Analysis of Banking Risks - Case Study Example

Analysis of Banking Risks Operation and Capital Risks Although operational risks may not have a greater impact on a bank’s risk profile, some unexpected events accruing from operations may jeopardize the activities of a bank and lead to an eventual collapse (Abreu and Markus, 2003). At the strategic level of every bank, calculation of exposure to capital risks leads to proper mechanism of management. In this case, extreme capital allocation system of calculation provides a clear viewpoint of assessing and calculating bank’s exposure to capital and operational risks (Caballero and Krishnamurthy, 2008). Operational risks may result to loss of billions of money and at some points render a bank bankrupt hence collapse. Therefore, operations a banking will need a clear framework to ensure holistic operations (Allen and Douglas, 2007). External operational risks may occur due to involvement of a rogue customer while internal operational risks results from internal processes and systems. Economic capital is the amount of equity a certain bank needs to have to absorb unexpected losses from risks already exposed to it. Determining the level of economic capital depends on shareholders expectations of adjusted risk returns accruing from their investments and regulator’s point of view on capital to ensure soundness in the financial market (Diamond, 2000). In most cases, several transactions in a bank results in too many gross income. This finally exposes the bank to greater operational risks. In most cases however, a bank may estimate the probability of distribution functions as well as frequent occurrence of losses in certain line and or risk. The bank may then compute the probability distribution function across the entire year across all operational risks. According to Klugman et al. (1998), Mirzai (2001) and Courage (2001), the model applied in insurance industry also applies to banking institutions in which case, a simple sum of all capital charges per every single business unit and risk gets summed up together. Liquidity Risks in Banking Industry According to journal of money investments, issue ten (2009), liquidity refers to several varied managerial parameters. Although liquefying most assets of a bank may not have serious implications on it operations, it at times may have negative impacts depending on the period between depositing and withdrawal. It also depends on the bank’s intentions to maintain a suitable equilibrium of financial inflows and outflows over a certain period. The journal further describes liquidity to refer to firm’s ability to change assets into cash without any unprecedented loss of capital or any penalty regarding interest. Liquidity risk therefore refers to the bank’s inability to have enough financial resources to allow it meet some obligations. The risks also comes in the event where a bank meets such obligations quite costly thus affecting its capital base. Risk of interest rates According to Schwanitz (1996), interest risks are those risks incurred when there is a reduction in the targeted net interest income because of constant changes in the interest rates of the market. However, this definition may seem too flawed to rely on. This is because the use of targeted income to measure net income comes with many risks as well. In a more broad and diverse way, interest risk is the risk of the possibility of failure to attain the targeted net income because of diverse changes in the market interest rates (Morris and Song, 2004). In contrast, banks may benefit largely in the event of favorable changes in the market rates pushing up interest rates thus increasing income. Changes in interest rates thus affect banks in different ways ranging from their earnings to the risks situations (Pascal, 2010). Economic and earning perspectives are the two most common perspectives with which bank’s exposure to interest rates affect the banks. The earning perspectives of the interest rate risks focus much on how the risk affects the near-term-earnings of a bank. Most evidently, the bank’s total earnings face large severity with poor interest rates as a bank will go at a loss (Seidman, 2013). The perspective of the economic value effect of interest rates has much focus on the effect of interest rates on the future cash flows. This means that a negative impact on the future cash flows affects the net economic value of a bank. Banking Ratio analysis Banking ratio is an analysis involving the evaluation financial condition in the present, past and the future (Hughes et al., 2009). The aim of ratio analysis seeks to consider the strengths and weaknesses of the bank in question. The tools used in ratio analysis include financial statements and comparison of the past and industry firms. Its main objective is for the purposes of ratio analysis is to evaluate current bank operations, compare its present performance to past performances, analyze the effectiveness and efficiency of operations, evaluate risk operations and standardize most financial information for the purposes of comparison. A clear ratio analysis therefore becomes useful in the evaluation of customer creditworthiness, evaluation of loan applications, analysis