How to Analyze Banks (part 4)
A dive deep into understanding how to analyze the asset quality of a bank.
30 minute read
This is part four of the series How to Analyze Banks. In this article, we explore how to analyze the assets quality of a bank.
Overview
Why is analyzing the asset quality of a bank important?
Evaluating the quality of a bank’s assets is both he most important and normally the most difficult part of analyzing a bank. This is because poor asset quality is probably the greatest cause of bank failure. Since bank’s operate on thin margins and are highly leveraged, the impact of a relatively small volume of non-performing loans can wipe out a bank’s capital.
A rise in non-performing loans can wipe out a bank because they can trigger a problematic cycleÂ
As loans are classified as non-performing, the bank will stop earning interest on those loans, causing interest income and net interest income to fall.
The bank will have to increase loan-loss provisions and that will reduce loan-loss reserves and negatively affect net income.
If loan charge-offs exceed loan-loss reserves, shareholder’s equity will have to be written down.
To bolster capital levels, it is likely that the bank will need to reduce loan growth and reduce its loan portfolio. This will impact interest income going forward.
As the market learns of the bank’s problems, cost of funding will rise, furthering reducing profitability.
As depositors learn of the bank’s problems, they could loose confidence in the bank and withdraw funds. In a worst case, a bank run might be triggered. The result will be higher funding costs, reduced liquidity, or both.
What causes high levels of non-performing loans?
A rise in non-performing loans can be attributed to multiple causes, including inadequate credit management, or a severe deterioration in economic conditions. Banks are a business where management matters, a lot. An idiot can not run this business. This is because management can lead the bank astray with aggressive lending practices, over-concentration of lending in a particular sector, lack of compliance with loan policies, and lending outside the bank’s core market. Finally, a severe deterioration in economic conditions, like a recession, could cause the bank’s customers to default on their loans. If the bank’s is commercial and focuses on consumers, then a high rise in unemployment can significantly affect the customer’s ability to pay back its loan. Likewise, if the bank is commercial and mainly loans to SMEs, then a decrease in economic activity or less access to credit can affect its ability to meet its obligations.Â
What happens if a loan is classified as non-performing?
Once a loan is classified as non-performing, generally three possible outcomes exist.
Write-Off
Loan is removed from the balance sheet
Equity is reduced
Usually the write-offs hit the balance sheet through the income statement. In some countries, asset losses can be deducted directly from equity without being recorded as losses in the income statement. This is unacceptable and should be checked for.
Foreclosure
The loan is written off but the collateral used to secure the loan is recovered
Workout
A bank may negotiate with the borrower to work out, or restructure the loan
In jurisdictions where restructured loans are still considered to not be non-performing loans and there is lesser bank supervision, banks may engage in restructurings to reduce Non performing loan levels. In the short-term this could create a false impression, since the reality is that many of these loans will ultimately return to a nonperforming state.
Asset Quality Assessment
Asset quality assessment is mainly concerned with the proportion of performing assets to nonperforming assets and the implication on the bank’s financial condition.
The amount of non-performing loans should be viewed both as an essential indication of a bank’s its financial condition, and, more skeptically, a mere approximation of reality. In the end, what is most important is not the label but the underlying characteristics of the loan book. The quality of a loan portfolio is dictated by the creditworthiness of the borrowers, the value of any associated loan collateral, and the terms of the loan.
Other Accounting Considerations
In some countries, loan losses can be deducted from equity directly without being recorded as losses in the income statement. This is unacceptable, as it is a way to mask the profitability of a bank.Â
If a non-performing loan is recovered and an amount of loan-loss reserve has been allocated to it, then the recovery will be added back to the loan loss reserve pool.Â
So…how do we know if a bank’s non-performing loans are accurately represented?
