CHAPTER 16
Analysis of Financial Institutions

Learning Outcomes

After completing this chapter, you will be able to do the following:

describe how financial institutions differ from other companies;
describe key aspects of financial regulations of financial institutions;
explain the CAMELS (capital adequacy, asset quality, management, earnings, liquidity, and sensitivity) approach to analyzing a bank, including key ratios and its limitations;
describe other factors to consider in analyzing a bank;
analyze a bank based on financial statements and other factors;
describe key ratios and other factors to consider in analyzing an insurance company.

Summary Overview

Financial institutions’ systemic importance results in heavy regulation of their activities.
Systemic risk refers to the risk of impairment in some part of the financial system that then has the potential to spread throughout other parts of the financial system and thereby to negatively affect the entire economy.
The Basel Committee, a standing committee of the Bank for International Settlements, includes representatives from central banks and bank supervisors from around the world.
The Basel Committee’s international regulatory framework for banks includes minimum capital requirements, minimum liquidity requirements, and stable funding requirements.
Among the international organizations that focus on financial stability are the Financial Stability Board, the International Association of Insurance Supervisors, the International Association of Deposit Insurers, and the International Organization of Securities Commissions.
Another distinctive feature of financial institutions (compared to manufacturing or merchandising companies) is that their productive assets are predominantly financial assets, such as loans and securities, creating greater direct exposures to a variety of risks, such as credit risk, liquidity risk, market risk, and interest rate risk. In general, the values of their assets are relatively close to fair market values.
A widely used approach to analyzing a bank, CAMELS, considers a bank’s Capital adequacy, Asset quality, Management capabilities, Earnings sufficiency, Liquidity position, and Sensitivity to market risk.
“Capital adequacy,” described in terms of the proportion of the bank’s assets that is funded with capital, indicates that a bank has enough capital to absorb potential losses without severely damaging its financial position.
“Asset quality” includes the concept of quality of the bank’s assets—credit quality and diversification—and the concept of overall sound risk management.
“Management capabilities” refers to the bank management’s ability to identify and exploit appropriate business opportunities and to simultaneously manage associated risks.
“Earnings” refers to the bank’s return on capital relative to cost of capital and also includes the concept of earnings quality.
“Liquidity” refers to the amount of liquid assets held by the bank relative to its near-term expected cash flows. Under Basel III, liquidity also refers to the stability of the bank’s funding sources.
“Sensitivity to market risk” pertains to how adverse changes in markets (including interest rate, exchange rate, equity, and commodity markets) could affect the bank’s earnings and capital position.
In addition to the CAMELS components, important attributes deserving analysts’ attention include government support, the banking entity’s mission, corporate culture and competitive environment, off-balance-sheet items, segment information, currency exposure, and risk disclosures.
Insurance companies are typically categorized as property and casualty (P&C) or life and health (L&H).
Insurance companies earn revenues from premiums (amounts paid by the purchaser of insurance products) and from investment income earned on the float (amounts collected as premiums and not yet paid out as benefits).
P&C insurers’ policies are usually short term, and the final cost will usually be known within a year of a covered event, whereas L&H insurers’ policies are usually longer term. P&C insurers’ claims are more variable, whereas L&H insurers’ claims are more predictable.
For both types of insurance companies, important areas for analysis include business profile, earnings characteristics, investment returns, liquidity, and capitalization. In addition, analysis of P&C companies’ profitability includes analysis of loss reserves and the combined ratio.

Problems

The following information relates to Questions 1–7

Viktoria Smith is a recently hired junior analyst at Aries Investments. Smith and her supervisor, Ingrid Johansson, meet to discuss some of the firm’s investments in banks and insurance companies.

Johansson asks Smith to explain why the evaluation of banks is different from the evaluation of non-financial companies. Smith tells Johansson the following:

Statement 1: As intermediaries, banks are more likely to be systemically important than non-financial companies.

Statement 2: The assets of banks mostly consist of deposits, which are exposed to different risks than the tangible assets of non-financial companies.

