Understanding International Bank Risk / Edition 1

by Andrew Fight

Overview

In an era of globalisation, syndicated lending and consolidation within the banking industry, virtually all industries will have international dealings, whether directly or indirectly, and will therefore be exposed to consequential risks. An understanding of international risk, from that of bank of country failure to the idiosyncrasies of different regulatory frameworks, is essential for the modern banker. This book gives the reader a thorough understanding of how to calculate, analyse and manage such risks.

Product Details

ISBN-13:	9780470847688
Publisher:	Wiley
Publication date:	02/13/2004
Series:	The Wiley Finance Series , #258
Pages:	248
Product dimensions:	6.87(w) x 10.14(h) x 0.78(d)

About the Author

ANDREW FIGHT provides financial training and consulting services in the areas of Financial Analysis, Commercial, Syndicated, and Project Finance Lending, Asset Liability Management, Credit Risk Management, and Problem Loan Management.
He has over 15 years of experience in international banking and financial analysis gained in Paris and London with Chase Manhattan Bank, IBCA Rating Agency, Euromoney Training, and the French Banker's Training Institute.
He is a financial trainer and consultant to several banks, central banks, and IT companies, and a successful author, having written over 15 books on financial analysis, banking risk analysis, credit risk management, credit rating agencies, and information technology in financial services.
He divides his time between London, where he works, and his home in the South of France.

Read an Excerpt

Understanding International Bank Risk

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By Andrew Fight

John Wiley & Sons

ISBN: 0-470-84768-9

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Chapter One

The Banking Background

When equipped with trustworthy, up-to-date, and independent information on a company and its competitors, investors, whether professional or amateur, can choose stocks wisely. But without sound information or, even worse, with misleading information, they may as well go gambling.

1.1 DIFFERENT TYPES OF BANKS AND THEIR RISK PROFILE

1.1.1 Bank failure and the financial services community

Bank of Credit and Commerce International, Continental Illinois, Crédit Lyonnais, RUMASA, Barings. Major bank failures years in the making. Yet all were surprises when they occurred. Why?

The list of banking collapses and losses seems to be endless, and endlessly entertaining. How is it that the most heavily regulated of industries seems to provide us with a steady stream of highly entertaining and edifying stories in which record amounts of monies are lost and bankruptcies occur?

How is it that a galaxy of economic gurus from academia and business, CEOs with their legions of disciples, accountants, bankers, and consultants, regulated by governments and transnational entities, seem not only to get it wrong, but massively wrong, and so often?

Can this be attributed simply to the fact that the business environment is ridden by incompetence and greed? Or is the state of the industry more complex than these mere generalisations?

The fact is, that individually, all experts and parties agree on the risks and pitfalls which characterise the liberal economic model (which resides on apparently ineffective structures attempting to regulate the twin pillars of human nature and greed), which presents itself as the universal panacea and most perfect system of allocating resources ever devised by mankind.

Individually. All the players, of course, are in on the secret.

The secret is that these "failures" are indeed not "failures" but rather the manifestation of various players interacting on a tableau of greed and chaos, and that when the balloon bursts, scandal and outrage ensue. Fall guys are left holding the bag. Mea culpas are made. A few sacrificial lambs are thrown in the fire to give the illusion that the system is self-cleansing. At the end of the day, however, the exercise is highly profitable for the few that have the intuition or connections to pull their chestnuts out of the fire before it is too late. Consider the quote in Box 1.1.

Collectively, things assume a momentum of their own, as varying individuals and parties, with interests and agendas of their own, collide in the wonderfully speculative, volatile, and chaotic free for all game which is our economic system. In order to protect oneself in a zero sum game, whose short-term focus means that resources are merely reallocated rather than created, parties will act to further their own interests at the expense of overall economic performance and rationality.

Banks of course are the indispensable intermediaries in the game and their role and the risks attending them will form the focus of this book.

This book will endeavour to explore the underlying nature of the industry, regulatory environment, and analytical techniques in vogue to try to answer some of the questions underlying the basic question of bank and country risk. For the truth of the matter is that the industry is comprised of several players with differing agendas and the occasional hiccups manifested by the industry are merely the logical outcome of their interactions.

In other words, the problems are not due to the specific personal characteristics, honesty or competence of individuals, they are the manifestation of those most basic of human characteristics - greed and fear - and how individuals with those characteristics interact within their structures as well as with the regulatory system.

The problems are also the manifestation of another human characteristic - creativity. Creativity at the service of the incessant and ongoing quest to circumvent rules (created by compromise, allegedly designed to minimise the volatile excesses and risks inherent in the financial services arena), and generate quick profits.

