Risk Analysis and Bank Financial Statements
Hennie van Greuning
World Bank Treasury
FirstRand Board of Directors
FD
Financial Diplomats
Outline – key messages
1. Discuss the common causes of financial crisis and failure.
2. Key lessons learned from the financial crisis
3. Proposed regulatory reforms and risk enhancements as a
result of the financial crisis.
4. Basic risk analysis
Risk Analysis and Bank Financial Statements
2
FD
Financial Diplomats
1. Credit Crises – Common Causes
Unusual Times
“…all consequential events in human history have come from
unexpected, rare occurrences” Nassim Nicholas Taleb
Risk Analysis and Bank Financial Statements
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FD
Financial Diplomats
1. Financial / Banking Sector Crises – Common Causes
Recent bank failures – generic 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
Risk Analysis and Bank Financial Statements
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Financial Diplomats
1. Financial Crises – Common Causes
Global imbalances have built up over years
$bn
Advanced economies
Emerging and developing economies
800
CA balances
600
Excess savings
400
Financial
200
0
-200
Excess consumption &
Investment
-400
-600
1980
1983
1986
Risk Analysis and Bank Financial Statements
1989
1992
1995
5
1998
2001
2004
2007
2010
FD
Financial Diplomats
1. Financial Crises – Common Causes
400%
US Private Sector Debt to GDP
350%
•“Debt can be viewed as sustainable as long as
the debt to GDP ratio is non-increasing”*
300%
250%
200%
150%
100%
50%
0%
1916
1926
1936
1946
1956
1966
1976
1986
1996
2006
Source: US Federal Reserve
*Nouriel Roubini (2001) Debt Sustainability: How to Assess Whether a Country is Insolvent, Stern School of Business, NYU
Risk Analysis and Bank Financial Statements
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FD
Financial Diplomats
1. Financial Crises – Common Causes
US Housing Market Fundamentals
240
2.40
CPI (left scale)
220
2.20
Home Price Index (left scale)
200
2.00
Price-Rent Ratio (right scale)
180
1.80
160
1.60
140
1.40
120
1.20
100
1.00
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
80
2001
2002
2003
2004
2005
2006
2007
2008
0.80
•Source: OFHEO and US Federal Reserve
Risk Analysis and Bank Financial Statements
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FD
Financial Diplomats
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
Risk Analysis and Bank Financial Statements
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Financial Diplomats
Risk Analysis and Bank Financial Statements
Mar-66
Jan-69
Nov-71
Sep-74
Jul-77
May-80
Mar-83
Jan-86
Nov-88
Sep-91
Jul-94
May-97
Mar-00
Jan-03
Nov-05
Sep-08
Aug-08
Jan-06
Jun-03
Nov-00
May-98
Oct-95
Mar-93
Aug-90
Jan-88
Jun-85
Nov-82
Apr-80
Sep-77
Feb-75
Jul-72
Dec-69
%
90
20
15
10
5
0
-5
-10
-15
80
Mar-69
Aug-71
Jan-74
Jun-76
Nov-78
Apr-81
Sep-83
Feb-86
Jul-88
Nov-90
Apr-93
Sep-95
Feb-98
Jul-00
Nov-02
Apr-05
Sep-07
Mar-60
Feb-63
Jan-66
Nov-68
Oct-71
Sep-74
Aug-77
Jul-80
Jun-83
May-86
Apr-89
Mar-92
Feb-95
Jan-98
Nov-00
Oct-03
Sep-06
1. Financial Crises – Common Causes
South Africa’s macro economic imbalances monitor
Current account balance
Household debt to disposable income
%
70
60
50
40
30
Current account balance
Household debt to disposable income
Inflation
House prices
25%
20
15
10
5
0
%
50
40
30
20
10
0
-10
-20
Inflation
House price growth
9
FD
Financial Diplomats
1. Financial Crises – Common Causes
Consequences of macro economic imbalances
Global macroeconomic crisis
Global financial sector crisis
%
Index
10
6
5
8
Bank share prices
6
4
3
4
2
2
1
0
0
-2
Global growth
-4
-6
JP Morgan
Lehmans
Goldman Sachs
Barclays
Global
Risk Analysis and Bank Financial Statements
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Developed
Emerging
FD
Financial Diplomats
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/
Risk Analysis and Bank Financial Statements
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Financial Diplomats
Key Lessons Learned
What did management learn?
