Key parameter to assess future default risk of a bank, credit union, or a similar institution that raises funds from depositors
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In an age of highly pronounced financial risks, especially after the 2008 financial crisis and the 2020-2021 crisis period, investors' risk perceptions are heightened. With high volatility in equity prices and overall concerns of risks being high, investors may have to liquidate asset positions and move into cash, for example, to protect against a significant price readjustment event in asset prices (crash in asset prices).
Investors from a wide variety of primary sectors may require the liquidation of their position to move into cash; real estate investors may want to move into cash for protection against a negative move in prices, investors in equities, bonds, commodities, alternative investments, etc., may require a move into cash for the same, or similar reasons.
However, when an investor liquidates a significant amount of positions, or if an investor has made a choice to stay in liquid and hold her wealth in cash, the wealth of the investor is exposed to another risk: the risk that the bank she holds her money in would default, and she may not be able to recover her principal sum, or part of the principal, especially in tax-haven jurisdictions or jurisdiction where, in a crisis, the central bank, usually a guarantor of depository institutions (implicitly in some jurisdictions & explicitly in others) may be severely compromised and its capacity to manage systemic risk may be impaired. Even if this is not the case, as explained later, the entire sum deposited may not be insured by the central bank.
Other idiosyncratic reasons may trigger concerns as well.
Regardless of the reasons, this report evaluates how an investor can assess whether their bank or depository institution is financially stable and if it would survive long-term or survive a crisis.
How can investors evaluate this risk?
An investor, depositor, or risk analyst can utilize the below-mentioned factors to assess the strength/survivability of their depository institution against the risk of default, to ascertain chances of long-term survival:
Value of residual claims
Banks and other depository institutions raise capital from depositors and other lenders. However, the banks' equity holders cannot be considered the providers of capital; instead, shareholders (those that hold the equity) have a residual interest in the performance of the loans that the bank makes.
If the bank's borrowers default, the depositors and other lenders have a superior claim, or a higher priority claim, over the equity owners. Nonetheless, if insufficient money is collected from borrowers, shareholders' equity is used to pay the depositors and other lenders. This risk, of losing the capital, keeps equity holders and the top management team vigilant regarding sensible issuance of loans and acts as a governance mechanism in ensuring that principles of prudence are followed in lending.
Because the ability of depository institutions to bear or cover credit defaults and losses, in practicality, is limited to the capital invested by the owners, or the total equity, the investors & depositors should pay a very close attention to the amount of owners' capital at stake, in relation to the liabilities of the institution/firm.
For example, if a bank has issued loans worth $100 million, and the total amount of owners' capital, the residual interest, is worth $5 million, there is, compared to the total lending, little at stake for a diversified equity holder base to prevent imprudent or irresponsible lending. The firm would, comparatively, have little at risk, reduced incentive to lend to creditworthy borrowers only, and to collect outstanding payments efficiently.
Such a condition may also push management towards making high-risk loans to charge a high rate of interest, thinking that the bank's leverage ratio is already out of the bounds of reasonable risk, and a slight further increase in leverage for a higher rate of return shan't be very problematic.
Shareholders, being rational actors, viewing a deterioration in the leverage ratio and the increase of irresponsible lending, should sell their shares. Such an action would further reduce the market value of shares, further reducing the ratio of capital at stake in relation to the liabilities.
In the above example, with $100 million in liabilities and $5 million in equity, the ratio of loans issued to equity would be 20 (100/5), i.e., $1 in equity supporting $20 in loans; if further imprudent lending is done, this ratio should further deteriorate, as the numerator increases, and the denominator decreases.
Therefore, one of the most important factors that investors should assess to evaluate the health of their commercial bank, credit union, or depository institution is the ratio of the total value of loans issued to the market value of its equity. (some sophisticated investors can further use the market value of loans issued or the inflation-adjusted value; nonetheless, such advance methods may not be available to retail investors or smaller family offices, etc., the book value of the overall lending, thus, can be used for a quick analysis.)
Therefore, we can see that the value of the residual claims that support the firm in case of defaults and loss of capital is a key factor in assessing the subject of this report.
