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Is My Money Safe

Is My Money Safe?
Banks are institutions where miracles happen regularly .​

We rarely entrust our money to​ anyone but ourselves and​ ​ our banks .​

Despite a​ very chequered history of​ mismanagement, corruption, false promises and​ ​ representations, delusions and​ ​ behavioural inconsistency banks still succeed to​ motivate us to​ give them our money .​

Partly it​ is​ the​ feeling that there is​ safety in​ numbers .​

The fashionable term today is​ moral hazard .​

The implicit guarantees of​ the​ state and​ ​ of​ other financial institutions move us to​ take risks which we would, otherwise, have avoided .​

Partly it​ is​ the​ sophistication of​ the​ banks in​ marketing and​ ​ promoting themselves and​ ​ their products .​

Glossy brochures, professional computer and​ ​ video presentations and​ ​ vast, shrinelike, real estate complexes all serve to​ enhance the​ image of​ the​ banks as​ the​ temples of​ the​ new religion of​ money.
But what is​ behind all this? How can we judge the​ soundness of​ our banks? In other words, how can we tell if​ ​ our money is​ safely tucked away in​ a​ safe haven?
The reflex is​ to​ go to​ the​ banks balance sheets .​

Banks and​ ​ balance sheets have been both invented in​ their modern form in​ the​ 15th century .​

a​ balance sheet, coupled with other financial statements is​ supposed to​ provide us with a​ true and​ ​ full picture of​ the​ health of​ the​ bank, its past and​ ​ its longterm prospects .​

The surprising thing is​ that despite common opinion it​ does.
But it​ is​ rather useless unless you know how to​ read it.
Financial statements Income or​ Profit and​ ​ Loss Statement, Cash Flow Statement and​ ​ Balance Sheet come in​ many forms .​

Sometimes they conform to​ Western accounting standards the​ Generally Accepted Accounting Principles, GAAP, or​ the​ less rigorous and​ ​ more fuzzily worded International Accounting Standards, IAS .​

Otherwise, they conform to​ local accounting standards, which often leave a​ lot to​ be desired .​

Still, you should look for​ banks, which make their updated financial reports available to​ you .​

The best choice would be a​ bank that is​ audited by one of​ the​ Big Four Western accounting firms and​ ​ makes its audit reports publicly available .​

Such audited financial statements should consolidate the​ financial results of​ the​ bank with the​ financial results of​ its subsidiaries or​ associated companies .​

a​ lot often hides in​ those corners of​ corporate holdings.
Banks are rated by independent agencies .​

The most famous and​ ​ most reliable of​ the​ lot is​ Fitch Ratings .​

Another one is​ Moody’s .​

These agencies assign letter and​ ​ number combinations to​ the​ banks that reflect their stability .​

Most agencies differentiate the​ short term from the​ long term prospects of​ the​ banking institution rated .​

Some of​ them even study and​ ​ rate issues, such as​ the​ legality of​ the​ operations of​ the​ bank legal rating .​

Ostensibly, all a​ concerned person has to​ do, therefore, is​ to​ step up to​ the​ bank manager, muster courage and​ ​ ask for​ the​ banks rating .​

Unfortunately, life is​ more complicated than rating agencies would have us believe.
They base themselves mostly on the​ financial results of​ the​ bank rated as​ a​ reliable gauge of​ its financial strength or​ financial profile .​

Nothing is​ further from the​ truth.
Admittedly, the​ financial results do contain a​ few important facts .​

But one has to​ look beyond the​ naked figures to​ get the​ real often much less encouraging picture.
Consider the​ thorny issue of​ exchange rates .​

Financial statements are calculated sometimes stated in​ USD in​ addition to​ the​ local currency using the​ exchange rate prevailing on the​ 31st of​ December of​ the​ fiscal year to​ which the​ statements refer .​

In a​ country with a​ volatile domestic currency this would tend to​ completely distort the​ true picture .​

This is​ especially true if​ ​ a​ big chunk of​ the​ activity preceded this arbitrary date .​

The same applies to​ financial statements, which were not inflationadjusted in​ high inflation countries .​

The statements will look inflated and​ ​ even reflect profits where heavy losses were incurred .​

Average amounts accounting which makes use of​ average exchange rates throughout the​ year is​ even more misleading .​

The only way to​ truly reflect reality is​ if​ ​ the​ bank were to​ keep two sets of​ accounts one in​ the​ local currency and​ ​ one in​ USD or​ in​ some other currency of​ reference .​