“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
Risk Analysis and Bank Financial Statements
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FD
Financial Diplomats
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“The
combination
of quantitative
qualitative
risk
last time anybody
made a listand
of the
top hundred
information
character attributes of New Yorkers, “common sense” snuck
in at number 79.” Douglas Adams
•
Align risk, capital, funding and strategy – and incorporate it in a
dynamic risk appetite process
•
“Nothing travels faster than the speed of light with the
possible
exception
of bad
news,
which
obeys its own special
Escalate
clearly
and early
– to
avoid
surprises
laws.” Douglas Adams, "The Hitchhiker's Guide to the Galaxy"
Risk Analysis and Bank Financial Statements
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Financial Diplomats
Financial Failure - Nothing New ?
Lehman
Brothers
Kidder,
Peabody &
Co
Dick Fuld
Joseph Jett
Themes
Barings
Orange
Societe
Bank
County
Generale
Nick Leesam Bob Citron
Jerome
Kerviel
Board failure
Management failure
Failure in Internal controls
Weak risk management
Accounting failure
Corporate Governance failure
Regulatory failure
IT
Compensation
Risk Analysis and Bank Financial Statements
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Financial Diplomats
History: Analysis from Kidder Peabody to the present crisis
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
Risk Analysis and Bank Financial Statements
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Financial Diplomats
3. Regulatory reform
Risk Analysis and Bank Financial Statements
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FD
Financial Diplomats
3. Regulatory Reform
Not everything is bad news...
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.
Risk Analysis and Bank Financial Statements
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Financial Diplomats
4. Key stakeholders - Accountability
Key stakeholders
Accountability
A. Regulators
Set regulatory framework, including risk exposures limits
and other risk management parameters, which will
optimize risk management in the banking sector
A. Supervisors
Monitor financial viability and effectiveness of risk
management. Check compliance with regulations.
B. Shareholders
Appoint “fit and proper” boards, management, and
auditors
C. Board of directors
Set risk management and other bank policies. Ultimate
responsibility for the entity
D. Executive management
Create systems to implement board policies, including
risk management, in day-to-day operations
E. Risk Committee and ERM
Monitoring of risk management practices
F. Audit Committee and Internal Audit
Test compliance with board policies and provide
assurance regarding corporate governance, control
systems, and risk management processes
G. External Audit
Express opinion and evaluate risk management policies
H. External stakeholders (depositors, customers,
investment analysts, rating agencies, financial
press, NGO's)
Risk Analysis and Bank Financial Statements
Insist on transparency and full disclosure
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FD
Financial Diplomats
4. Risk information not directly reflected in AFS
Summary of risk types
Financial risks
Operational risks
Business risks
Event risks
Balance sheet
structure
Internal fraud
Macro policy
Political
Income statement
structure
External fraud
Financial
infrastructure
Contagion
Capital adequacy
Employment practices
Legal infrastructure
Banking crisis
Credit
Clients, products and
business
Legal liability
Other exogenous
Liquidity
Damage to physical
assets
Regulatory
compliance
Market
Business disruption
and system failures
Reputational and
fiduciary
Interest rate
Execution, delivery
and process
Country risk
Currency
Risk Analysis and Bank Financial Statements
Strategic issues
FD
Financial Diplomats
4. Risk information not directly reflected in AFS
Risk in the context of a Bank Balance Sheet
Assets
Jun-09
High level allocation to key risk types
Cash and Short Term Funds
25,756
Liquidity risk
Derivative Financial Instruments
60,229
Market risk + Banking book hedges
Net Advances
420,224
Credit risk +Interest Rate in the banking book +Liquidity
Investment Securities and Other
113,083
Investment risk + Liquidity risk + Market risk
Property and Equipment
Other Assets
Total Assets
9,488
18,052
646,833
Liabilities
Jun-09
Deposits
489,129
Liquidity & Funding risk + Interest rate in the banking book
Derivative Financial Instruments
54,436
Market risk + Banking book hedges
Short Trading Positions
23,434
Market risk
Long Term Liabilities
10,887
Funding risk
Capital related
49,429
Capital risk
Other Liabilities
Total Liabilities
19,518
646,833
Note: figures are provisional
Risk Analysis and Bank Financial Statements
FD
Financial Diplomats
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?
