Analyse Asset Quality of Commercial Banks
As part of series of “Analyse Performance of Commercial Banks“, this article focus on the second area of FACE: Asset Quality.
FACE stands for:
- Core Metric: Impaired Loans/Gross Loans (%)
- Complementary Metric: Growth of Gross Loans (%)
- Complementary Metric: Loan Loss Coverage
- Complementary Metric: Loan-Impairment Charges/Average Gross Loans (%)
- Oher useful ratios and metrics that useful to deep dive into warning signals in asset quality of banks
- What to look for in the loan book?
- What to look for in the securities trading and derivatives?
Why does analysing asset quality of commercial banks so important?
Lending is the primary business line for the banking industry, and credit quality in the loan book remains the predominant source of risk. We should also analyse other on- and off-balance sheet exposures to the extent these are relevant for an assessment of a bank’s asset quality.
The core metric, impaired loans/gross loans, has the greatest explanatory power for the asset quality factor score because it is the simplest expression of the extent of problem exposures in what is usually a bank’s main asset class.
Click to learn “Loan Impairment in Commercial Banks – How does it work?“; Examples of analysis commercial banks: Malayan Banking Berhad (MAYBANK) and Public Bank Berhad (PBBANK). Want to test your knowledge of earnings ratios of banks, click here to take a test.
Core Metric: Impaired Loans/Gross Loans (%)
[Gross Impaired Loans]/[Gross Loans] ×100%
What does Impaired Loans/Gross Loans (%) tell us?
This ratio indicates the degree of impaired loans by comparing them to the total loan portfolio. In other words, this ratio measures how much risk is in the loan book. Impaired loans are also known as non-performing loans (NPLs), bad, troubled, doubtful, or problem loans.
Typically, impaired loans comprise loans 90 days past due plus those not yet 90 days past due but identified as having incurred some degree of impairment so that the bank has started to doubt that it will receive full repayment. Impaired loans may exclude certain loans that are 90 days past due for banks reporting under IFRS if there is sufficient collateral to ensure that full repayment of loan and interest will be received. Where disclosed, impaired loans will be loans classified as being at ‘stage 3’ under IFRS 9.
Trend of this ratio will reflect overall economic conditions or changes in underwriting standards. The lower the ratio, the higher the quality of loan book. However, comparing with peers will be more meaningful.
To improve the ratio, banks usually will grow loan rapidly and/or write off problem loans faster. This ratio can be distorted by securitisation of lower quality assets, definition of impaired loans, and valuation of collateral.
Complementary Metric: Growth of Gross Loans (%)
Increase in total customer gross loans (retail, corporate and institutional, excluding bank loans and repos) at the end of the accounting period less total customer gross loans at the beginning of the accounting period as a percentage of customer gross loans at the beginning of the accounting period.
What does Growth of Gross Loans (%) tell us?
This growth rate measures how much lending is increasing. A high growth rate (in excess of the market) suggests imprudent lending and may be an indicator of a future deterioration in loan quality. Trend of this ratio will reflect overall economic conditions or changes in underwriting standards. Comparing with peers will be more meaningful.
Besides, by analysing the growth rate of gross loans (of the company and industry), pair with management’s target on loan growth, we can estimate the future growth and valuation of bank.
This ratio can be distorted by securitisation off balance sheet, acquisitions, and disposals.
Complementary Metric: Loan Loss Coverage
[Loan Loss Reserves]/[Impaired Loans] ×100%
Loan loss allowances constitute net accumulated impairment charges (also called reserves or provisions) held against loans remaining on the balance sheet (so excluding those written off). These are shown as a percentage of impaired loans. The ratio includes all loan loss allowances, not only those relating specifically to the loans classified as impaired. The inclusion of general or collective loan loss allowances (or allowances held against stage 1 and stage 2 loans under IFRS 9) means that the ratio can be over 100%, and, where jurisdictions allow conservative provisioning, sometimes substantially in excess of 100%.
This ratio is also known as the coverage ratio, but “coverage ratio” may also be used to include collateral in the numerator or total gross loans rather than impaired loans only in the denominator.