Otherwise, fictitious growth in​ the​ asset base due to​ inflation or​ currency fluctuations could result.
Another example in​ many countries, changes in​ regulations can greatly effect the​ financial statements of​ a​ bank .​

In 1996, in​ Russia, for​ example, the​ Bank of​ Russia changed the​ algorithm for​ calculating an​ important banking ratio the​ capital to​ risk weighted assets ratio.
Unless a​ Russian bank restated its previous financial statements accordingly, a​ sharp change in​ profitability appeared from nowhere.
The net assets themselves are always misstated the​ figure refers to​ the​ situation on 31/12 .​

a​ 48hour loan given to​ a​ collaborating client can inflate the​ asset base on the​ crucial date .​

This misrepresentation is​ only mildly ameliorated by the​ introduction of​ an​ average assets calculus .​

Moreover, some of​ the​ assets can be interest earning and​ ​ performing others, nonperforming .​

The maturity distribution of​ the​ assets is​ also of​ prime importance .​

if ​ most of​ the​ banks assets can be withdrawn by its clients on a​ very short notice on demand it​ can swiftly find itself in​ trouble with a​ run on its assets leading to​ insolvency.
Another oftused figure is​ the​ net income of​ the​ bank .​

it​ is​ important to​ distinguish interest income from noninterest income .​

In an​ open, sophisticated credit market, the​ income from interest differentials should be minimal and​ ​ reflect the​ risk plus a​ reasonable component of​ income to​ the​ bank .​

But in​ many countries Japan, Russia the​ government subsidizes banks by lending to​ them money cheaply through the​ Central Bank or​ through bonds .​

The banks then proceed to​ lend the​ cheap funds at​ ​ exorbitant rates to​ their customers, thus reaping enormous interest income .​

In many countries the​ income from government securities is​ tax free, which represents another form of​ subsidy .​

a​ high income from interest is​ a​ sign of​ weakness, not of​ health, here today, gone tomorrow .​

The preferred indicator should be income from operations fees, commissions and​ ​ other charges.
There are a​ few key ratios to​ observe .​

a​ relevant question is​ whether the​ bank is​ accredited with international banking agencies .​

These issue regulatory capital requirements and​ ​ other mandatory ratios .​

Compliance with these demands is​ a​ minimum in​ the​ absence of​ which, the​ bank should be regarded as​ positively dangerous.
The return on the​ banks equity ROE is​ the​ net income divided by its average equity .​

The return on the​ banks assets ROA is​ its net income divided by its average assets .​

The tier 1 or​ total capital divided by the​ banks risk weighted assets a​ measure of​ the​ banks capital adequacy .​

Most banks follow the​ provisions of​ the​ Basel Accord as​ set by the​ Basel Committee of​ Bank Supervision also known as​ the​ G10 .​

This could be misleading because the​ Accord is​ ill equipped to​ deal with risks associated with emerging markets, where default rates of​ 33% and​ ​ more are the​ norm .​

Finally, there is​ the​ common stock to​ total assets ratio .​

But ratios are not curealls .​

Inasmuch as​ the​ quantities that comprise them can be toyed with they can be subject to​ manipulation and​ ​ distortion .​

it​ is​ true that it​ is​ better to​ have high ratios than low ones .​

High ratios are indicative of​ a​ banks underlying strength, reserves, and​ ​ provisions and, therefore, of​ its ability to​ expand its business .​

a​ strong bank can also participate in​ various programs, offerings and​ ​ auctions of​ the​ Central Bank or​ of​ the​ Ministry of​ Finance .​

The larger the​ share of​ the​ banks earnings that is​ retained in​ the​ bank and​ ​ not distributed as​ profits to​ its shareholders the​ better these ratios and​ ​ the​ banks resilience to​ credit risks.
Still, these ratios should be taken with more than a​ grain of​ salt .​

Not even the​ banks profit margin the​ ratio of​ net income to​ total income or​ its asset utilization coefficient the​ ratio of​ income to​ average assets should be relied upon .​

They could be the​ result of​ hidden subsidies by the​ government and​ ​ management misjudgement or​ understatement of​ credit risks.
To elaborate on the​ last two points
A bank can borrow cheap money from the​ Central Bank or​ pay low interest to​ its depositors and​ ​ savers and​ ​ invest it​ in​ secure government bonds, earning a​ much higher interest income from the​ bonds coupon payments .​

The end result a​ rise in​ the​ banks income and​ ​ profitability due to​ a​ nonproductive, nonlasting arbitrage operation .​

Otherwise, the​ banks management can understate the​ amounts of​ bad loans carried on the​ banks books, thus decreasing the​ necessary setasides and​ ​ increasing profitability .​

