Reading 11: Analysis of Financial Institutions

Page No. 12922nd Sep 2022 unsuayDate / /ReadingAnalysisofFinancial InstitutionsM121/:FinancialInstituteFinancial Institutionprovidediverse servicesFinancial IntermediationFacilitate asset risk managementExecute translation (securities , derivatives, Commodities, RE)Focus of ReadingBank (deposite - takingloan-making institution)InsuranceCompaniesbADSt Systematic ImportanceH includeslinkagebet"financialInsitutionintroduceaSystemwideriskoffailureDeposite andborrowers, financialinstitutional + households,Corporationsandgovernment.When onemember of institution fails results inContagion effectBank Run} The Bly RiskftilidateRegulations ;Min Capital requirement, min liquidity requirements limits onRisk taking. Page No. 130Date/AssetsFinancial assets usually reportedat FV I EquityBasel IIIlending at - Amout lostAn International framework focused on :Improving the banking Sectors ability to absorb shockImproving risk management and governancestrengtheningBanktransparency and disclosuresBaselCommitte developed the frame workand monitorsadoption by member jurisdictionsKey Aspects of RegulationsRisk of global Contagion requires globally coordinatedrulesand oversight (prevention of regulation arbitiage)Basel international committee regulatory on fromwork Banking Supervision (develops an1]Mimimum Capital : Based on Risk of banks assets2 Minimum liquity Sufficient liquid assets to meet demandunder 30- - day liquidity stress 8 scenar3] Stability of funding: proportionate to tenor of banks assets Page No. 131Date / /Other Global: Organizations1Financial stability Boards : Identifiesandmanagessystematicrisksinthefinancialsector2InternationalAssociationofdepositeInsurers:Enhancestheeffectivenessof depositeinsurance3] InternationalOrganizationofSecuritiesCommission(losco)Fair andof4International Association of Insurance Supervisors :maintains fair t safe and stable insurance marketM12.2 Capital Adequacy and Asset QualityprimingrogCAMELS ApprochCapital adequacyAssets qualityFramework for Banks:Managementcapabilitydeposit takers loan makerEarningsLiquiditypositionscti20996Andlawtomarket Riskstoropia)Sensitivityotologia)Capital AdequacyGoal = Sufficient Capital to absorb potential losseswithout causing insolvency. Page No. 132Date / /Based onrisk - weightedassets(considers:credit RiskMarket Risk&operationalrisk)More riskyassetsrequirehigherCapitalRisk weighting specifiedbyindividualregulatorsBanks nonperformingsloanshavea Riskweighting in excessof 100%.off Balanceitemshouldbe included inrisk weighted assetsExample:Assets TypeRisk WeightsCashandCentralbankdepositsway07.aCorporate loans - performing100%Corporate loans - non-performing2007.Consumer RE loans90%Analysis of Mega BanksBls 20X8Asset TypeAmt C $ 000)Cash and Central bank deposits120Corporateloans - performing1130Corporate loans- Nonperforming920ConsumerREloan2450 Page No. 133Date//RiskSol Asset TypeAmtRWACash and Central bank depositsWeight($'000)($ 000.)Oz.1200Corporate loans - Performing100%x1130Corporate loans - Nonperforming4302007.X920Consumer1840REloans90%X24502205Total5175BasedonBasel IIItierdapproachTier I :Most IMPACommon EquityCommon equity 1 APICRIEandOCI+lessintangiblesandDTAsBSubordinatedinstrumentwithnoandcontractualdividends / Intspecifiedmaturity¬thebanksfullyatdiscriptionTier II :SubordinatedInstrumentswithorginalmaturity5yrBasellIIIRulesTier I :Common Equitymin4.5% RWA}6% Tier I BinTier I Capital min6%RWATotal CapitalCItII)min8% Page No 134Date //AWAS20x7&20x8were$4700,000andEx: MegaBankRWAfor5175000AnalysisofMegaBankCapitalrevealsthefollowingAmt ($ 000)20X72088Capital Types200190Common equity tier ITier I8595Subordinateddebtnomaturity or interest120Subordinate debt maturity >5 unsitier IIII 110%RRASol" Capital Type20X72088200Common equity tier 1S1754.263.671.811.84Subordinate debt no maturity or IntTotal tier I6.075.51Subordinated debt maturity > 5 yr2.342.34Total Capital8.47.83Basel III BreachesAsset QualityEvaluates : Processofgeneratingandassetsmanagingwell asriskcontrol.Evaluating includes existing&potentialcreditrisk Page No. 135Date / /Bank Asset AccountingBankloan'sCV=AmortCost-AllowanceforlossesSecurityGAAPIFRS :New GARPDebtHTML Avail forAmorted + Fvoc,sale trading tFVTPLlales effectivepost IS deEquityFUTPLFvocl, FUTPLblad UnlistedequityGRAP:CosttoImpairmentBank Bls ComposionofAssetsLon's :largest portion of Bank assetsLoansandadvancestobanksdepends of credit qualityLoans and advances to costomersof burcower & loanReverse repos Collateralized lending)loss allowanceAssets held for Sale :termassets no longer held - for - use9BIS longValuedriven by disposal. 28.Page No. 136Date / /Asset Credit Risk : Factors to Consider tozen Nood1. Credit risk of loans (considerparty risk)2. Assets composition : loans + securities , etc.3. off-Balance sheet : guarantees + unused committed credit lineletters of credit4. Liquity of assets5. Diversification of credit risk across assets types ( assetbased) and counterparities.Example: The following table provides info for loans held byMega Bank at the end of 2087 & 20x8$'000ILoans20x820X7Very strong credit quality661596Strong Credit quality882894Good credit quality14881292Satisfactory credit quality606696Substandard credit quality992894Past due but not impaired276199Impaired441298.Seriously impaired16599Total gross amt55,114968 Page No. 137Date//% of tatal Loans501" Loans20x820x7Very strong credit quality12%12%Strong credit quality167.187.Good credit quality27%267.Satisfactory credit quality11%14%Substandrd credit quality18%187.Past due but not impaired5%4%Impaired8y.6%Seriously Impaired3%27,Total gross amt100%100%Conclusions :Proportion of highquality ( satisfactory and above)has declinedby4%Totalofoans pastdueorimpairedhasincreasedby4%Loan Loss Provisions and AllowanceAllowance for loan losses= B/S Contra accountRepresents expectedlossesonBlsloanassets.Charge - offs = BadloanseliminatedfromB/Sandchargedagainstallowance(netofrecoveries)Provision for loanlosses=Baddebtexpensein the Vs=Net charge offs + A allowance forloan losses Page No. 138Date / /Loan F loss Example :($000)20X820x7Total loans55114968 KNon-performing loans606397Provisionforloanlosses122108Allowancefor loan losses338404202Not includedCharges-offs1787188Recoveries(14)(19) 159Net change offs188159two$000Loan loss allowance 20x740420x7 Contra B/SCharge -off(202) } (188)Recoveries14Loan loss provision B(Plug)12220x8 exp llsLoan loss allowance 20x833820x8 Contra B/SSol" :Key Ratio20x820X7Allowance for loan losses0.561.02Non performing loansBISHigher RatioAllowance for loan losses#II 1.802.54Net loan Charge offsConservativeI/SProvision for loan losses0.650.68Net change Charge offsloan Page No. 13923rd Sep 2022Date / /Conslusions :Loan loss allowancehas declinedfromperformingloansto56%102% of non- -Reductioninloanlossallowancealso seen indecline in provisionforloanlossestonetloancharges - offsdecliningfrom0.68 to 0.65Possibleunderprovision( aggressiveaccountings)M 12.3 : ManagementCapabilitiesAndEarningsQualityManagement CapabilitiesQuality : Ability to exploitprofitiableopportunitieswhileControllingriskCompliance with law and regulationStrong Corporate governance :independentboardavoidanceof