ANALYZING BANKING RISK

By Hennie van Greuning and Sonja Brajovic Bratanovic

1.5 Analytical Tools Provided

While each analysis may be unique, the overall analytical process has many consistent aspects with regard
to off-site surveillance, on-site examination, a bank’s own risk management, or evaluation by technical
professionals. This publication provides tools to assist with the bank analysis, including a questionnaire
(Appendix 1) and a series of spreadsheet-based data input tables to enable an analyst to collect and
manipulate data in a systematic manner. The tables can be found on the CD-Rom included. A series of
output tables and graphs on the same CD-Rom can also assist executives in the high-level interpretation
and analysis of a bank’s financial risk management process and its financial condition. This type of
analytical tool can be easily mechanized by using commercially available computer software, such as
Microsoft Excel. This publication is not a manual on how to use the tools, but a conceptual framework to
explain the background to the tools.

Input questionnaire. The questionnaire and data tables should be completed by the bank being
evaluated. The questions (see Appendix A) are designed to capture management’s perspective on and
understanding of the bank’s risk management process. The background and financial information requested
in the questionnaire should provide an overview of the bank, as well as allow for assessment of the quality
and comprehensiveness of bank policies, management and control processes, and financial and
management information. Questions fall into several categories, as follows:

• institutional development needs;

• overview of the financial sector and regulation;
• overview of the bank (history and group and organizational structure);
• accounting systems comprising management information and internal controls;
• information technology;
• corporate governance, covering certain key players and accountabilities;
• financial risk management, including asset/liability management, profitability, and the six other
major types of financial risk, discussed in Chapters 6 through 11.

Data input tables. The CD-Rom contains a series of input tables for financial data collection. The
data can be manipulated into either ratios or graphs. The tables are related to the eight major financial risk
management areas. The balance sheet and income statements serve as anchor schedules, with detail
provided by all the other schedules.

Output summary report. The framework enables the production of tables, ratios, and/or graphs
based on manipulated input data. The report allows an analyst to measure a bank’s performance and to
judge the effectiveness of its risk management process. Combined with the qualitative information obtained
from the questionnaire, these statistical tables and graphs make up the raw material needed to carry out an
informed analysis, as required in off-site (or macro-level analysis) reports. The ratios cover the risk
management areas in varying degrees of detail, starting with balance sheet and income statement schedules.
The graphs provide a visual representation of some of the analysis results and give a quick snapshot of both
the current situation in banks (such as financial structure and the composition of loan portfolios) and
comparisons over time.

Ratio analysis. Ratios are a basic tool for financial analysts and are essential to examine the
effectiveness of a bank’s risk management process. They are normally the initial points that provide clues
for further analysis. Changes in ratios over time offer a dynamic view of bank performance. The outputs of
the framework include ratios on balance sheet structure, profitability, capital adequacy, credit and market
risk, liquidity, and currency risk. These comprise a complete set of a bank’s ratios that are normally subject
to off-site surveillance. The framework therefore serves as an effective tool to be used in bank supervision.

Graphs. Graphs are powerful tools for analyzing trends and structures. They facilitate comparison
of performance and structures over time, and show trend lines and changes in significant aspects of bank
operations and performance. In addition, they provide senior management with a high-level overview of
risk trends in a bank. Samples of graphs illustrate discussions on risk exposure and risk management in
Chapters 4 through 11 of this publication. These pertain to asset and liability structures, sources of income,
profitability and capital adequacy, composition of loan portfolios, major types of credit risk exposures, and
exposure to interest rate, liquidity, market, and currency risk. The graphs produced by the framework may
also be used during off-site surveillance. In this context, they can serve as a starting point to help with on-
site examination and to succinctly present the bank’s financial condition and risk management aspects to
senior management. They can also help to illustrate points made by external auditors in their presentation to
management or by other industry professionals who intend to judge a bank’s condition and prospects.

Table 1.3 illustrates the more general use of the tools provided with this publication. Such a table
could provide a useful tool for analysts when the effectiveness of financial risk management is assessed. In
principle, the tools provided in Appendix A and on the CD-Rom can be used during the entire bank
analysis cycle. They can help an analyst make a thorough diagnosis of a bank’s financial condition, risk
exposures, and risk management, as well as to evaluate trends and make projections about future
developments.
 Table 1.3 Possible Uses of Tools Provided

Analytical Phase Source and Tools Output

Available

Data collection Questionnaire Completed input data, questionnaires,

Manipulation of data
Analysis and interpretation of
both manipulated and original
input data
Off-site analysis of a bank’s
financial condition
Focused follow-up through an
on-site examination, audit, or
review engagement
Institutional strengthening
Financial data tables
Completed input data,
questionnaires, and financial
data tables
Manipulated data
Analytical results
Off-site examination report
and/or terms of reference for
on-site examination
On-site examination report
and financial data tables
Data manipulated by the model
Analytical results (output summary
report, tables and graphs)
Report on a bank’s financial condition
and risk management and/or terms of
reference for on-site examination
On-site examination report
Well-functioning financial intermediary