investment opportunities and evaluating potential merger candidates. It also helps in analyzing internal management control (Hanson, 2003). Ratio analyses are of different types. The main types of ratios include financial ration, valuation ratios and operation ratios. Financial ratios Liquidity ratios Barrnote bank liquidity ratio assesses the bank’s ability to encounter current obligations. Liquidity ratio has other sub ratios such as current ratio, quick ratio, and cash ratio. Current ratio involves the assessment of current assets and liabilities (Douglas and Raghuram, 2005). Current assets include cash, accounts receivable and inventory, and marketable securities. Current liabilities on the other hand include the bank’s accounts payable and debt due within one year. Current ratio is the ratio of current assets to current liabilities. Quick ratio is the ratio of current assets less inventory to current liabilities. It is hard to convert this ratio to cash (Mitchel et al., 2013). Leverage Ratios This ratio measures the extent to which the bank has enjoyed financing by debt. High ratio makes the acquisition of loan quite difficult (Diamond, 2000). Total debt ratio is the ratio of total debt to net assets of the bank. Debt-equity ratio on the other hand seeks to measure the bank’s extent to rely on debts. It is the ratio of total debt to net worth. Dynamics of Major Financial Ratios during the Financial Crisis Banks corporations in developed countries are chiefly blamed for precipitating, the great recession and other global economic downtrend in history (Claessens and Laeven, 2004). This assertion is supported by empirical financial theories, which traces the beginning of the great recession to the bankruptcy of globally distinguished banks corporations in Europe and US (Diamond, 2000). A typical example includes the collapse of JPMorgan Chase bank, which officially marked the beginning of the financial crisis in US and Europe. Other noticeable failures of the bank corporations, which earmarked the precipitate of the great recession includes the bankruptcy of European and US banks such as the Lehman Brothers and Bear and Stearns among other banks institutions (Altunbas, 2007). The collapse of these bank institutions is attributed to a number of financial factors which can be explained by examination of some of the banks’ financial ratios during this period. This report focuses of two banks which were significantly affected by the financial crisis, JPMorgan Chase Bank and Lehman Brothers Commercial Bank, with the objective of analyzing their financial performance ratios between 2007 and 2011 to their dynamics (Brunnermeier, 2008). JPMorgan Chase Bank National Association Return on Assets (ROA) indicates the profitability of a company relative to its total assets. A higher ROA indicates high efficiency in utilization of company assets to make profit (Eisenberg and Thomas, 2001). The ROA for JPMorgan Chase Bank started reducing as the financial crisis started in 2007/2008, in 2009 the bank recorded the lowest ROA in that period before it started improving again in 2010 and 2011 as the bank started stabilizing (Table 1). The implication is that the bank’s ability to utilize its assets well for profitability was affected by the crisis. Table 1: Financial Performance Ratios for JPMorgan Chase Bank (2007-2011)          Performance Ratios (% Annualized) 2007 2008 2009 2010 2011 Yield on earning assets 5.61 4.57 3.55 3.12 2.95 Cost of funding earning assets 3.40 2.06 0.74 0.51 0.54 Net interest margin 2.21 2.51 2.81 2.61 2.41 Noninterest income to assets 2.55 2.08 2.21 2.19 2.05 Noninterest expense to assets 2.77 2.43 2.61 3.03 2.94 Loan and lease loss provision to assets 0.35 1.08 1.34 0.59 0.31 Net operating income to assets 0.86 0.49 0.44 0.59 0.65 Return on assets (ROA) 0.86 0.68 0.50 0.73 0.71 Pretax return on assets 1.29 0.86 0.71 0.97 0.93 Return on equity (ROE) 10.70 8.99 6.52 9.23 9.84 Retained earnings to average equity (YTD only) 7.21 8.13 -5.25 -2.87 5.10 Source: Federal Deposit Insurance Corporation (2014) Chart 1 below illustrates the fluctuation of the ROA and ROE for JPMorgan during the crisis. Figure 1: JPMorgan Chase Bank ROA/ROE trends between 2007 and 2011 Return on Equity (ROE) is a ratio that indicates the profitability of a company through comparison of its net income to its average shareholder’s equity. This ratio generally measures the earnings of shareholders for their investment in the company during a particular period. As illustrated by table 1 and figure 1, the ROE for JPMorgan Chase bank behaved considerably similarly to the ROA. From 2007 to 2009 there was a negative trend in the ROE values from 10.7% to about 6.5%. After 2009, the ROE had a positive growth reaching just under 10% to coincide with the recovery of the bank after the crisis. As illustrated in Table 1, the yield on earning assets for the bank also recorded a downward trend from 2007 to 2011 as the bank suffered the impact of the financial crisis. The net operating income to assets also exhibited a similar trend with negative growth in the first two years of the crisis and positive growth from 2009 to 2011. These two statistics are combined in figure 2 below. Figure 2: JPMorgan Chase Bank