1.1.2 What do banks do? How do they earn their money?

Let us begin with basic questions. What are banks? What do banks do? How do they earn their money?

Banks, as with all business enterprises, establish goals and make the decisions necessary to achieve those goals. Banks, however, have specificity in that they do not actually manufacture tangible goods but rather are in the role of intermediaries and manage abstract resources (more commonly known as "money"). The management and processing of these abstract resources moreover bears some resemblance to the processing and transferring of information. This has important implications in an era in which information technology not only accelerates transaction cycles but also enables the processing of information crucial to the ongoing management of a bank's operations (e.g. asset liability management, capitalisation, and customer centric database systems).

Implementation of the Basle capitalisation directives means that the unspoken goal of banks (those that can, that is) is to make money by collecting fees as deal originators as well as operating as intermediaries in the money markets (arrangers as well as lenders of monies).

The ability to integrate information systems in order to provide a seamless one-stop shop to major corporate clients is increasingly becoming the key differentiator in building market positioning. Hence, the issues of economies of scale and the wave of mergers witnessed. To illustrate, the present day JP Morgan Chase is the amalgam of four venerable New York banks - Manufacturer's Hanover, which was taken over by Chemical Bank, which in turn took over Chase Manhattan (and adopted the more upmarket name in the process), which in turn merged with JP Morgan). This quest to increase economies of scale, however, has other negative ramifications which we shall cover later.

Despite the high school soporifics of Economics 101 and buzzwords referring to "multiple providers" and "perfect competition", the industry, at least in European countries where the major retail banks are rarely more than a half-dozen, is basically exhibiting some of the characteristics of an oligopoly, and has witnessed increasing consolidation and elimination of marginal players.

This trend has been welcomed and fostered by governments and their regulatory bodies, as part of the current ideological movement which originated during the Reagan-Thatcher era as an antidote designed to dismantle the Keynesian economic model which came into existence during the administration of Franklin Roosevelt. The heart of the current "Globalisation" agenda, which is the dismantling of the "New Deal", the exorcising of Woodrow Wilson, and the building of a New World Order akin to the mercantile model pre 1914, except it's wired and interconnected.

This poses two dilemmas.

The first is ideological: the increasing concentration and oligopolisation of the business is a very negation of the basic principles of capitalism and competition, where buyers ostensibly enforce discipline on the market by selecting the most efficient or best product and eschewing the uncompetitive one. It is the erection of an oligopoly or monopoly structure designed to ensure that the providers can dictate their own prices and conditions, and stamp out any potential entrants or competitors threatening not their existence, but their ability to dictate the terms of the market. In the words of investment banker Felix Rohatyn, it is a "betrayal of capitalism".

The second is a practical one: with the weeding out of several players, risk becomes increasingly concentrated and the economic system increasingly vulnerable and volatile. To take an example, consider the syndicated loan. This has traditionally been a vehicle to raise large amounts of funds to lend to major corporates. A large loan will be underwritten by one or two banks and parcelled out to some say 20 banks, which results in reducing the loan into digestible chunks, as well as in dissipating the risk among the participating institutions. In the New York example, however, where in the past you had four banks able to assume the risk (or provide varying services and lending policies to the corporate borrower), you now have only one. Moreover, due to the onset of capitalisation ratios limiting a bank's level of exposures, the larger entity does not necessarily take a proportionally larger commitment. This means that risk becomes more concentrated and the number of players reduced, thereby increasing the possibility of volatility and confidence sensitivity in the markets.

This reduction in the number of players in the market and increasing concentration of risk mean that the market increasingly assumes the characteristics of an oligopoly.

The New York example is similarly paralleled by Citicorp merging with Travellers Corp., Bank of America merging with NCNB, HSBC taking over Midland Bank, BNP merging with Paribas, Crédit Agricole merging with Banque Indosuez, the spate of bank mergers in Scandinavia, the merging of three Japanese banks into the Mizuho leviathan, etc.

The industry is increasingly assuming the attributes of a one entity state monopoly provider (a criticism oft levelled at the defunct Soviet Union by disciples of "free trade") except that they are not accountable to any government or indeed effective regulation as the spate of financial scandals witnessed in 2002 testifies. They are increasingly becoming de facto if not de jure arbiters of the system, in no small part due to their ability to channel funds into the political process. And they are fostering the increasing concentration of risk.

Rather than have some 50 banks, of which say 10 may lend to an entity such as Enron, you now have three leviathans, all queuing up to fill up at the Enron trough (with resultant concentration of risk), and the economic system collectively getting a massive case of indigestion when the house of cards collapses (except for the loan officers who cashed in their bonuses for "booking assets").

