Free Custom «Rating of Commercial Banks» Essay Paper

In every business enterprise, risks are part of running this business. For running these enterprises, there has to be a consideration of the underlying risks that are likely to affect smooth sailing to ensure that there is an adequate preparedness in the event that these risks materialize. In this chapter analyzes the types of risks that commercial banks are faced with. Addressing the risks that face commercial banks, a special emphasis is put on the risks associated both with credits and liquidity. Commercial banks are faced with a variety of risks because of their poor performance. Risks reduce a business value. There are the following major sources of value loss:

1. Market Risk: This is a change of the net market value caused by changes in economic factors, such as interest rates, exchange rates and commodity prices. This risk may be caused by poor planning prior to expect market changes, like changes in the prices of commodities, changes in exchange rates and interest rates. A poor management of a commercial bank may lack information on the latest prices of commodities and, moreover, the latest interest rates and exchange rates bringing losses to a bank. It poses a very big risk to a bank.

2. Operational Risk: This is a risk caused by mistakes made in the operation of a bank. These risks may include a failure to meet regulatory requirements, for example, a failure to produce an operational report to the government. This may be also a result of carrying out untimely collections that may lead to confusions in the operation of a bank.

3. Performance Risk: This is a risk brought about by improper monitoring of employees. This may lead to the underperformance of a bank. A good management ensures that its employees are well-monitored by conducting regular performance assessments. A manager should also make sure that active members are rewarded for keeping up their good work and underperforming once is motivated in such a way that they can pull up their socks.

4. Model Risk: This is a risk that comes as s result of the use of inappropriate methods to monitor employees. This may include the following: quarreling employees for underperforming. It may discourage them and even encourage more underperforming leading to a risk to a bank.

5. Credit Risk: This is a risk transferred from and to a business, a sovereign bank, consumer and inter-bank loans, as well as associated transactions caused by an improper management of a bank. This leads to uncoordinated transfers from one bank to another posing this kind of risk. According to Barnhill & Souto (2009), it is evident that banks that possess high credit risks, as well as concentrated portfolios are more likely to fail especially at the time of financial stress (244). This is mainly attributed to the fact that the risks associated with having high credits are caused by the fact that organizations are not likely to honor their repayment plans. A good example is captured by Chijoriga (2011), when there is a focus on the recently experienced financial crisis in the world. It is argued that the reason why many banks and other financial institutions have failed is caused by the fact that these commercial banks have high credits (133).

One thing that is highlighted by Barnhill and Souto (2009) is a fact that banks, to a certain degree, are interdependent on each other through what they term as a nexus established by inter-bank financial contracts (245). This means that even though banks appear separate, they cannot be solely independent if they have to thrive. For example, when customers need to carryout inter-banks funds transfers, banks have to be interconnected for this to be made possible. Because of this kind of interconnection, there may be a possibility that at the time of financial stress one bank is pressed to a level that, though willing, it is not in a position to honor the predefined financial contract (p. 245). This means that the other bank has to undergo a credit crisis, as a result of which the bank can even collapse. A good example is in the works by Elsinger, Lehar and Summer (2003 as cited by Barnhill & Souto (2009)), where they argue that because of one bank being unable to honor its end of the deal, there is a provocation of financial distress in their counterpart(s) (245).

Many companies borrow loans to spruce-up their ventures and to offer better and affordable services and goods to their customers. Doing so, there are times when there is a downward business cycle (Barnhill & Souto, 2009, p. 245). When this trend continues for a long duration of time, it can affect a commercial bank because of the fact that many loans will become delinquent greatly decreasing the bank’s lending ability and plunging a bank even deeper (Gorton, 1988). When there is no more money to lend to business, especially during a financial stress, this in essence leads to a business plunging further and that will in return worsen financial crisis, which will affect more commercial banks (Gorton, 1988; Barnhill & Souto, 2009, p. 245).

6. Equity Price: Assuming that a depositor comes to make withdrawal and a bank is unable to make payment because of a run, such a bank is said to have undergone solvency risk, which can be fatal for a commercial bank if this progresses for a lengthened period of time (Sensarma & Jayader, 2009, p. 11). For maximizing ROE (Return on Equity), there must be a tradeoff established between EM (Equity Multiplier) and ROA (Return on Assets), which is a risky trend if allowed to progress for a long time (Sensarma & Jayader, 2009, p. 11). In this case, the term “EM” can be calculated by getting the reciprocal of the capital to asset ratio as described in Sensarma & Jayader (2009, p. 11).

Commercial banks that record a high Equity Multiplier have a capability of increasing the Return on Equity especially for its shareholders as seen in Sensarma & Jayader (2009, p. 11). This is a good tiding for shareholders. However, this is not a story as far as capital to asset ratio is concerned as discussed previously. Because of every increase in Equity Multiplier, there is an equivalent decrease in the capital to asset ratio, which is a clear indication of a high level of solvency risk (Sensarma & Jayader, 2009, p. 11). When this trend progresses passing a certain stage, it will eventually make a commercial bank to close its doors (Sensarma & Jayader, 2009, p. 11). It is proposed that hedging, which increases Return on Assets, can be done without necessarily increasing the risks associated with the increase in Return on Assets (Sensarma & Jayader, 2009, p. 11).

To calculate the Return on Equity, the following formula is to be applicable:

ROE = (Profit After Tax / Total Assets) * (Total Assets / Equity) (i) (Sensarma & Jayader, 2009).

ROA = {(II – IE) / (TA)} + {(NII – NIE) / (TA)} – {Provisions / TA} (ii) (Sensarma & Jayader, 2009).

Such that,

II Þ stands for Interest Income, IE Þ stands for Interest Expense, NII Þ is Non Interest Income, NIE Þ is Non Interest Expense and TA Þ is Total Assets

On the basis of the equations (i) and the equation (ii), the Return on Assets can be rewritten in the following way:

ROA = (Net Interest Margin + Non Interest Margin – Provisions to Total Asset) … (iii)

As a result of this argument, it is clear that from the equation (iii) mentioned above, the Return on Equity’s equation can be rewritten as follows:

ROE = (NETIM + NONIM - PROV) * (EM) (Sensarma & Jayader, 2009).

Such that,

NETIM Þ is Net Interest Margin, NONIM Þ is Non Interest Margin, PROV Þ stands for Provision and EM Þ is Equity Multiplier.

From the calculations stated above, it is clear that Assets affect Equity. However, the greatest contributors to Equity are an interest income and interest expenses. This is because two interests have a direct correlation with Return on Assets affecting Return on Equity. This means that if Return on Assets is low, there will be a considerable decrease in Return on Equity, which is reflected in Equity Price.

For example, a loaner is unable to repay his or her loans and the asset that was kept, as a guaranty is valued for less money. This means that the value of assets will be less than that of a loan. Despite assets being repossessed by a commercial bank, there is likely to be a decrease both in the principal amount loaned and the net interest being denied from the whole transaction. When it comes to accounting for this risk in a financial statement, there is a challenge as to where this should be addressed, as noted by Chen, Liu and Ryan (2008, p. 1190).