Banks and mutual funds put out their half-yearly balance sheets in the media glare with tonnes of pages. It is a matter of doubt as to how many even glance at them leave alone understand them. It is only fond hope that the stakeholders would go through and gauge for themselves the strength of the institution. However, it is not easy to read a bank’s balance sheet.
Whenever issues of financial stability come to the fore, both, the government and the regulator do not loose time to ensure the public that the banks have adequate capital and that there is no need to worry on that count.
But did Lehman Brothers or Bear Sterns or for that matter a host of other banks like Citi, caught in the current turmoil caused in the US, fail for want of adequate capital? Or did the European banks or Australian banks or Japanese banks also fail for want of capital adequacy? Could the 12% capital adequacy or even more save a bank bereft of lending discipline and proper house-keeping? Not if you look at those banks’ balance sheets a quarter before their failure.
Suddenly banks are found to put up the non-performing assets (NPA) front seeking either capital infusion or liquidity. But where does the capital figure in the balance sheet? At the top obviously. After exhausting all avenues from the bottom that includes, profits, revenues and other sources, recourse to capital comes into the picture. How do you know that these sources are strong enough for you to keep trusting the bank?
If a bank, like a manufacturing concern, speaks of operating profit as its strength instead of net profit, one has to be watchful about that bank. In this short piece, a few essential ratios to look at are covered.
Return on Equity (ROE) is one parameter that is arrived at by dividing net income with total equity capital. It measures the amount of net income after taxes earned for each rupee of equity capital contributed by the bank’s shareholders.
If there is an increase of ROE due to an increase in equity multiplier (total assets ? total equity capital) it would mean that the bank’s leverage and therefore its solvency risk has increased. It is not so much the size of capital that is of comfort as the composition of assets that have the potential to lay claim on capital with a speed that does not normally occur.
The next important ratio is in the report of income. This identifies the interest income and expenses, net interest income, provision for loan losses, non-interest income and expenses, income before taxes and extraordinary items and net income for the year for the bank earned from on-balance sheet and off-balance sheet items. The composition of financials institutions (FI’s) assets and liabilities, combined with the interest earned or paid on them, directly determines the interest income and expense on the income statement. Further, assets and liabilities of the banks are mostly financial, with most of the income and expense reported on the income statement being interest related.
However, in days of recession like the present period, net margins of banks go down under with the pressure on liquidity haunting them on one side and demand for loans rising on the other at cheaper rates of interest.
For example, today banks are vying with each other to buy deposits or access liabilities at 10-11% (average of funds could be at 8-9%, with most people wanting to live in cash through the savings accounts) and the loans or assets having to go at 12-13%. I chose not to discuss the implications of bond market movements in this piece as it opens up a host of other issues on treasury management and its impacts on the balance sheet that calls for another article.
Most people find difficulty in reading off-balance sheet items (the derivatives that caused the current turmoil), as these come to the surface when it is difficult to escape their consequences. In addition, these off-balance sheet items are in fine print below the profit line and several people read up to the profit line and draw their comfort or otherwise.
After the securitisation of assets came into force, we have to see the position of loans sold. Loans originated by the bank and then sold to other investors can be returned to the originating institution.
The ability to put an asset or loan back to the seller should the credit quality of that asset deteriorate is known as loans sold with recourse. When an outside party buys a loan with absolutely no recourse to the seller of the loan should the loan eventually go bad, loan sales have no off-balance sheet contingent liability implications for the financing institutions.
Specifically, no recourse means that if the loan the FI sells goes bad, the buyer of the loan must bear the full risk of loss. Securitisation is a feature that can make a bank do a sleep-walk like Lady Macbeth, as has happened in the subprime crisis.
I have not discussed the benchmark ratios, as they relate to the size of the bank and also the country in which a particular bank is located. Off-balance sheet items have to be read in conjunction with the movement of prices of gold, commodities, collaterals and other metals as also the political environment.
One lesson that the regulators in this turmoil have learnt and that too at a huge price, is that leveraging needed to be monitored more than the capital.
?The author is an economist and regional director, PRMIA-Hyderabad Chapter