excessiveCompensationRiskmanagementCidertificationand Control)Strong internalcontrolsriskmonitoringQualityoffinancialreportsEarning QualityHigh Quality = ROE >RSustainablePositive trendUnbiased estRecurring Sources Page No. 190Date / /Est and judgementonestlosses :.Impairment allowancesbased+ Default assessmentAssumptions sentivitive to economicand credit conditions+Value of Collateralwhen not basedonmarket pricesFair Value estimation+FV hierarchybased onobservabilityofinputs.EstincludegoodwillimpairmentandOTAFV HierarchyLevel 1Level 2Level 3Quoted market pricesInputs observable butInputs non-observableof identical assetsnot market prices ofand therefore subjectidentical assets (e.g(eg , mo del- basedQuated Pricegouted price ofvaluation based onsimilar assets, Intdiscounted futureIdenticalrates , spreads impliedCF )volatility )ActiveQuateted priceobservable PriceUnobservable&subjectiveIdenticalSimilarIdenticalInactiveActiveActive Page No 141Date / /Bank's Major Earning Sources1NetInt IncomeTypically largest SouriesAught RuteInt margin = Avg Int PEarning asse tInt RevAvg lost of funding = Int exp.Avy Int-bearing Liabili ty2]ServiceIncome (fees and Commission ) Less Volotile3] TradingIncomeMost volatileHigher % for net Int and Service Income = Increased stabilityM12.4 : Liquidity Position and Sensitivitytomarket RiskAsset : loans with long dated maturities require stablefunding t highlyliquidassets do not.FundingSources : longdateddepositsare more stable thanShurftermdepositesDepositesfromretailCustomeraremorestablethansimilar maturity deposite from other counter parties(i.e Corporates) Page No. 142Date / /Basell III 2 min liquityStandardLiquidity Coverage Ratio = Highly liquidassetsone monthI(LCR)Expected CFneeds in a StreScenc as io Minfunding SourceLCR 11 100 x2Net stable Funding Ratio = Available stable fundingReq stable fundingASF based onBank asset baseSources .RSF based on asbase min NSFRAvailable Stable funding ComponentsFocus on maturity and CompositionFunding ComponentASF FactorRegulatoryCapital less ties 2 intstrumentsmaturity < \ yr100 %OtherCapital instruments maturity > lyrStable term and demand deposits (maturity < 1yr)95%from retail & small biz CostomerLess stable demand deposits (Maturity < lyr) from}90%retail & small biz customersMaturity = Residual Maturity Page No. 153Date / /Funding fromOperationalnon fiancial Corporates (maturity < lyr)depositFundingfrom Sovereign t public sector entities50%andmultilateral and national development bank (MKlyr)other funding (not Covered above) with maturity bet"6 months & LyrAllthe liabilities0%Concentration of funding- proportion of fundingrum- Excessivesingle SourceConcen trationexposure to withdrawalRisk-Liquidity Risk--Asset Contractual maturity Mismatch& liability (funding sources) maturitydiff- Upwards sloping yield culve : borrow short ma turitylendlong- Create liquidity RiskmaturityExample$000Description20X920X8Highly liquid asset12501100MonAvg monthly withdrawls900750thly outflows in a stress Scenario13001050SolLCR 20X8 =1100/1050=104.76%LCR 20x9 = 1250 / 1300=96.157. Page No. 144Date/Condusion:Banks LCR has declined yr on yr20x9 CCR below min 100% basell III CritisiaIncreasing liquidity RiskSensitivity to Market RiskEarnings sensitivity to market Risks:Volalitity of SecurityDerivative positions cieateCurrency valuesInt RatechangeSteamingoff balance sheet exposurestomarket RiskCommodity PricesLiquidtyRiskBank disclose earnings sensitivity to differentmarket RisksMeasurementEquity : BetaFI : Duration & ConverityOptions : deltavega 1 gammaDiscussed in forted(Overgeas assets : exch rate riskBPF MangeredVARSensitivity and scenario analysis 23Page No. ISSDate//Sensitivity to but RateTypicallyassets> liabilities:an increase inrateincreases netIntincomeInt rate sensitivity factor :- Maturity (Maturity mismatch)- Repricingfrequency(bloatingRatenote)TifreyGreaterIntroun be ear n- Referencerates -u BORA2idasT.