Most banks classify loans as non-performing after 90 days since the customer stops paying principal and interest. Eventually, if the customer continues to not paying interest, then the value of such loan must be adjusted to have little real value and be removed from the balance sheet or written off.Â
However, a bank can temporarily make their loan book look better by re-financing loans with customers that will likely not be able to pay them back. To re-finance a loan means to change the terms, such as due date, interest rate, etc. By re-financing, a bank can avoid labeling a loan as non-performing. Decreasing or increasing charge-offs to loan loss reserves can also affect non performing loans. As non-performing loans decline as a result of being written down against provisions.Â
Government regulation can also cause definitions of non-performing loans to vary across jurisdictions. If and when countries adopt recommendations under Basel II and Basel III, the definition of a non-performing loan are more consistent. The Basel classification system provides benchmarks with which to grade loans in terms of the loss the bank is likely to suffer and allocate loan loss reserves for the relevant credit costs.Â
Thus, to better estimate the amount of non-performing assets, we can add NPLs + foreclosed + restructured loans + defaulted securities.Â
Types of Problematic Loans
Special mention
Loans that are not more than 90 days past due, and technically still performing, but where the borrower has experienced deterioration in credit.
Loan-loss provision allocation should be between 5-10% of the nominal value of the loan
Substandard
Loans more than 90 days past due where the borrower or collateral suffer a significant weakness, meaning that they are likely to default.Â
Loan-loss provision allocation should be 25% of the nominal value of the loan
Doubtful and Loss Loans
Loans more than 90 days past due where full payment is unlikelyÂ
Loan-loss provision allocation should be 90%-100% of the nominal value of the loan
Key Data and Indicators of a Bank’s Assets and Capital
The most critical figures to obtain for the periods being examined are:
Total loans [4]
Total nonperforming loans
Total nonperforming assets (NPLs + foreclosed + restructured loans)
Loan loss provisioning [1]
Total loan loss reserves [2]
Net charge offs
Pre-provision income
Total shareholder’s equity
With this data, we can calculate the following asset quality ratios:
Year on year loan growth
Reason: How rapidly a bank is growing can influence asset quality. Also, it is a signal that the bank is not applying good credit control and maintain good capital levels. It is important to note than an increase in lending in one period may not be reflected until a later period.
Rules of thumb: growth > 15% should be seen as cautious, 5-15% is healthy, 0-5% tends to indicate a very large bank or a bank operating in a mature industry in a weak phase of the credit cycle.
Year on year Non-performing loans growth vs loan growth
Rate at which NPLs as a percentage of loans is increasing is a good indicator of decreasing asset quality.
Notes: It is important not to accept percentages at face value, but to understand the reasons for the change.
Non-performing loans to gross loans [3] (NPL ratio)
Reason: An NPL ratio that is higher than the bank’s peer group or industry indicated a lower asset quality.
Notes: The usefulness of this ratio depends upon consistent definitions of its numerator and denominator. It is important that when comparing banks we apply the same definitions for NPL.
Loan loss reserves to total non-performing loans (NPL coverage ratio)
Reason: Shows a well a bank is prepared to face future losses. If the ratio is high it suggests that the bank has a large cushion to absorb losses.
Notes: A value that exceeds 100% is adequate.
Non-performing assets to total loans AND loan-loss reserves to non-performing assets
Using non-performing assets instead of non-performing loans can facilitate the making of comparisons with other banks
Non-performing assets can be approximated by adding foreclosed assets and restructured loans to NPLs
Net charge-offs to total loans
Reason:Â
Total recoveries to total write offs
Reason:Â The meaning of this ratio will depend on what factors are pushing write-offs and recoveries up and down.
Loan-loss provisions to total loans
Reason: Measures how hard a bank is trying to raise its overall reserves
Net Charge Offs to Pre Provision Income
Reason: Measures a bank abilities to absorb expected loan losses without consuming capital. This is because earnings can be used to absorb losses.
Notes: A bank with a high profitability has a better asset quality than a low profitable bank.
Pre provision income to net loans [5]
Reason: Measures a bank abilities to absorb expected loan losses without consuming capital. For example, a bank with a ratio of PPI to net loans of 4% can write-off 4% of its loan book every year.
Net Charge Offs to Non Performing Loans
Reason: Measures the relationship between NPLs and the time it would take for them to be removed. For example, if total NPLs were $100 million and NCOs for the year were $20 million, then in five years all NPLs would be removed from the balance sheet. Thus, if the ratio is high it means that NPLs will not accumulate on the balance sheet, and the bank will tend to report a decreasing level of problem loans. On the contrary, if the ratio is low then NPLs will accumulate. This can threaten capital solvency if provisions are not set aside.
