Other Factors to Consider when Analyzing a Bank

While the CAMELS approach to evaluating a bank is reasonably comprehensive, it does not address some of the banks’ attributes. In this section, we will discuss bank attributes that are either unaddressed or not adequately addressed by a CAMELS analysis.

Government Support

A nation’s economy is affected by financial institutions’ lending activities. This makes it a government interested in having a healthy banking system. Apart from providing deposit insurance, governments often serve as a backstop against bank failure. This is done through closing banks that might fail or arranging mergers with healthy ones that can absorb them. This is usually due to the systemic importance of the banking sector.

For example, during the 2008 financial crisis, the US Treasury created the Troubled Asset Relief Program (TARP) to buy loans held by banks and to provide equity injections to the banks. The treasury department also arranged mergers among banking giants, leading to even bigger financial conglomerates.

The expected level of government support is related to the size of the bank. Usually, the larger the bank and the 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. Additionally, the status of the country’s banking sector should be considered. A healthy overall sector may be able to absorb the failure of a specific 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 cases, the absence of government ownership makes the depositors lack faith in the banking sector, a critical element for a bank’s existence. Government ownership in financial institutions adds another layer of security for investors. Decreasing government ownership would conversely reduce this security blanket. During the financial crisis of 2008, some governments became reluctant owners of failing banks. When the governments eventually exited their ownership stakes, it was portrayed as a sign of confidence in such banks.

Mission of the Banking Entity

Different banks have different missions. For example, community banks may be guided by community development in their lending decisions. If the community is dependent on a primary industry such as farming or mining, it may lead to a concentration of risk in a community bank’s asset portfolio. In contrast, global banks have well-diversified asset bases, reducing their overall risk.

Corporate Culture

A bank’s culture influences its tendency to seek risky investments. A relatively conservative culture may be too risk-averse to provide adequate returns to shareholders, while a risk-seeking culture may lead to high volatility of returns. Therefore, it is essential to have a healthy balance.

A bank’s cultural environment can be evaluated by considering:

• The 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: These are due to internal control failures relating to financial reporting. Restatements may indicate an unethical culture.
• Management compensation: Excessive compensation that is closely tied up to the short-term performance of the bank’s stock may lead to a culture of excessive risk-taking.
• The 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.

Competitive Environment

A bank’s competitive environment affects how it allocates capital and assess risks as well as its cultural mindset. For example, a regional bank may be satisfied with its current market position and may not be tempted to take excessive risk. Global banks, on the other hand, may end up taking excessive risks as their management seeks to outdo their giant rivals.

Off-balance-sheet-items

Off-balance-sheet assets and liabilities may significantly affect an entity if the underlying risks are more significant than the available resources. Often, essential information about a bank’s off-balance-sheet exposures may be cloudy or not readily available to analysts, making it very difficult to examine. However, not all off-balance-sheet items involve exotic or highly engineered financial instruments. Operating leases, for example, are low-risk off-balance-sheet liabilities. Bank analysts should look out for variable interest entities, or VIEs which are usually consolidated. VIEs are a form of “special-purpose entity.“ However, if an SPE is not considered to be a VIE, it does not get consolidated. This leads to a significant off-balance-sheet risk not reflected in the financial statements.

Segment Information

The segment information may provide insights into different lines of business or different geographical markets that the bank operates in. Each line of business is exposed to different types of risks. Regardless of the lines of business a bank may pursue, segment information should illustrate the information used by the primary decision-maker in the entity. That information is crucial in deciding whether the capital is well allocated within the bank’s internal operations.

Currency Exposure

Currency exposure severely affects global banks trading in currencies or holding significant assets or liabilities in different currencies whose values fluctuate. Volatility in exchange rates can have a significant impact on a bank’s earnings. Global banks face the same balance sheet translation issues that affect other multinational corporations. A bank’s home currency appreciation is relative to subsidiaries’ functional currency results in currency translation adjustments. These adjustments cause a capital reduction.

Risk Factors

Investors must look at the risk factors section of a company’s filing. There may be valuable information to fill gaps in an investor’s knowledge about legal and regulatory issues that might not otherwise be open.

Basel III Disclosures

The Basel III requirements comprise of extensive disclosures that complement the minimum risk-based capital requirements and other quantitative requirements. It aims at promoting market discipline by providing useful regulatory information on a consistent and comparable basis to investors.

Question

One limitation of CAMELS approach used to evaluate banks is that it fails to address a bank’s:

    A. Management capabilities.

    B. Competitive environment.

    C. Sensitivity to market risk.

Solution

The correct answer is B.

The CAMELS approach has six components: (1) capital adequacy, (2) asset quality, (3) management capabilities, (4) earnings sufficiency, (5) liquidity position, and (6) sensitivity to market risk. While the CAMELS approach to evaluating a bank is relatively extensive, some attributes of a bank are not addressed by this method. A bank’s competitive environment has one such attribute. A bank’s competitive position relative to its peers may affect how it allocates capital and assesses risks.

A and C are incorrect. Both management capabilities and sensitivity to market risk are addressed under the CAMELS approach.

Reading 14: Analysis of Financial Institutions

LOS 14 (d) Describe other factors to consider in analyzing a bank.