- Shapingrisk-Nonparallelmovementinyield curite06longer materity assetshort matarity liability effected by diff Int Ratechap!*M 12.5Other Factors :1. Government SupportfromofSystematiceconomic/riskof failure(SIFIs)MaintainconfidenceinbankingsectorClosebanksthatmightfallAssetsbankstokeepthemafloatCTARP)Implicitsupportlulisinverselyrelatedtotheoverallhealth2GovernmentOwnershipAidsof banking SectorAidsfinancialdevelopmentpublic confidenceBailoutsleg2008financialcrisist) Page No. 146I24th Sep 2022 SaturdayDate / /3] Bank MissionCommunity banks: less diversified t concentrated assetsGlobal banks : better diversifiedMission affects management of assets and liabilities4) Corporate CultureRisk averse Vs. Risk takingToo Risk averse = insufficient returnsToo Risk loving = Boom t Bust, f volatilityCorporate Culture Evaluation1. Has the bank generated recent losses from narrowfocused investment stratigies or over exposureto risky sectors ?unethical culture2. Accounting restatements due to internal control failures3. Excessive management compensation linked to Stock4. Speed with which the bank adjusts loan loss provisionprice performanceto actual loss behaviorGeneral Factors1. Competitive environment : position relative to peers+growth of market share with little regards toRil Page No. 147Date / /2.off B/S item :Derivative positionLeasesNon- - Consolidated VIES / SPEsAsset AA undermanagement(AUM)3. Segmental DisclosureAllowationofcapitalbet'thebanksCompetingfunctionEach segment is exposed to diff lul or type ofrisk suchasaSensitivity to marketbGeo- politicalC(yclicality4. Currency Exposure :Transaction RiskTranslation Risk (subs)Asset valuesDerivative ContractsTrading positionMR.6Insurance Companies1 Property and Casu sality (P&C) :Provide protection againstadverse event related to homes, Cars & commercialactivities (liabilityinsurance)Termwhole2lifeLife and Health (L4H) : provides mortality and healthrelated insurance products ; also offer saving products.Annuties -fixorflooting filPage No 148Date / /3Reinsurance : Insure insurance T reimburse insurance g Companiesfor claims paid ; global business Systemic RiskInsurersbatabilienolI Property and (ausality (P&E) : Provide protection againstadverseeventsrelatedtohomesCarslandCommerciaactivities( liabi*Revenue writen (total Prem over life of Contruct)(Premiums Earned C Amt recognized in Its in this period)2Income earned on float premiums not paid out in ChinAnnualPoliciesProperty and (ausality (P&C) : Short term i claims are" lumpies" (based on unpredictable events)castlifeand Health (L4H) : longer terms ; Claims are predictbased on actuarial mortality late.Accounting RaleesLiquidity Based precentationDiffer from us GRAP and IFRS 4 Greater focus on solvency reportaccord"tolasurance e losStatutory AccountingStandardPage No. 149which difer from I FRS or GAAPDate//Property & Causality (P&C)Protect insured parties for losses many times greaterthan premium paid. Prem - 1000for80000 insured amt-Act as risk managersandinvestment,CompaniesDiversificationia)Key to Profitability1Prudence in underwriting2 Pricing of PremMultiple Customers3 Diversification of RiskDiff policiy typea)5Reinsurance (Re)Geo ghophyShort term policy period Coften annual)Property InsuranceInsures specific assets against losstuldue to