The Financial Situation of the Saint Charles Bank - Coursework Example

? Risk Management Report A case study of Saint Charles Bank Question Comment on the financial situation of the bank as presented on the Exhibits 1 and 2. (LO2, LO5) With the deteriorating health of the banking institutions and the recent surge of bank failures as a result of the current global financial crisis, it is justified that bank performance receives increased investigation from both scholars and industry specialists . There are two broad approaches used to measure bank performance, the accounting approach, which makes use of financial ratios and econometric techniques . Traditionally accounting methods primarily based on the use of financial ratios have been employed for assessing bank performance (Gregory, 2012) . However, the limitations of this method coupled with advances in management sciences have led to the development of alternate methods such as non-parametric DEA and parametric Stochastic Frontier Approach (Berger and Humphrey,1997) . Berger & Humphrey (1997) assert that the whole idea of measuring bank performance is to separate banks that are performing well from those which are doing poorly. They further indicated that, “evaluating the performance of financial institution can inform government policy by assessing the effects of deregulation, mergers and market structure on efficiency” (p175). Bank regulators screen banks by evaluating banks’ liquidity, solvency and overall performance to enable them to intervene when there is need and to gauge the potential for problems (Casu et al, 2006). On a micro-level, bank performance measurement can also help improve managerial performance by identifying best and worst practices associated with high and low measured efficiency. When looking to improve their performance, banks compare the performance of their peers and evaluate the trend of their financial performance over time. I will therefore use financial ratios were used to evaluate the performance of Saint Charles Bank. .The most common measure of bank performance is profitability. Profitability is Measured using the following criteria: Return on Assets (ROA) = net profit/total assets shows the ability of management to acquire deposits at a reasonable cost and invest them in profitable investments (Erick, 2002) . This ratio indicates how much net income is generated per ? of assets. The higher the ROA, the more the profitable the bank. Return on Equity (ROE) = net profit/ total equity. ROE is the most important indicator of a bank’s profitability and growth potential. It is the rate of return to shareholders or the percentage return on each ? of equity invested in the bank. Cost to Income Ratio (C/I) = total cost /total income measures the income generated per ? cost. That is how expensive it is for the bank to produce a unit of output. The lower the C/I ratio, the better the performance of the bank. In banking the risk-reward trade off is constantly present. Risk taking generates higher expected earnings through various mechanisms. For example granting high margin loans to risky customers may increase earnings in the short term but it also increases the credit risk profile and the probability of future losses (Hull, 2012). The analysis of the bank ratio’s show a constant profitability trend from 2009 to 20011 with a slight increase in 2010. Return on assets reduced to 1.23% in 2009 to 1.05% in 2010 to 1 17% in 2011. The Return on Equity increased from 18.81% IN 2009 to 20.13% in 2010 and dropped to 18.45% in 2011Loans and advances were the main contributors to the increase in assets mainly due to increase in mortgage loans . The higher ratios indicate a better prospective as the high net interest margin was feeding through greater net income thus boosting ROA and ROE . The decline in the C/I ratio is as a result of cost efficiency levels. These results are compared to Barclays performance for the same period shows that Barclays has an increasing trend as it experienced a and increase form 7.5% in 2009 to 9.9% in 2010 to 14.9% in 2011% Question 2 Explain the differences in terms of capital and risk-weighted assets, between 2010 and 2011, in Exhibits 3. (LO1, LO2, LO3) Capital requirement (also known as Regulatory capital or Capital adequacy) is the amount of capital a bank or other financial institution has to hold as required by its financial regulator. This is usually expressed as a capital adequacy ratio of equity that must be held as a percentage of risk-weighted assets (Mishkin & Eakins, 2011). These requirements are put into place to ensure that these institutions do not take on excess leverage and become insolvent. Capital requirements govern the ratio of equity to debt, recorded on the right side of a firm's balance sheet Risk-weighted asset is a bank's assets or off-balance sheet exposures, weighted according to risk. This sort of asset calculation is used in determining the capital requirement or Capital Adequacy Ratio (CAR) for a financial institution (Andry, 2013). In 2010 Credit risk; borrowers fail to pay loan or otherwise meet contract; obligation may arise whenever a borrower is expecting to use future cash flow to pay current debts. Investors are compensated for assuming credit risk by away of interest payment by the insurer, the higher credit risk the higher interest risk (Dorfman, 2007). Determined by calculation based on collateral assets ,revenue generated ability and taxing authority use collaterals guarantors and credit derivatives regulatory capital requirement and risk weighed asset is higher by 168374, In 2011 