Risk Analysis and Bank Financial Statements
FD
Financial Diplomats
Financial Analysis – Principles
What is Financial Analysis?
What happened?
Why did it happen?
What is the Impact of event?
Action plan going forward
– Accountability
– Target date
Risk Analysis and Bank Financial Statements
FD
Financial Diplomats
Financial Analysis – Tools and techniques
Tools
Questionnaires
Techniques
Data input tables (excel, etc)
Manipulate the data to facilitate analysis
Manipulated data
Structure of the balance sheet
Structure of the income statement
Common-Size analysis
Cross-Sectional / comparative analysis
Ratios
Pie, Bar, Trend Analysis, etc
Structural change in the business
Annual growth (from year-to-year)
Cumulative growth (base to current year)
Graphs & charts
Ratios
Risk Analysis and Bank Financial Statements
Group response to answers per risk category
Ratio analysis
Regression analysis
FD
Financial Diplomats
4. Regulatory Returns Analytical Value
Balance Sheet Overview
Balance Sheet Analysis
FD
Financial Diplomats
4. Regulatory Returns Analytical Value
Composition of Assets : Structural Change & Growth
Balance Sheet Analysis
FD
Financial Diplomats
4. Regulatory Returns Analytical Value
Asset Growth Over Time
Balance Sheet Analysis
SARB -2008 Annual Bank Supervision Report
FD
Financial Diplomats
Financial Analysis – Tools and techniques
Trend analysis – Asset Growth: cumulative from a base period
500,000
450,000
400,000
350,000
300,000
250,000
200,000
150,000
100,000
50,000
0
FY99
FY00
Cash and short term funds
FY01
FY02
FY03
Derivative financial instruments
Risk Analysis and Bank Financial Statements
FY04
FY05
Advances
FY06
FY07
FY08
FY09
Investment securities and other investments
FD
Source: 2009
ABACUS
Financial
Diplomats
6. Financial Analysis – Tools and techniques
Trend analysis: Total Assets, Gross Loans and Advances
Risk Analysis and Bank Financial Statements
SARB – 2008 Annual Bank Supervision Report
FD
Financial Diplomats
Financial Analysis – Tools and techniques
Common Size Analysis - “Vertical” Analysis
Period 1
(%)
Period 2
(%)
Revenue source: Service A
30
45
Revenue source: Service B
23
20
Revenue source: Service C
30
30
Revenue source: Service D
17
5
Total Revenue:
100
100
Salaries and employee benefits
15
25
Administrative expenses
22
20
Rent expense
10
10
Earnings before interest, tax, depreciation (EBITDA)
53
45
Depreciation and amortization
4
4
Earnings before interest and tax (EBIT)
49
41
Interest paid
7
7
Earnings before tax (EBT)
42
34
Income tax provision
15
8
Net Income
27
26
Operating expenses (excluding depreciation)
Risk Analysis and Bank Financial Statements
FD
Financial Diplomats
Regulatory Returns Analytical Value
Assets Vs Income: Energy Applied Vs Income Earned
Assets
Risk Analysis and Bank Financial Statements
Income
FD
Financial Diplomats
4. Regulatory Returns Analytical Value
Cost-to-Income Ratios of Individual banks
Categorized by Asset Value of Each Bank
Financial Sector Failure
SARB – 2008 Annual Bank Supervision Report
Copyright © 2010
Dr. Hennie van Greuning
Regulatory Returns Analytical Value
Composition of Income Statement - Multi Year Trend
Risk Analysis and Bank Financial Statements
SARB – 2006 Annual Bank Supervision Report
FD
Financial Diplomats
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)
Risk Analysis and Bank Financial Statements
FD
Financial Diplomats
Financial Analysis – Tools and techniques
Correlation: Total Banking-Sector Assets to GDP
Risk Analysis and Bank Financial Statements
SARB – 2008 Annual Bank Supervision Report
FD
Financial Diplomats