Yield on Earning Assets/ Net Operating Income to Assets trends (2007-2011) Lehman Brothers Commercial Bank The ROA for Lehman Brothers Commercial Bank showed an interesting fluctuation during the financial crisis. In 2007 the value of ROA for the bank was relatively low at 1.49% before it collapsed sharply to a value of -12.02 in 2008 at the height of the crisis. The ROA then regained growth in 2009, the growth was significantly strong a year later with a value of about 5.355 (Table 2). However in 2011, the ROA for Lehman Brothers Commercial Bank experienced a negative shift again before the closure of the bank at the end of the year (Figure 3). Table 2: Financial Performance Rations for Lehman Brothers Commercial Bank (2007-2011)          Performance Ratios (% annualized) 2007 2008 2009 2010 2011 Yield on earning assets 7.55 5.27 2.34 1.87 1.42 Cost of funding earning assets 5.00 2.86 1.95 3.26 1.90 Net interest margin 2.54 2.41 0.39 -1.39 -0.48 Noninterest income to assets 0.42 -8.30 5.96 5.46 1.46 Noninterest expense to assets 0.13 6.36 4.08 -1.31 -0.34 Loan and lease loss provision to assets 0.00 0.00 0.02 -0.05 0 Net operating income to assets 1.49 -12.02 2.05 5.35 1.53 Return on assets (ROA) 1.49 -12.02 2.05 5.35 1.53 Pretax return on assets 2.49 -12.56 2.22 5.55 1.35 Return on equity (ROE) 10.45 -85.67 15.27 21.48 3.76 Retained earnings to average equity (YTD only) 10.5 -85.67 15.27 21.48 3.76 Source: Federal Deposit Insurance Corporation (2014) The fluctuations of the ROA indicate the instability that the bank faced during the crisis. While the huge negative value for ROA reveal a deep financial problem in 2008, the positive growth in the two years following that indicate positive efforts towards recovery and stabilization. Irrespective of the positive trend towards 2010, the bank went back into greater struggles a year later leading to a dip in the ROA and its eventual close down in 2011. Figure 3: Lehman Brothers Commercial Bank ROA between 2007 and 2011 The ROE results for Lehman Brothers Commercial Bank also display similar trends as the ROA. As illustrated in figure 4, there was a sharp decline in the bank’s ROE between 2007 and 2008 with the later year experiencing results of about -85% ROE. Figure 4: Lehman Brothers Commercial Bank ROE between 2007 and 2011 This implies that during the peak of the financial crisis in 2008, the return on equity for the company’s shareholders was negative due to heavy losses to the bank. Instead of the bank making return on equity, it was utilizing equity for survival and making losses. A sharp recovery was achieved in the ROE between 2009 and 2010 as illustrated in figure 4 but the recovery was short lived as the bank slumped back to poor performance and a lower ROE before its collapse in 2011. As Table 2 reveals, the yield on earning assets for the bank also recorded a downward trend from 2007 to 2011 as the bank suffered the impact of the financial crisis. The net operating income to assets exhibited a heavy negative growth in 2008 and positive growth from 2009 to 2010. The positive growth was negated again in 2011 as the bank struggled before its eventual close down. Figure 5 illustrates the trends in the two ratios. Figure 5: Lehman Brothers Commercial Bank Yield on Earning Assets and Net Operating Income on Assets between 2007 and 2011 Conclusion It is evident that banks face a lot of challenging situations in their quest to attain success. However, with a descriptive practical framework on how operations of a certain bank run, bank’s success is not a nightmare. Management of operational risk remains the first priority of every bank (Thompson and Strickland, 1996). This is because the risks mostly accrue from within the bank itself and therefore easy to control. Banks also need to remain competitive in order to maintain their market share. Banks remain competitive by adjusting and coping with the emerging trends of the market for better results. In doing so, banks maintain their market viability and relevance (Seidman, 2013). The two banks discussed in this paper were all heavily affected by the financial crisis of 2007/2008. As their financial ratios indicate, their performances went down during the crisis as illustrated by negative ROA and ROE growth. Of the two banks, Lehman Brothers was hit harder by the crisis with the values for its ROA and ROE registering negative digits, however the bank survived the crisis to register some growth mainly making use of the Fed’s Primary Dealer Credit Facility (MF, 2008). However, because of other strategic and market issues the bank encountered another slum in 2010 which led to its collapse a year later (Loutskina, 2011). The financial ratios show clearly what happened in that period although explanations can be derived by examining strategic information. On the other hand JPMorgan Chase Bank also experienced similar problems during the crisis but its growth was much more stable after the crisis as evidenced by positive values of ROA and ROE. A number of other financial ratios can also be applied in the explanation the performance of the banks during the same period. A number of these ratios have been explained in the paper. 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