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"Financial stability 2002"

Analysis of Banks in Relation to Financial Stability

This chapter describes the analysis of the banks in relation to financial stability. The banks evolve all the time, so the methods and analyses described here cannot be applied mechanically. Instead, they should be adjusted and improved on an ongoing basis. The analyses described provide partial views of aspects of the banking sector. Subject to a certain amount of caution, these partial views can be pieced together to form an overall view of the banking sector's robustness and thus the conditions for financial stability.

The most important data sources for the analyses of the banks in relation to financial stability are the banks' own annual financial statements, data releases from the Danish Financial Supervisory Authority and the central bank's own statistics on financial institutions. Consolidated figures comprise all elements of the groups, which means that several major Danish groups are included for business areas, i.e. banking, mortgage credit and insurance. Consolidated figures are most relevant e.g. in an analysis of capital adequacy, while individual bank figures are most relevant e.g. in an analysis of the banks' lending.

The analysis can be conducted at several levels ranging from the overall banking sector to the individual bank. In an analysis of the banks as a whole, the overall average approach is supplemented with distribution measures to achieve a more varied presentation of the sector. The Danish banks vary considerably, which emphasises the need for distribution measures. The figures can be broken down using various methods, depending on the type of data and the areas to be analysed. One method is to break down key indicators for the individual banks into percentiles. This makes it possible to e.g. identify the 10 per cent of the banks showing the strongest deviation from the median. Another method is to determine a cut-off value for a given key indicator and simply count the number of banks below the cut-off value. A third method is attributing weights to the key indicators. Weighting can be in terms of e.g. total balance-sheet value or equity.

The banks' financial statements

The general principles for the banks' presentation of financial statements are laid down in the Commercial Banks and Savings Banks, etc. Consolidated Act, while more detailed accounting requirements are set out in the Danish Financial Supervisory Authority's Executive Order on the Presentation of Accounts, etc., by credit institutions, specialised credit institutions and certain savings and lending institutions. The Financial Business Act adopted in the spring of 2001 provides for several amendments of the accounting regulations for banks among others. However, the chapter on annual financial statements and audit will not enter into force until a committee established by the Financial Supervisory Authority has examined the consequences of introducing new rules. The committee will assess such issues as how valuation is affected by the introduction of the fair-value principle as a new valuation principle^[1].

The banks' annual financial statements are subject to specific requirements and must consist of a balance sheet, a profit and loss account, notes and an annual report. These components must be combined into a whole which provides a true and fair view of the banks' assets and liabilities, financial position and result.

The banks' valuation is subject to the prudent accounting principle, whereby gains must not be included before they are realised, while losses must be included as soon as they are likely. Furthermore, the banks interpret the prudent accounting principle in the sense that within the framework of the Act the banks deliberately adopt a prudent approach to the valuation of assets and liabilities. Besides the prudent accounting principle the valuation rules are influenced by the fact that individual balance-sheet items are subject to varying valuation principles. The valuation principles are overall applied to valuation of fixed assets, current assets, debtors and items in foreign currency and financial instruments.

A bank's balance sheet is a snapshot of the composition of assets and liabilities as at the balance-sheet date. It does not show – possibly significant – fluctuations during the accounting period. The balance sheet is not an exact statement of the value of the bank's assets and liabilities, including equity capital, since valuation of e.g. loans and guarantees is based on estimated expected losses which may be influenced by the banks' own assessments. Off-balance-sheet items such as guarantees are also presented in connection with the balance sheet. The balance-sheet items fluctuate on an ongoing basis in accordance with the banks' focus and strategies in various areas. The balance sheet is also affected by changes in market conditions or business cycles. Table 9 shows the balance sheet for all banks in categories 1-3 in 2000.

Table 9 Balance-sheet and off-balance-sheet items, end-2000, kr. billion

The profit and loss account shows the operating result for a given period. The result is closely associated with the development in the balance-sheet items and with general economic trends as well as the banks' operations. Table 10 shows the profit and loss account for banks in categories 1-3 for 2000.

