03 September, 2007
(The Banker) As stock markets wobble, bank capital ratios come under increasing scrutiny. But perhaps this is the wrong tack and instead liquidity is a better way of determining a bank’s stability. The Banker asked rating agency DBRS to look into the matter.
At a time when analysts, regulators, rating agencies, and other market observers focus more than ever on capital adequacy as the principle line of defence against troubles in the banking industry – spurred by the lengthy Basel II debate — it is liquidity that remains the soft underbelly of bank risk. Bank regulators have a crucial say in determining when a bank crosses below the solvency floor, but with respect to liquidity it is the market at large that makes the call.
It is through the liquidity door that banks getting into distress are going to be primarily hit, and this summer’s crisis in the US subprime market clearly illustrated this. The very few cases of financial institutions in crisis in Europe in recent years (AHBR, BAWAG, and more recently IKB), while operating above solvency-floor parameters, necessitated outside support to shore up their liquidity, before questions were raised and answers were given on their survival.
Unfortunately, information about banks’ total liquidity positions is not always available. Two measures that are accessible, however, are loans/deposits and deposits/funding ratios. These measures tell analysts about the stability of funding as deposits are a more stable source of funds than issuing in the markets because bonds are affected by market volatility.
At the request of The Banker, DBRS has taken the Top 100 banks in the magazine’s Top 1000 annual ranking of the world’s largest banks by Tier 1 capital and ranked them instead by loans/deposits. This new Top 100 does not resemble in terms of bank names exactly The Banker’s Top 1000, because in some cases information from certain banks was unavailable and DBRS moves such banks further down the list.
The results are interesting. Norinchukin Bank, which ranks 33rd in the Top 1000, comes out top in this ranking with loans that are only 30.98% of deposits. The two Swiss leaders, Credit Suisse and UBS, also do well as do the Chinese banks, presumably because of their vast deposit bases and undeveloped balance sheets. By contrast some European banks, notably Swedish banks, come lower by this method of ranking. Nordea, for example, slips from 30th in the Top 1000 to 89th in this system. This may be because loans are growing faster than new deposits can be generated, leading to other forms of funding. As a shareholder you would no doubt support this growth spurt for the profits it generates but there is clearly a cost in terms of liquidity.
Liquidity risk should be moving to the front burner, where it definitely belongs. In this context, DBRS expects bank disclosure with respect to funding and liquidity to improve further in the future. One step in this direction could be better information regarding the stock and flow of short-term market funding – which not all banks disclose in detail. It is short-term market and interbank funding (including commercial paper) that can be more volatile and unpredictable in times of uncertainty – as this summer’s crisis has shown.
A thorough analysis of bank liquidity should cover two different levels: first, the going-concern scenario, under which sub-optimal liquidity management can hurt earnings and potentially dent the bank’s franchise as well; and second, the stress scenario, under which liquidity troubles can threaten the very existence of the bank – through short-term debt no longer being rolled, or worse, through massive deposit withdrawals or forced redemption of long-term debt due to various triggers. DBRS pays particular attention to the manner in which specialised lenders – which often rely on asset liability management (ALM) mismatch revenues to supplement their bottom line – manage their liquidity cushion and stress-test their assumptions.
While DBRS keeps track of a few key liquidity and funding-related ratios – such as the ratio of loans funded by deposits, or the weight of customer deposits as part of overall bank funds – its analysis is primarily qualitative. The key areas are first, liquidity-risk governance, which is a very important indicator of a bank’s overall risk philosophy; and second, bank’s contingency measures for, and ongoing stress testing of, extreme liquidity-crunch scenarios (the so-called Fat Tail that everyone dreads).
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