Comparison of Major Balance Sheet Risks That Banks Take - Essay Example

Running header: Liquidity risk Student’s name: Instructor’s name Subject code: Date of submission: Comparison of major balance sheet risks that banks take with reference to Westpac and Bendigo Adelaide banks Introduction There are various sources of funding for companies including shareholders capital, retained earnings and debt. Apart from debt, the other sources of funding can be considered internal since it originates from the business itself in terms of retained earnings or from the members in terms of share contribution. This being the case, creditors are concerned about the ability of the company to meet its obligation to pay the principle as well as the interest. According to Matz & Neu (2007) this gives rise to liquidity concerns and hence liquidity risk on the part of the company since its operations would be threatened should it not be able to meet its obligation to pay. In this regard, companies should strive to maintain high levels of liquidity implying that theyhave adequate assets that can be converted to cash in a bid to meet their obligation to pay at a given time. On the other hand, companies with low levels of liquidity will have less assets that they can convert into cash for meeting their obligations to creditors as stated by Duttweiler (2009). Such companies obviously have high levels of liquidity risk which is unhealthy for their operations. As stated by Chorafas (2009), creditors will more willingly led to companies including banks whose level of liquidity risk is sufficiently low implying that the lower the liquidity risk, the more that the bank can borrow from outside sources.Banks also need to regulate theirliquidity risks in a bid to ensure safety of depositors’ funds and preserve their reputation. It is in this vein that the government established the Australian prudential regulatory authority (APRA) which is charged with the responsibility of regulating how banks operate in a bid to ensure their liquidity risks are properly managed in a bid to protect the welfare of their creditors, depositors/customers and investors. In this regard, APRA requires that banks adhere to a number of liquidity management policies (APRA, 2014). As such, this paper aims at examining the liquidity management strategies employed by the above banks as they seek to comply with APRA’s requirements. This is achieved through comparison of the banks maturity mismatch levels, diversification of liabilities and liquidity holdings among other measures. In so doing, the paper will also establish the level of compliance to APRA’s standards by the banks. Analysis of liquidity risks As stated above, bank’s investors, creditors and depositors are usually concerned about the bank’s ability to give a return on their investment while being able to meet its financial obligations to them. According to Ruozi and Ferrari (2013), this gives rise to the relevance of analyzing banks liquidity. Thus, this paper uses Westpac and Bendigo and Adelaide bank for comparative liquidity analysis between the banks. It is hoped that the comparative analysis would be beneficial to investors and other stakeholders in deciding which of the bank is more capable of meeting its financial obligations. Comparison of Maturity mismatch Simply put, maturity mismatch occurs when the bank mismatches its balance sheet through having more short term liabilities compared to its short term assets as well as possessingmore assets than liabilities for medium and long-term obligations. Changes in maturity profile therefore are an indication of the bank’s ability to borrow. This is because a banks propensity to pay its current obligations is dependent on its balance sheet showing relatively equal volumes of current liabilities and current assets. Figure 1. Maturity Mismatch ($ million) Percentage Bendigo and Adelaide bank Percentage Westpac 51.3 58,194.2 51.4 676,737 Short Term Assets 48.7 55,225 48.6 639,792 Short term Liabilities 100 113419.2 100 1,316,529 Total From the table above, it can be seen that the short term assets for both WBC and BEN banks are greater than the current liabilities implying a match in both the banks’ balance sheets. It should however be noted that WBC has slightly greater percentage of short term assets in comparison to BEN. This is an indication that WBC has more propensity to pay its financial obligations to creditors by utilizing its current assets in comparison to BEN. In essence, WBC bank can be said to be more liquid in comparison with BEN. Loans to deposit ratio This is also an indicator of maturity mismatch. This it does by measuring whether a bank’s total loans being a component of its total assets can meet the bank’s total deposits which are a component of the bank’s current liabilities. Figure 2. Loans-to-Deposit (LTD) Ratio BEN WBC 1.06 1.26 The figure above shows that both banks have made greater amounts of loans in comparison to deposits. However, WBC has a greater ratio than BEN. This implies that WBChas a greater ability to meet its obligations to depositors using the loan assets in comparison to BEN. It also implies that BEN has a higher likelihood of defaulting in its obligation to depositors in comparison to WBC. This is an implication that WBC is more liquid than BEN. Liquid Holdings Banks also need to have sufficient liquid assets in a bid to ensure they are able to meet their current financial obligations while still being