capital requirement is also less than the risk weighted asset by 159450 which may help bank reduce the risk. Market risk; it is a possibility for a customer to experience loss due to factors that affect the overall performance of financial market emanated through diversification though can be hedged against risks that a major natural disaster will cause those changes include interest rate and terrorist attack in 2010 (Hubbard, 2009). Capital requirement for the market rate is 735and that of risk weighted asset is 9205 bearing an increase of 8470. In 2011 market capital requirement increased by 18319 which is due to hedging and diversification to reduce the risk Profitability risk; is the type of risk where income statement lacks income diversification and income variability thus income statement concentrate in limited no of proceeds (Jorion, 2011). Profit risk is a kin to well known 80-20 rule or pare to principle which states 20% of company customers claims80% of the business ,in the St Charles bank income statement types of income are ; net interest income ,net fees ,commission income, net trading income and other operating incomes .The risk can be mitigated by diversifying amount of income through many sources . Operational risk; is a risk incurred by organizational activities which are internal it arises due loss resulting from inadequate or failed internal process, people systems and external events that can be used to generate profit (Jorion, 2011) .unlike other risks they all however manage operational risk to keep losses within their risk appetites the amount of risk are prepared to accept in per suite of their objectives because the cost of correcting errors or improving the system is proportionate to the benefit they receive, this benefits also determine the appetites they receive, according to the data in 2010 capital requirement is 1467 and risk weighted assets for operational risks 18340 an increase of6873 compared to capital requirement of 2011 of 1656 risk weighted assets of 20696 a difference of 19040 which helps the bank to reduce its internal activities risks. Saint Charles Bank experienced an increase in the capital and the risk weighted assets (RWA) required against credit risk as the capital requirement increased from 12,902 in 2010 to 13,865 in 2011. Similarly, the risk weighted assets increased from 161,276 to 173,315. The requirements for the market risk increased from 735 in 2010 to 1,593 in 2011 or the capital required and from 9,205 to 19, 1912 for the RWA. The capital requirements for operational risk increased from 1.467 to 1,656 in 2011. The RWA increased from 18,340 to 20.969. Question 3 Analyze the credit risk situation of the bank, between 2008 and 2009, as it appears in the Exhibits 4.1 to 4.6. (LO1, LO2) Risk is the deviation of returns when an investor invests in a company that has loans. It is a measure of potential loss of finance and impact on a business. Security is a financial instrument of value that represents ownership in a stock corporation. It is used to represent money that must be returned once it has been borrowed from a business or financial institution (Bessis, 2010). Saint Charles Bank may suffer financial loss if its clients, customers as well as market counterparts fail to honor their contractual obligation. Other sources of the credit risk to the bank would be from trading activities such as debt securities, balance settlement with the counterparts, available for sale assets as well as reverse purchase loans. The credit risk may also arise as a result of the bank’s credit rating downgrading therefore leading to a fall in the value of Saint Charles investment in the issued financial instruments (Mishkin & Eakins, 2011). While it is expected that banks would bear some bad loans and losses in their lending activities, one of the key objectives of the bank is to minimize such losses (Casu et al, 2006) . Credit performance evaluates the risks associated with the bank’s asset portfolio i .e. the quality of loans issued by the bank. Credit performance is concerned with the examination of the risk associated with a bank’s asset portfolio.. However, 2008-2009 shows a significant deterioration in the credit quality. The ratio registered a decline of 12% from 1 .83 to 1 .61 during 2008-2009 before slightly increasing from 1 .61 to 1 .68 in 2010. The slight improvement was due to continued growth in loans to customers as well as growth in non performing loans which continued on a downward trend. The loan portfolio deteriorated in 2008-2009 as the ratio increased by 8 .33% from 1 .92 in 2008 to 2 .08 in 2009 . Credit risk ratios increased during 2008 indicating the deterioration of the quality of the loan portfolio as compared to 2009. For the period 2008 to 2009 nonperforming loans and advances increased from 2 .8% in 2008, to 5 .5 % in 2009, as a result of the crisis and the period was also marked by an increase in credit losses in line with the tougher market conditions . This is because the banks were more exposed to increased credit risk as risky loans given during the 2008-2011 period began to go bad and the banks reported higher charge off or additional provision for loan losses. Hence Saint Charles bank is facing increased credit risk, especially in its home loan portfolios, in the face of record household indebtedness and a mounting debt service burden. Overall, although risk appetites were adjusted in line with challenging economic conditions and caution was exercised with regard to lending, the operating environment continued to be under pressure during 2009 as evidenced by