These esoteric arguments, however, do not even figure on the bank CEO's radar screen - they have their own agenda to gain "critical mass" to browbeat the competition, and have a horde of share analysts badgering them for ever rising quarterly dividends, eager to pounce on the CEO for the slightest hiccup in forecasted results. The CEO will naturally be more preoccupied with these more immediate concerns (to his job safety) rather than the more esoteric questions of economic philosophy.

For most banks, the public message is that they exist to "ensure the safety of their depositors' funds and to maximise the value of the organisation to its shareholders". For publicly traded banks, this means maximising the return on and market value of its publicly traded stock. For banks that are not publicly traded, the usual yardstick for performance is its performance in achieving profitability and controlling risk.

It is important, however, not to confuse prudent management theories with reality. The excerpt in Box 1.2 from a New York Times article on the Enron shenanigans and bogus posting of loans by Citigroup provides a useful contrast.

Regarding the safety of depositors' funds, it seems akin to asking one to believe in fairy tales when reading about real life bank failures (see Section 1.3 on the "four aces").

Indeed one can recall four major cases of excessive risk taking by banks in the last 20 years:

The massive lending to LDC (lesser developed countries) in the 1970s as a way of recycling the glut of petrodollars arising after the 1973 Yom Kippur war and OPEC oil boycott

The mergers and acquisitions and leveraged buyout fever of the 1980s

The boom and bust in property lending in the late 1980s/early 1990s (Canary Wharf, La Défence)

The emerging market speculative ventures which came undone in the volatile 1990 markets (Asian crisis/Barings)

Ultimately the players all know that in the event of bankruptcy, the "flyover people" will foot the bill as they did in the Reagan era savings and loan crisis bailout. Who are the "flyover people"? Those folks that one flies over when to-ing and fro-ing from New York to Los Angeles.

Still, within the game, there are certain conventions and accepted methodologies used to assess banks.

We shall consider the accepted methodology of analysing these banks with their sophisticated regulations, structures, financial statements, mathematics, and some of their shortcomings, and how common sense can significantly supplement the efficacy of that analysis.

Despite failure, the tools are effective. Acting on the information provided by analysis, however, is another matter, and is beyond the scope of this book.

1.1.3 Different types of banks and their revenue structures

It is helpful to begin first by considering the fundamental question of what characterises a bank. Basic definitions soon become inadequate, as banks are highly varied in the type of business they do, the types of revenues they generate, and the types of risks they assume in their ongoing operations.

There are several different types of banks and financial institutions. Some may be hybrids and others may be entities specialising in a particular operational niche.

These characteristics obviously affect a bank's risk profile and the risk analysis to be undertaken.

Risk (and return) occurs through financial and non-financial decisions, as well as operational and loan portfolio development strategies. The risks arise from the bank's operations and are all interrelated. We will examine these risks later in the book.

Banks differ widely in the composition of their activities, and can differ widely in culture due to their historical development. Merchant banks (or investment banks) differ considerably from other types of banks such as agricultural banks or cooperative banks. The differences in culture immediately become apparent in a merger, such as the merger of Crédit Agricole, initially an agricultural cooperative bank, with Banque Indosuez, a merchant bank with a colonial heritage.

While to an outsider, banks may appear to be only in the business of taking and lending money and issuing credit cards, this view is only skin deep.

Continues...

