Bank financial management - Essay Example

? BANK FINANCIAL MANAGEMENT Table of Contents Introduction 3 Assessing the Financial Position of European & US Banks during the Period 2002-07 4 Conclusion 6 References 8 Introduction The financial health of a bank can be evaluated from the information that is derived from its financial statements. By analysing the financial statements, that is, the balance sheet, income statements, and the cash flow statements, the risk associated with the assets of the bank can be understood up to a certain extent. The risk is defined as the variation of actual return from expected return. But the word ‘expected’ differs from one individual to another because different people have different appetite for risk taking propensity. While some considers the commodities and equity market as one of the riskiest assets for an investor to put his or her money, the riskiness of a bank is defined differently. The financial statement of a bank reflects the true picture of its assets and liabilities at a particular point of time for a particular period. The balance sheet of a bank shows the total assets owned by the bank and the total liabilities owed by the bank, on a given date. Different countries have different capital adequacy ratio and guidelines that help the banks to maintain adequate capital to protect the bank from defaulting. The global financial crisis that affected almost all the economies, directly or indirectly, changed the perception of risk in the multinational banks all over the world. The Basal committee on banking supervision which was established by the central bank authorities of ten countries encourages common standard and common capital adequacy requirements for its members to ensure investor protection of funds. Assessing the Financial Position of European & US Banks during the Period 2002-07 A bank is considered as one of the safest place for putting money when compared to other investments instruments like equities or corporate debt instruments, derivatives, hybrid instruments, etc. However, the perception of many people around the world has changed with time. If banks has inadequate capital base, it will need third party assistance to infuse capital which will increase borrowing cost and risk. Consider an example, and investor has the option to invest in Bank A, operating in US, or in Bank B, operating in Germany. Moreover, the rate of return from both the bank is same, say 5%. So, in this case, how does an investor decide in which bank he or she should park money? One way to answer this question is to ascertain the risk of default for both the banks, since the given expected return is same. To determine the riskiness of default, an individual or corporate need to assess the financial statement of both the banks. Key variables like the total assets, loans, deposits and short term funding, equity, net interest margin, liquidity, profit before tax, operating income, fee and commissions, loans to total asset ratio, interest coverage ratio, profitability ratio, etc. are used to evaluate the financial health of the banks (Selvavinayagam, 1995, pp.11-32). From the given data, if we analyse the performance of the European banks with US banks on the basis of Net Interest Margin, their efficiency can be assessed. To analyse the given data, we first concentrate on the NIM of commercial banks from the year 2002 to 2007. The net interest margin or NIM is defined as the difference between the interest income and the interest paid by the banks relative to other assets. This is similar to the gross profit margin of the non-financial institutions (Maudos & Guevara, 2002, pp.18-19). Higher values mean that the banks are earning higher spread between the interest receivable on loans given out and the interest payable on the loans taken. The average Net Interest Margin for the U.S. from 2002-07 is above 3.00% compared to the European bank of is 2.9931%. Thus, keeping other things constant, on the basis of NIM, the US banks are marginally more efficient compared to the European banks during 2002-07. Similarly, in order to get a meaningful conclusion we must also observe the other important variables too. The average total asset of the US commercial banks in million USD is $ 11612.12 million for the period 2002-07 which is higher than European banks. Although, this may seem favourable for the US banks but this was mainly due to the housing bubble of US which led to the Global financial crisis. A significant portion of total Asset included sub-prime mortgage loans which were considered as one of the major causes of the crisis. Keeping other things constant, it appears that the US banks have higher assets compared to major European banks. But, one should not underestimate the riskiness of defaulting. The higher the loans given out, the higher would be the monitoring cost of ensuring timely repayments of interests. Along with that the banks will also have to ensure that the principal will be recovered in time. If this does not happen, then the banks’ non-performing assets will increase and some of them might turn into bad debts. This means that the banks will have to keep higher provisions for bad debts which will squeeze their bottom line. There are various accounting standards practised by the banks across the world that allows them to present their financial statements on the estimated revenues and expenses. These accounting standards also give them ample opportunity to conceal some facts that may compel the investor to withdraw money if truth is found out. For example, by the concept of window dressing, a bank might not disclose true facts to investors about the riskiness of investment. The ratio of Loan loss provision to interest actually received reflects the bank’s ability to cover its losses due to bad loans with interest earned. A very high value is considered as risky while a moderate value is acceptable. Among 11,664 US commercial banks, the average ratio of Loan loss Provision to Net interest Receivable is 13.58 while for 16,819 European banks, the average value is 15.55 during the period 2002-07. This implies that the European banks are riskier from their US counterparts because of their lower interest income to cover losses of bad loans. Another indicator to assess the riskiness of bank is the ratio of Net-Loans to total Asset. It helps to understand that what proportion of total asset is taken by the loans (Heider & Inderst, 2012, pp.2-3). The average value for 17863 European banks is 58.26 while the same for 12569 US commercial banks is 57.573 during the same period 2002-07, which is almost at par with their counterparts. This implies that the loans take up a significant portion of total asset which could turn bad if the credit worthiness of the investor is not judged before giving out loans to customers. The banks generally perform Credit Appraisal before giving any loans or advances to individual or corporate. The credit risk arises due to non repayment of interest and loans. In order to ascertain the riskiness of giving credit to customers, it is a better option to assess the customers’ financial viability to pay interest and repayment of the principal on time or before maturity (Vossen & Ness, 2010, pp.2-3). Conclusion One of the most important variables to assess the riskiness of bank is its liquidity management or the working capital management. The working capital is the difference between the current asset and current liability that is used to fund the day to day operations. The bank finances its working capital by investing in short term securities and treasury bills (Luckett, 1980, p.14). During the period 2002-07, the average deposits and short term funding in 12674 US banks is USD 6935.47 million while the same for 17956 European bank of is USD 5479.28 million. Thus, the values indicate that the US banks invested about 21% higher than the European banks during the period to finance their short term capital requirements (Srinivasan & Gupta, 2007, p.3). It means the working capital requirement of the former is higher. The risk of putting money in the banks is also related to the total loans given out by the bank to its customers. During the period 2002-07, the average loan given out by 17,863 European commercial banks was USD 4509.719 million, with an average total Asset amount of USD 8902.85 million. For the same period, the total loan of 12,569 US commercial banks was USD 5827.32 million, with an average total asset of USD 11,605.97 million. Thus the ratio of Loans to total asset of European bank was slightly higher than their US counterpart. Now, during analysis of small magnitude these slight differences may not matter. But when the amount involved is huge, as in this case, an average value gives an idea of overall performance. Thus, it can be inferred that during the period 2002-07, the European banks were slightly riskier than the US banks. References Vossen, B. & Ness, R. 2010. Bank Liquidity Management. [Pdf]. Available at: http://www.albany.edu/van_der_Vossen_Thesis.pdf. [Accessed on February 13, 2013]. Srinivasan, K. & Gupta, V. 2007. Liquidity Management in Banks – An increasingly complex affair. [Pdf]. Available at: http://www.icra.in/Files/Articles/2007-February-LiquidityMgmtinBanks.pdf. [Accessed on February 13, 2013]. Luckett, D. 1980. Approaches to Bank Liquidity Management. [Pdf]. Available at: http://www.kansascityfed.org/PUBLICAT/ECONREV/econrevarchive/1980/1q80luck.pdf. [Accessed on February 13, 2013]. Maudos, J. & Guevara, J. 2002. FACTORS EXPLAINING THE INTEREST MARGIN IN THE BANKING SECTORS OF THE EUROPEAN UNION. [Pdf]. Available at: http://www.uv.es/maudosj/publicaciones/JBF.pdf. [Accessed on February 13, 2013]. Heider, F. & Inderst, R. 2012. Loan Prospecting. [Pdf]. Available at: http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1439.pdf. [Accessed on February 13, 2013]. Selvavinayagam, K. 1995. FINANCIAL ANALYSIS OF BANKING INSTITUTIONS. [Pdf]. Available at: ftp://ftp.fao.org/docrep/fao/007/ae362e/ae362e00.pdf. [Accessed on February 13, 2013]. Read More