Table 10 Profit and loss account for 2000, kr. billion

The financial statements must also include a number of notes with further specification of the items in the profit and loss account and balance sheet, as well as off-balance-sheet items. This information provides more details on the content of the items and contributes to clarifying the relationship between items in the profit and loss account and balance-sheet and offbalance-sheet items. The notes also include key indicators, primarily capital adequacy, profitability and market, liquidity and credit risks. Stock-exchange-listed banks must provide key indicators related to the stock market.

The annual report gives an account of the development in the banks' financial activities and aspects. If the annual accounts are influenced by significant extraordinary circumstances or subject to significant uncertainty, this must also be stated and quantified, if possible. The annual report also contains information on any important events after the closing of the accounts, as well as the bank's expected main development activities. The report's more qualitative orientation often supplements the quantitative data in the accounts. In addition, the report must describe the expected main development activities. This part of the report is thus more forward-looking than the accounts data.

Areas of analysis of relevance to financial stability

The analysis in relation to financial stability covers three main areas: capital adequacy, earnings capacity and profitability, and risks. At an overall level, the most interesting analysis would be of banks that are systemically important to the financial system. A number of the described key indicators are used in the chapter on trends in the financial sector.

Capital adequacy

The Commercial Banks and Savings Banks, etc. Consolidated Act imposes a minimum solvency requirement on the banks^[2] whereby liable capital plus any short-term supplementary capital must at any time constitute at least 8 per cent of the bank's risk-weighted assets, etc., including items associated with market risk. In case of non-compliance with the capital-adequacy requirement the Financial Supervisory Authority may stipulate a time frame for compliance or revoke the authorisation to carry out credit-institution activities. In view of the latter condition, it is the capital in excess of 8 per cent that constitutes the bank's buffer against unexpected losses.

An analysis of capital adequacy provides an indication of the financial institutions' robustness to unexpected losses which cannot be absorbed by earnings.

The solvency and core capital ratios are the two most frequently used key indicators. The two indicators have the same denominator, i.e. total risk-weighted assets, but different numerators, i.e. liable capital and core capital after deductions, respectively. The denominator, which consists of risk-weighted items, covers both credit and market risks. The current rules apply very coarse risk weights, so that the actual economic risk may deviate from the risk calculated according to the statutory risk weights. However, the forthcoming^[3] new capital-adequacy rules will take greater account of the actual risks assumed by financial institutions.

A falling trend in the key indicators for capital adequacy can be attributed to increased risk and/or a declining capital base. If the capital base alone is viewed in terms of financial stability, a high capital-adequacy level would enable the bank to withstand losses at least in the short term.

Earnings capacity and profitability

The earnings capacity is closely associated with the banks' strategy and balance-sheet composition. The analysis of earnings capacity covers income as well as the expenses defrayed to generate that income. The purpose is to achieve an indication of the robustness of the banks' earnings. Profitability is assessed in terms of the result as a ratio of the resources applied, such as total assets.

At first, the composition of the banks' business activities is considered. Lending and deposits are still the most important business activities for most Danish banks. The income from these activities is primarily reflected in net interest income. The area of securities trading and management has become more and more important to Danish banks in recent years due to such factors as re-mortgaging of an increasing number of mortgage-credit loans and growing securities trading. These activities mainly generate fee and commission income. Some business activities, such as deposits and lending, appear directly in the banks' balance sheet, while other activities, such as securities trading on behalf of customers, do not appear in the balance sheet. These off-balance-sheet activities are in many cases described in the notes to the financial statements or in the banks' reports on their business activities.

Net interest income and fee and commission income are normally the banks' most important income items. Net interest income can be examined in terms of e.g. the interest margin. The interest margin is interest income as a ratio of interest-bearing assets less interest expenses as a ratio of interest-bearing liabilities. The interest margin tends to vary between the individual banks due to e.g. different strategies and balance-sheet compositions.

Fee and commission income is closely associated with the banks' price policy and with customer behaviour. The development in the share of net fee and commission income of total net interest income and fee and commission income can provide an indication of how dependent the banks' earnings are on various business areas.

