A Comparison of Major Balance Sheet Risks Faced by Banks - Example

Running header: NAB & BOQ Student’s name: Instructor’s name: Subject code: Date of submission A comparison of major balance sheet risks faced by banks for National Australia Bank (NAB) and Bank of Queensland (BOQ) Introduction Banks and other organizations source for their funding from various sources including contribution by shareholders or equity, debts and retained income. The sources of funds for the can thus be grouped into two including debt which is an internal source of funding while retained income and shareholders contributions being regarded as internal funding sources as they originate from within the business. Given that auditors are not insiders to the business neither are they owners, their major concerns regard whether the company or bank to which they have lend their resources will be able to meet their interest and principle obligations. This can be regarded to as liquidity concern which in turn gives rise to liquidity risk. The essence of liquidity risk is that the operations of the company become threatened if the company is unable to fulfill its obligations to the creditors of paying both interest and principal. This calls for companies to ensure they have adequate liquidity levels which are convertible to cash so that they can always pay both interest and principal as per the debt agreement (Bank for International Settlements, 2008). Therefore, companies that have low liquidity levels and hence less cash convertible assets that can be used to meet their debt obligations are said to have high liquidity risk which threatens their operations and hence future survival due to the threat of liquidation or take over. In addition, their ability to attract external financing is limited since creditors readily led to banks and companies that have adequate liquidity levels since this indicates ability to pay back. For the bank, there is an additional reason for the need to keep adequate liquidity levels. This is for the purpose of ensuring that depositors’ funds are safe while preserving the banks name. Therefore with the sole aim of protecting depositors’ funds, the Australian government has set up the Australian prudential authority (APRA) and given it the mandate to regulate banks operations so that their liquidity risks are managed properly. This way, the interests of the shareholders, debtors and depositors are properly guarded. In a bid to fulfill its mandate, the APRA developed a number of liquidity management policies that banks have to comply with. The aim of this paper is evaluating the liquidity management strategies that NAB and BOQ have adopted in accordance to APRA’s liquidity management policies. In so doing, the paper compares the institutions liquidity mismatch their liquidity and liability holdings diversifications and other relevant policy measures. In addition, the paper will examine whether the APRA’s policies have been successfully followed by NAB and BOQ. Liquidity risks analysis The greatest concern for depositors, creditors as well as the investors is in the banks’ ability to deliver the promised investment return while being able to pay the principle. As such, there is need to analyze the banks liquidity in a bid to ensure that the ideal liquidity levels are maintained thus guaranteeing this groups the safety of their monies. In this paper, I analyze National Australia Bank and Bank of Queensland in a bid to compare their liquidity levels. This will help one in making decisions regarding the bank with better liquidity policies and hence better able to meet its obligations to investors, creditors and depositors. Analysis of maturity mismatch Maturity mismatch refers to a situation where the bank has mismatched its balance sheet because it has more current/short-term liabilities Vis a Vis its short term assets. The situation also arises when the bank has more assets compared to its liabilities for meeting its long-term and medium term obligations. By analyzing the changes in the banks maturity profile, we can gauge the banks liquidity and hence ability to borrow. It should be noted that a banks propensity to meet its current obligations depends on whether the banks’ balance sheet is showing relatively equal levels of current assets and current liabilities (RBA, 2015). The table below has been used to analyze maturity mismatch for the two banks. NAB Percentage BOQ Percentage Short term assets $688,759,000,000 53.01% $45,891,100,000 55.45% Short term liabilities $610,478,000,000 46.99% $36,862,600,000 44.55% Total $1,299,237,000 100% $82,753,700,000 100% The analysis above reveals that both the banks have greater current assets than their current liabilities. This means that there is a mismatch in both of their balance sheets. Bank of Queensland has its short term assets at 55.45% while its current liabilities are 45.55%. Its current assets percentage is greater than those of National Australia Bank which has its current assets at 53.01% while its current liabilities are 46.99%. the implication of this is that BOQ has a greater potential or ability to meet its short term financial obligations using its assets when compared to NAB meaning that BOQ is the more liquid bank. Analysis of loans to deposit ratio The loan to deposit ratio also indicates maturity mismatch through examining whether the bank’s total loans are able to meet all its total deposits. Note that banks loans are part of its assets while deposits are part of its liabilities. The following table shows the banks’ loan to deposit (LTD) ratio NAB BOQ 0.913 1.06 In the above figure, it has been shown that NAB advanced less loans than the