A primer on Analysis of Banks – Part 1

Recently I had a chat with one of my fellow junior..He asked me what is the significance of ratios like “D/E , Accounts payable , Accounts receivable ratio” for a bank…I had to elaborate what we learnt in Commercial bank management course in about half an hour…Here is the summary of our discussion

Function of a bank: Every organization has some reason for its existence. They benefit the owner, his relatives and to a certain extent a society at large..But the existence of banks is driven by the societal motive (Not that every owner wants to do it so, but the very design of a banking system makes it so!!)

If I want to put in simple terms the role of a bank is to borrow money from who have surplus and lend it to somebody who has deficit. This very definition of the bank makes its financial analysis different from companies in all other sector..

D/E ratio does not have any significance: How often have we heard analysts cribbing about the fact that the D/E of the company is almost reaching 1 which is a danger sign..But have we ever thought about the D/E of a bank..It’ll be approximately 10-12..Thats a very big number..It means the owner has put around 8 rs from his pocket and has borrowed 92 rs from outside..

As I have already said this is the business of a bank..They borrow it at a cheaper rate (through the deposits – fixed, floating …inter bank borrowings, borrowing from other agencies, borrowing from RBI) and lend it at a little higher rate..Hence they make a profit margin out of this transaction.

So can a banks always borrow and lend (with no money of its own) : Luckily there are stringent regulations (??!!) concerning the amount the owner of the bank needs to infuse in order to be complaint . We call it the capital adequacy ratio. Capital adequacy ratio, in simplified terms , is the amount of equity that a bank needs to hold given its balance sheet size..Now the Basel II regulation for banking assigns risk weights according to asset subclasses and according to the risk weighted assets you have to maintain a capital..and this ratio has to be atleast 8%...Let me clarify risk weight with an example..If the bank lends out to a AAA borrower like Infy it entails a risk weight of 50% meaning if he gives out loan of 100 rs to Infosys then the bank need to have 4 Rs(8/2) as equity capital..In the same way if it lends a housing loan , which entails 150% risk weight then it has to maintain 12 Rs(8*1.5) for every 100 Rs of loan it lends out..With every default that happens it is the equity capital which absorbs the losses..Hence if the equity capital goes below zero then the bank is said to be bankrupt(even if the bank might have 90% of its good loans still in the market)..

P/E ratio will also be closer to one: Turn into any newspaper and the first ratio that an analyst speaks about is the Price earnings ratio of a company..I was surprised yesterday to see a company with a P/E of 800..A company quotes at a P/E at such high levels because of the expectations of its future earnings..It means that the assets in the balance sheet of the company are worth much more than what is quoted..But if we observe for a bank it’ll be closer to 1..This is because of the fact that the bank has just interest income and interest expense..Hence there is nothing which is being quoted at a wrong value..All the assets and liabilities are quoted at proper values in the balance sheet(I don’t want to confuse you with the HTM , AFS , HFT concepts)..


Hope the part 1 has brought in some clarity..I will discuss some of the major risks faced by a bank and concepts like VAR in the part 2….

Risky Assumptions - Lessons on Risk management learnt from the financial crisis

Through this article I highlight some of the assumptions on risk that investors, companies made which has terribly backfired on us/them during the recent financial crisis

Mean reverting characteristic

The first assumption in any standard book on risk management is the mean reverting characteristic of the risk variables..Let me explain this with the help of my favorite variable sigma (standard deviation)

When companies underwrite on securities(even during volatile times) they believe that the volatility(SD) will return to the long run average…Quite a decent assumption as long as the companies are able to stand the test of time..For example some of the companies/traders (who were short) were completely wiped out on a single day when the UPA government was elected because the volatility increased to a life time high of 75(VIX figure – source: NSE)

In the time of crisis the company’s liquidity takes a big beating which gives them no other choice but to wind off their positions at big losses.

Again I’m not completely supporting the mean reverting characteristic. During complete structural changes in the financial market in a country the variables change a lot and it will never come back to its historical mean.

Do we really STRESS the conditions?

The regulators and companies were smart enough to devise a system(even before the crisis) called as stress testing wherein they will simulate extreme scenarios and try to see what would be the impact on their balance sheet/profitability..