able to smoothly run their daily operations. In this regard, the measure used to measure the bank’s capacity for covering its current liabilities using its current assets hence supporting its operations is its working capital which is also another indicator of liquidity. An excess of the bank’s current assets over its current liabilities will thus indicate its liquidity. Figure 3. Working Capital ($ million) BEN WBC 2,969.2 36,945 From the table, it can be established that WBC has a greater working capital than BEN. The implication of this is that WBC is more capable of supporting its day today operations using more of its liquid assets as opposed to BEN. On the other hand, it means that BEN is more likely to run its normal operations through the use of current liabilities as compared to WBC. This means that WBC has greater liquidity in comparison to BEN. Quick Ratio This is another tool for measuring a bank’s liquid holdings. Quick ratio is a determinant of the bank’s ability of meeting its current liability obligations through the use of the more readily available assets that are convertible to cash. These assets are cash as well as liquid assets. Figure 4. Quick Ratio BEN WBC 1.05 1.06 From the table, it can be seen that WBC has a slightly greater quick ratio when compared with BEN. The implication of this is that WBC is better placed to meet its current financial obligations through the use of its most liquid assets that are easily converted into cash. This also shows that WBC has relatively more assets that are liquid compared to BEN. In essence, it implies that BEN is exposed to higher levels of liquidity risk in comparison to WBC due to its less quick ratio. Comparison of the banks’ diversification of Liabilities APRA recommends that banks use various types of financing in funding its capital requirements if they are to minimize their liquidity risks. In this regard, banks are dissuaded from relyingon only one source of finance to fund their capital requirements since this would expose them to being severely affected if an unfavorableevent impactingthese sources of fund happens. On the contrary, banks would face lesser risk if they were to spread their liabilities in different capital sources in a bid to diversify risk and hence effectively manage their liquidity risk. The table below shows how the banks have diversified their liabilities; Figure 5. Allocation of Fund Sources ($ million) Percentage BEN Percentage WBC 97.93% 47,439 73.3% 424,482 Deposits 0.78% 379.5 1.5% 8,836 Debt from other institutions 0.73% 354.3 24.6% 144, 133 Subordinated debts 0.56% 268.9 Convertible preference shares 1.6% 9,330 Loan capital 100% 48,441.7 100% 586,781 Total The figure below has depicted that majority of capital in both WBC and BEN to have come from deposits. In WBC, subordinated debts account for 24.6% and are the second biggest source of funding for the bank followed by loan capital at 1.6% and debt from other institutions at 1.5%. The deposits at WBC accounted for 73.3%. On the other hand, BEN had deposits amounting to 97.93%. This was followed by debt from other institutions at 0.78%, subordinated debts at 0.73% and convertible preference shares at 0.56%. It has thus been demonstratedthat BEN’s capital is mostly financed through deposits in comparison with WBC. In addition, it has demonstrated WBC’s capital to be more diversified in comparison with BEN. This demonstrates BEN to have higher liquidity risk than WBC (Tarantino, 2011). Comparison of the banks access to wholesale markets Management of liquidity risks could also be done by use of wholesale funds from other stable institutions and from the government. The benefits that banks accrue from wholesale funding arise from the lower interest rate charged on the borrowed capital as well as the long period that they are allowed for repaying the funds. In addition, the funds are easily accessible to the banks. Figure 6. Wholesale Funds: 2013 BEN (Million) Westpac ($ million) 5,193.2 201,821 In the figure, it can be seen that WBC has a relatively higher amount of wholesale funding in comparison to BEN. Furthermore, the wholesale funding is more diversified for it is sourced from the government as well as domestic and foreign sources. On the other hand, BEN’s whole sale funding is sourced from domestic and foreign sources. It should also be noted that owing to WBC’s scale of operations being more global compared to BEN, it has a wider access to wholesale funding. In this regard, WBC is more likely to utilize wholesale funding in its operations and managing liquidity risk in comparison to BEN. Comparison of foreign currency and other markets Banks liquidity is also at the risk of the dynamic nature of the exchange of exchange rates in various countries. In this regard, WBC has put in measures of dealing with such foreign exchange risks including investing in various forms of financial derivatives in a bid to hedge against its exposure to exchange rate risks through its nature of operations in various international markets (WBC, 2013). In this regard, the bank is protected from exchange risks when it borrows capital from various foreign institutions as well as when customers transactions are done in foreign currencies. Though BEN is a relatively domestic bank, it is still exposed to some level of foreign risk since it has foreign operations. In addition customers operations at times involve foreign currencies. In recognition of this risk, BEN also uses