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Financial Soundness of Commercial Banks

The document discusses key aspects of assessing the financial soundness of commercial banks, including: 1) Understanding banks' assets, liabilities, income, and off-balance sheet activities like derivatives and how they affect financial soundness. 2) Introducing models like CAMELS that analyze capital adequacy, asset quality, earnings, liquidity, and other factors. 3) Discussing how to quantitatively analyze banks' balance sheets, income statements, ratios over time and qualitatively assess management quality to determine overall financial soundness.
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0% found this document useful (0 votes)
19 views37 pages

Financial Soundness of Commercial Banks

The document discusses key aspects of assessing the financial soundness of commercial banks, including: 1) Understanding banks' assets, liabilities, income, and off-balance sheet activities like derivatives and how they affect financial soundness. 2) Introducing models like CAMELS that analyze capital adequacy, asset quality, earnings, liquidity, and other factors. 3) Discussing how to quantitatively analyze banks' balance sheets, income statements, ratios over time and qualitatively assess management quality to determine overall financial soundness.
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Financial soundness of

commercial banks
Dr. Tu Le
Institute for Development and Research in Banking
Technology
University of Economics & Law
Leaning objectives
• Understanding the bank’s assets, liabilities
and bank’s income
• Understanding some bank’s off-balance
sheet activities
• Introducing some models to assess bank’s
financial soundness
Bank’s assets
• Liquid assets and quasi-liquid assets
– Cash and cash equivalent
– Due from banks (interbank Assets)
– Government securities
– Marketable securities
– Unquoted securities
Banks’ Assets (Cont’d)
• Illiquid assets
– Loans and advances
– Investments in and assets in respects of
subsidiaries and affiliated companies
– Fixed assets
– Other assets: prepayment and goodwill
The breakdown of
ACB’s assets
Bank’s liabilities
• Funding liabilities
– Often but not always interest bearing
– Customer and interbank deposits
– Long-term liabilities
– Other liabilities
Customer and interbank liabilities
• Customer Deposits
– Retail-core deposits
• USA: NOW and Super Now Accounts: interest bearing checking accounts and money market
accounts
– Demand deposits:
• current or checking account deposits
• Traditionally, bearing no interest
– Saving deposits
• Paying interest but no fixed term
– Time deposits
• For a certain time
• Paying higher interest rate than saving deposits
• Interbank deposits (due to other banks)
– Large denomination certificates of deposits
– Short-term borrowing: purchased funds or hot money
Long-term liabilities
• Borrowing for a term (> year)
• Loan capital
• Subordinated debt
Other liabilities
• Checks and demand draft outstanding
• Accrued taxes, interest, and other
expenses
• Dividends payable
• Liabilities in respect of subsidiaries and
affiliates
• Miscellaneous liabilities
ACB’s liabilities
Bank’s capital
• Share Capital: share capital or paid-in capital refers to the value of the
assets contributed by the shareholders. It is comprised of the par value of
the bank’s shares
• Common Shares: represents the equity ownership of the banks
• Preferred Shares: have limited voting and ownership rights but are
guaranteed a specified dividend
• Retained Earnings- undivided profits: represents the earnings of the bank
that have been plowed back into its business- so called the source of
internally generated capital
• Equity Reserves: are reserves designated for special purposes. Watch out
don’t confuse it with Loan-Loss Reserves
• Minority Interest in Subsidiaries: In consolidated reporting for a bank that
has subsidiaries, the investment of outside shareholders as minority owners
in the bank’s subsidiaries will be counted as part of the consolidated group’s
capital
ACB’s equity capital
Bank’s OBS activities
• Do not appear on the balance sheet,
• May appear in notes to the financial statements.
• Loan commitments: the promise that a bank will
make a loan if the bank customer so opts
• Letter of credit,
• Guarantees: the bank’s promise, in exchange for a
fee, to pay if a customer defaults
• A various types of financial derivatives (interest rate
swap, income swaps), and foreign exchange
contracts
Interest rate swap
• Assume A offers B a fixed rate of 5% in
exchange for receiving a floating rate of
the LIBOR rate plus 1% (assume LIBOR is
4%). Therefore, A has 5 % fixed rate and B
has 5% (LIBOR rate of 4% + 1%)
• What if LIBOR rate of 5.25% and LIBOR
rate of 3.75%, what happens to A and
B???
Credit default swap
• How total returns swap works?
Letter of credit
Bank’s income statement
• Interest income (gross interest income)
• Interest expenses (cost of funding)
• Non-interest income
• Operating income
• Non-interest expenses
• Loan loss provisions (non-cash expense)
• Minority interest
Interest income
• Income from loans- advances to customers
and securities (investments in fixed income
securities such as treasury bills and bonds, and
comprises the bulk of income from most banks
• The mere increase in general interest rates will
cause a bank’s interest income to rise even
though net interest income remains the same.
Note that a rise in either interest income or net
interest income does not necessarily imply a
rise in profitability
Interest expenses
• Interest the bank must pay to its depositors
and creditors from whom it has borrowed
funds to on-lend to bank customers
• Customer deposits, interbank borrowing,
medium- and long –term borrowing.
• Commercial banks obtain the bulk of their
funding from deposits
• Wholesale banks tend to rely to a great
extent on commercial borrowing for funding
Non-interest income
• Fees and commissions(providing
guarantees, letter of credit, trust services,
arranging financing, rental of safe, deposit
boxes, checking clearing fees and
automatic teller machine fees
• Gains on securities and foreign exchange
trading
Non-Interest Expenses