But what we/they failed to understand was the behavior of the market when conditions are stressed..So we merely do a scenario analysis of projecting different variable to extreme cases (example: Interest rate moving by 5%, volatility jumping by 100% etc)…Recently my friend gave me a hypothetical scenario – a really stressful situation and asked me how will I behave in that situation …My answer was ‘I don’t know’..He was surprised at the answer and asked me why I myself did not know..Simple because I have not experienced such a situation in my life and I myself can’t predict my behavior under such extreme conditions..So I said since I’m a very kind and nice person during normal circumstance does not mean I’ll be the same forever..Situations can drive a person crazy…Projection of the behavior is not the way out here..
Lot of the assumptions that we have taken during the normal market conditions fail terribly during stressed condition..One such important failure was the increasing asset correlations. Any global manager with significant exposure in various countries would have thought his positions to be safe because of the diversification..But during the financial crisis the asset correlations increased substantially that all their assumptions regarding correlation went for a toss..

United we stand – Says different risks

True to the proverbial statement which says ‘history always repeats itself’, there have been various individual cases of bank failure in the past due to individual risks which triggered the other risks and caused the collapse of the entire bank. For example it was a rogue trader (operational risk) who collapsed the billion dollar organization ‘Barings’ in no time. It was unacceptably higher levels of hedge fund investing (Liquidity risk) which triggered other risks and eventually caused the collapse of LTCM (long term capital management- A very famous hedge fund).It is entirely the banks and the financial institutions to blame who did not give the due respect for such historical incidents and went ahead doing whatever they were aggressively doing. The root cause of these problems lies in the fact that the organization failed to see the risk management from the enterprise perspective. Hence we infer that though there are different names for the risks (market risk, liquidity risk, credit risk, reputational risk) – they generally occur together

We use VAR:(Value At Risk)

VAR – Simple but an effective tool in identifying the pile of risk that you are sitting upon..Many companies were proud about the fact that they were using complicated models of VAR as the risk management tool and they knew exactly their risk..

But the problem with VAR is that it does not focus on extreme events..Regulators for banks say that the banks have adequate capital for their VAR with 99% confidence level…But what if the risk is only after the 99%..What if the magnitude of risk is exponential in nature after that 99%..Go ask any option writer and he’ll be able to explain this better (I luckily/unluckily being one among them)..

So using VAR is just a hygiene level..If companies want to identify the real risks they need to go much beyond what VAR suggests!!

An interesting hypothesis about a career in finance

As I have experienced some practicalities of the market in the past , have had a formal knowledge of finance , seen few people who succeed and few who have failed in the field of finance , I wanted to hypothesize the ‘could be’ reasons for being successful in finance

I would attribute the success in finance to only three factors..
1. Knowledge of economics
2. Risk taking ability
3. Understanding people

Knowledge of Economics: The mother of finance..The field of economics has been existing even before the existence of money …A thorough understanding of this subject is necessary to master finance(Be it trading , be it corporate finance or Structuring of products in a IBank , Assessing the credit risk in a bank loan portfolio)..

Just look back , if there was some rationale while designing all the ‘structured finance products’ like CDO’s , would there have been a financial crisis..Is it the greed of some of the wreckless bankers to blame or should we pity the ignorance of those bankers who were not able to understand the basics of economics and thought the prices of house will always go up(Or where they believing fools theory will work always…)

It is like a Value at Risk for options …The so called traders earn lakhs every year only to lose crores on a particular point of time , finally ending up with less than risk free rate of return..The most rational(who understand economics) always expect little more than the risk free rate(to compensate for the risk that they take) and earn them consistently..

Risk taking ability :

This is one another important aspect to be successful in the field of finance..How much of a risk can you bear in your belly??

I was the first guru to my friend ‘Manikandan’ to do trading during the third year of my UG at CEG..I was pretty comfortable with most of the technical terminologies , was able to predict the market movement etc…At a time when I was trading with 5000 , mani pulled out a 1.5 lakh rupee loan from the bank and started trading(that was a real surprise for everybody)…After a year ROE for both of us was around 20% …Obviously the difference showed up in the magnitude of profits…(not to mention that his taxes last year was in lakhs!!)

Both were rational..Both understood the market…The only difference which separated us was the risk taking ability..It could have gone either ways for him..But it was that calculated risk taking which made him succesful..