What does Loan Loss Coverage tell us?
This ratio measures adequacy of coverage of impaired loans – how adequate are the reserves in relation to the impaired loans in the loan portfolio. This ratio provides indication of how conservative, or not, credit risk management is.
Low ratios might demonstrate:
- An over-optimistic view on the potential improvement in impaired loans or the value of collateral
- An unwillingness to hit profits and capital by making adequate impairment charges.
Trend of this ratio will reflect overall economic conditions or changes in underwriting standards. Comparing with peers will be more meaningful.
To improve the ratio, by rights, a bank can increase reserves. However, the bank can play creative accounting by slowing down charge off impaired loans and underestimating impaired loans.
This ratio can be distorted by regulations related to reserves, definition of impaired loans, and securitisation.
Complementary Metric: Loan-Impairment Charges/Average Gross Loans (%)
[Loan Impairement Charges]/[Average Gross Loans] ×100%
This ratio is sometimes called the cost of risk. The numerator is the charge to the income statement for loan impairment (also called loan loss allowances or provisions). Where the bank reports average loans gross of loan loss reserves, this is taken as the denominator. Otherwise, the denominator is a numerical average of gross loans (excluding bank loans and repos) calculated for a minimum of two data points, the number for the end of the reporting period and the one for the end of the previous reporting period. Where relevant and disclosed, the numerical average also considers interim data during the reporting period.
What does Loan-Impairment Charges/Average Gross Loans (%) tell us?
This ratio indicates to what degree the loan book has deteriorated over the past year. Trend of this ratio will reflect overall economic conditions or changes in underwriting standards. Comparing with peers will be more meaningful.
To improve this ratio, banks will improve lending criteria to reduce future impairment charges. This ratio can be distorted by provisioning policy, regulations and excessive growth in loans.
Oher useful ratios and metrics that useful to deep dive into warning signals in asset quality of banks
| Business Risk | Ratio and Calculation | Meaning | Ways to Improve Ratio | Ratio Distortions |
|---|---|---|---|---|
| Adequacy of reserve cushion | Reserve for impaired loans / Gross loans | Reserve adequacy – How adequate are the reserves in relation to loan book | Increase reserves Failure to charge off impaired loans | Regulations related to reserves Definition of impaired loans |
| Capital impairment Ratio | Unreserved impaired loans / Equity | How much equity would be lost if all impaired loans were fully provided for | Provide for impaired loans aggressively Obtain collateral on impaired loans | Definition of impaired loans Revaluation reserves |
| Adequate pricing of loans | Loan impairment charge / Net interest income | How much net interest income is lost through poor lending | Risk-based pricing Increase spread on loans (over cost of funds) | Regulations Management judgment regarding the loan loss provision |
| Charge-offs (write offs) and recoveries | Net charge-offs / Total Loans Net charge-offs = Charge offs minus recoveries | What portion of the loan book is being written off as bad debts | Rapid loan growth Improved monitoring of delinquent loans | Bank’s policies on charge-offs Economic cycle |
What to look for in the loan book?
1. Composition of the loan portfolio
- Growth in loan portfolio – must be backed by sufficient deposits
- Breakdown by industry and geography as % of total
- Breakdown by credit quality (if disclosed)
- Profit and asset allocation comparison – Profit should be from core business.
2. Potential problem areas as % of total portfolio
- Emerging markets/developed markets
- Commercial real estate
- Specific industries: Banks, automobile, retail, etc.
What to look for in the securities trading and derivatives?
Commercial banks issued many different types of securities trading and derivatives to market, such as Convertible Bonds, Exchangeable Bonds and Mezzanine Debt.
Considerations
- Management: Risk appetite and controls
- Credit risk: Issuer and counterparty exposure
- Disclosure: Risk profile of assets, liabilities and off balance sheet
- Market risk: Value at risk (VaR) modeling capability
Earnings at Risk
- Volatility and sources of trading income (quarterly monitored)
- How significant is trading income as a % of total operating income for a bank?
- How volatile has trading income been over the past couple of years?
- Trading income/average balance of securities