Net Charge Offs to Loan loss provisions
Reason: Provides a clue if a bank is being preventative or reactive. If the ratio is low, then it means that LLPs exceed NCOs, which means that the bank is building up or rebuilding loan loss reserves. If the ratio is high, the it means that the bank is responding to an asset quality crisis.
Loan portfolio composition
Having explored the quantitative side of a bank’s asset quality, it is time to analyze it from a qualitative perspective. These include a bank’s business and regulatory environment, credit management policies, and composition and risk profile of its loan portfolio.
We can understand the quality of a bank’s loan book by looking at what constitutes it. This type of analysis may give clues to problems that have yet to appear in asset quality ratios. Specifically, the average loan maturity, industry of the borrower, and borrower type may suggest potential concerns.Â
Maturity
Short-term loans: one year or less
Medium-term loans: one to five years
Long-term loans: more than five years
Banks seek to avoid a big difference in maturity between their earning assets and funding liabilities. Short term exposure from the asset side tends to be less risky than medium or long term loans. This is because there is less time for things to go wrong. Therefore, from an analytical perspective, a bank with a greater proportion of medium and long term loans vs their peers implies higher credit risk and must be investigated.
Borrower Type
Lending activity can be labeled as wholesale or retail. Wholesale lending means large loans mainly to big corporations. Retail lending refers to smaller loans, mainly to small and medium sized businesses, and individuals. Neither wholesale or retail is necessarily more risky than the other. On average, larger companies are more credit worthy than SMEs, but yields will be lower.Â
Finally, policy lending is another type of activity that refers to subsidized lending mandated by government. This type of lending is risky because the low yield may not be enough to support the risk obtained from issuing the loan. Also, lending to state-owned companies can raise difficult issues because they frequently have poor credit quality. These businesses are often not profitable, efficient, and reliant on government subsidies.Â
Another way of categorizing loans by borrower type is by dividing loans into functional groupings, five of which are described below.
Commercial and Industrial Loans: These loans are made either on a short term basis to to help businesses fund working capital needs, or less frequently on a medium and long term to fund capital expenditures.
Consumer Loans: These loans are made to individuals and families, and span from mortgage loans and auto loans, to personal loans.Â
Real Estate Loans: These include loans to finance all type of real estate, including investment properties, as well as for the purchase of houses, apartments, and other real estate. Home mortgage loans are sometimes put into this category, but can also be classified as consumer loans.Â
Agricultural Loans: These include loans to farmers and ranchers to fund seasonal planting and livestock-raising operations. These loans can be secured by crops harvested.
Interbank and Financial Institutions Loans: This category includes loans made to other banks and financial institutions.
Making Sense of Loan Book Composition
Over-concentration is a recipe for disaster. Likewise, a bank that made all loans to a small number of borrowers is vulnerable to big losses if one of them defaults.Â
The higher the level of risk associated with an industry, the lower he margin of error. Consequently, over-concentration is dangerous when the industry is one in decline, highly cyclical, or prone to excessive credit that can make an asset bubble.
As for geographic concentration, a large proportion of loans made in a region can make the bank vulnerable to a downturn affecting that place. In such markets such as Thailand, Mexico, Colombia, and Australia, a small number of banks dominate the country. In other markets, like the US, the banking system is very fragmented and many banks are highly concentrated in a town, city, or state.
On a specific note, it is important to note that over-concentration in real estate lending has been a cause for many cases of bank distress. The property market is cyclical in nature. Loans to real estate developers are among the riskiest category of property lending activity. Developers are vulnerable to severe cashflow problems in downturns, and they often are very leveraged. On the other side, home mortgage lending to finance owner-ocupied homes, is less risky.Â
References
[1] Loan loss provisions refers to the charge made against operating income in the income statement to contemplate probable loan losses.
[2] Loan loss reserves refers to a balance sheet item that measures cumulative loan loss provisions minus loan write-offs plus recoveries. This is the bank’s reserve against total loan losses.
[3] Gross loans refer to the loan principal plus unearned interest income.
[4] Total loans refer to the face value of a loan.
[5] Net loans refer to total loans minus loan loss provisions, and therefore a better approximation of the true accounting value of a bank’s loan book.