Buffet bought stocks which were shunned by investors ..There were stocks like GEICO which dropped to the point of near bankruptcy and almost every investor sold it off...but Warren Buffet invested billions in that stock during that time believing in that stock..That is risk taking ability...

When i mentioned the example of my friend , I don’t mean to say that you have to leverage through loans every time…When you believe in something, when you think that you are not investing the essential money for a risky proposition(essential money – money that might be needed to fund your college fees , or to pay your house loan etc), then go invest that money without any second thoughts…

Understanding people

Be it structuring of a product and selling it to a client or giving a loan to a client under CCC category or managing the wealth for your client , ‘understanding people’ becomes a key asset..
When I was reading credit risk measurement topic , there are a lot of complex things done to finally arrive at the probability of default and the expected loss out of the default…This is done through models..If i give a model(KMV , Merton..what else??) to the most knowledgable finance guy(with a formal education) and let me compare his predictions with my friends father who has been in the loan disbursement section for about 15 years (no formal education in finance)…I can bet 9/10 times my friends father can judge the credit quality of the person with just five minutes of interaction with him…The complex models are just tools to substantiate our beliefs..They are not the ‘panacea’..

PS: The above are the three factors for being successful in finance according to my hypothesis..In case if you wish to differ from me you are welcome to do so…

PS: For Gods sake dont interpret this as a propoganda against formal education in finance....I'm a die hard fan of academic finance and still consider studying finance in a great campus like IIML being my life time achievement!!

Swap - A concept to remember

Couple of weeks back we went to ‘Kaminey’...Not a very exciting movie, I would say, except for couple of facts..One – Priyanka Chopra, who is becoming more beautiful with every passing day …Second – I got an example to explain the concept of ‘Swap’ in financial market...

Definition:
Two parties in the financial market enter into a swap agreement when they feel the agreement can bring in mutual benefit to each other (which would not have existed individually)…

Example: Shahid Kapoor vs Shahid Kapoor..

Group of Mafias would be searching for Shahid Kapoor 1 in the movie (elder of the twins) and the police would be searching for Shahid Kapoor 2..Now each of the Shahid kapoor will get caught in the hands of the wrong party (ie SK1 in the hands of police and SK2 in the hands of mafia)…Now assume if both the parties (police and mafia) had to take the trouble of getting the other person, it’s going to cost them huge resources , time , money….


But once they get to know the whereabouts of the Shahid Kapoors they enter into a private agreement (Rule no 1: Swap is a private agreement as opposed to futures or options) , to exchange the Shahid Kapoors..

Very easy right…This is all what Swap is about…

Example 1 in financial market: ICICI wants to raise Euros to serve its High net worth client(say maruthi …because maruthi has some parts manufactured from Britan and hence has a liability in Euros)..And a bank in Europe say Bank of England wants Indian currency to serve its client (say an FDI who wants to invest in India and hence needs rupees)..


If ICICI wants to borrow Euro the cost would be somewhere around 5% and if BOE wants to borrow Indian Rupee it would cost them around 10-11 %(approximate figures)..But if ICICI wants to raise money in India it is just the cost of deposit for them which would be like 7-8%(or even in debt markets around 9%) and for BOE it would be around 3% in their own backyard for raising Euros..

So both of them enter into a private deal..You raise money in your country and I’ll do it in my country and we’ll swap it amongst ourselves..ICICI will be able to get euros from BOE at say 4%(a net saving of 1%) and BOE will be able to get it at 9% from ICICI(around a percent of savings)..Both of them will mostly enter into a deal such that the mutual gain for each of them are equal(but not a necessary condition..depends upon the bargaining power)…


Example 2:Another case could be when one bank within the same country is trying to raise fixed rate loans because of its balance sheet structure(I don’t want to confuse you by introducing the technical terminologies) and another bank wants to raise floating rate loans . But they are able to give loans in the other way(floating and fixed respectively) ..Now they enter into a swap deal so that it benefits both of them…First bank gets the fixed loans and second bank gets the floating loans

So simple right….All finance concepts are very simple…It would be denefitly a concept which we would have unconsciously used in some time in our life..Just that they are embedded into complex names: P


PS:If you are further interested abt swaps just go through existing literature on ‘valuing swaps’…I promise you that it’ll not take more than fifteen minutes to understand how is a swap valued..It is interesting as well!!