insured events/PCasuality InsuranceProtects against a legal liability dueto the ton Occurrence of a loveredeventMultiple peril policyCovers bothproperty and causalitylosses occurring duringacoveredevent.pec ProfitabilityP&C Margin CydicalPremHigh Competition t pricing Cutting / slim ( or negative) profitmargins (soft pricing) Page No. 150Date / /Soft pricing leads to losses 9 and reduction of Capital basedInsurers leave industry or stop underwriting new policiesReduced Competition higher Piem margins (hard procing) t andIncreased Capital based.Higher margins attract new competitionDirect writers : Own Sales and marketing staff+ Higher Fixed CostAgency writers ; Use agents and insurance brokert Higher Variable lostSoft / hard pricing : Combined RatioClaims paid + A loss ReserveTotal incured losses+ expNet prem earnedLower the betterhigh = Soft market11100= underwriting lessllow is hard marketCombined Ratio = Underwriting loss ratio and Exp ratioIunderwriting lossRatio Closs & loss adj exp)Measures efficiency of Company's undersuriting standardsclaims +of loss reserveIncurred losses + loss adj expNet premearnedCost of investigating claims Page No. 151Date / /Claim paid + A loss reserveNet prem BearnedorFintreeLoss exp t loss adj exp.Net premearnedthe betterlower ratieBetteratesttheriskqualityofunderwritingactivities2Expense RatioCUnderwritingexpratio):exp includes :-Underwriting exp (ind comission)Agent commisionNet prem writtenstaff salariesMarketing expOverheadsMeasure efficincy of Operations ( efficenancy of spendingorobtaining new prem)lower RatioMore efficientthe betterNoteNet Prem written - Prem earned over period of coverage (net of Reinsu)NetPremearned - Premearnedoverarelevantaccountingperiodloss Ratio&ExpRatiohave diffdenominatorsGRAP usenetptemearnedforbothRatios. Page No. 152Date//Loss ReserveClaims that have occuredbut not yet been paid outUnpaid daims est valueVEst + AssumptionBased on historical dataIncorporates est of future lossesOptimisticloss reserve (small) can result in insufficientprem given the risk borneLonger obligations percod = harder to est loss reserve(Changes in the size of court awarded payouts)Constantly adjusedDownward revision & 11 Conservative initial est GoodUpward resion T =AggressiveinitialestBadRevision Could Indicate earnings mangementProfitability RatioMutual policyownersIDividentto policyholders(shareholders)Ratios:expDiv to policyholderlowerthebetter\INet prem earnedliquiditymealu2CombinedRatio after Div (CRAD)CombinedRatio+Div to policyholders Ratuoloss Ratro t exp Ratio Page No. 153Date / /Combined Ratio > 1007-underwriting lossExample:DiscriptionABCPOQXYZLoss & loss adj exp540032122467Underwriting exp211118601387Div to policyholder412232148Net prem earned811454454087Net prem paid821753484299501" Loss & loss adj exp ratioUnderwritting exp RatioMust efficientABC = 5400 - 66-85% Policies pricedABC = 2111 =25.6978114most profitubility8217underwritingExpoperationsPDQ = 3212 - 58.99 Y. relative toPDQ 1860 = 34.7875445premRisk burn5348XYZ = 2467 = 60.30%XYZ = 1387 = 32,2640874299Combined RatioABC : 66.55 % + 25.64% = 92.24%lowest Combuined cost to premPDQ : 58.99% + 34.78% = 93.77%= greatest profitability onXYZ : 60 .36% + 32.26% = 92.63%operating activities Page No. WSDate / /Div to policy holderRatioCombined after div(CAD)ABC = 412 = 5.087 Gretest divABC : 92.24% +5.087. 