• Staff salaries and benefits-compensation


expenses
• Occupancy expenses- rent on the bank’s
premises and utility costs
– depreciation, an accounting construct
comprises a significant portion and for credit
analytical purposes might permissibly be set
aside when making analytical calculations
• Other expenses-office supplies
Loan Loss Provisions (non-cash expense)

• Adequate capital put in aside to cover the costs of loss from


default and
• Provisioning costs are kept to a minimum to prevent profits
from being reduced
• Requisite specific provisioning was reduced by RELEASES of
provisions previously set aside as the change in classification
of a group loans from a more severe category to a less severe
category or due to the loans maturing
• The net specific provisioning charge has been further reduced
RECOVERIES – recoveries on loans previously deemed to be
loss loans and fully provided against.
• Provisioning – an income statement line item differs from
provisions or loan loss reserves
Minority Interest

• The allocation of profits to those who hold


minority interests in bank’s subsidiaries.
• Representing the share of income from
subsidiaries not attributable to the bank’s
shareholders. The category thus
represents a deduction from net income.
Dong A bank’s
Income Statement
The assessment of financial soundness of
banks
• Quantitative vs Qualitative analysis
– Review of the bank’s historical performance, its present
condition and future prospects
• Quantitative approach
– Compare financial indicators and ratios
– Compare a bank’s performance and financial conditions to
a peer group of banks
• Qualitative approach
– A review of a bank’s management
– The plausibility of a bank’s strategy
– The competence of senior management
Annual reports
Quantitative
Income statement, Balance sheet Minimum 3 years
Supplementary statements

Interim financial Frequently these are limited to a only a condensed or rudimentary


statements balance sheet and income version of the annual statements
statement, are often unaudited
Notes from the For rating agency analysts, Information formally obtained in
bank visit and questionnaire the course of a bank visit as well
third parties as informal views about the banks
from various sources
Prospectuses More detailed company and market Depends on many jurisdiction
data than provided in the annual
report
News Articles: acquisitions, capital raising, Newspaper, magazine clipping
changes in management and
regulatory developments

Other research Regulatory authorities, rating In-house management heavily


reports agencies, investment banks relies on rating agency
CAMELS Framework
• Capital adequacy (C)
• Asset Quality (A)
• Management (M)
• Earnings (E)
• Liquidity (L)
• Sensitivity to market risks
Capital adequacy (C)

• Assess the financial health of the banking


system
• Reflect the capacity of this sector to absorb
the eventual losses caused by either internal
or external factors or even both
• Total capital adequacy
• Total equity/total assets
• Total equity/total debts
Asset quality (A)
• Assess the strength of a bank
• Is directly linked to capital adequacy
because insolvency risk is accompanied by
the deterioration of the bank’s assets
• the ratio of loan loss provisions to total loans
• the ratio of loan loss provisions to net
interest income
• The ratio of total loans to total assets
Management quality (M)
• Reflect the ability of bank management to
control operating costs.
• Operating expenses/total assets
• Interest expenses/total deposits
• Non-interest expenses/(total net income)
• The cost to income ratio
• Staff expenses/average assets
Earnings ability (E)
• Profitability
• Return on assets (ROA),
• Return on equity (ROE)
• Net interest margins (NIM).
Liquidity (L)
• The ability of a bank to withstand shocks
to cash flows and unexpected withdrawals
of depositors
• The ratio of liquid assets to the short-term
funding, (LASTF)
• The ratio of net loan to the short-term
funding (NLSTF) as measures of bank
liquidity
Sensitivity to market risks
(S)
• How the market prices (the interest rates, the
exchange rates, and the equity prices) impact the
bank’s earnings and capital negatively.
• The ratio of the difference between rate-sensitive
assets and rate-sensitive liabilities to total assets.
• Rate-sensitive assets comprise dues from financial
institutions and total loans whereas rate sensitive
liabilities include interbank liabilities and other
liabilities.
• The ratio of total assets to total assets of the
banking industry.
Summary
• Understanding the financial statements of
banks
• Understanding some key tools to help
banks mitigate risk
• Understanding the CAMELS models
• How to conduct a research

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