Windsor Castle, London (2008)
Strategy & Stewardship Consultant in International Finance
Our Professional Mantra: Ethical Discipline, Theoretical Grounding, & Winning Values!
Friday, November 21, 2008
Sunday, September 28, 2008
Simple Analytics of the Financial Crisis
28 September 2008
by Cenen Herrera
Writing from Bracknell, Berkshire, United Kingdom
Understanding a bank’s operation starts with a simple balance sheet analysis. The typical balance sheet of a bank, i.e., large or small, would normally comprise of four main components:
Earning assets (loans and liquid) and non-earning assets (property, plant and equipment and others) on its left side, while liabilities and equity will be on its right side. Asset mix will be typically different when compared with its liability-equity mix. For example, a liability-equity mix of 80/20 would be compared to a 90/10 earning/non-earning asset mix. This means that the pre-shock financial scenario (before the sub-prime lending contagion) would typically have a large proportion of earning assets when compared to the total asset portfolio. An example is provided below.
Simplified Balance Sheet (pre-shock scenario)
[Rounded to the nearest billion of currency]
Earning Assets -------90-----Liabilities -------------------80
Non-Earning Assets --10-----Equity ----------------------20
Total Assets --------100-----Total Liabilities & Equity----100
The sub-prime lending financial shock gave rise to massive loan defaults arising mainly from the inability of bank clients to pay the debt service payments due on their housing loans. The corresponding market decline of housing prices led to borrowers defaulting on their loans instead of holding to their properties which were mortgaged to banks at much higher-than-market price. In the post-shock scenario, earning assets had been substantially reduced as a result of massive loan defaults giving rise to a “debt-overhang scenario” (where liabilities had no matching earning assets). Thus, bank failure was a result mainly of the inability of the institution to meet its maturing obligations, i.e., liability exceeding by large amounts the bank’s earning assets. Using the example presented earlier, a possible view of the balance sheet accounts after the post-shock scenario is provided below:
Simplified Balance Sheet (post-shock scenario)
[Rounded to the nearest billion of currency]
Earning Assets--------- 90--Liabilities----------------- -80
Loan Losses
from Sub-prime*------ (70)
Non-Earning Assets-- - 10 --Equity Beginning – Loan--- 20
----------------------------Losses from Sub-prime* --(70)
Total Assets----------- 30--Total Liabilities & Equity----30
*Note that earning assets were reduced by 70 as a result of loan losses, but liability remains at 80. Thus, negative equity stood at 50 [the amount of deficit that must be considered in business recovery].
In my view, it is expected that very few market participants would have avoided the current financial difficulties considering that such structured portfolio was a typical loan product of bank lending activities during the pre-shock scenario. Thus, market recovery appears to be dependent on a large-scale financial rescue program that may be considered as an inevitable exogenous variable in the post-shock scenario.
by Cenen Herrera
Writing from Bracknell, Berkshire, United Kingdom
Understanding a bank’s operation starts with a simple balance sheet analysis. The typical balance sheet of a bank, i.e., large or small, would normally comprise of four main components:
Earning assets (loans and liquid) and non-earning assets (property, plant and equipment and others) on its left side, while liabilities and equity will be on its right side. Asset mix will be typically different when compared with its liability-equity mix. For example, a liability-equity mix of 80/20 would be compared to a 90/10 earning/non-earning asset mix. This means that the pre-shock financial scenario (before the sub-prime lending contagion) would typically have a large proportion of earning assets when compared to the total asset portfolio. An example is provided below.
Simplified Balance Sheet (pre-shock scenario)
[Rounded to the nearest billion of currency]
Earning Assets -------90-----Liabilities -------------------80
Non-Earning Assets --10-----Equity ----------------------20
Total Assets --------100-----Total Liabilities & Equity----100
The sub-prime lending financial shock gave rise to massive loan defaults arising mainly from the inability of bank clients to pay the debt service payments due on their housing loans. The corresponding market decline of housing prices led to borrowers defaulting on their loans instead of holding to their properties which were mortgaged to banks at much higher-than-market price. In the post-shock scenario, earning assets had been substantially reduced as a result of massive loan defaults giving rise to a “debt-overhang scenario” (where liabilities had no matching earning assets). Thus, bank failure was a result mainly of the inability of the institution to meet its maturing obligations, i.e., liability exceeding by large amounts the bank’s earning assets. Using the example presented earlier, a possible view of the balance sheet accounts after the post-shock scenario is provided below:
Simplified Balance Sheet (post-shock scenario)
[Rounded to the nearest billion of currency]
Earning Assets--------- 90--Liabilities----------------- -80
Loan Losses
from Sub-prime*------ (70)
Non-Earning Assets-- - 10 --Equity Beginning – Loan--- 20
----------------------------Losses from Sub-prime* --(70)
Total Assets----------- 30--Total Liabilities & Equity----30
*Note that earning assets were reduced by 70 as a result of loan losses, but liability remains at 80. Thus, negative equity stood at 50 [the amount of deficit that must be considered in business recovery].
