Banks Face New Risks - Research Paper Example

Topic_- Are the German banks riskier than the European competitors This present paper attempts to explain what are the risk factors facing the banks and how return on assets and liquidity are relevant indicators for a identifying a safe bank. The recent economic downturn has affected the European countries, though to a lesser degree than their US counterparts. Though banks such as the Deutsche Bank in Germany is performing relatively well, but the German resistance to reforms and the fragmented banking sector in Germany has given other European banks a lead in terms of safety. Table of Contents 1. Introduction 2. Review of Relevant Literature and Theory 3. Methodology and Data 4. Results and Discussions 5. Conclusions and Recommendations 6. References Introduction The Banking Banana Skins report, 2008 has identified the top 30 risk factors that affect the banks. This survey was conducted by the Centre for the Study of Financial Innovation, Johannesburg, and Pricewaterhouse Coopers. The survey identified liquidity, credit risk and credit spreads as the top three factors that pose a risk to banks. The report highlights the fact that the global financial situation has changed the importance of various risks; liquidity is now the highest risk to threaten banks. The shortage of liquidity has the power to impact the credit and derivative markets and this fear can lead to further worsening of the recessionary situation. Of the three top risks, liquidity and credit spreads had never before been considered as a risk; this is a clear indication of the changing risk scenario. The survey listing also has 'regulatory over-reaction' as the only non-financial risk in its top ten factors. This again is a clear indication that the market fears actions by politicians and regulators who will try to rectify the issue. The survey had varied opinions depending on the class of the respondent. While the bankers saw sharp variations in the credit, derivative and equity market as the most important risks, the non-banking people saw poor risk management and a liberal system of bonuses as the chief risks. Review of Relevant Literature and Theory The global economic crunch has affected not only the US but also Europe. Not only are the East European banks going to be affected but also the West European banks having loaned out to these banks, will be equally affected. A survey done by credit rating agency Moody's Investors Services states that Hungary and Latvia has already appealed to the IMF for a bailout; Bulgaria, Estonia, Lithuania and Romania may soon be going the same way. Some of the Western European banks were affected; UniCredit of Italy fell 7.3 percent and Societe Generale of France fell by 9.5 percent. The German Banking scenario is dominated by savings banks, cooperative banks and landesbanks, all of which are less-profit oriented than commercial banks. The market is fragmented and there is lot of competition. September 2008, saw two big mergers in the German banking sector. Commerzbank took over Dresdner Bank and Deutsche Bank took over Postbank. This was a direct reaction to other European banks entering German terrain. Banco Santander of Spain, UniCredit of Italy and 'ING of Netherland were the new entrants in the German market. UniCredit purchased Hypo Vereinsbank while Credit Mutuel of France took over Citigroup's German subsidiary. The German banks realised that size matters and the only way they could keep off European banks were through merger. The current economic crisis has led to banks writing down approximately 400 billion dollars in bad loans. Market liquidity and funding liquidity are two factors that interplay to create the funding environment. Market liquidity is said to be low when it becomes difficult to sell an asset that is when it is difficult to raise money by selling an asset. Funding liquidity is said to be high, when money to buy an asset can be easily borrowed. According to Brunnermeier and Pedersen (2008), more funding can be garnered (funding liquidity) if more assets can be sold (market liquidity). According to Manfred Weber, the CEO of the Association of German Banks, Germany has one of the slowest growth rates in Europe and in the last 10 years the per capita income in Germany has gone below the average of the EU countries. German banks are behind other European banks because of this unwilling attitude to change itself. Financial experts rightly feel that the German banking sector lies at the lowest rung of the European banking hierarchy. Methodology and Data The European Central Bank (ECB) has written off an estimated 553 billion Euro for the period 2007 to 2010. Since the property slump in the US, almost 1.2 trillion Euro has been written off by financial institutions of the world. Though the Deutsche Bank and Credit Suisse have reported rising in their earnings, banks across the world are treading with care, heading the ECB warning that banks should be careful of their loan exposure. ECB has also promised that it will resort back to its unlimited offering of cash to banks by the next year. The ECB in its effort to provide banks support in this crisis has also spent 3.7 trillion Euro, cut interest rates and has been buying covered bonds worth of 60 billion Euro. Here is an interesting survey result. Finanztest is a German magazine; this magazine did a survey where 21 banks in Germany were surveyed for financial advice given by the bank. The survey included big names such as Deutsche Bank, Sparda Bank, Commerz Bank, Sparkasse and City Bank. The survey had 147 consultations, with the surveyors posing as the clients. The question put to the bank consultants was 'what was the best secure investment for five years for a sum of 30,000 Euros asking for a return of four percent per year.' In the present situation the right advice by the bank would have been that for a return of four percent the customer should be able to take more risk. However, if the consumer preferred to take less risk then only a two percent return would have been possible. Unfortunately all banks recommended high risk products to the 'clients' or on the other hand suggested low-risk, low-return products that fetched higher commissions. The most important point here was that most consultants did not even find out the clients background, which is a legal necessity before consultation is provided to a new customer. This incident is highlighted in this paper to provide evidence to a survey methodology that shows that German banks are working in an undependable manner. Results