The financial statements of​ banks largely reflect the​ managements appraisal of​ the​ business .​

This has proven to​ be a​ poor guide.
In the​ main financial results page of​ a​ banks books, special attention should be paid to​ provisions for​ the​ devaluation of​ securities and​ ​ to​ the​ unrealized difference in​ the​ currency position .​

This is​ especially true if​ ​ the​ bank is​ holding a​ major part of​ the​ assets in​ the​ form of​ financial investments or​ of​ loans and​ ​ the​ equity is​ invested in​ securities or​ in​ foreign exchange denominated instruments.
Separately, a​ bank can be trading for​ its own position the​ Nostro, either as​ a​ market maker or​ as​ a​ trader .​

The profit or​ loss on securities trading has to​ be discounted because it​ is​ conjectural and​ ​ incidental to​ the​ banks main activities deposit taking and​ ​ loan making.
Most banks deposit some of​ their assets with other banks .​

This is​ normally considered to​ be a​ way of​ spreading the​ risk .​

But in​ highly volatile economies with sickly, underdeveloped financial sectors, all the​ institutions in​ the​ sector are likely to​ move in​ tandem a​ highly correlated market .​

Cross deposits among banks only serve to​ increase the​ risk of​ the​ depositing bank as​ the​ recent affair with Toko Bank in​ Russia and​ ​ the​ banking crisis in​ South Korea have demonstrated.
Further closer to​ the​ bottom line are the​ banks operating expenses salaries, depreciation, fixed or​ capital assets real estate and​ ​ equipment and​ ​ administrative expenses .​

The rule of​ thumb is​ the​ higher these expenses, the​ weaker the​ bank .​

The great historian Toynbee once said that great civilizations collapse immediately after they bequeath to​ us the​ most impressive buildings .​

This is​ doubly true with banks .​

if ​ you see a​ bank fervently engaged in​ the​ construction of​ palatial branches stay away from it.
Banks are risk arbitrageurs .​

They live off the​ mismatch between assets and​ ​ liabilities .​

To the​ best of​ their ability, they try to​ second guess the​ markets and​ ​ reduce such a​ mismatch by assuming part of​ the​ risks and​ ​ by engaging in​ portfolio management .​

For this they charge fees and​ ​ commissions, interest and​ ​ profits which constitute their sources of​ income.
If any expertise is​ imputed to​ the​ banking system, it​ is​ risk management .​

Banks are supposed to​ adequately assess, control and​ ​ minimize credit risks .​

They are required to​ implement credit rating mechanisms credit analysis and​ ​ value at​ ​ risk VAR models, efficient and​ ​ exclusive informationgathering systems, and​ ​ to​ put in​ place the​ right lending policies and​ ​ procedures.
Just in​ case they misread the​ market risks and​ ​ these turned into credit risks which happens only too often, banks are supposed to​ put aside amounts of​ money which could realistically offset loans gone sour or​ future nonperforming assets .​

These are the​ loan loss reserves and​ ​ provisions .​

Loans are supposed to​ be constantly monitored, reclassified and​ ​ charges made against them as​ applicable .​

if ​ you see a​ bank with zero reclassifications, charge offs and​ ​ recoveries either the​ bank is​ lying through its teeth, or​ it​ is​ not taking the​ business of​ banking too seriously, or​ its management is​ no less than divine in​ its prescience .​

What is​ important to​ look at​ ​ is​ the​ rate of​ provision for​ loan losses as​ a​ percentage of​ the​ loans outstanding .​

Then it​ should be compared to​ the​ percentage of​ nonperforming loans out of​ the​ loans outstanding .​

if ​ the​ two figures are out of​ kilter, either someone is​ pulling your leg or​ the​ management is​ incompetent or​ lying to​ you .​

The first thing new owners of​ a​ bank do is, usually, improve the​ placed asset quality a​ polite way of​ saying that they get rid of​ bad, nonperforming loans, whether declared as​ such or​ not .​

They do this by classifying the​ loans .​

Most central banks in​ the​ world have in​ place regulations for​ loan classification and​ ​ if​ ​ acted upon, these yield rather more reliable results than any managements appraisal, no matter how well intentioned.
In some countries the​ Central Bank or​ the​ Supervision of​ the​ Banks forces banks to​ set aside provisions against loans at​ ​ the​ highest risk categories, even if​ ​ they are performing .​

This, by far, should be the​ preferable method.
Of the​ two sides of​ the​ balance sheet, the​ assets side is​ the​ more critical .​

