BFS Coursework Seminar

1. BFS Coursework Seminar Part Two: Measurements of Risk

2. Last Time… • We examined the need to measure bank performance • We decided that bank performance is dependant on risk exposure and profitability. • We discussed how we can assess profitability through ratios (such as ROA and ROE).

3. Bank Risks • Credit Risk • Liquidity Risk • Market Risk • Interest Rate Risk • Earnings Risk • Solvency Risk

4. Credit Risk • The Probability that Some of the Bank’s Assets Will Decline in Value and Perhaps Become Worthless

5. Credit Risk Measures • Total Loans / Total Deposits • Non-performing Loans / Total Loans • Provision for Loan Losses / Total Loans

6. Credit Risk Measures Explained • Total loans to total deposits: As this ratio grows, the bank may begin to endanger the interests of depositors. • Non-performing loans to total loans and leases: The rise in this ratio signals that bank’s credit risk is increasing. If this ratio persistently rises, the bank may be heading for bank failure. • Annual provision for loan losses / Total loans and leases: The increase in this ratio signals that the management is has more funds available to control bad loans. A higher value is considered ‘better’.

7. Liquidity Risk • Probability the Bank Will Not Have Sufficient Cash and Borrowing Capacity to Meet Deposit Withdrawals and Other Cash Needs

8. Liquidity Risk Measures • Net Loans / Total Assets • Purchased Funds / Total Assets • Cash assets and Government Securities / Total Assets

9. Liquidity Risk Measures Explained • Net loans to total assets: Higher the value of the ratio, lower amounts of cash and reserves are available and the higher the chance of a liquidity crunch. • Purchased funds (securities) to total assets: Higher use of purchased funds increases the chances of a liquidity crunch. • Cash asset and government securities to total assets: Higher the value, more easily the bank can convert these securities into cash. A higher value is ‘better’.

10. Market Risk • Probability of the Market Value of the Bank’s Investment Portfolio Declining in Value Due to a Rise in Interest Rates

11. Market Risk Measures • Book-Value of Assets / Estimated Market Value of Assets • Book-Value of Equity / Market Value of Equity • Market Value of Bonds / Book-Value of Bonds

12. Market Risk Measures Explained • Book / Market Value (of Assets, Equity and Bonds): This ratio shows the variation between accounting and market values of various assets. • The higher the value, the greater the negative disparity between book and market values of assets. • Higher value therefore means more risk.

13. Interest Rate Risk • The Danger that Shifting Interest Rates May Adversely Affect a Bank’s Net Income, the Value of its Assets or Equity.

14. Interest Rate Risk Measures • Interest Sensitive Assets / Interest Sensitive Liabilities

15. Interest Rate Risk Measures Explained • Ratio of interest sensitive assets to interest sensitive liabilities: When interest sensitive assets exceed interest sensitive liabilities in a particular maturity range, a bank is vulnerable to falling interest rate. • The same is the case for the opposite situation.

16. Earnings Risk • The variation (Risk) inherent in the Bank’s Bottom Line – Its Net Income After All Expenses

17. Earnings Risk Measures • Standard Deviation of Net Income • Standard Deviation of ROE • Standard Deviation of ROA

18. Earning Risk Measures Explained • Standard Deviation: The higher the standard deviation or variance of bank income, the more risky is the banks earnings profile.

19. Solvency Risk • Probability of the Value of the Bank’s Assets Declining Below the Level of its Total Liabilities. The Probability of the Bank’s Long Run Survival.

20. Solvency Risk Measures • Stock Price / Earnings Per Share • Equity Capital / Total Assets • Equity Capital / Risk Assets

21. Solvency Risk Measures Explained • P/E Ratio: This ratio often falls if investors come to believe that a bank is undercapitalised relative to the risks it has taken on. • Ratio of equity capital to assets: A decline in equity funding relative to assets may indicate increased risk exposure for the banks shareholders and debt-holders. • Ratio of equity capital to risk assets: It reflects how well current bank capital covers potential losses from these assets most likely to decline in value. A higher value is ‘better’.