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Of two sides of balance sheet, assets side is more critical. Within it, interest earning assets deserve greatest attention. What percentage of loans is commercial and what percentage given to individuals? How many borrowers are there (risk diversification is inversely proportional to exposure to single or large borrowers)? How many of transactions are with "related parties"? How much is in local currency and how much in foreign currencies (and in which)? A large exposure to foreign currency lending is not necessarily healthy. A sharp, unexpected devaluation could move a lot of borrowers into non-performance and default and, thus, adversely affect quality of asset base. In which financial vehicles and instruments is bank invested? How risky are they? And so on.
No less important is maturity structure of assets. It is an integral part of liquidity (risk) management of bank. The crucial question is: what are cash flows projected from maturity dates of different assets and liabilities – and how likely are they to materialize. A rough matching has to exist between various maturities of assets and liabilities. The cash flows generated by assets of bank must be used to finance cash flows resulting from banks' liabilities. A distinction has to be made between stable and hot funds (the latter in constant pursuit of higher yields). Liquidity indicators and alerts have to be set in place and calculated a few times daily.
Gaps (especially in short term category) between bank's assets and its liabilities are a very worrisome sign. But bank's macroeconomic environment is as important to determination of its financial health and of its creditworthiness as any ratio or micro-analysis. The state of financial markets sometimes has a larger bearing on bank's soundness than other factors. A fine example is effect that interest rates or a devaluation have on a bank's profitability and capitalization. The implied (not to mention explicit) support of authorities, of other banks and of investors (domestic as well as international) sets psychological background to any future developments. This is only too logical. In an unstable financial environment, knock-on effects are more likely. Banks deposit money with other banks on a security basis. Still, value of securities and collaterals is as good as their liquidity and as market itself. The very ability to do business (for instance, in syndicated loan market) is influenced by larger picture. Falling equity markets herald trading losses and loss of income from trading operations and so on.
Perhaps single most important factor is general level of interest rates in economy. It determines present value of foreign exchange and local currency denominated government debt. It influences balance between realized and unrealized losses on longer-term (commercial or other) paper. One of most important liquidity generation instruments is repurchase agreement (repo). Banks sell their portfolios of government debt with an obligation to buy it back at a later date. If interest rates shoot up – losses on these repos can trigger margin calls (demands to immediately pay losses or else materialize them by buying securities back).
Margin calls are a drain on liquidity. Thus, in an environment of rising interest rates, repos could absorb liquidity from banks, deflate rather than inflate. The same principle applies to leverage investment vehicles used by bank to improve returns of its securities trading operations. High interest rates here can have an even more painful outcome. As liquidity is crunched, banks are forced to materialize their trading losses. This is bound to put added pressure on prices of financial assets, trigger more margin calls and squeeze liquidity further. It is a vicious circle of a monstrous momentum once commenced.
But high interest rates, as we mentioned, also strain asset side of balance sheet by applying pressure to borrowers. The same goes for a devaluation. Liabilities connected to foreign exchange grow with a devaluation with no (immediate) corresponding increase in local prices to compensate borrower. Market risk is thus rapidly transformed to credit risk. Borrowers default on their obligations. Loan loss provisions need to be increased, eating into bank's liquidity (and profitability) even further. Banks are then tempted to play with their reserve coverage levels in order to increase their reported profits and this, in turn, raises a real concern regarding adequacy of levels of loan loss reserves. Only an increase in equity base can then assuage (justified) fears of market but such an increase can come only through foreign investment, in most cases. And foreign investment is usually a last resort, pariah, solution (see Southeast Asia and Czech Republic for fresh examples in an endless supply of them. Japan and China are, probably, next).
In past, thinking was that some of risk could be ameliorated by hedging in forward markets (=by selling it to willing risk buyers). But a hedge is only as good as counterparty that provides it and in a market besieged by knock-on insolvencies, comfort is dubious. In most emerging markets, for instance, there are no natural sellers of foreign exchange (companies prefer to hoard stuff). So forwards are considered to be a variety of gambling with a default in case of substantial losses a very plausible way out.
Banks depend on lending for their survival. The lending base, in turn, depends on quality of lending opportunities. In high-risk markets, this depends on possibility of connected lending and on quality of collaterals offered by borrowers. Whether borrowers have qualitative collaterals to offer is a direct outcome of liquidity of market and on how they use proceeds of lending. These two elements are intimately linked with banking system. Hence penultimate vicious circle: where no functioning and professional banking system exists – no good borrowers will emerge.
Sam Vaknin is the author of Malignant Self Love - Narcissism Revisited and After the Rain - How the West Lost the East. He is a columnist for Central Europe Review, United Press International (UPI) and eBookWeb and the editor of mental health and Central East Europe categories in The Open Directory and Suite101.
Web site:
http://samvak.tripod.com/