Smith and Johansson also discuss key aspects of financial regulations, particularly the framework of Basel III. Johansson tells Smith:

“Basel III specifies the minimum percentage of its risk-weighted assets that a bank must fund with equity. This requirement of Basel III prevents a bank from assuming so much financial leverage that it is unable to withstand loan losses or asset write-downs.”

Johansson tells Smith that she uses the CAMELS approach to evaluate banks, even though it has some limitations. To evaluate P&C insurance companies, Johansson tells Smith that she places emphasis on the efficiency of spending on obtaining new premiums. Johansson and Smith discuss differences between P&C and L&H insurance companies. Smith notes the following differences:

Difference 1:	L&H insurers’ claims are more predictable than P&C insurers’ claims.
Difference 2:	P&C insurers’ policies are usually short term, whereas L&H insurers’ policies are usually longer term.
Difference 3:	Relative to L&H insurers, P&C insurers often have lower capital requirements and can also seek higher returns offered by riskier investments.

Johansson asks Smith to review key performance ratios for three P&C insurers in which Aries is invested. The ratios are presented in Exhibit 1.

Exhibit 1 Key Performance Ratios for Selected P&C Insurers

	Insurer A	Insurer B	Insurer C
Loss and loss adjustment expense ratio	68.8%)	65.9%)	64.1%)
Underwriting expense ratio	33.7%)	37.8%)	32.9%)
Combined ratio	102.5%)	103.7%)	97.0%)

Johansson also asks Smith to review key performance ratios for ABC Bank, a bank in which Aries is invested. The ratios are presented in Exhibit 2.

Exhibit 2 Key Performance Ratios for ABC Bank*

	2017	2016	2015
Common equity Tier 1 capital ratio	10.7%	11.5%	12.1%
Tier 1 capital ratio	11.5%	12.6%	13.4%
Total capital ratio	14.9%	14.8%	14.9%
Liquidity coverage ratio	123.6%	121.4%	119.1%
Net stable funding ratio	114.9%	113.2%	112.7%
Total trading VaR (all market risk factors)	$11.9%	$13.9%	$15.9%
Total trading and credit portfolio VaR	$15.9%	$18.9%	$21.9%

*Note: VaR amounts are in millions and are based on a 99% confidence interval and a single-day holding period.

Which of Smith’s statements regarding banks is correct?
1. Only Statement 1
2. Only Statement 2
3. Both Statement 1 and Statement 2

The aspect of the Basel III framework that Johansson describes to Smith relates to minimum:
1. capital requirements.
2. liquidity requirements.
3. amounts of stable funding requirements.

One limitation of the approach used by Johansson to evaluate banks is that it fails to address a bank’s:
1. sensitivity to market risk.
2. management capabilities.
3. competitive environment.

The best indicator of the operations of a P&C insurance company emphasized by Johansson when evaluating P&C insurance companies is the:
1. combined ratio.
2. underwriting loss ratio.
3. underwriting expense ratio.

Which of the differences between P&C insurers and L&H insurers noted by Smith is incorrect?
1. Difference 1
2. Difference 2
3. Difference 3

Based on Exhibit 1, Smith should conclude that the insurer with the most efficient underwriting operation is:
1. Insurer A.
2. Insurer B.
3. Insurer C.

Based on Exhibit 2, Smith and Johansson should conclude that over the past three years, ABC Bank’s:
1. liquidity position has declined.
2. capital adequacy has improved.
3. sensitivity to market risk has improved.

The following information relates to Questions 8–14

Ivan Paulinic, an analyst at a large wealth management firm, meets with his supervisor to discuss adding financial institution equity securities to client portfolios. Paulinic focuses on Vermillion Insurance (Vermillion), a property and casualty company, and Cobalt Life Insurance (Cobalt). To evaluate Vermillion further, Paulinic compiles the information presented in Exhibit 1.

