces banks to set aside provisions against loans at the highest risk categories, even if they are performing. This, by far, should be the preferable method.
Of the two sides of the balance sheet, the assets side is the more critical. Within it, the interest-earning assets deserve the most significant attention. What percentage of the loans is commercial, and what percentage is given to individuals? How many borrowers are there (risk diversification is inversely proportional to exposure to single or large borrowers)? How many of the transactions are with "related parties"? How much is in local currency and how much in foreign currencies (and in which)? Extensive exposure to foreign currency lending is not necessarily healthy. A sharp, unexpected devaluation could move many borrowers into non-performance and default and, thus, adversely affect the quality of the asset base. In which financial 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 bank's liquidity (risk) management. The crucial question is: what are the cash flows projected from the maturity dates of the different assets and liabilities – and how likely are they to materialize. The cash flows generated by the bank's assets must be used to finance the cash flows resulting from the banks' liabilities. A rough matching exists between the various maturities of the support and the disadvantages. A distinction must be made between stable and hot funds (the latter in constant pursuit of higher yields). Liquidity indicators and alerts must be set and calculated a few times daily.
Gaps (especially in the short-term category) between the bank's assets and liabilities are very worrisome. But the bank's macroeconomic environment is as essential to determine its financial health and creditworthiness as any ratio or micro-analysis. The state of the financial markets sometimes has a more significant bearing on the bank's soundness than other factors. A fine example is an effect that interest rates or a devaluation have on a bank's profitability and capitalization. The implied (not to mention the explicit) support of the authorities, other banks, and investors (domestic and international) sets the psychological background for any future developments. This is only too logical. In an unstable financial environment, knock-on effects are more likely. Banks deposit money with other banks on a security basis. Still, the value of securities and collaterals is as good as their liquidity and the market itself. The larger picture influences the very ability to do business (for instance, in the syndicated loan market). Falling equity markets herald trading losses and loss of income from trading operations.
Perhaps the single most crucial 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 realized and unrealized losses on longer-term (commercial or other) papers. One of the most important liquidity generation instruments is the repurchase agreement (repo). Banks sell their portfolios of government debt with an obligation to repurchase it later. If interest rates shoot up – the losses on these repos can trigger margin calls (demands to immediately pay the losses or else materialize them by repurchasing the securities).
Margin calls are a drain on liquidity. Thus, with rising interest rates, repos could absorb liquidity from the banks and deflate rather than inflate. The same principle applies to leverage investment vehicles used by the bank to improve the returns of its securities trading operations. High-interest rates here can have an even more painful outcome. As liquidity is crunched, the banks are forced to materialize their trading losses. This is bound to put added pressure on the prices of financial 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, also strain the asset side of the balance sheet by applying pressure on 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 rapidly transformed into credit risk. Borrowers default on their obligations. Loan loss provisions need to be increased, increasing the bank's liquidity (and profitability) even further. Banks are then tempted to play with their reserve coverage levels to improve their reported profits and this, in turn, raises a genuine concern regarding the adequacy of the stories of loan loss reserves. Only an increase in the equity base can then assuage the (justified) market fears, but such an increase can come only through foreign investment in most cases. And foreign investment is usually a last resort, pariah, or solution (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 some of the risks could be ameliorated by hedging in forward markets (=by selling it to willing risk buyers). But a hedge is only as good as the counterparty that provides it, and in a market besieged by knock-on insolvencies, the comfort is dubious. For instance, in most emerging markets, there are no natural sellers of foreign exchange (companies prefer to hoard the stuff). So forwards are considered a variety of gambling with a default in case of substantial losses, a very plausible way out.
Banks depend on lending for their survival. The lending base, in turn, depends on the quality of lending opportunities. In high-risk markets, this depends on the possibility of connected lending and the quality of the collateral offered by the borrowers. Whether the borrowers have qualitative collaterals to offer is a direct outcome of the market's liquidity and how they use the lending proceeds. These two elements are intimately linked with the banking system. Hence, the penultimate vicious circle: no good borrowers will emerge where no functioning and professional banking system exists.