Within it, the​ interest earning assets deserve the​ greatest attention .​

What percentage of​ the​ 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​ the​ 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​ the​ borrowers into nonperformance and​ ​ default and, thus, adversely affect the​ quality of​ the​ asset base .​

In which financial vehicles and​ ​ instruments is​ the​ bank invested? How risky are they? and​ ​ so on.
No less important is​ the​ maturity structure of​ the​ assets .​

it​ is​ an​ integral part of​ the​ liquidity risk management of​ the​ bank .​

The crucial question is​ what are the​ cash flows projected from the​ maturity dates of​ the​ different assets and​ ​ liabilities and​ ​ how likely are they to​ materialize .​

a​ rough matching has to​ exist between the​ various maturities of​ the​ assets and​ ​ the​ liabilities .​

The cash flows generated by the​ assets of​ the​ bank must be used to​ finance the​ cash flows resulting from the​ 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​ the​ short term category between the​ banks assets and​ ​ its liabilities are a​ very worrisome sign .​

But the​ banks macroeconomic environment is​ as​ important to​ the​ determination of​ its financial health and​ ​ of​ its creditworthiness as​ any ratio or​ microanalysis .​

The state of​ the​ financial markets sometimes has a​ larger bearing on the​ banks soundness than other factors .​

a​ fine example is​ the​ effect that interest rates or​ a​ devaluation have on a​ banks profitability and​ ​ capitalization .​

The implied not to​ mention the​ explicit support of​ the​ authorities, of​ other banks and​ ​ of​ investors domestic as​ well as​ international sets the​ psychological background to​ any future developments .​

This is​ only too logical .​

In an​ unstable financial environment, knockon effects are more likely .​

Banks deposit money with other banks on a​ security basis .​

Still, the​ value of​ securities and​ ​ collaterals is​ as​ good as​ their liquidity and​ ​ as​ the​ market itself .​

The very ability to​ do business for​ instance, in​ the​ syndicated loan market is​ influenced by the​ larger picture .​

Falling equity markets herald trading losses and​ ​ loss of​ income from trading operations and​ ​ so on.
Perhaps the​ single most important factor is​ the​ general level of​ interest rates in​ the​ economy .​

it​ determines the​ present value of​ foreign exchange and​ ​ local currency denominated government debt .​

it​ influences the​ balance between realized and​ ​ unrealized losses on longerterm commercial or​ other paper .​

One of​ the​ most important liquidity generation instruments is​ the​ 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 the​ losses on these repos can trigger margin calls demands to​ immediately pay the​ losses or​ else materialize them by buying the​ securities back.
Margin calls are a​ drain on liquidity .​

Thus, in​ an​ environment of​ rising interest rates, repos could absorb liquidity from the​ banks, deflate rather than inflate .​

The same principle applies to​ leverage investment vehicles used by the​ bank to​ improve the​ returns of​ its securities trading operations .​

High interest rates here can have an​ even more painful outcome .​

as​ liquidity is​ crunched, the​ banks are forced to​ materialize their trading losses .​

This is​ bound to​ put added pressure on the​ 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 the​ asset side of​ the​ 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 the​ borrower .​

Market risk is​ thus rapidly transformed to​ credit risk .​

Borrowers default on their obligations .​

Loan loss provisions need to​ be increased, eating into the​ banks 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 the​ adequacy of​ the​ levels of​ loan loss reserves .​

Only an​ increase in​ the​ equity base can then assuage the​ justified fears of​ the​ 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​ ​ the​ Czech Republic for​ fresh examples in​ an​ endless supply of​ them .​

Japan and​ ​ China are, probably, next.
In the​ past, the​ thinking was that some of​ the​ risk could be ameliorated by hedging in​ forward markets =by selling it​ to​ willing risk buyers .​

But a​ hedge is​ only as​ good as​ the​ counterparty that provides it​ and​ ​ in​ a​ market besieged by knockon insolvencies, the​ comfort is​ dubious .​

In most emerging markets, for​ instance, there are no natural sellers of​ foreign exchange companies prefer to​ hoard the​ 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 the​ quality of​ lending opportunities .​

In highrisk markets, this depends on the​ possibility of​ connected lending and​ ​ on the​ quality of​ the​ collaterals offered by the​ borrowers .​

Whether the​ borrowers have qualitative collaterals to​ offer is​ a​ direct outcome of​ the​ liquidity of​ the​ market and​ ​ on how they use the​ proceeds of​ the​ lending .​

These two elements are intimately linked with the​ banking system .​

Hence the​ penultimate vicious circle where no functioning and​ ​ professional banking system exists no good borrowers will emerge.

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