and Discussions The return on assets is a convenient indicator to measure the safety and the investment worthiness of a company. The ROA should be clearly more than the rate of interest a company pays on its debts, for the company to be in a comfortable profit situation. Also, a company that has higher ROA than its capital cost, is one in which the investors have faith, as such a company is more likely to increase the shareholders value. The company's ROA should also match its competitors and the industry average, for an investor to have confidence in the company. To increase its ROA, a company either increases its profit margin or increases its asset turnover. The later process is more sustainable and shows the efficiency of the company. Though return on equity (ROE) is more commonly used as a profitability measure, it does not reveal the company debts or if the company is using the debts to increase its return. This issue is solved when ROA is taken as a profitability measure as the Total Assets (used as the denominator in the ROA calculation) include liabilities such as debts. So, mathematically speaking a lower debt will directly lead to higher ROA. Though banks can go through periods of stress from non-performing assets or also bear period of losses, a liquidity stress is an extremely challenging situation for a bank. In spite of liquidity being a contributing risk factor, it has not received the importance in risk management process. However, many European banks now understand the importance of liquidity in their risk-management agenda. Banking institutes sometimes maintain an alternative and less-sensitive source of funding, even though it may add to the costs incurred by the bank. If this is not done, then a rising liquidity in a situation of stress would lead to more expenses. Conclusions and Recommendations However, there are a few things that one must keep in mind while taking the ROA figure to judge the stability of the bank. ROA is calculated as Net Income divided by Total Assets. The net income figure is not always correct because of accrual-based earnings and in some cases managed earnings. Another difficulty in taking ROA as a measure is that the assets taken into consideration are fixed assets and not the intangible assets such as people and ideas. Some company may have assets in the form of trademarks, patents, etc, which do not get reflected in the ROA calculations. To give a simple example; a manufacturer of machines such as the hardware of computers will have more assets to show on paper than the maker of computer software. So when ROA is calculated the software company will have a higher figure than the hardware company but this high figure is not the right safety indicator for the company. Liquidity risk management comprises two aspects that are interrelated; one controlling the business as usual cash flow and the planning for contingencies of stress. Banks are increasingly investing in technology for monitoring the cash flow. For contingency planning the best practices is to study the consequences of various firm-specific stress scenarios and document the likely responses. Risk managers face great challenges in the present economic scenario. However, as Mr. Jose Manuel Gonzalez-Paramo, executive committee member of ECB said in his speech at Risk Europe 2009, the central bank can help meet these challenges. The ECB with no liquidity constraints have limitless power to help resolve economic crisis. In any intervention process, the ECB should not show any bias by providing liquidity support to a certain sector and hindering a competitive atmosphere. The collateral management framework of the ECB should be used with prudence. The liquidity measures can also be accompanied by non-standard monetary policy measures. References 1. 'Banana Skins' report identifies top risks facing banks. [Internet] (Updated NA) Available at: http://www.pwc.com/za/en/press-room/archives/banana-skins-report-identifies-top-risks-facing-banks.jhtml [Accessed 20 Jan 2010.] Investopedia. ROA on the Way. Ben McClure. [Internet] (Updated NA) Available at: http://www.investopedia.com/articles/fundamental/04/012804.asp [Accessed 20 Jan 2010.] Investopedia. The Industry Handbook: The Banking Industry. [Internet] (Updated NA) Available at: http://www.investopedia.com/features/industryhandbook/banking.asp [Accessed 20 Jan 2010.] European banks face new risks from east. [Internet] (Updated NA) Available at: http://en.youth.cn/news/business/200902/t20090219_866567.htm [Accessed 20 Jan 2010.] Givanomics. The Vicious Circle: West European Banks versus CEE. [Internet] (Updated 23 Feb 2009) Available at: http://givanomics.blogspot.com/2009/02/vicious-circle-west-european-banks.html [Accessed 20 Jan 2010.] Liquidity Risk: What is it How to Measure it Ren Garcia. Jan 2009 [Internet] (Updated NA) Available at: http://www.cirano.qc.ca/realisations/grandes_conferences/risques_liquidite/liquidityintro.pdf [Accessed 20 Jan 2010.] ECB warns banks facing 187bn more in writedowns. [Internet] (Updated 19 Dec 2009) Available at: http://www.independent.ie/business/european/ecb-warns-banks-facing-8364187bn-more-in-writedowns-1981624.html [Accessed 20 Jan 2010.] German Banking Industry: An Analysis. [Internet] (Updated NA) Available at: http://docs.google.com/viewera=v&q=cache:yUy70WgblhIJ:www.researchandmarkets.com/reports/313123/german_banking_industry_an_analysis.pdf+ROA+and+security+of+german+banks&hl=en&gl=in&sig=AHIEtbRoe5PxOlyBCLUOiVKqEhUsTtmUSQ [Accessed 20 Jan 2010.] 2. Riskier than Most Realized. How the Crisis Is Hitting Europe. Jack Ewing. [Internet] (Updated 27 Feb 2009) Available at: http://www.spiegel.de/international/business/0,1518,610229,00.html [Accessed 20 Jan 2010.] 3. The Atlantic Times. Size Matters Why German banks are merging. Alexander Hagelken. Oct 2008. [Internet] (Updated NA) Available at: http://www.atlantic-times.com/archive_detail.phprecordID=1475 [Accessed 20 Jan 2010.] 4. Banking Survey 2006 Facts, Opinions, Outlook. Manfred Weber. [Internet] (Updated NA) Available at: http://www.german-banks.com/html/15_press/statement_00_060612.asp [Accessed 20 Jan 2010.] 5. German banks perform poorly in financial advice test. Vanessa Johnston. [Internet] (Updated 16 Dec 2009) Available at: http://www.dw-world.de/dw/article/0,,5019615,00.html [Accessed 20 Jan 2010.] 6. Managing risk - the role of the central bank in a financial crisis. Jose Manuel Gonzalez-Paramo. Risk Europe 2009. [Internet] (Updated 04 June 2009) Available at: http://www.bis.org/review/r090610d.pdf [Accessed 20 Jan 2010.] Read More