increased credit impairments and resultant lower profitability levels. This resulted in the quality of the loan portfolio sharply deteriorating during 2008- 2009. Question 4 Finally, point out the asset and liability management challenges facing the bank as you examine the liquidity condition of the institution, as mentioned on the Exhibit 5. (LO1, LO4, LO5) Even though it is rated to be among the top 20 world economies in terms of size, Saint Charles Bank National economy still remains comparatively small contributing to less than 1% of the world GDP (Dorfman, 2007). In spite of being relatively small in terms of global standards, Saint Charles Bank is the economic motivating force for the country. The country’s economic performance during the last decade was remarkable having strong domestic demand and favorable external environment (Jorion, 2011). Regardless of the worsening of economic indicators, the country has progressed on several social economic and has also maintained a strong macro-fiscal stabilization making the country economic resilient in any given global financial crisis. As a result of the National’s open economy, Saint Charles Bank has been able to weather the global crisis comparatively well as compared to other banks in the region (Dorfman, 2007). The social and political challenges in the region resulted to structuring of both banking sector and delivery of financial services. The liberation of the economy, relaxation of exchange controls and political transformation in the region has increasingly made Saint Charles bank an important financial provider. This financial liberalization not only did it bring higher competition in the domestic financial market but also increase the requirement of quality services in the country (Hopkin, 2012). The Saint Charles bank’s banking industry is characterized by international connection through relative banking relations with international institutional investment in domestic banks and offshore banks. Thus, supervision and regulation of banking sector is still a challenge, particularly with respect to the current financial innovations as a result of 2008 to 2009 global financial crisis. Even though the America’s banking sector has been moderately insulated from the direct shocks of the global financial crisis through appropriate supervision and monitoring of the domestic banking sector, the negative corruption effects of the crisis had a negative effect on Saint Charles bank balance sheets (Hubbard, 2009). Liquidity performance Liquidity indicates the ability of the bank to meet its financial obligations in a timely and effective manner. Samad (2004:36) states that ‘‘liquidity is the life and blood of a commercial bank’’. Financial liabilities are attracted through retail and wholesale distribution channels. Retail generated funding is considered less interest elastic and more reliable than deposits attracted from wholesale distribution channels (Thygerson, 1995) . The following ratios are used to measure liquidity. Liquid assets to deposit-borrowing ratio (LADST) = liquid asset/customer deposit and short term borrowed funds. This ratio indicates the percentage of short term obligations that could be met with the bank’s liquid assets in the case of sudden withdrawals (Hull, 2012). Net Loans to total asset ratio (NLTA) = Net loans/total assets NLTA measures the percentage of assets that is tied up in loans. The higher the ratio, the less liquid the bank is. Net loans to deposit and borrowing (NLDST) = Net loans/total deposits and short term borrowings. This ratio indicates the percentage of the total deposits locked into non-liquid assets. A high figure denotes lower liquidity (Gregory, 2012). Liquidity Performance Liquidity performance measures the ability to meet financial obligations as they become due and is crucial to the sustained viability of banking institutions. What began as credit concerns for the US sub-prime market developed into concerns in global credit markets with unknown financial exposures and potential losses Andry, 2013). The resultant uncertainty made financial market participants exceedingly risk averse, such that they were unwilling to invest in any markets or financial instruments other than ‘safe havens’. This severely reduced the levels of liquidity in the global financial markets (Thygerson,1995). Saint Charles Bank was not immune to such developments and this is reflected in the liquidity ratios. Saint Charles Bank relies on customer’s deposits and their current balances with the Federal Reserve bank for their liquidity. These banks are required to hold an average daily amount of liquid assets that shall not be less than 5% of adjusted liabilities. In as much as the ratio of net loans to total assets does not directly measure liquidity, it gives an indication of how much of the bank assets are tied into illiquid loans . From the trend displayed by NLTA, it increased by 2 .84% from 73 .00 in 2008 to 75 .08 in 2008 and increased again to 76 .48 in 2009 when favorable economic conditions and preparations for the World Cup 2010 increased the demand for loans from businesses and allowed banks to grow their loan portfolios . Loans to customers increased by 30% in 2008 while total assets increased by 21 .67% at the end of 2011. . In 2008 NLTA dropped to 72.94 before finally increasing again to 73.99 in 2009. The change in the trend signifies the slowing down in loans to customers and a continued increase in impaired loans leading to a decrease in net loans and in total assets which consequently decreased by 4 .78% at the end of 2009 . Generally, a