Market value of equity
Fluctuations in the market value of equity are a further relevant factor. In a distress period or during a sharp decline in market prices, the overall market value of equity may drop drastically. Such a move would, of course, increase the possibility of default and overall risk pertaining to the subject financial institution in this assessment. Investors can use the beta of the share price of the firm in relation to the overall market, and calculate how it may fluctuate in a period of severe volatility. Such an adjustment would enable a multi-scenario analysis.
For example, in the U.S., our report and the insights provided in it regarding the average, best and worst-case calculations can be utilized; by multiplying the stocks beta with the base-case, best-case, and worst-case, investors can determine an expected range of stock price movement and devise a worst-case, best case, and base-case scenarios for the assessment of this risk (see report for conducting range analysis: How Much Does the US Stock Market Fall/Decline on Average in a Market Crash?).
Application of this method
Most simply, the investor can divide the total value of the loans issued by the firm in question by the market value of the equity. The same should be done for the last 5-10 years to assess the trend in this ratio retrospectively, i.e., whether this ratio has been improving or deteriorating.
More sophisticated investors should input the inflation-adjusted market value of debt in the numerator. Investors that may not have the capacity or the time to conduct an advance analysis can contact us to administer an advanced, in-depth analysis of this risk for a specific institution.
Nature of depository institutions/firms, and insights it provides
In a way, depository banks and financial corporations, in terms of their nature, resemble pass-through securities issuing securitized asset pools. Those that deposit funds in them and other capital investors, in a sense, own securities that are ultimately backed by an asset pool consisting of the loan portfolios of these firms/institutes.
The depositors, seen through this prism of thinking, hold the most senior tranche, the creditors hold the second most senior tranche, and the shareholders hold the most junior tranche. Hence, if bankruptcy occurs, shareholders only receive proceeds when everyone else is paid.
The significance of this viewpoint here is that if the institution is in good financial health, bearing minimum risk, as with other securitized loans, even its lowest tranche should be relatively valuable, as the risk of default would be perceived to be low, and the lowest tranche holder would expect regular coupons, which in this analogy would be dividends.
However, suppose the value of the lowest tranche, the market value of equity viewed through this analogy, declines considerably or demonstrates a downward trend. In that case, investors should consider this factor a signal from the market regarding the risks or creditworthiness of the institution/firm in question. Alternatively, if the share price is on an upward trend, all else being equal, the depositors can take it as a positive signal from the market regarding the risk exposure & creditworthiness of the subject.
Can we rely on central banks to mitigate the risk of bank defaults and be insurers of depositors' capital?
Some investors may feel confident that this risk wouldn't impact them because the CB in their specific jurisdiction may provide insurance against bank default. While such a guarantee may be 'good enough' for retail customers with amounts equivalent to $5,000 or less in their accounts, for high net-worth individuals, however, CB guarantee of the deposits isn't a real risk mitigator, and shouldn't be considered as one.
The deposit insurance, first of all, is applicable till a specific amount in most jurisdictions, i.e., if the insurance is up to, say, 250,000 units of currency, and the investor has over a million in the account, they are still at risk of losing 75% of the sum in their account.
In the U.S., the FED insures up to $250,000 per depositor, per insured bank; this figure stands at $100,000 (CAD) in Canada, £85,000 in the U.K., $250,000 (AUD) in Australia, and $100,000 (NZD) in New Zealand. As we can see, this risk is considerably more relevant for high-net-worth individuals as no major developed jurisdiction provides full deposit insurance, and individuals exposed to this risk must evaluate its gravity on their own, using methods/models such as elaborated in this report.
It is also worth noting that those content with vague promises of a government financial entity, may already be lacking the circumspection & watchfulness required for the preservation of wealth, long-term. If an investor dismissively overlooks risks, expecting the government to intervene if they are exposed to them, long-term preservation of the wealth of such an individual is, more likely than not, going to be a precarious state.
Lastly, it is important the depositors remain vigilant continually, and use a wide variety of existing and emerging models to assess their risk exposures. A single model or method may be used as an indicator, nonetheless, a single model or method cannot be all-encompassing for evaluating risks. Continual vigilance & assessment, therefore, are of utmost importance.
Reference: Model presented in this report is a modified version, adapted from the work of Larry Harris, PhD, CFA (2019): CORPORATE FINANCE AND EQUITY. Publisher: CFA Institute. ISBN 978-1-946442-79-6