Exhibit 1 Select Financial Ratios for Vermillion Insurance

Ratio	2017	2016
Loss and loss adjustment expense	59.1%	61.3%
Underwriting expense	36.3%	35.8%
Combined	95.4%	97.1%
Dividend	2.8%	2.6%

In addition to the insurance companies, Paulinic gathers data on three national banks that meet initial selection criteria but require further review. This information is shown in Exhibits 2, 3, and 4.

Exhibit 2 Select Balance Sheet Data for National Banks—Trading: Contribution to Total Revenues

Bank	2017	2013	2009	2005
N-bank	4.2%	7.0%	10.1%	8.9%
R-bank	8.3%	9.1%	17.0%	7.9%
T-bank	5.0%	5.0%	11.9%	6.8%

Focusing on N-bank and T-bank, Paulinic prepares the following data.

Exhibit 3 2017 Select Data for N-bank and T-bank

	N-bank		T-bank
	2017	2016	2017	2016
Average daily trading VaR ($ millions)	11.3	12.6	21.4	20.5
Annual trading revenue/average daily trading VaR	160×	134×	80×	80×

Paulinic investigates R-bank’s risk management practices with respect to the use of credit derivatives to enhance earnings, following the 2008 financial crisis. Exhibit 4 displays R-bank’s exposure over the last decade to credit derivatives not classified as hedges.

Exhibit 4 R-bank’s Exposure to Freestanding Credit Derivatives

Credit Derivative Balances		2017		2012		2007
Notional amount ($ billions)		13.4		15.5		305.1

All of the national banks under consideration primarily make long-term loans and source a significant portion of their funding from retail deposits. Paulinic and the rest of the research team note that the central bank is unwinding a long period of monetary easing as evidenced by two recent increases in the overnight funding rate. Paulinic informs his supervisor that:

Statement 1: Given the recently reported stronger-than-anticipated macroeconomic data, there is an imminent risk that the yield curve will invert.

Statement 2: N-bank is very active in the 30-day reverse repurchase agreement market during times when the bank experiences significant increases in retail deposits.

Paulinic’s analysis of the two insurance companies most likely indicates that:
1. Cobalt has more-predictable claims than Vermillion.
2. Cobalt has a higher capital requirement than Vermillion.
3. Vermillion’s calculated risk-based capital is more sensitive than Cobalt’s to interest rate risk.

Based only on the information in Exhibit 1, in 2017 Vermillion most likely:
1. experienced a decrease in overall efficiency.
2. improved its ability to estimate insured risks.
3. was more efficient in obtaining new premiums.

Based only on Exhibit 2, which of the following statements is correct?
1. The quality of earnings for R-bank was the highest in 2009.
2. Relative to the other banks, N-bank has the highest quality of earnings in 2017.
3. Trading represented a sustainable revenue source for T-bank between 2005 and 2013.

Based only on Exhibit 3, Paulinic should conclude that:
1. trading activities are riskier at T-bank than N-bank.
2. trading revenue per unit of risk has improved more at N-bank than T-bank.
3. compared with duration, the metric used is a better measure of interest rate risk.

Based only on Exhibit 4, R-bank’s use of credit derivatives since 2007 most likely:
1. increased posted collateral.
2. decreased the volatility of earnings from trading activities.
3. indicates consistent correlations among the relevant risks taken.

Based on Statement 1, the net interest margin for the three banks’ most likely will:
1. decrease.
2. remain unchanged.
3. increase.

Based on Statement 2, the financial ratio most directly affected is the:
1. Tier 2 capital ratio.
2. net stable funding ratio.
3. liquidity coverage ratio.

The following information relates to Questions 15–20

Judith Yoo is a financial sector analyst writing an industry report. In the report, Yoo discusses the relative global systemic risk across industries, referencing Industry A (international property and casualty insurance), Industry B (credit unions), and Industry C (global commercial banks).

Part of Yoo’s analysis focuses on Company XYZ, a global commercial bank, and its CAMELS rating, risk management practices, and performance. First, Yoo considers the firm’s capital adequacy as measured by the key capital ratios (common equity Tier 1 capital, total Tier 1 capital, and total capital) in Exhibit 1.