Earnings from value adjustments fluctuate according to trends in the markets where the assets are placed. The item is influenced by value adjustments of financial derivatives, foreign-exchange items and the banks' pool schemes, all of which complicate an analysis.

Personnel and administration expenses constitute by far the largest expense item for the banks and can be assessed in relation to the development in the overall balance sheet. This gives an indication of the correlation between growth in costs and growth in business volume. The indication of business volume based on the development in the balance sheet does not consider trends in off-balance-sheet income items, such as fee income from securities trading.

Another significant item in the profit and loss account is provisions for bad and doubtful debts, which can be assessed in terms of the ratio of losses and provisions for the year (losses and provisions for the year as a ratio of loans, guarantees and provisions). In relation to the profit and loss account the development in this item can give an indication of any historical correlation between the risk premium so far (earnings) and the losses occurred.

The banks' earnings capacity can be analysed by considering the development in operating income over operating expenses which shows the relationship between all income and expense items except extraordinary items and tax. A declining trend can be attributed to earnings problems, which could adversely affect the banks' robustness in the longer term. However, a declining trend can also be attributed to investments which are expected to boost earnings in the longer term. Chart 5 shows the development in operating income over operating expenses. The Chart shows a time series for the 10th and 90th percentiles, the median and the average. The percentiles delineate the 10 per cent of the banks with respectively the lowest and the highest operating income over operating expenses ratio. The Chart shows that it is often insufficient to consider the average alone, and that it is also necessary to look at distribution measures. Since the average is above the median, the Chart can be interpreted to show that the major banks had higher operating income over operating expenses than the smaller banks in the period analysed. In addition, the Chart indicates a narrowing of the spread between the most efficient and the least efficient banks viewed over the entire period.

Profitability can be considered in terms of profit post tax as a ratio of the overall balance sheet. This gives a simple measure of the result as a ratio of the business volume. As mentioned, the size of the balance sheet should be interpreted with caution when assessing the volume of activity. Return on equity based on profit pre and post tax gives a similar simple measure of overall profitability. This ratio is often used by shareholders, since it gives an impression of the return as a ratio of the invested capital. Extraordinarily high returns can be attributed to a high degree of efficiency or substantial risks.

Sensitivity analyses and stress tests are used more and more frequently in analysis work. The purpose of these analyses is to determine the robustness of the banks' result or capital adequacy to various risk scenarios. Sensitivity analyses and stress tests can be of varying design, e.g. with relations to economic development or with dynamic relations between various items in the balance sheet and the profit and loss account. Sensitivity analyses and stress tests are more forward-looking than analyses of accounts data and key indicators.

Risks

The banks' most important risks, e.g. credit, market and liquidity risks, are closely associated with the balances and items stated in the balance sheet and as off-balance-sheet items. There are other types of risk which are not related to the balance sheet, such as operational risks and strategic risks. The risk analysis provides partial views of various risk areas which can be combined to form an overall picture of the banks' risks.

The rest of this article describes some of the indicators applied in the analysis of the banks' risks.

Credit risk
Credit risk is the risk of losses should the counterparty or borrower default on the loan. The credit risk is especially associated with loans and guarantees. Previous banking crises were typically related to loan losses. As a result, this type of risk has become a focus area. Extraordinarily high growth in lending could indicate that the banks require a lower credit quality, which could subsequently lead to higher losses and provisions. Another reason for high growth in lending could be that the bank requires lower risk premia than other banks for strategic or other reasons. All other things being equal, a lower risk premium will reduce the bank's robustness to losses.

Losses and provisions can be assessed on the basis of losses and provisions as a ratio of credits and guarantees for the year. The development in the account for bad and doubtful debts (correction account) may also be considered in terms of the provision ratio. It is calculated as total provisions on loans and guarantees as a ratio of total loans, guarantees and provisions. The analysis can also include the share of non-performing credits, i.e. the share of total loans, guarantees and provisions for which the banks have reduced the rate of interest due to the borrower's reduced ability to service the obligation. For such exposures earnings do not match the bank's expectations at the time of accepting the exposure. The rate of interest for non-performing exposures will often be 0 per cent. The three key indicators together can provide an indication of the banks' approach to credit risk.

