11 (FS&A) - Analysis of Financial Institutions Flashcards
How do financial institutions differ from other companies?
- Systematic risk - the failure of any one bank could result in contagion
- Regulated status - they are regulated
- Types of assets - they have mostly financial assets as opposed to tangible assets
What types of risks do financial institutions have more exposure to than other companies?
Why is this the case?
- Market risk
- Interest rate risk
- Credit risk
- Liquidity risk
They are exposed to these risks because their assets are primarily made of financial assets as opposed to tangible assets. Financial assets have values that fluctuate with market values., exposing institutions to this increased risk.
What does Basel III do?
Specifies three major requirements for financial institutions:
- Minimum capital requirements
- Minimum liquidity requirements
- Minimum funding requirements
What is systemic risk?
Risks that have the potential to spread and negatively impact the whole economy.
Why are banks regulated?
Financial institutions have systemic importance (i.e. risk of contagion) to the entire economy.
What does the Financial Stability Board seek to do?
Seeks to coordinate actions of participating jurisdictions in identifying and managing systemic risks.
What does the International Association of Deposit Insurers seek to do?
Seeks to improve the effectivness of deposit insurance systems.
What does the International Organization of Securities Commissions (IOSCO) seek to do?
Seeks to promote fair and efficient security markets.
What does the International Association of Insurance Supervisors (IAIS) seek to do?
Seeks to improve supervision of the insurance industry.
What are the two major categories of insurance firms?
- Life and Health (L&H)
- Property and Casualty (P&C)
What is the float for insurance companies?
The income earned on premiums paid between their collection and the payment of claims.
What are the two income streams for insurance firms?
- Income from premiums
- Float - Income earned from investment returns on the funds collected from premiums but are hyet to be paid out in claims.
What does Basel III recommend for the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR)?
A minimum of 100% for both.
What are considered highly liquid assets?
Those assets that can easily convert to cash.
Discuss market risk exposure for banks
Banks are exposed to a variety of market risks in various ways. Including the below:
- market risk of their investment portfolio (volatility in market values)
- currency risk
- credit risk
- interest rate risk
Why is interest rate risk important to banks?
They hold a lot of bonds that are impacted by interest rates. Any mismatches between assets and liabilities concerning maturity and repricing frequency caused increased risk.
What is the CAMELS approach?
A six-factor analysis of systematically scrutinizing a bank’s level of systematic risk.
What does CAMELS look at?
C - Capital adequacy
A - Asset quality
M - Management capability
E - Earnings sufficiency
L - Liquidity position
S - Sensitivity to market risk
Risk-weighted assets
Capital adequacy is based on risk-weighted assets., meaning more risk assets require a higher level of capital. Risk weighting is specified by individual regulators.
According to Basel III, what are the three tiers of capital?
- Common Equity Tier-1 Capital - Common stock, additional paid-in capital, retained earnings, and OCI-less intangibles and deferred tax assets.
- Other Tier-1- Capital - Subordinated instruments with no specified maturity and no contractual dividends (e.g. preferred stock with discretionary dividends,
- Tier-2 Capital - Subordinated instruments with original (i.e. when issued) maturity of more than five years.
According to Basel III, what are the minimums for the a bank’s capital base?
Common Equity Tier-1 Capital = 4.5% of RWA
Other Tier-1 Capital = 1.5% of RWA
Tier-2 Capital - 2% of RWA
Total Tier-1 Capital - 6% of RWA
Total Capital = 8% of RWA
When using CAMELS, what goes into evaluating asset quality?
Analyzing the value and quality of a bank’s loans and investments in securities. Considers not only the liquidity and credit quality of the assets but also take into account how diversified those assets are.
Loans - Evaluated for their credit quality.
Investment in securities - Evaluated based on their current value which can differ between IFRS and US GAAP.
Discuss the importance of loan loss provisions
Given loans represent a large portion of a bank’s total assets, the credit quality of the loans and loss provisions are critical in evaluating the bank’s financial position and performance. Analysis of loan loss provisions relative to actual loss behavior may provide key insights into performance.
Allowance for loan provisions - Contra asset account to loans
Provision for loan losses - An expense subject to management’s discretion.
What are the three important ratios with regard to loan loss provisions?
- Allowance for loan losses to nonperforming assets
- Allowance for loan losses to net loan charge-offs (i.e. write-offs)
- Provision for loan losses to net loan charge-offs (i.e. write-offs)
These three ratios are calculated exactly how they sound.
Ex.
Allowance for loan losses to nonperforming assets = Allowance for loan losses/Nonperforming loans
Which off-balance sheets items are looked at when evaluating asset quality?
- Guarantees
- Unused lines of credit
- Letter of credits
When using CAMELS, what goes into evaluating management capability/quality?
Management quality influences how prudent management is at seeking and managing risks that the bank takes. Management’s capacity to manage risks while at the same time taking advantage if suitable opportunities for new business drives performance.,
Quality of corporate governance, compliance with applicable regulations, risk management systems, and quality of internal controls all form part of this analysis.
Outside of the CAMELS framework, what other factors (unique to the banking sector) should analysts consider?
What factors (not unique to the banking sector) should analysts consider?
Unique
1. Government support for the banking sector
2. Government ownership of a bank
3. Bank’s mission and culture
Not-Unique
1. Competition environment
2. Off-balance sheet obligations
3. Segment information
4. Currency exposure
