assignment 1 mbl93ev st no. 71020438 final

8/6/2019 Assignment 1 MBL93EV St No. 71020438 Final

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MBL 93EV Student Number 7102 043 8 1

Reviewed by C. J. Masina

Are bank stocks sensitive to risk management?


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Publication Information

The Authors

Rudra Sensarma,Department of Accounting, Finance, and Economics,

University of Hertfordshire Business School, Hatfield, UK

M. Jayadev,Indian Institute of Management, Bangalore, India

Article Type: Research paper

Journal: The Journal of Risk Finance

Year: 2009

Copyright Emerald Group Publishing Limited


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Purpose and Theoretical Review

The paper under review attempts to summarize the information contained in bank

financial statements on the risk management capabilities of banks and then ascertains

the sensitivity of bank stocks to risk management focusing on Indian Banks.

The paper under review interprets the selected accounting ratios as risk management

variables and attempts to gauge the overall risk management capability of banks by

summarizing these accounting ratios as scores through the application of multivariate

statistical techniques.

Finally, the paper analyzes the impact of these risk management scores on stock returns

through regression analysis.


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Topics to be Presentation

1. Du Pont identity

2. Return on Equity

3. Return on Assets

4. Risk Measurement Profit Margin

5. Risk Measurement - Interest Rate Risk6. Risk Measurement - Natural hedging strategy

7. Risk Measurement Credit Risk

8. Risk Measurement Solvency risk or capital risk

9. Risk management scores and data

10. Stock market response to risk management - Regression analysis

11. Conclusion


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Du Pont identity

Return On Investment

ROI = (Net Income /Sales Sales) x (Sales/Total Assets)

=Net Income/ Total Assets

Measures combined effects of profit margin and asset turnover

Various Textbooks and Journals


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Du Pont identity

ROE = (Net profit/Sales) (Sales/Assets) (Assets/Equity)

= (Profit margin) (Asset turnover) (Equity multiplier)

ROE = (Net profit/Equity)

=(Net profit/ Pre-tax profit ) x (Pre-tax profit/EBIT) x (EBIT/Sales)

x (Sales/Assets) x (Assets/Equity)



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Du Pont identity

The du Pont system is a financial analysis and planning tool designed to provide

an understanding of the factors that drive the return on equity (ROE) of the

firm using basic accounting relationships.



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Du Pont identity Ratios

Various ratios used in fundamental analysis.

Net profit Pretax profit = The company's tax burden.

This is the proportion of the company's profits retained after paying incometaxes.

Pretax profit EBIT = The company's interest burden.

This will be 1.00 for a firm with no debt or financial leverage.

EBIT Sales =The company's operating profit margin or return on sales

(ROS).

This is the operating profit per dollar of sales.Various Textbooks and Journals


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Du Pont identity Ratios

Sales Assets = The company's asset turnover (ATO).

Assets Equity = The company's leverage ratio, which is equal to thefirm's debt to equity ratio + 1.

This is a measure of financial leverage.

Return on sales x Asset turnover = The company's return on assets (ROA).

Interest burden x Leverage = The company's compound leverage factor.



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Modified Du Pont identity

Sensarma and Jayadev

(2009)


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Return on Equity

ROE = (Net Interest Margin + Non Interest MarginProvisions to Total Assets)

(Equity Multiplier) Sensarma and Jayadev (2009)

The equation tell us that a banking firm can achieve its objective of maximizing shareholder

returns by either of the following means: maximizing Net interest Margin (NETIM),

maximizing Non Interest Margin (NONIM), minimizing Provisions to Total assets (PROV),

maximizing equity-to-assets ratio (EM). In what follows, the authors suggested that each of

these four factors represents a bank's capability of managing various risks.

Sensarma and Jayadev (2009)


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Return on Equity

ROE = (Net Interest Margin + Non Interest MarginProvisions to Total

Assets) (Equity Multiplier)

= ((IIIE)/TA + (NIINIE)/TAProvisions/TA) x Assets/Equity



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Return on Assets

ROA = Net Interest Margin + Non Interest MarginProvisions to Total Assets

= (IIIE)/TA + (NIINIE)/TAProvisions/TA

In addressing the definition of return on assets, the differences in the way in which balance

sheets are laid out in various countries of the world must be investigated. These

differing approaches to balance sheet layout have their counterparts in the way in which

returns on assets can be defined.


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Return on Assets

Conceptually the ratio "return on assets" consists of a numerator derived from the income

statement and indicating a level of earnings of the firm, and a denominator derived from

the balance sheet and reflecting resources devoted to the generation of those earnings.

Bernstein (1993) notes that "care must be used in determining which elements enter the

computation as there exists a variety of views, which reflect different objectives, of how

these elements should be defined."


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Return on Equity

ROE = Tax burden x Interest burden x Margin x Turnover x Leverage

ROE = Tax burden x ROA x Compound leverage factor


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Risk MeasurementProfit Margin

Profit Margin = Net Interest Margin + Non Interest Margin

= (IIIE)/TA + (NIINIE)/TA

Therefore

Net Interest Margin = (IIIE)/TA

= (EBITTaxesInterest)/(EBITTaxes)

= Interest Rate Risk

Non Interest Margin = (NIINIE)/TA

= (EBITTaxes)/Sales

= Natural Hedging



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Risk Measurement - Interest Rate Risk

Interest Rate Risk refers to the risk of decline in net interest income of a bank due to

change in interest rates.