Concentration of the banks' lending on a few sectors or a limited geographical area makes the banks more vulnerable to a slowdown in activity in these sectors or geographical areas. The distribution analysis can include such measures as the distribution between households and business sectors and the key indicator "Sum of large exposures"^[4]. This key indicator shows the banks' exposure to relatively large- exposures.

The analysis of key indicators related to credit risk should be interpreted with caution, since valuation of the loan portfolio, including the need for provisions, will to a certain degree be estimated.

Market risk
Market risk is the risk that fluctuations in market prices (interest rates, exchange rates or stock prices) impose losses on the banks. There are various methods to calculate the market risk such as Value-at-Risk (VaR) models. They indicate the maximum loss which within a fixed time horizon will arise at a given probability, based on historical experience. These complex analyses cannot be performed by external analysts, who lack the necessary knowledge of the exact composition of the banks' portfolios. Likewise, the analysts are unable to track the constant portfolio adjustments. However, the banks submit a number of calculated key indicators related to the their risks which can be used in the analysis.

Bond and share portfolios as a ratio of the overall balance sheet can give a general impression of the banks' balance-sheet preferences. The higher the proportion of the bond and/or share portfolio, the more exposed the bank is to fluctuations in bond and/or stock prices. However, the banks may have hedged risks associated with interest-rate and stock-price fluctuations. The portfolios also include the banks' pool schemes, so that the indicator should be interpreted with caution. The banks' interest-rate risks indicate the amount of tier 1 capital after deductions lost if interest rates increase by 1 percentage point. This is a good key indicator of the banks' willingness to assume risks related to changes in the interest-rate markets.

Foreign-exchange-exposure indicator 2 in the notes indicates the exchange-rate risk and implies that unless the bank adjusts its foreign-exchange positions in the following 10 days, there is a probability of 1 per cent of the bank suffering losses exceeding the value of the indicator. The exchange-rate risk states foreign-exchange-exposure indicator 2 as a ratio of tier 1 capital. This key indicator is more complicated than the interest-rate risk indicator, but the rationale behind it is similar to that for the interest-rate risk indicator.

Liquidity risk
Liquidity risk is the risk that the bank will be unable to meet its obligations due to insufficient liquidity. Insufficient liquidity reflects the fact that the banks are unable to realise their assets as fast as the depositors^[5] require redemption. Liquidity is partly related to costs of realisation or redemption. Liquidity problems in one financial institution may spread quickly to the rest of the banking sector, either via payment systems or due to declining confidence in the entire sector. Payment-system risks are described in the preceding chapter. In February 2000 the Basle Committee under the auspices of the BIS issued an updated an extended set of guidelines and recommendations concerning principles for good liquidity management.

Excess liquidity in relation to the statutory requirement of 10 per cent is a measure of liquidity. Liquidity must account for at least 10 per cent of the banks' total debt and guarantee commitments. The key indicator shows excess liquidity after compliance with the statutory requirement as a ratio of the statutory minimum requirement. In this key indicator liquidity includes cash in hand, fully secure and liquid claims at call on Danish and foreign credit institutions, and the portfolio of secure, easily marketable, unpledged securities and credit instruments. The higher the excess liquidity, the lower the risk of insufficient liquidity. See also Box 2.

In addition, the difference between the volumes of deposits and lending can be used as an indicator of the banks' ability to attract deposits to finance growth in lending. The difference between debt to other credit institutions and claims on other credit institutions can also indicate whether the banks in net terms need other credit institutions as a source of financing. Other credit institutions are expected to react strongly^[6] to irregularities concerning one or more banks. Liquidity analyses should be interpreted with caution, since the banks' balance-sheet composition is by no means constant.

Footnotes

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Version 1.0 Maj 2002 Nationalbanken.
Published by Danmarks Nationalbank Maj 2002, http://www.nationalbanken.dk/