derivatives including domestic and foreign swaps in hedging against such foreign exchange risks (BEN, 2013). However, as can be seen, WBC is relatively exposed to more risk in comparison to BEN. However, as revealed above, both banks have put in place adequate measures for dealing with foreign exchange and other market risks. As such, the threat of exposure to such risks and hence their impact on the banks’ operations and hence profitability is greatly minimized. Intra Group Liquidity The BEN group has a liquid assets portfolio. During the years 2013, the bank’s liquid assets rose from $561 million in 2012 to $677.7 million in 2013. This is a significant increase from the previous year’s figures. The group’s liquid assets represented by Australian dollar also increased with the same margins. The group has also maintained contingent liquidity worth $535.5 million in 2013 and this has increased from $444.8 million which is a significant increase. On the other hand, WBC holds a total of $ 2.2909 billion in comparison with $2.2751 billion in 2012. It is therefore clear that WBC has more liquid assets in comparison to BEN. This is an indication that WBC has bigger intragroup liquidity in comparison to BEN. This means that WBC is exposed to higher intragroup liquidity risk in comparison to BEN. Industry Liquidity Support Arrangement It is obvious that if banks face huge liquidity problems, this will have a negative impact on the liquidity for companies in the same industry. In this regard, the reserve bank of Australia (RBA) As well as the Association of Prudential Authority (APRA) have a major role to play in the provision of liquidity support to these banks and financial institutions that are likely to experience major liquidity risk according to RBA (2014). Both the banks i.e. The Bendigo and Adelaide bank as well as Westpac could borrow from the reserve bank were they to experience liquidity risk which is not likely to be resolved despite their applying the various measures mentioned above. However the reserve bank only acts as the last resort for banks and hence it can only lend if the banks liquidity problem has the likelihood of adversely impacting on the interest of many of its stakeholders as well as those of other financial institutions. This however does imply that before the two banks are hit by worst liquidity problems, they as well as other players in the industry could be supported by APRA by way of its liquidity management policies aimed at ensuring compliance for all the banks. The policies would include forming of internal liquidity policies and control system which adheres to the limitations suggested by APRA for the industry. APRA also provides that top management of banks should take the major responsibility in ensuring that their banks properly implement their internal liquidity policies while strictly adhering to the rules and guidelines provided by APRA regarding various liquidity areas (APRA, 2008). Conclusion As has been demonstrated above, both WBC and BEN have to a large extent complied with APRA’s policy guidelines on setting limits for maturity mismatch, maintaining liquid assets as well as diversification of liabilities among other provisions. However, the two banks differ on their liquidity levels as demonstrated above. It can be seen that WBC has more liabilities in its balance sheet in comparison to those of BEN. The same has been demonstrated of assets. It has also been demonstrated that WBC has diversified its liabilities more than BEN has done in addition to have a wider Access to wholesale markets in comparison to BEN (Wu, 2011). It has also been demonstrated that WBC has higher working capital and quick ratio when compared for BEN thus implying that WBC has a lower liquidity risk in comparison with BEN. However, it has been demonstrated that both the companies have effectively recognized the threat to liquidity posed by the impact of the dynamic exchange rate in various countries while WBC has more liquid assets in comparison to BEN. As such, this paper has generally found that WBC has less liquidity risk in comparison to BEN. This implies that investors, depositors and creditors will most likely choose WBC over BEN in their investment decisions. References: APRA. (2000). AGN 210.1: Liquidity management strategy. Retrieved September, 12 2014, from http://www.apra.gov.au/adi/PrudentialFramework/Documents/AGN210-1-1-3.pdf APRA.(2008). Australian Prudential Regulation Authority. Retrieved September, 12, 2014,from http://www.apra.gov.au/Pages/default.aspx. Banks, E. (2014). Liquidity risk: Managing funding, and asset risk. London: Palgrave Macmillan. Westpac annual report 2013 Bendigo and Adelaide Bank annual report 2013 Chorafas, D. N. (2002).Liabilities, liquidity, and cash management: Balancing financial risks. New York, NY: John Wiley & Sons. Duttweiler, R. (2009). Managing liquidity in banks: A top-down approach. West Sussex, U.K.: John Wiley & Sons. Matz, L., & Neu, P. (2007).Liquidity risk measurement & management.Clement Loop, Singapore, John Wiley & Sons. RBA.(2014). Reserve Bank of Australia. Retrieved May 19, 2014, from http://www.rba.gov.au/ Ruozi, R., & Ferrari, P. (2013).Liquidity risk management in banks: Economic and regulatory issues. U.S.A.: Springer. Tarantino, A. (2011). Essentials of risk management in Finance. Hoboken, NJ: John Wiley & Sons. Wu, D. D. (2011). Quantitative financial risk management.Heidelberg, Germany: Springer-Verlag. Read More