97-327.8119relative toPQD = 232 2 4-267. net premPPQ : 93,77% + 4.267. = 98.03 Y.8445SISE earnedXYZ: 9263% + 3.62%=96.25XYZ = 148 = 3.627.S082stricter measure of2NN2efficiency than , CombiPPSNPNECFISSRatioSummeryABCPDQXYZLoss & loss adj exp Ratio66.55 %58.99 X60.36>25.69 1.34.78%32,267Underwriting exp Ratio9224793.71%92637Combined Ratio5.08%4.26-1.3.62Div to policyholder97.32%9803%96,257Combined ratio after div*Invest" ReturnsUncertainty+ Risk insured 7 uncertainity of payouts+Competitionduringhardpricing- Cyclical to Page No. 155Date / /Conservative Investment- Low Risk- Steady returnHigh proportions of fixed income- Divergificationand money market instruments- High liquidityLow proportions of equity and RE.Performance Evaluation :Div, Int, RG, UGTotal Invesment return ratio =Total Invesment IncomeInvested assets At start of periodCalculated using total investmentincomewithandwithoutunrealized gainLiquidityUncertainty of payment requires high liquidityUse hierarchyofFVreporting(seeCAMELS):- Tier Itradedin liquidmarketsTier 2:-less liquid- Tier 3:- illiquid*CapitolizationUnlike in banking no international risk-basedCapitalStandards existsLAIS is developing a risk - based global insurance capitalStandards.200 judriction 97% of Prem wordlide Page No. 156Date//Jurisdrictional Standards :- EU solvency 11 Regime 2014- us NAIC risk-based Capital requirements 1990Life and Health Insurance (L&H)Revenue:longer Contract periodthan RfPremiumsHigher Int rate riskinsuranceProvision of Investment products Higher floatInvestment IncomeProduct (life Insurance) :Payout on death to beneficiary within term periodPeriod benefits on death and act as savings vehiclesAnnuities (fixed or variable payments)Product Health Insurance) :Cover specific medical expenses and treatmentsProvide income on injury or sicknessSales 6 Direct or via agents C agents more expensive butvariable cost)Diversification : distribution Revenue sources, channels, product and offerings, investment geographic assets Coverasgrigolovate Page No. 157Date//Expenses :Benefit payments to policyholders (life insurance)2Other claims to policyhodersAnnuity paymentsContractsurrenders( Contracts that have Saving elements)Whole life policyexist policy before maturityEst and Assumptions:Est of future benefits and claims by policyholders( actuarial assumption)A loss ReservesExp impacted by benefits paid and estimated liabilityfor futureclaims / benefits liabilityCost of acquiring new and renewal biz Capitalizedand amortized based on actual and est future profitsMismatches : assets at MV, liabilities at historic Cost.Earnings MetricsGeneral measures : ROE , ROA , growth volatility of Capital,BV per share, pre and post tax operatings marginsSpecific Metrics :Total benefits PaidNet of ReinsuranceNet prem paid t depositslower thebetterCommissions t ExpenseNet prem paid + deposits Page No. 158Date//Investment ReturnsKey Aspects : Diversification + performanceInt Rate risk4liquidityAnnuitiesCharacteristics:longerfloatperiodandmorepredicatableclaims (relativeto P&C)Impact : Can takemore riskInvestments : Long - termdebt,equityRE derivatives+Issues:DurationmismatchCassets&liabilities)Performance : Total Investment IncomeInvested AssetsLiquidityPolicy Surrendersunpredictable butclaims/perdictablethan P&CbenefitsmoreLiquiditylessimportantthanP&CCALiquidity Ratio used by S&P:CLLiquidity adj investment assetsBased on ConvertibilityWithdrawal adj liabilitiesRatioBased onassumptions aboutCalculated under normal market Conditions and streseStre Scenario Page No. 159Date//Capitalization L&HUnlike banking there are no internationalRisk- basedCapital Standards.Typically + claims Considered more predictableResult :- lower equity cushions and Capital requirements.Many products create exposerse to interest rate risks;Calculation on risk-based capital factors in Int rate Risk