Other Factors

We have already described the CAMELS framework that should be used to analyze a bank. Due to the limitation of time allocated to each question on the exam, focus on different types of analysis (e.g., of capital adequacy, asset quality, liquidity risk, etc.) rather than a comprehensive analysis.

In addition to the CAMELS approach to analyzing bank, other factors that analysts should consider include the following.

Government Support

Apart from providing deposit insurance, governments often serve as a backstop against bank failure. This is usually due to the systemic importance of the banking sector. During the financial crisis of 2008, the U.S. government created the Troubled Asset Relief Program (TARP) to prop up numerous banks that had taken on more risk than their capital could handle.

The expected level of government support is related to the inter linkages in the banking sector. Usually, the larger the bank and more inter linked it is, the more likely that its failure will have a contagion effect. Therefore, larger banks enjoy a higher probability of implicit government support.

Further, the current status of the banking sector in the country should be considered. A healthy overall sector may be able absorb the failure of an isolated bank. Hence, the implicit support level is inversely related to the overall health of the banking sector; during good times, support levels are low.

Government Ownership

Public ownership of banks may be due to the strategic importance of banks in promoting economic development. In some countries, absent government ownership, depositors may not have faith in the banking sector, a critical element for a bank’s existence. Public ownership increases faith (of implicit government backing) in a bank.

Shrinking public ownership and divestment would conversely reduce this security blanket.

During the financial crisis of 2008, some governments became reluctant owners of struggling banks. When the governments eventually exited their ownership stakes, it was perceived as a sign of confidence in the bank’s balance sheet.

Bank Mission

Apart from profit making, banks may also pursue other objectives. For example, community banks may be guided by community development in their lending decisions. If the community is dependent on a primary industry (e.g., banks in Houston, TX, had their fortunes tied to the oil industry in the 1980s), it may lead to concentration of risk in a community bank’s asset portfolio.

Global banks, on the other hand, have well diversified asset bases, reducing their overall risk.

Culture

A bank’s culture influences its propensity to seek risky investments. A relatively conservative culture may result in calculated risk taking, while a risk seeking culture may lead to an overly aggressive risk stance. There is a need for balance, because if the culture is too risk averse, it may fail to provide an adequate return on investment.

Culture evaluation can be conducted by a review of:

Diversity of a bank’s assets. Banks that have generated losses due to an investment strategy with a narrow focus may be too aggressive. Accounting restatements due to failures of internal controls pertaining to financial reporting.

Restatements may indicate an unethical culture.

Management compensation. Excessive compensation that is too closely tied to the performance of the bank’s stock may lead to a culture of excessive risk taking.

Speed with which a bank adjusts its loan loss provisions relative to actual loss behavior. A slower response rate generally indicates aggressive accounting practices and a risk taking culture.

Apart from these factors, there are general factors that are relevant to analysis of any company (not just banks). These include:

A competitive environment affects a bank’s culture and risk taking behavior. For example, a regional bank may be satisfied with its current market position and may not be tempted to take excessive risk. Global banks may end up taking excessive risk as their management seeks to outdo their large rivals.

Off balance sheet assets and/or liabilities may seriously affect an entity if the underlying risks turn out to be larger than the available resources. Often, key information about a bank’s off balance sheet exposures may be opaque or not readily available to analysts, making it very difficult to examine. However, all off balance sheet items are not equally nefarious.

Operating leases, for example, are a lot less risky compared to selling protection in a CDS. Bank analysts should look out for variable interest (or special purpose) entities, which are usually required to be consolidated. In some instances, if an SPE is not deemed to be a VIE and therefore does not get consolidated, there may be a significant off balance sheet risk not reflected in the financial statements.

• Segment information may provide insights into different lines of business or different geographical markets that the bank operates in. Each segment may be exposed to different levels or types of risk, such as sensitivity to markets, geo political risks, or cyclicality. − Currency exposure is significant for large, global banks trading in currencies or holding significant

assets or liabilities in different currencies whose values fluctuate. Volatility in currency values can have a significant impact on a bank’s earnings.