Reading 12: Analysis of Financial Institutions Flashcards
Basel III Pillars
1) Minimum required capital for a bank is based on the risk of the bank’s assets. The riskier a bank’s asset are, the higher its required capital.
2) Bank should hold enough liquid assets to meet demands under a 30-day liquidity stress scenario.
3) Requires stable funding relative to a bank’s liquidity needs over a one-year time horizon.
Global Orgs and their Regulations
1) Financial Stability Board: seeks to coordinate actions in identifying and managing systemic risk.
2) International Association of Deposit Insurers: Seeks to improve the effectiveness of deposit insurance systems.
3) International Organization of Securities Commissions (IOSCO): seek to promote fair and efficient security markets
4) International Association of Insurance Supervisors (IAIS): seeks to improve supervision of insurance industry.
CAMELS Approach
1) Capital Adequacy
2) Asset Quality
3) Management
4) Earnings
5) Liquidity
6) Sensitivity
Capital Adequacy (C)
- a bank must maintain adequate capital to sustain business losses.
- Capital adequacy is based on risk-weighted assets (RWA); more assets require a higher level of capital.
Capital Tiers
1) Tier 1 Capital (6%)
a) Common Equity Tier 1 Capita (4.5%)l: Common stock, additional paid-in capital, retained earnings and OCI less intangibles and deferred tax assets.
b) Other Tier 1 Capital: subordinated instruments with no specified maturity and no contractual dividends (preferred stock with discretionary dividends)
2) Tier 2 Capital: Subordinated instruments w/ original maturity of more than five years.
Total Capital is 8%
**minimum capital level of risk weighted assets
Asset Quality (A)
Looks at quality of the assets banks hold
Credit Risk Analysis
-Looks at credit quality of banks assets
Loan Loss Provisions
- Loans are huge part of bank balance sheet. They are critical in evaluating the bank’s financial position and performance.
- Allowance for loan losses: contra asset account to loans driven by the provision for loan losses
- Provision for loan losses: expense subject to management discretion
**Actual losses are written off against these provisions
Helpful Ratios
1) Allowance for loan losses/nonperforming loans
2) Allowance for loan losses/net loan charge-offs
3) Provision for loan losses/net loan charge-offs (This says, what % expense was recorded for loan losses given actual losses during the year)
Management Capabilities (M)
- Influences the success with which the bank is able to exploit profitable opportunities while also controlling the level of risk taken.
- Internal control system helps manage risk (credit, market, operating, legal)
Earnings (E)
- Are they high quality? Adequate (rate of return above cost of capital) as well as sustainable.
- Need to make sure the inputs into balance sheet are accurate. (Fair Value hierarchy)
Fair Value Hierarchy
- Level 1: quoted market prices of actual assets
- Level 2: Observable but not quoted prices of identical assets (quoted prices of similar assets, identical assets in non-active markets, observable interest rates, spread, implied volatility)
- Level 3: non-observable, subjective
Liquidity Position
- Two minimum liquidity standards: liquidity coverage ratio and net stable funding ratio
- Focus on concentration of funding and maturity mismatch
Liquidity Coverage Ratio (LCR)
-calculated as the value of a bank’s highly liquid assets divided by expected cash flows
highly liquid assets/expected cash outflows
Net Stable Funding Ratio (NSFR)
- the percentage of required stable funding that is sourced from available stable funding
- relates the liquidity needs of a banks assets to the liquidity provided by the banks liabilities (funding sources)
- Minimum NSFR of 100%
available stable funding/required stable funding `
Available Stable Funding Components
-Function of the composition and maturity distribution of a bank’s funding sources (capital, deposits and other liabilities)
Regulatory
Sensitivity (H)
-Currency risk, interest rate risk, market risk
Government Support
- serve as backstop against bank failure
- larger banks more inter-linked and would cause higher contagion
Government Ownership
-public ownership in a bank may increase faith in a bank
Culture
- conservative or risk-taking?
- Look at:
- diversity of banks assets
- accounting restatements due to failures of internal controls pertaining to fin reporting
- Management compensation
- speed with which a bank adjusts its loan loss provisions relative to actual losses
- Off-balance sheet assets and/or liabilities
- segment information
- currency exposure
Insurance Company Revenues
- premium income and income on float
- premium on float: income earned on premiums between collection and claims
P&C Insurance Companies
- tend to be lumpier
- premium income is highest source of income for a P&C insurer
- keys to profitability are prudence in underwriting, pricing of adequate premiums for bearing risk and diversification of risk
P&C Profitability
- margins are cyclical: heightened competition causes price cutting to obtain new business leads (soft pricing). Vice versa with hard pricing.
- Major expenses: claims and obtaining new policy business.
Combined Ratio
- Sum of the underwriting loss ratio and expense ratio
- Ratio in excess of 100% indicates and underwriting loss
Underwriting Loss Ratio
(claims paid + change in loss reserves)/net premium earned
- measure efficiency of company’s underwriting standards
- loss reserve: estimated value of unpaid claims (based on estimated losses incurred during reporting period). Downward revisions is conservative.
Expense Ratio
(underwriting expenses including commissions)/net premium written
Measures efficiency of the company’s operations
Loss and loss adjustment expense ratio
(loss expense + loss adjustment expense)/net premiums earned
-measures the relative success in estimation of risks insured (lower is more successful)
Dividends to policyholders (shareholders) ratio
dividends to policyholders/net premiums earned
-liquidity measure measuring the cash outflow on account of dividends relative to premium income.
Combined Ratio
loss and loss adjustment expense ratio + underwriting expense ratio
CRAD (after dividends): combined ratio + dividends to policyholder ratio
L&H Insurance Companies
-get revenue primarily from premiums w/ investment income as a secondary source
Revenue Diversification L&H Insurance
-income from premiums, investments and fees
Earnings Characteristics L&H
- current period claim expense includes not only actual claim payments, but also interest on the estimated liability to policyholders
- L&H insurers capitalize the cost of acquiring new and renewal policies and amortize it based on actual and estimated future profits from that business
- Apart from standard ratios such as ROA, ROE, and EBIT margins, industry-specific cost ratios include:
a) total benefits / net premiums written and deposits
b) commissions and expense / net written and deposits
Investment Returns L&H
- longer float period than P&C so investment returns are a key component of the insurers profitability
- Duration mismatch between A&L’s is an area of concern
Liquidity L&H
- liquidity needs fairly predictable
- adjusted investment assets / adjusted obligations
- assets are adjusted based on their ready convertibility into cash. Obligations are adjusted based on assumptions about withdrawals
Capitalization L&H
- similar to P&C, there are no minimal cap standards
- usually interest rate risk b/c a&l mismatch