deposits it made. On the other hand, BOQ made a greater amount of loans than the deposits it made. Therefore, despite BOQ having less amounts of both deposits and loans in comparison to NAB, it had a greater LTD ratio than BOQ (Hagel, 2011). The implication of this is that BOQ has a greater propensity to meet its obligations to depositors, investors and depositors than NAB which is less liquid. Liquid Holdings In their bid to ensure their smooth running of day to day operations while still performing their financial obligations, banks should strive to have adequate liquid assets. Thus, banks capacity for covering their current liabilities using the current liabilities can be measured using its working capital as an indicator of liquidity. The banks liquidity is therefore indicated by the excess of its current assets above its current liabilities. The following table compares the banks working capital; NAB BOQ $78,281,000,000 $9,028,500,000 The above analysis has shown that NAB has more working capital when compared to BOQ. This means that NAB has a greater ability of running its day to day operations through the use of these liquid assets when compared to BOQ which on the other hand may be forced to run some of its normal operations using its current liabilities meaning that NAB is the more liquid bank (APRA,2000). Quick Ratio We can also measure a bank’s liquid holdings through the use of quick ratio which tells us about the ability of the bank to pay its current liabilities using its more liquid assets or current assets. The following table compared the two banks in terms of quick ratio. NAB BOQ 1.128 1.245 The results above indicate that BOQ’s quick ratio is far much greater than that of BOQ. This means that BOQ is in a better position to pay up its financial obligations by utilizing its highly liquid assets. On the other hand, NAB is exposed to greater amounts of risk as far as liquidity is concerned when compared to BOQ owing to its smaller quick ratio. How the banks have diversified their liabilities One of the APRA’s policies is that banks make use of diverse finance sources in funding their capital needs in a bid to minimize their levels of liquidity risk. As such, banks ought not to rely on a single source of financing owing to its potential to expose them to severe effects should the capital source be affected by an unfavorable event (Johansen, 2013). By spreading their liabilities into diverse capital sources, banks will face less risk which is a good step towards liquidity risk management. The diversification of liabilities by the banks is analyzed below. Liability type NAB Percentage BOQ Percentage Due to other institutions 45,204 5.41% 207.5 0.48% Deposits 476,208 57.0% 35,935.8 82.49% Derivative financial liabilities 55858 6.69% 248.7 0.57% Accounts payable 399.1 0.92% Current tax liabilities 729 0.09% 71.5 0.16% Provisions 2,914 0.34% 104.1 0.29% Insurance policy liabilities 71,701 8.58% 63.0 0.14% Borrowings including subordinated notes 118,165 14.14% 6,534.4 15% Amounts due to controlled entities Other financial liabilities at fair value 28,973 3.45% Hedging derivatives 3,445 0.41% Liabilities on acceptances 61 0.01% Other debt issues 4,686 0.56% Defined benefit superannuation plan liabilities 12 0.00% External unit holders liabilities 14,123 1.69% Other liabilities 13,314 1.59% Total 835,393 100% 43,564 100% From the comparison above, it is clear that the majority of the two banks’ funding is in terms of deposits. The second biggest sources of finance include borrowings including subordinated notes for both banks which composed 14.14% in NAB and 15% in BOQ. NAB’s 57% of financing is from deposits compared to 82% for BOQ. Furthermore, NAB has more sources of financing or liabilities in comparison to BOQ. This implies that NAB’s liquidity risk is more diversified than BOQ. Comparing the banks’ access to wholesale markets Managing liquidity risk could also be approached from using wholesale funds form governments and other financial institutions. These funds are important since they attract low interest rates despite the long period required for their repayment. The funds also have high level of accessibility to the banks. NAB ($million) 118,165 BOQ ($million) 6,534.4 As can be seen above, NAB has more wholesale funding when compared to BOQ. NA’s source of wholesale funding are also more diversified as they come from more sources when compared to those of BOQ (APRA, 2008). The increased wholesale funding for NAB are largely attributed to its more global face compared to BOQ implying that it is able to access wholesale funding from more sources than BOQ. As such, NAB can be said to be more liquid as it is able to use wholesale funds in meeting its liability obligations. Comparison in regard to foreign currency and other markets The dynamic nature of exchange rates in various markets or countries exposes banks to significant liquidity risk. As such, banks have to put in measures of dealing with such exposure to risk. Such measures include investment in a variety of financial derivatives which are useful in hedging against the banks’ exposure to such risk owing to their dealing with various currencies as well as operating in foreign markets. As can be seen below, both NAB and BOQ have taken adequate measures in guarding themselves against such risks. NAB being a largely international bank makes use of various measures to caution itself against the foreign currency risk. The bank for instance has a substantial investment in a number of derivatives types for the purpose of hedging against its exposure to foreign exchange risks. In this regard, the bank is adequately protected from foreign