Credit Analysis of Banks

What will the credit analyst consider when analysing a financial sector company/bank?

1. Customer base
   • The type of customer base served by the company. For example, how much of a bank’s lending is to the wholesale sector, how much is retail etc
2. Asset quality of the institution
   • For example, the event of diversification of a bank’s lending book. Diversification can be across customer base as well as geographically
3. The level of loans compared with levels in peer companies and the risk involved with this type of lending
   • For example, the expected frequency of bad loans from direct unsecured retail customer loans is higher than for retail customer loans secured by a second mortgage on a property

What financial ratios can be used to assess a bank’s asset quality?

• Loss reserves / net charge-off level
• Net losses / average level of receivables
• Non-performing loans / average level of receivables

What are some other important measures for financial companies?

1. The leverage ratio
   • For financial sector companies in particular, the industry and business itself are highly leveraged. Banks are therefore permitted a significantly higher leverage level than other companies
2. Liquidity
   • Due to the nature of the industry and the capital structure of banks, the lack of liquidity is the primary reason behind banking failures

Why do some firms struggle to raise liquidity?

1. Internal Factors - Deterioration in earnings or a very poorly performing loan book, connected perhaps with a downgrade in credit rating
2. External Factors - Major structural faults in the money markets

What are the main sources of liquidity?

• Cash
• Cash equivalents
• Level of receivables under one year / level of short-term liabilities

What are some other measures of financial strength?

• Asset coverage
• Earnings per share
• Size of the institution

What are the reasons for obtaining a credit rating?

1. Provides independent verification of the financial strength of the bank
2. Provides access to wholesale markets for the issuance of:
   • Additional Tier 1 and Tier 2 capital
   • Covered bonds
   • Senior unsecured bonds
   • Short-term funding such as commercial paper and certificates of deposit
3. Focuses strategy development: management needs a strong business plan to present to the rating agencies