In my view, it is expected that very few market participants would have avoided the current financial difficulties considering that such structured portfolio was a typical loan product of bank lending activities during the pre-shock scenario. Thus, market recovery appears to be dependent on a large-scale financial rescue program that may be considered as an inevitable exogenous variable in the post-shock scenario.
Saturday, January 26, 2008
Financial Shocks, Risk Bearing Capacity and Social Responsibility
By Cenen Herrera
Writing from Martinez, San Francisco Bay Area
The recent financial shocks, i.e., financial institutions adversely affected by the sub-prime contagion and the large French bank rogue trader scandal of about $7 billion, demonstrated the importance of an institution’s risk bearing capacity and social responsibility. Risk bearing capacity represents the sum of net income retained by the institution over time plus freely usable paid-in capital contributed by its shareholders minus special reserves divided by the sum of its risk assets. Social responsibility is the ethical response of an institution to society in light of these financial shocks.
Strategic management provides the platform for projecting the level of risk bearing capacity that would be appropriate in meeting regulatory standards, e.g., Basel II requirements, and the planned cushion needed to protect an institution from expected and unexpected losses. On the one hand, expected losses such as bad debt expenses projected during an accounting period, e.g., after applying a probabilistic or non-probabilistic methodology, are viewed as part of operational expenses. On the other hand, unexpected losses are viewed as the risk of doing business. The adverse impact of the sub-prime contagion and the large French bank rouge trader scandal are examples of unexpected losses, i.e., risks of doing business. Both events (expected and unexpected losses) are traditionally considered in crafting the long-term plans of an institution. However, the magnitude and intensity of the recent financial shocks may have been extremely difficult to consider in the course of an ordinary strategic planning exercise. While sensitivity analysis and scenario planning tools provide the platforms for considering the degree of financial shocks that could be absorbed given a particular level of risk bearing capacity, adequate and effective controls are also needed to ensure that strategic plans are executed within the boundaries of the planning framework.
At the end of the day, what mattered most was the social responsibility demonstrated by the affected institutions in addressing the repercussions of the financial shocks, i.e., adverse impact of the sub-prime contagion and the French bank rogue trader scandal. Protecting the overall interest of the stakeholders goes beyond the metrics of risk bearing capacity. The affected institutions clearly demonstrated their social responsibility by prioritizing renewal efforts in bringing back normalcy to their operations.
At least two lessons emerged from the recent financial shocks: (i) the underpinnings of good governance such as character and reputation are invariably linked to performance, i.e., adverse impact of sub-prime contagion and the French rogue trader scandal are both governance and risk management issues, and (ii) the accompanying financial losses highlight the importance of an institution’s risk bearing capacity in meeting expected and unexpected losses, as well as the need to go beyond established controls in ensuring the effectiveness of risk management.
Writing from Martinez, San Francisco Bay Area
The recent financial shocks, i.e., financial institutions adversely affected by the sub-prime contagion and the large French bank rogue trader scandal of about $7 billion, demonstrated the importance of an institution’s risk bearing capacity and social responsibility. Risk bearing capacity represents the sum of net income retained by the institution over time plus freely usable paid-in capital contributed by its shareholders minus special reserves divided by the sum of its risk assets. Social responsibility is the ethical response of an institution to society in light of these financial shocks.
Strategic management provides the platform for projecting the level of risk bearing capacity that would be appropriate in meeting regulatory standards, e.g., Basel II requirements, and the planned cushion needed to protect an institution from expected and unexpected losses. On the one hand, expected losses such as bad debt expenses projected during an accounting period, e.g., after applying a probabilistic or non-probabilistic methodology, are viewed as part of operational expenses. On the other hand, unexpected losses are viewed as the risk of doing business. The adverse impact of the sub-prime contagion and the large French bank rouge trader scandal are examples of unexpected losses, i.e., risks of doing business. Both events (expected and unexpected losses) are traditionally considered in crafting the long-term plans of an institution. However, the magnitude and intensity of the recent financial shocks may have been extremely difficult to consider in the course of an ordinary strategic planning exercise. While sensitivity analysis and scenario planning tools provide the platforms for considering the degree of financial shocks that could be absorbed given a particular level of risk bearing capacity, adequate and effective controls are also needed to ensure that strategic plans are executed within the boundaries of the planning framework.
At the end of the day, what mattered most was the social responsibility demonstrated by the affected institutions in addressing the repercussions of the financial shocks, i.e., adverse impact of the sub-prime contagion and the French bank rogue trader scandal. Protecting the overall interest of the stakeholders goes beyond the metrics of risk bearing capacity. The affected institutions clearly demonstrated their social responsibility by prioritizing renewal efforts in bringing back normalcy to their operations.
At least two lessons emerged from the recent financial shocks: (i) the underpinnings of good governance such as character and reputation are invariably linked to performance, i.e., adverse impact of sub-prime contagion and the French rogue trader scandal are both governance and risk management issues, and (ii) the accompanying financial losses highlight the importance of an institution’s risk bearing capacity in meeting expected and unexpected losses, as well as the need to go beyond established controls in ensuring the effectiveness of risk management.
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