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Balance sheet management in commercial banks

  • Published at 08:00 pm January 20th, 2020
balance sheet management
Local banks cannot remain indifferent to the importance of balance sheet management Bigstock

The books don’t tell the whole story

People often blame credit losses or non-performing loans as the root cause of banks’ bad situation in Bangladesh or similar emerging countries.

My experience as a treasury manager, financial institutions risk manager, and corporate relationship head tells me that it is more about our failure to manage the bank’s balance sheet well.

The balance sheet of a commercial bank is significantly different in comparison to typical companies. Its asset side reflects the bank’s credit expansion through loans and investments. 

In the liabilities section, the bank’s operations act as an intermediary in time deposits. The section also reflects its involvement as a component in the nation’s monetary system in demand deposits. 

Maximizing returns while minimizing risks related to alternative portfolio combinations are some of the competing aims of bank balance-sheet management.

Banks tend to have a huge sum of off-balance sheet exposures, such as contingent exposures or derivative positions. 

Some of the biggest global banks have trillions of dollars’ worth of gross national value of derivative positions, which only appear on their balance sheet after their debtors exercise the option to draw down the loan. 

Therefore, simply the information published in a bank’s balance sheet understates their riskiness, particularly the larger ones.

The capital of a bank acts as a form of self-insurance whilst also providing a shield against unanticipated losses and the motivation to manage risk-taking mutually. Financing additional assets with capital increases the bank’s leverage ratio.

Compared to non-financial intermediaries, banks issue a much larger portion of debt. For example, US commercial banks have a debt-to-equity ratio of about $8, whilst non-financial companies typically tend to have a number between $0.80 and $1.50. 

This dependency on debt boosts a bank’s expected return on bank equity risk and makes them susceptible to insolvency. 

Low capital relative to their assets give bank managers the incentive to take risk known as the debt overhang. This is because while upside opportunity is unlimited, their downside risk is limited to initial investment. 

Deterioration of capital potentially shrinks losses, but gains do not. In such cases, shareholders tend to encourage bank managers to act more prudently till capital increases and the issue goes away. 

Shortage of capital in a banking system may strain the economy in three ways. 

It prevents the bank from loaning to healthy borrowers. Moreover, these banks issue evergreen loans to indebted companies, which are also called “zombie firms.” To avoid undermining their already weak capital position, the bank adds unpaid interest to those loans. 

Measuring a bank’s capital can be tricky. Valuation of liquid instruments such as US Treasury bonds is easy. But other securities such as municipal, corporate and emerging market bonds are notably less liquid than treasuries. 

Therefore, determining market prices of bank loans are difficult. A bank’s asset becomes further difficult to value in times of financial strain. Liquidity aside, the solvency state of the bank is also an important determinant of their asset value.

Alongside capital, computation of assets and exposures against which net worth delivers a buffer, are also necessary. 

This calculation is complicated due to accounting conventions and derivatives. These off-balance sheet exposures and credit conversion factors (CCFs) are applied to translate them into asset equivalents used to compute capital ratios.

However, accounting frameworks differ significantly. For example, under US GAAP, the bank may use their collateral against derivatives exposure, but cannot with IFRS.

Additionally, exposure measures do not consider the riskiness of assets. Therefore, a bank with treasury debt is appreciably less risky in contrast to those with illiquid loans in a similar duration. 

Due to this, risk-weighted assets are measured. Treasury debts have zero risk weight and the riskiest have 100%. 

However, banks tend to understate assets with higher risk weights and their internal models show significantly diverse measures used to calculate it. Therefore, leverage ratios are a more useful supplement in contrast to those which are risk weighted.

Unpredictable fluctuations in exchange rates lead to Foreign Exchange risks when banks hold assets or liabilities in foreign currencies. This uncertain movement impacts the earnings and capital of the bank significantly. 

As commercial banks deal with foreign currencies, they are constantly exposed to FOREX risk, which comes from their trade and non-trade services. FOREX risk rises for any unhedged position -- called an open position -- of a specific currency in a bank. 

The risk is mitigated through various hedging techniques.

One such technique is by matching the banks’ assets and liabilities in foreign currencies, as that warrants a profitable spread. 

Foreign currency derivatives, foreign currency futures, foreign currency swap, foreign currency options and foreign currency forward contracts, are used for hedging as well. 

Lastly, diversification of foreign asset-liability portfolio is another method of hedging.

Studies show that FOREX risk also exposes a bank to interest rate risk. This is because the fluctuating rates lead to a mismatch in the maturity pattern of foreign assets and liabilities. 

Even in cases of matching assets and liabilities, forward positions taken by the bank may also lead to interest rate risks.

Holding assets and liabilities in foreign currency further exposes banks to default or counter-party risk. Time Zone and Country risk due to parties being situated outside of the host country also arises with FOREX transactions.

The balance sheet of a bank provides an overview of their assets, liabilities and shareholders’ equity at a specific date. The components act as a basis of computing rates of return and capital structure evaluation. 

Therefore, balance sheet management of a commercial bank is vital. The practice mitigates FOREX, default, interest rate and various other types of risk through hedging and off-balance sheet methods. 

Local banks in Bangladesh seem to be indifferent to this balance sheet risk. It is high time that banks start changing the gear.

Mamun Rashid is a banker and economic analyst. He’s worked as country treasurer with ANZ Grindlays and Standard Chartered Bank.

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