Understanding Myths About Bank Financials
The only real assets that a bank has are the amounts that shareholders invest, the buildings and computers the bank owns, and the retained earnings (i.e. cumulative profits made). These are no different than any other business.
However, since banks make money by loaning money, they also count the debt owed to them as an “asset” even though in the real world it is actually a liability from the perspective of the borrower. Arguably this is not an “asset” from the perspective of the bank either because there is a chance that the borrower might never repay the loan. Banks deal with this issue by assigning a probability of default to the loan based on the credit or the borrower and the collateral pledged for the loan.
So do banks only count the risk-wieghted value of these loans as “assets”? No! They are currently allowed to account for the whole loan amount as “assets”. Even if the loan has a 100% chance of not being repaid (i.e. an impaired loan), the amount loaned is still counted as an asset until the bank choses to write it off.
One of the missing pieces of bank regulation is proper accounting for the risk weighted assets of a bank. In the meantime, don’t be fooled into thinking that a bank is secure just because it has a huge “asset” base. In reality, all the size of an asset base means is the extent to which the bank is risking money.
Since it is no fun to be able to lend only the money you actually have, chartered banks are allowed to take in deposits and then use these deposits to create loans using other people’s money.
A deposit appears on the bank’s balance sheet as a liability because it owes that money to you as the depositor. Basically the bank is borrowing money from you, paying you interest for the money you deposit, and providing financial services such as cheque clearing, bank drafts, etc. to make it easier for you to handle your money with other people and businesses.
The neat accounting trick here is that even though your savings deposited into the bank are actually liabilities owed by the bank to you, banks turn these liabilities into “assets” because they are used to provide the funds for loans made using your money. For example, if you deposit $1000, the bank has a liability of $1000, but since the bank can loan out that $1000, it generates an “asset” of $1000 when it does so.
Some jurisdictions have regulations that require banks to reserve some percentage of deposits so that they have cash on hand for withdrawls. This is to prevent the classic scenario for a bank failure caused by a “run on the bank” = depositors asking for their money back faster than the bank can liquidate loans. The most recent example of this causing a bank failure occured in the UK in 2007.
The other missing piece of bank regulation are higher standards for liquidity. So don’t think that your deposits are safe just because it is in a bank that has a lot of assets. The reverse is actually true.
The Tier 1 capital ratio is the total amount of “assets” managed by the bank divided by the amount of money actually invested by shareholders in the bank plus the cumulative retained earnings made by the bank.
A ratio of more than 6% is considered good by international banking standards and a ratio of 8% or higher is considered “excellant”. Most Canadian banks crow about their high Tier 1 capital ratios of 9 – 10%.
Banks are allowed by law to lend up to 25x more than what is actually invested into the bank. If the Tier 1 ratio is 8%, then the banks actually owe 12.5x more money than is actually invested.
Historically, most of this leverage comes from lending out deposits, but more recently banks have found many ways to “generate assets” by securitizing loans (e.g. asset backed securities), creating derivative products, off-balance sheet asset swaps, and inter-bank wholesale lending.
Generated assets are even riskier than loan-based assets because the banks have proved that they have less and less ability to accurately assess the risk of default as these instruments get increasingly complex. Impairment of generated assets is one of the main causes of the current financial crisis.
Yet another missing piece of bank regulation are tighter controls on generated assets. For example, limiting the use to only those assets where the bank can reasonably assess risk and then only allow the risk-weighted value to be counted as an asset.
The banking industry uses a well-defined terminology of denial for admitting to credit losses:
- High Risk Loans (HRL) = loans that have a probability of default that is higher than 6.5%. While this may not seem like a lot, refer to the Understanding Debt Ratings page to see that it means that this is C-grade debt that has a greater than 50% chance of default within 5 years. This is the Monty Python equivalent to “this parrot is not quite dead yet”. HRL is in addition to GIL and does not include those amounts.
- Gross Impared Loans (GIL) = non-performing loans that the bank will have to either write off or sell off at a discount to a debt collector who will seize the collateral. This is the Monty Python equivalent to the “parrot is supposed to be blue, he’s a Norweign Blue Parrot”. GIL includes ACL amounts.
- Allocation for Credit Loss (ACL) = loans that the bank knows it will have to eventually write off but hasn’t done so yet. This is the Monty Python equivalent to the “parrot is just pining for the fijords”. ACL includes PCL amounts.
- Provision for Credit Loss (PCL) = loans that the bank has had to write off. This is the Monty Python equivalent to agreeing that the “parrot is dead”.
The most useless statistic in banking is the ratio PCL / Avg Assets. That ratio is commonly used by banks as a comforting measure of low loss rates as a percentage of total business. It is a myth because both PCL understates the loss exposure and Avg Assets overstates the true asset stability of the bank.
Another sorely missing piece of banking regulation is a requirement that banks report (HRL + GIL) / Risk-Weighted Assets. That statistic more accurately captures loan loss rate as a percent of total business.
Despite all the smoke around assets as the basis for stability, banks are just like any other business in that they are only as stable as their liquidity. If their cash flow dries up, the bank is just as insolvent as any other business.
The 2007 failure of Wachovia, is an excellent example of this. Immediately prior to its failure Wachovia had a 9% Tier 1 capital ratio and was the 3rd largest US bank by assets. Yet it failed in less than 90 days when its liquidity dried up due to problem loans.
Liquidity can be assessed by looking at the total of Economic Profit (the amount of cash coming in net of expenses), Retained Earnings (cash already in hand), emergency lines of credit (government or central bank lifelines), and equity market credit available (the ability to issue common & preferred shares). Do not count any amounts due from other banks, loans, etc., as these are all risky and may not be as readily callable as the bank would like.
Loss exposure can be assessed by looking at the total of HRL, GIL, generated assets, and all investment assets that are rated less than investment grade.
If the banks total loss exposure is greater than its total liquidity, the bank is not stable.
If the market capitalization (total shares issued x current price) of the bank is less than the shareholder equity (total amount invested in common and preferred shares), then the market knows that the bank is not stable and is saying that it is currently worth less than what shareholders invested into it.