unisa risk analysis

FDFinancial Diplomats

Risk Analysis and Bank Financial Statements

Hennie van GreuningWorld Bank TreasuryFirstRand Board of Directors

Risk Analysis and Bank Financial Statements FDFinancial Diplomats

Outline – key messages

• Discuss the common causes of financial crisis and failure.

• Key lessons learned from the financial crisis

• Proposed regulatory reforms and risk enhancements as a result of the financial crisis.

• Basic risk analysis

2


1. Credit Crises – Common Causes

“…all consequential events in human history have come from unexpected, rare occurrences” Nassim Nicholas Taleb

3

Unusual Times


1. Financial / Banking Sector Crises – Common 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

4

Recent bank failures – generic causes


1. Financial Crises – Common Causes

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Global imbalances have built up over years

-600

-400

-200

0

200

400

600

800

1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010

Advanced economies Emerging and developing economies$bn

Excess savings

Excess consumption & Investment

CA balances

Financial



6

•“Debt can be viewed as sustainable as long as the debt to GDP ratio is non-increasing”*

0%

50%

100%

150%

200%

250%

300%

350%

400%

1916 1926 1936 1946 1956 1966 1976 1986 1996 2006

US Private Sector Debt to GDP

Source: US Federal Reserve*Nouriel Roubini (2001) Debt Sustainability: How to Assess Whether a Country is Insolvent, Stern School of Business, NYU



7

US Housing Market Fundamentals

80

100

120

140

160

180

200

220

240

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

0.80

1.00

1.20

1.40

1.60

1.80

2.00

2.20

2.40

CPI (left scale)

Home Price Index (left scale)

Price-Rent Ratio (right scale)

•Source: OFHEO and US Federal Reserve



8

Unrestrained asset (derivative) growth – CDS market growth

Source: ISDA, The World Bank, US Bureau of Economic Analysis and US Treasury



9

South Africa’s macro economic imbalances monitor

Current account balance Household debt to disposable income

House pricesInflation

-15-10

-505

101520

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

Current account balance

%

30

40

50

60

70

80

90

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

Household debt to disposable income

%

05

10152025

Dec-69

Jul-72

Feb-75

Sep-77

Apr-80

Nov-82

Jun-85

Jan-88

Aug-90

Mar-93

Oct-95

May-98

Nov-00

Jun-03

Jan-06

Aug-08

Inflation

%

-20-10

01020304050

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

House price growth

%



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Consequences of macro economic imbalances

0

1

2

3

4

5

6

JP Morgan Goldman SachsLehmans Barclays

Index

Global financial sector crisis Global macroeconomic crisis

Bank share prices

-6

-4

-2

0

2

4

6

8

10

Global Developed Emerging

%

Global growth


Financial Crises – Common Causes

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Bank Failures Statistics

Source: http://investingcontrarian.com/global/us-1800-bank-failures-tsunami-on-horizon/

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 20Failures – 72 so far this year Problems - 775 institutions with aggregate assets of $431 billion8,384 FDIC insured banks


Key Lessons Learned

“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

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What did management learn?


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 combination of quantitative and qualitative risk information

• Align risk, capital, funding and strategy – and incorporate it in a dynamic risk appetite process

• Escalate clearly and early – to avoid surprises

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“The last time anybody made a list of the top hundred character attributes of New Yorkers, “common sense” snuck in at number 79.” Douglas Adams

“Nothing travels faster than the speed of light with the possible exception of bad news, which obeys its own special laws.” Douglas Adams, "The Hitchhiker's Guide to the Galaxy"


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ThemesLehman Brothers

Kidder, Peabody &

Co arings Bankrange

County

ociete

Generale

Dick Fuld Joseph Jett Nick Leesam Bob CitronJerome Kerviel

Board failure

Management failure

Failure in Internal controls

Weak risk management

Accounting failure

Corporate Governance failure

Regulatory failure

IT

Compensation

Financial Failure - Nothing New ?


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

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History: Analysis from Kidder Peabody to the present crisis


3. Regulatory reform

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3. Regulatory Reform

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.

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Not everything is bad news...


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)

Insist on transparency and full disclosure

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4. Risk information not directly reflected in AFS

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 Strategic issues

Summary of risk types


4. Risk information not directly reflected in AFS

Risk in the context of a Bank Balance Sheet Assets

Liabilities

Credit risk +Interest Rate in the banking book +Liquidity

Market risk + Banking book hedges

Investment risk + Liquidity risk + Market risk

Liquidity risk

Liquidity & Funding risk + Interest rate in the banking book

Market risk + Banking book hedges

Market risk

Jun-09

Deposits 489,129

Derivative Financial Instruments 54,436

Short Trading Positions 23,434

Long Term Liabilities 10,887

Capital related 49,429

Other Liabilities 19,518

Total Liabilities 646,833

Capital risk

Funding risk

High level allocation to key risk typesJun-09

Cash and Short Term Funds 25,756

Derivative Financial Instruments 60,229

Net Advances 420,224

Investment Securities and Other 113,083

Property and Equipment 9,488

Other Assets 18,052

Total Assets 646,833

Note: figures are provisional


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?


Financial Analysis – Principles

What happened?

Why did it happen?

What is the Impact of event?

Action plan going forward– Accountability– Target date

What is Financial Analysis?


Financial Analysis – Tools and techniques

Tools Techniques

Questionnaires Group response to answers per risk category

Data input tables (excel, etc) Manipulate the data to facilitate analysis

Manipulated data Structure of the balance sheet Structure of the income statementCommon-Size analysisCross-Sectional / comparative analysisRatios

Graphs & charts Pie, Bar, Trend Analysis, etcStructural change in the businessAnnual growth (from year-to-year)Cumulative growth (base to current year)

Ratios Ratio analysis Regression analysis

Balance Sheet Analysis FDFinancial Diplomats

Balance Sheet Overview

4. Regulatory Returns Analytical Value


Composition of Assets : Structural Change & Growth



Asset Growth Over Time

SARB -2008 Annual Bank Supervision Report




Trend analysis – Asset Growth: cumulative from a base period

Source: 2009 ABACUS


6. Financial Analysis – Tools and techniques

Trend analysis: Total Assets, Gross Loans and Advances

SARB – 2008 Annual Bank Supervision Report



Common Size Analysis - “Vertical” AnalysisPeriod 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

Operating expenses (excluding depreciation)

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


IncomeAssets

Assets Vs Income: Energy Applied Vs Income Earned

Regulatory Returns Analytical Value

Financial Sector Failure Copyright © 2010Dr. Hennie van Greuning

Cost-to-Income Ratios of Individual banks Categorized by Asset Value of Each Bank




Composition of Income Statement - Multi Year Trend


Regulatory Returns Analytical Value



Ratio Analysis: Liquidity statistics

0%

50%

100%

150%

200%

250%

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)



Correlation: Total Banking-Sector Assets to GDP


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