The practices of bank supervisors and the appraisal methods practiced by financial analysts continue
to evolve. This evolution is necessary in part to meet the challenges of innovation and new developments,
and in part to accommodate the broader process of convergence of international supervisory standards and
practices, which are themselves continually discussed by the Basel Committee on Banking Supervision.
Traditional banking analysis has been based on a range of quantitative supervisory tools to assess a bank’s
condition, including ratios. Ratios normally relate to liquidity, the adequacy of capital, loan portfolio
quality, insider and connected lending, large exposures, and open foreign exchange positions. While these
measurements are extremely useful, they are not in themselves an adequate indication of the risk profile of
a bank, the stability of its financial condition, or its prospects. The picture reflected by financial ratios also
largely depends on the timeliness, completeness, and accuracy of data used to compute them. For this
reason, the issue of usefulness and transparency is critical, as discussed in Chapter 12. Chapter 12 also
 attempts to add another dimension to the issue of transparency, i.e., accountability, which has become an
important topic due to both the increasing importance of risk management for modern financial institutions
and the emerging philosophy of supervision (considered in Chapters 3 and 13).

The central technique for analyzing financial risk is the detailed review of a bank. Risk-based bank
analysis includes important qualitative factors, and places financial ratios within a broad framework of risk
assessment and risk management and changes or trends in such risks, as well as underscoring the relevant
institutional aspects. Such aspects include the quality and style of corporate governance and management;
the adequacy, completeness, and consistency of a bank’s policies and procedures; the effectiveness and
completeness of internal controls; and the timeliness and accuracy of management information systems and
information support.

The elements of the risk-based analytical review covered in this publication are summarized in Table 1.2.
Chapter 4 discusses the overall structure of a bank’s balance sheet and focuses on the imbalances and
mismatches in balance sheet structure that expose a bank to financial risk. The approach to asset/liability
management and aspects of profitability, including management of a bank’s income and expenses, is
elaborated in Chapter 5. Chapter 6 considers capital adequacy and the quality of a bank’s capital, while
Chapter 7 covers credit risk management, including aspects of portfolio composition and quality and
related policies and procedures. Aspects of liquidity management are discussed in Chapter 8, interest rate
risk management in Chapter 9, market risk management in Chapter 10, and currency risk management in
Chapter 11. Understanding of these subjects is facilitated by numerous graphs and tables. Although the
discussions and information contained in the graphs and tables in Chapters 4 through 12 refer to individual
institutions, the same type of analysis can be conducted at the industry level.

Table 1.2 Summary of Financial Risks Covered in this Publication

Financial Risk Found In Summary

Area

Balance Sheet Structure Chapter 4 Risks resulting from the structure and composition of a bank’s
(including off-balance- assets and liabilities and off-balance-sheet positions
sheet)
Income Structure and Chapter 5 Risk of a bank that does not have sufficient income to cover its
Profitability expenses and maintain capital adequacy
Solvency Risk and Chapter 6 Risk of a bank having insufficient capital to continue
Capital Adequacy operations. Risk of noncompliance with minimum regulatory
capital standards
 Financial Risk Found In Summary
Area

Credit Risk Chapter 7 Risk that a party to a credit agreement will not be able or
willing to service interest or repay the principal
Liquidity Risk Chapter 8 Risk of a bank having insufficient funds on hand to meet its
current obligations
Interest Rate Risk Chapter 9 Risk of changes in interest rates that will have an adverse
effect on a bank’s income and/or expenses
Market (Position) Risk Chapter 10 Risk of capital loss resulting from adverse market price
movements related to investments in commodity, equity, fixed
interest, or currency markets
Currency Risk Chapter 11 Risk of adverse exchange rates movements, due to the
mismatch between foreign receivables and payables

This publication pays special attention to risk exposures and the quality and effectiveness of a
bank’s risk management processes. Risk management normally involves several steps for each type of
financial risk and for the overall risk profile. These steps include the identification of an objective function,
or the risk management target and/or measure of performance. Also important is the identification and
measurement of specific risk exposures in relation to the selected objective function, including assessment
of the sensitivity of performance to expected and unexpected changes in underlying factors. Decisions must
also be made on the acceptable degree of risk exposure and on the methods and instruments to hedge
excessive exposure, as well as on choosing and executing hedging transactions. In addition, the
responsibilities for various aspects of risk management must be assigned, the effectiveness of the risk
management process assessed, and the competent and diligent execution of responsibilities ensured.