Movement of interest rates would affect a bank's NETIM and therefore ROA and finally

shareholder returns.

To manage Interest Rate Risk

introduced risk control measures based on value at risk techniques.

Banks also use derivative contracts like futures and swaps to mitigate interest rate risk.

NETIM would reflect the resilience of banks to interest rate risk. In this paper, the ratio

of net interest income to total assets, i.e. NETIM is taken an indicator of interest rate

risk management capabilities of a bank.



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Risk Measurement - Natural hedging strategy

Non-interest income is generated out of various activities, e.g. through services such as

transfer of funds or other payment services, letters of credit, usage of derivative

contracts such as forwards, futures, swaps, etc. which increase ROA without any

corresponding increase in risks.

Sustained increase in non-interest income of banks might indicate that the banks are

adopting natural hedging strategies to improve profitability and shareholder returns.

The proportion of net non-interest income to total assets, i.e. NONIM as an indicator ofnatural hedging strategy of a bank which is expected to have a positive bearing on the

ROA.



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Risk MeasurementCredit Risk

Asset turnover = Sales/Assets

= Provisions to Total Assets = Provisions/TA

= Credit risk



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Risk Measurement - Credit Risk

Credit risk indicates the failure of a bank to receive interest and/or the principal amount

from loans and non-treasury securities. Credit risk also arises when a bank gives

commitment or guarantees on behalf of customers.

Furthermore, credit risk is present in all counterparty exposures like interest rate swaps.

To manage credit risk on-balance sheet strategies for managing credit risk include

increasing provisions for all anticipated loan losses. Although, higher provisions reduce

the profitability of a bank but higher provisions as percentage of total assets also signal a

bank's efforts towards mitigating credit risk.

Provisions as percentage of total assets can provide an indication of the extent of credit

risk management.



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Risk MeasurementSolvency risk or capital risk

ROE = (Net profit/Sales) (Sales/Assets) (Assets/Equity)

Leverage ratio = Assets/Equity

= Equity Multiplier

= Capital Adequacy= Solvency risk or capital risk

Solvency risk is the risk that a creditor will lose his entire investment if a debtor cannotrepay him in full, even if all the debtors assets are liquidated to recover the creditorsinvestment. Solvency risk can also arise out of lack of sufficient funds to pay depositorsin the event of a run.

Capital to assets ratio indicates the cushion available to a bank against unexpected lossesand implicitly protects the interests of uninsured depositors. Higher capital to assetsratio builds confidence of bank depositors but may reduce shareholder value due to

reduction in ROE.



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Risk MeasurementSolvency risk or capital risk

Thus, maximization of ROE is often linked to a trade-off between ROA and the EM

(reciprocal of capital to assets ratio).

Higher EM may increase the ROE for shareholders but higher EM indicates low capital

to assets ratio and therefore higher solvency risk.

Capital to assets ratio as a measure of a bank's solvency risk management capabilities.

For this purpose we consider regulatory capital adequacy ratios, i.e. CAR of banks (a

proxy for the reciprocal of the EM.



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Risk management scores and data

Risk management scores were developed by the article authors for banks by

combining the identified four risk management variables into one measure and

applied the four alternative quantitative summaries of risk management capabilities,

which served as robustness checks for results whose corresponding values we use

as risk measurement score.

1.Risk management indicators: trends

2.Analysis of average risk scores

3.

Principal components analysis4.Discriminant analysis



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Stock market response to risk management

V =E (d)

r V is a stock's value (or price in an efficient market),E(d) is expected future dividends, and

ris the discount rate, which also incorporates

security risk.

Thus, for determining firm value, it is critical that value enhancing attributes in

E(d) and value reducing attributes in r are identified.



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Stock market response to risk management - Regression analysis

Stock market response to risk management was measured using regression analysis

RETit = + RETmarket (t) + UEit + RISKMGMTit + it

where RET itis returns on the i-th bank's stock in year t, RETmarket is returns on the market

which controls for systematic movements in the individual bank returns, UE is

unexpected earnings measured by change in profits, RISKMGMT is risk management

variable or score and is a random error. To proxy for the risk management term, they

returned to the four variables identified from the accounting framework discussed

before.

Results obtained suggest that

Banks with high-risk management scores were contributing to increase in shareholder'swealth. Thus, in all the specifications of their regression model it is revealed that

investors are attracted to banks which signal superior risk management capabilities

through their balance sheets.



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Conclusion

This paper attempts to makes several contributions.

First, it suggests a different way of looking at bank financial statements, viz from

the risk management perspective. To this end we demonstrate a decomposition of

ROE of commercial banks into risk management variables.

Second, the paper develops quantitative summaries of risk management capabilities

of banks by using several alterative multivariate techniques.

Third, risk management is shown to be an important determinant of stock returns of

banks, over and above standard factors used in the literature such as market returns

and earnings growth.

Fourth, the findings of the paper suggest that those banks that have better risk

management capabilities reward shareholders with enhanced wealth. Finally, this

exercise can be of value to all the different stakeholders in the banking system.



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End

Well!

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