Risk Analysis and Bank Financial Statements

Risk Analysis and Bank Financial Statements Hennie van Greuning World Bank Treasury FirstRand Board of Directors

Outline – key messages Discuss the common causes of financial crisis and failure. Key lessons learned from the financial crisis Proposed regulatory reforms and risk enhancements as a result of the financial crisis. Basic risk analysis

1. Credit Crises – Common Causes “…all consequential events in human history have come from unexpected, rare occurrences” Nassim Nicholas Taleb Unusual Times

1. Financial / Banking Sector Crises – Common Causes Business strategies flawed Poor governance oversight & risk management Balance sheets structurally weak Excessive gearing Excessive credit risk • Weak credit terms • Risky products Liquidity risk not well understood Risks taken at lower levels not understood by senior management Recent bank failures – generic causes

1. Financial Crises – Common Causes Global imbalances have built up over years CA balances Financial

400% 350% 300% 250% 200% 150% 100% 50% 0% 1916 1926 1936 1946 1956 1966 1976 1986 1996 2006 1. Financial Crises – Common Causes US Private Sector Debt to GDP • “Debt can be viewed as sustainable as long as the debt to GDP ratio is non-increasing”* Source: US Federal Reserve *Nouriel Roubini (2001) Debt Sustainability: How to Assess Whether a Country is Insolvent, Stern School of Business, NYU

1. Financial Crises – Common Causes US Housing Market Fundamentals • Source: OFHEO and US Federal Reserve

1. Financial Crises – Common Causes Unrestrained asset (derivative) growth – CDS market growth Source: ISDA, The World Bank, US Bureau of Economic Analysis and US Treasury

1. Financial Crises – Common Causes South Africa’s macro economic imbalances monitor Current account balance Household debt to disposable income House prices Inflation

1. Financial Crises – Common Causes Consequences of macro economic imbalances Global macroeconomic crisis Global financial sector crisis Bank share prices Global growth

Financial Crises – Common Causes Bank Failures Statistics 2010 began with a whimper for Bank Failures as the first week almost gave us the illusion that maybe and just maybe, the problem might just have solved itself as zero failures were reported. It was never going to be that easy, was it? As the graph, shows, a few weeks into 2010, the number of failures curve has already picked up steam and we see the red curve blasting away. May 20 Failures – 72 so far this year Problems - 775 institutions with aggregate assets of $431 billion 8,384 FDIC insured banks Source: http://investingcontrarian.com/global/us-1800-bank-failures-tsunami-on-horizon/

Key Lessons Learned “I spent too much time out of the office with clients and trusted other people to manage the risk – I am sorry.” Dick Fuld, ex-Lehman CEO.12 September 2009 “We strive to have a balance in our team and I will use the analogy of the soccer team. A balanced team has good forwards, sweepers, backs and a goalie. If too many goals are let in, you must strengthen your defense. However to score goals you must have good strikers. You can’t win matches with 11 goalies and nor can you win with 11 strikers. We have improved our defensive line but not at the expense of our forward line.” SA banker - September 2009 Remember, models are only as effective as the assumptions on which they’re built and the inputs they’re provided “Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.” Douglas Adams What did management learn?

Key Lessons Learned If things appear too good to be true, they probably are (“If something cannot go on forever, it won’t”) – know where profits come from Back to basics – use common sense approach to risk management: Risk management is about quality of people, experience, judgment and coordination Pro-active, holistic and forward looking analysis, through e.g. robust stress testing and a combination of quantitative and qualitative risk information Align risk, capital, funding and strategy – and incorporate it in a dynamic risk appetite process Escalate clearly and early – to avoid surprises “The last time anybody made a list of the top hundred character attributes of New Yorkers, “common sense” snuck in at number 79.” Douglas Adams “Nothing travels faster than the speed of light with the possible exception of bad news, which obeys its own special laws.” Douglas Adams, "The Hitchhiker's Guide to the Galaxy"

Financial Failure - Nothing New ?

Disconnect between risk and controls: “These are stories of what happens when the desire for excess returns overrides risk controls”. The person in charge (in each case) showed excellent results in the beginning, and thus was allowed to transact without proper supervision and controls.” Beware of star performer who is unconstrained by lack of supervision. If returns are too good to be true, there is likelihood of elevated risk Poor understanding of business and investment strategies by senior management and Board Fractured (and not always competent) oversight mechanisms: internal and external GREED History: Analysis from Kidder Peabody to the present crisis

3. Regulatory reform

3. Regulatory Reform Some emerging market countries way ahead of the governance & regulatory curve – already implemented many items the world is still debating The crisis provides a unique opportunity to make significant internal improvements in organizations Good time to foster a culture of risk and transparency Flexibility: Those better able to adapt have an advantage in the market going forward Building-up infrastructure and capacity takes commitment and resources. Not everything is bad news...

4. Key stakeholders - Accountability

4. Risk information not directly reflected in AFS Summary of risk types

4. Risk information not directly reflected in AFS Risk in the context of a Bank Balance Sheet Assets High level allocation to key risk types Liquidity risk Market risk + Banking book hedges Credit risk +Interest Rate in the banking book +Liquidity Investment risk + Liquidity risk + Market risk Liabilities Liquidity & Funding risk + Interest rate in the banking book Market risk + Banking book hedges Market risk Funding risk Capital risk Note: figures are provisional

Financial Analysis – Principles Questions to consider… What is the purpose of the analysis? What level of detail will be needed? What factors or relationships (context) will influence the analysis? What are the analytical limitations, and will these limitations have the potential to impair the analysis? What data is available? How will data be processed? What methodologies will be used to interpret the data? How will conclusions and recommendations be communicated?

Financial Analysis – Principles What happened? Why did it happen? What is the Impact of event? Action plan going forward • Accountability • Target date What is Financial Analysis?

Financial Analysis – Tools and techniques

4. Regulatory Returns Analytical Value Balance Sheet Overview

4. Regulatory Returns Analytical Value Composition of Assets : Structural Change & Growth

4. Regulatory Returns Analytical Value Asset Growth Over Time SARB -2008 Annual Bank Supervision Report

Financial Analysis – Tools and techniques Trend analysis – Asset Growth: cumulative from a base period Source: 2009 ABACUS

6. Financial Analysis – Tools and techniques Trend analysis: Total Assets, Gross Loans and Advances SARB – 2008 Annual Bank Supervision Report

Financial Analysis – Tools and techniques Common Size Analysis - “Vertical” Analysis

Assets Income Regulatory Returns Analytical Value Assets Vs Income: Energy Applied Vs Income Earned

Cost-to-Income Ratios of Individual banks Categorized by Asset Value of Each Bank 4. Regulatory Returns Analytical Value SARB – 2008 Annual Bank Supervision Report

Regulatory Returns Analytical Value Composition of Income Statement - Multi Year Trend SARB – 2006 Annual Bank Supervision Report

Financial Analysis – Tools and techniques Ratio Analysis: Liquidity statistics 250% 200% 150% 100% 50% 0% Period 1 Period 2 Period 3 Period 4 Current Period Customer loans as % of customer deposits Interbank loans as % of interbank deposits Readily marketable assets as % of total assets Volatile liabilities as % of total liabilities Volatility coverage (readily marketable assets as % of volatile liabilities) Bank run (readily marketable assets as % of all deposits type)

Financial Analysis – Tools and techniques Correlation: Total Banking-Sector Assets to GDP SARB – 2008 Annual Bank Supervision Report

Risk Analysis and Bank Financial Statements