higher NLTA may indicate possible liquidity problems for banks in a tight credit market in the face of a large deposit withdrawal or in case of unexpected withdrawals. However, the increase in NLTA for the five banks did not pose any liquidity problems as Saint Charles could still access the cash reserves that they held in excess of the minimum requirement with the reserve bank . The LADST ratio has been gradually falling for the period under review indicating reduced liquidity for the banks. The ratio decrease by 14 .56% from 18 .06 in 2009 to 15 .43 in 2010 indicating a fall in the amount of customer and short term funds that could be met if they were suddenly withdrawn . The ratio however slightly increased by 2 .03% in 2008 as the amount of liquid assets held by the banks increased by 20% during 2009 as banks increased their investments in instruments qualifying as liquid assets . The ratio then decreased from 15 .06 to 13 .40 in 2009 indicating a further deterioration in liquidity. Therefore in as much as banks have been increasing their percentage of liquid assets that mainly consist of current accounts/reserves with the regulatory body and other banks, customer deposits and short term funding have also been increasing such that the overall trend continued to show reduced levels of liquidity (Dorfman, 2007). NLDST followed a similar trend increasing by 2 .16% from 88 .02 in 2009 to 89 .93 in 2010 and subsequently increasing by 8 .55% to 97 .62 in 2011. The increasing trend indicate deteriorating liquidity in the banking sector as more and more assets, customer deposits and short term funding are tied into loans which are classified as illiquid assets. The liquidity of the banks contracted most between the years 2008-20011 when the banks were aggressively increasing their loan portfolios during the country’s preparation for World Cup 2010 . The variation in the ratio from 2008 onwards is ascribed to changes in both loans to customers and changes in deposit and short term funding. The banks tightened lending standards later in 2008 in response to the global financial crisis such that credit expansion slipped by 2 .6% in 2009 eventually reaching very low levels and zero growth by the end of the year . The lower rate may also be attributed to a tighter monetary policy stance and the implementation of the stringent risk based lending criteria by the banks As a result of the introduction of the National Credit Act of 2007, while bank loans and advances contracted during 2009, the contraction in credit extension had both demand-side and supply-side elements. On the demand side, it would appear that households continued to be reluctant to incur more debt leading to a fall in demand for loans, while on the supply side lending standards have remained tight and led to the slowing down in the growth of loans and advances to customers (Crouhy, Galai & Mark, 2006). . Financial stability issues lie at the profitability-liquidity nexus therefore a decline in liquidity is associated with an increase in profitability, since low liquidity means larger percentage of assets and total deposits are tied with loans . Under normal circumstances rapid loan growth tend to result in higher returns and higher risks. However, Erick (2002) argues that rapid growth in assets (loans) than in deposits is indicative of banks using borrowed funds excessively. This seems to highlight the position of the Saint Charles . There has been a growing trend in loans and advances to customers; however, this increase has not been met by an equal increase in customer deposits . This may then mean Saint Charles Bank has been turning to purchased liquidity in the form of money market instruments to fund the increase in loans (Bessis, 2010). . However, this remains uncertain as the data contained in Bank scope is not adequate to be able to back up the information with detailed ratios .Furthermore, a closer inspection of the balance sheets shows that retail deposits represent only about 25% of total deposits in the commercial banking system, while deposits with less than one year maturity represent close to 80% of total deposits (IMF, 2008) . It is therefore worth noting that as a result of the above mentioned issues concerning the composition of the deposits, the banking system faces long-standing structural risks rooted in the sector’s reliance on short-term wholesale deposits. The IMF has recommended that the banks regulatory body explore ways to reduce the risks associated with the banks’ reliance on short term wholesale deposits . One of the recommendations is implementing a deposit insurance system to counter such risks and provide the added benefit of inducing household saving to migrate from unguaranteed liquid financial instruments to competing bank deposits, thus strengthening the retail base of banks (Andry, 2013). References Andry, A. (2013). Liquidity Risk Framework, Financial Risk management Bessis, J. (2010). Risk Management in Banking, New York: John Wiley & Sons. Berger, A.N. and Humphrey, D.B. (1997). Efficiency of financial institutions: international survey and directions for future research . European Journal of Operational Research, Vol 98, pp .175-212 . Casu, B ., Molyneux, P . And Girardone, C . (2006) . Introduction to Banking, Prentice Hall/ Financial Times, London . Crouhy, D., Galai, D., & Mark, R. (2006). The Essentials of Risk Management, McGraw-Hill Professional Dorfman, M. (2007). Introduction to Risk management and insurance, Englewood Cliffs, N. J: Prentice Hall Erick, V. (2002). 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