Exhibit 1 Company XYZ: Excerpt from Annual Report Disclosure

At December 31	2017	2016	2015
Regulatory capital	$m	$m	$m
Common equity Tier 1 capital	146,424	142,367	137,100
Additional Tier 1 capital	22,639	20,443	17,600
Tier 2 capital	22,456	27,564	38,200
Total regulatory capital	191,519	190,374	192,900
Risk-weighted assets (RWAs) by risk type
Credit risk	960,763	989,639	968,600
Market risk	44,100	36,910	49,600
Operational risk	293,825	256,300	224,300
Total RWAs	1,298,688	1,282,849	1,242,500

Yoo turns her attention to Company XYZ’s asset quality using the information in Exhibit 2.

Exhibit 2 Company XYZ: Asset Composition

At December 31	2017	2016	2015
	$m	$m	$m
Total liquid assets	361,164	354,056	356,255
Investments	434,256	367,158	332,461
Consumer loans	456,957	450,576	447,493
Commercial loans	499,647	452,983	403,058
Goodwill	26,693	26,529	25,705
Other assets	151,737	144,210	121,780
Total assets	1,930,454	1,795,512	1,686,752

To assess Company XYZ’s risk management practices, Yoo reviews the consumer loan credit quality profile in Exhibit 3 and the loan loss analysis in Exhibit 4.

Exhibit 3 Company XYZ: Consumer Loan Profile by Credit Quality

At December 31	2017	2016	2015
	$m	$m	$m
Strong credit quality	338,948	327,345	320,340
Good credit quality	52,649	54,515	54,050
Satisfactory credit quality	51,124	55,311	56,409
Substandard credit quality	23,696	24,893	27,525
Past due but not impaired	2,823	2,314	2,058
Impaired	8,804	9,345	10,235
Total gross amount	478,044	473,723	470,617
Impairment allowances	–5,500	–4,500	–4,000
Total	472,544	469,223	466,617

Exhibit 4 Company XYZ: Loan Loss Analysis Data

At December 31	2017	2016	2015
	$m	$m	$m
Consumer loans
Allowance for loan losses	11,000	11,500	13,000
Provision for loan losses	3,000	2,000	1,300
Charge-offs	3,759	3,643	4,007
Recoveries	1,299	1,138	1,106
Net charge-offs	2,460	2,505	2,901
Commercial loans
Allowance for loan losses	1,540	1,012	169
Provision for loan losses	1,100	442	95
Charge-offs	1,488	811	717
Recoveries	428	424	673
Net charge-offs	1,060	387	44

Finally, Yoo notes the following supplementary information from Company XYZ’s annual report:

Competition in the commercial loan space has become increasingly fierce, leading XYZ managers to pursue higher-risk strategies to increase market share.
The net benefit plan obligation has steadily decreased during the last three years.
Company XYZ awards above-average equity-based compensation to its top managers.

Which of the following industries most likely has the highest level of global systemic risk?
1. Industry A
2. Industry B
3. Industry C

Based on Exhibit 1, Company XYZ’s capital adequacy over the last three years, as measured by the three key capital ratios, signals conditions that are:
1. mixed.
2. declining.
3. improving.

Based only on Exhibit 2, asset composition from 2015 to 2017 indicates:
1. declining liquidity.
2. increasing risk based on the proportion of total loans to total assets.
3. decreasing risk based on the proportion of investments to total assets.

Based on Exhibit 3, the trend in impairment allowances is reflective of the changes in:
1. impaired assets.
2. strong credit quality assets.
3. past due but not impaired assets.

Based on Exhibit 4, a loan loss analysis for the last three years indicates that:
1. Company XYZ has become less conservative in its provisioning for consumer loans.
2. the provision for commercial loan losses has trailed the actual net charge-off experience.
3. the cushion between the allowance and the net commercial loan charge-offs has declined.

Which of the following supplemental factors is consistent with a favorable assessment of Company XYZ’s financial outlook?
1. Competitive environment
2. Net benefit plan obligation
3. Equity-based compensation policy