currency and exchange risks resulting from its borrowing capital from foreign sources as well as serving customers who do foreign transactions and hence use foreign currency as well as the fact that the bank also has some foreign operations. BOQ though being a relatively smaller bank in comparison to NAB both in terms of capital size as well as foreign markets exposure also finds itself exposed to foreign exchange risks to a great extent arising from the nature of its operations. The bank hence has taken some measures to guard itself against such risks. The bank uses cross currency swaps and foreign exchange forwards in hedging its exchange rate exposures that arise from off-shore borrowing in foreign currencies (Banks, E2014). The bank also makes use of forward foreign exchange contracts in hedging potential exchange rate exposures arising from customer originated foreign currency. Its investment in New Zealand is hedged from potential exchange rate exposures arising from its net assets through forward foreign exchange contracts. Comparison of banks liquid assets portfolios BOQ maintains a high quality diversified liquid asset portfolio in a bid to support regulatory as well as internal requirements. The bank’s total liquidity portfolio was $6.4 billion which was substantially above the bank’s short-term funding levels and hence provided material buffer in case of market dislocation. In addition, the bank held $2.4 billion of internal securitization capacity that is eligible or repurchases arrangements with the Reserve Bank of Australia as a source of contingent liquidity in case of a crisis. The bank thus considers such a liquidity portfolio as adequate to guard it against liquidity risk. On the other hand, NAB maintains a well-diversified and high quality liquid asset portfolio in a bid to support regulatory and internal requirements in the countries where it operates. The bank held a total liquid assets portfolio of $117,279 million in 2014 (RBA, 2015). The bank also held $104,126 Million of regulatory liquid assets as well as internal securitization pools of residential mortgage backed securities of $34,418 as a contingent liquidity source. Arising from the analysis, it is clear that NAB holds greater liquid asset portfolio when compared to BOQ. This indicates a bigger intragroup liquidity than that of BOQ. Hence, it can be concluded that BOQ is exposed to less intragroup liquidity risk in comparison to NAB. Industry Liquidity Support Arrangements When banks are faced with huge liquidity problems, the situation affects the liquidity of companies in their industry negatively. As such, the government through the reserve bank of Australia (RBA) and the Australian prudential authority (APRA) play a key role in providing liquidity support to banks as well as other financial institutions likely to be faced with high levels of liquidity risk. Both NAB and BOQ could therefore borrow from the reserve bank in case they experienced liquidity risk of a high magnitude that cannot be addressed by applying the various strategies analyzed above. It is worth noting however that the RBA will only act as a bank of last resort for all banks and as such it only lends when the liquidity problems faced by the bank are likely to adversely affect the interests of majority of its stakeholders including other financial institutions. On the other hand, APRA does support banks before they are exposed to big liquidity problems through ensuring that its issued liquidity management policies are complied with by the banks and other financial institutions (APRA, 2000). For instance, APRA requires banks to form internal liquidity policies as well as control systems that adhere to its policies. The banks are also required to ensure that their top management be responsible for ensuring that their banks are implementing internal policies that strictly are in line to APRA’s rules and guidelines regarding their liquidity. Conclusion From the analysis above, both the banks are seen to have greatly complied with the policy guidelines laid down by APRA with regards to maturity mismatch, diversification of liabilities and liquidity asset portfolios among other APRA guidelines. The banks however have different levels of liquidity with NAB having greater levels of liability in comparison to BOQ. NAB has also been noted to have diversified its liabilities at a greater scale than BOQ. This is an indication of potential to deal with liquidity risk better than BOQ. It is however worth noting that both the banks have put adequate measures to deal with liquidity risks. With exception of the fact that BOQ needs to further diversify its liabilities owing to the fact that most of its liabilities are deposits, the two banks can be said to be adequately prepared against liquidity risk. This they have done in line with APRA’s guidelines and adherence to RBA’s liquidity asset portfolio requirements. \References: Bank for International Settlements, 2008, Basel Committee on Banking: Principles for Sound Liquidity Risk Management and Supervision, Retrieved on 30th April 2015, from; http://www.bis.org/publ/bcbs144.pdf RBA, 2015, Reserve Bank of Australia, Retrieved May 19, 2014, from http://www.rba.gov.au/ Hagel, Z2011, Liquidity risk management in banks, London, Rutledge. 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 Johansen, M2013, The liquidity reserve funding and management strategies, New York, Taylor & Francis. APRA, 2015, Australian Prudential Regulation Authority. Retrieved September, 12, 2014, from http://www.apra.gov.au/Pages/default.aspx. Banks, E2014, Liquidity risk: Managing funding, and asset risk. London: Palgrave Macmillan Read More