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Table of Contents

Foreword ix

About the Author xi

1 The Banking Background 1

1.1 Different types of banks and their risk profile 1

1.1.1 Bank failure and the financial services community 1

1.1.2 What do banks do? How do they earn their money? 3

1.1.3 Different types of banks and their revenue structures 6

1.1.4 Commercial banks 7

1.1.5 Investment banks 10

1.1.6 Risk profile of investment banks 13

1.1.7 Broking is a competitive business 13

1.1.8 Derivatives trading and AAA subsidiaries 13

1.1.9 The regulation of investment banks 14

1.1.10 “Analyst of the year” awards 14

1.2 Primary causes of bank failure 16

1.2.1 Types of failures 17

1.2.2 Causes of losses 18

1.2.3 Warning signals in predicting bank failure 24

1.2.4 Rescuing the bank! 28

1.2.5 Credit rating agencies 30

1.3 Bank failures – the four aces 31

1.3.1 Bank of Credit and Commerce International 31

1.3.2 Continental Illinois 34

1.3.3 Crédit Lyonnais 36

1.3.4 Rumasa 39

1.4 The macroeconomic environment 41

1.4.1 Banking system and industry risks 41

1.4.2 Economic environment 43

1.4.3 Industry competition and its impact on banks 43

1.4.4 Technology 44

2 The Rating Framework 45

2.1 What is a rating? 45

2.2 The development of ratings 46

2.3 Background to rating agencies 46

2.3.1 Inconsistent initial foundations 48

2.3.2 Secretive deliberations 51

2.3.3 Main source of revenues 51

2.3.4 Generating value 53

2.3.5 Growth and the future 54

2.4 The rating analytical framework 56

2.4.1 CAMEL, CAMEL B-COM, and CAMELOT 58

2.4.2 Capital 59

2.4.3 Asset quality 60

2.4.4 Management 62

2.4.5 Earnings 64

2.4.6 Liquidity (liability management) 64

2.5 How the rating agencies analyse bank risk 65

2.5.1 What is a rating? 65

2.5.2 Rating scale comparisons 66

2.5.3 Standard & Poor’s ratings 66

2.5.4 Moody’s ratings 68

2.5.5 Fitch performance and legal ratings 69

3 The Regulatory Framework 73

3.1 Banking system: structure, governing law, and regulations 73

3.1.1 Banking supervision 75

3.2 Core principles for effective banking supervision 78

3.2.1 Core principles for effective banking supervision 78

3.2.2 Basel committee publications No. 30 (September 1997) on banking principles 80

3.3 Risk management 83

3.3.1 Generally accepted risk principles 83

3.3.2 Derivatives and market risk 84

3.3.3 Managing bank limits 86

3.3.4 Generally accepted risk principles risk map 87

3.4 Basle Capital Adequacy and international convergence 88

3.4.1 Background to the Basle Capital Adequacy regime 88

3.4.2 Pressures for change 89

3.4.3 The BIS paper: the response of the central banks 90

3.4.4 Foreign exchange and interest rate related exposure 93

3.4.5 Implementation 95

3.4.6 Impact of the BIS proposals 95

4 The Analytical Framework 97

4.1 Introduction 97

4.1.1 The specific nature of bank financial analysis 97

4.1.2 Sources of information on banks 98

4.1.3 Other sources of information 100

4.2 Financial criteria – the key factors 101

4.2.1 Financial statement analysis 101

4.2.2 Spreadsheet analysis 105

4.3 Understanding the bank’s balance sheet 107

4.3.1 Overview 107

4.3.2 Balance sheet 110

4.3.3 Assets 111

4.3.4 Liabilities 114

4.3.5 Contingent liabilities 117

4.3.6 Income statement 118

4.3.7 Financial analysis of investment banks 121

4.3.8 Risk profile of investment banks 125

5 Bankscope and Comparative Techniques 127

5.1 Bankscope spreadsheet analysis 127

5.2 Bankscope ratios and ratio analysis 130

5.2.1 Lines of the Bankscope global format 130

5.2.2 Financial ratio analysis 131

5.2.3 The Bankscope ratios 131

5.3 Bank peer group analysis 139

5.3.1 Analytical techniques 139

5.4 Problems with intercountry comparisons 141

5.4.1 Local vs international accounting standards 141

5.4.2 Inflation accounting 142

5.4.3 Creative accounting and ratio manipulation 143

6 Country and Political Risk 145

6.1 Country risk 145

6.1.1 Introduction to country risk 145

6.1.2 Definition of country risk 145

6.1.3 Types of countries 146

6.1.4 Country risk assessment 147

6.2 Political risk 148

6.2.1 Introduction to political risk 148

6.2.2 Time dimension 149

6.2.3 Political risk analysis methodologies 149

6.2.4 World Bank list of countries 150

6.3 Typical sovereign ratings process 151

6.3.1 Introduction 151

6.3.2 Political risk 152

6.3.3 Economic risk 154

6.3.4 S&P’s sovereign ratings profiles 160

6.3.5 Behind the sovereign ratings exercise 160

7 The World of E-finance 163

7.1 A quick definition of e-finance 163

7.2 CRM – Customer Relationship Management 164

7.3 STP/CLS 165

7.3.1 STP – Straight Through Processing 165

7.3.2 CLS – Continuous Linked Settlement 166

7.3.3 Establishment of Continuous Linked Settlement services 166

7.4 SWIFT 167

7.4.1 Background 167

7.5 Electronic funds transfer 169

7.6 Online banking 169

7.7 Day trading 169

7.8 Smart cards 170

7.9 Evolution of e-finance 172

7.10 Origin of e-finance and internet commerce 173

7.10.1 Rise Of e-finance and electronic trading 174

8 Conclusion 177

Glossary 179

Suggested Readings 201

Appendix I 203

Appendix II 209

Appendix III 217

Index 223