COMMERCIAL BANKING

RISK MANAGEMENT IN
COMMERCIAL BANKING

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

 objectives
 Types of FI Risks
 Risk Management Credit Analysis
 Common ratio analysis includes:
 liquidity ratios
 current ratio
 quick ratio (i.e., the acid test)
 asset management ratios
 number of days in receivables
 number of days in inventories
 sales to working capital
 sales to fixed assets
 sales to total assets (i.e., the asset turnover ratio)
objectives
 debt and solvency ratios
 debt-to-assets ratio
 times interest earned ratio
 cash-flow-to-debt ratio
 profitability ratios
 gross margin
 operating profit margin
 return on assets (ROA)
 return on equity (ROE)
 dividend payout ratio
 Credit Risk Management
 Financial institutions (FIs) are special because of their
ability to transform financial claims of household
savers efficiently into claims issued to corporations,
individuals, and governments
 FIs’ ability to process and evaluate information and
control and monitor borrowers allows them to
transform these claims at the lowest possible cost to all
parties
 Credit allocation is an important type of financial claim
transformation for commercial banks
 FIs make loans to corporations, individuals, and
governments
 FIs accept the risks of loans in return for interest that
(hopefully) covers the costs of funding net of defaults
and, as a result, are exposed to credit risk
McGraw-Hill/Irwin 20-4
 Credit Analysis
 Mid-market C&I lending (cont.)
 FIs perform cash flow analyses, which
provide information regarding an applicant’s
expected cash receipts and disbursements
 statements of cash flows separate cash flows
into:
 cash flows from operating activities
 cash flows from investing activities
 cash flows from financing activities
 FIs may also perform ratio analyses
 time-series analyses
 cross-sectional analyses

McGraw-Hill/Irwin 20-5
 Types of Risk at FIs
Credit risk is the risk that the promised cash flows from loans
and securities held by FIs may not be paid in full
FIs make loans or buy bonds backed by a small percentage
of capital
Thus, banks, thrifts, and insurance companies can be
significantly hurt by even minor amounts of loan loss
Liquidity risk is the risk that a sudden and unexpected increase
in liability withdrawals or unexpected loan demand may require
an FI to liquidate assets in a very short period of time and at low
prices
Insolvency risk is the risk that an FI may not have enough capital
to offset a sudden decline in the value of its assets relative to its
liabilities.
Market risk is the risk incurred in trading assets and liabilities due
to changes in interest rates, exchange rates, and other asset prices
 Cont,
 Interest rate risk is the risk incurred by an FI when
the maturities of its assets and liabilities are
mismatched and interest rates are volatile
 Asset transformation involves an FI issuing
secondary securities or liabilities to fund the
purchase of primary securities or assets
 If an FI’s assets are longer-term than its
liabilities, it faces refinancing risk.
 If an FI’s assets are shorter-term than its
liabilities, it faces reinvestment risk.

McGraw-Hill/Irwin 19-7
Ratio Analysis:
• In addition to cash flow information, an
applicant requesting specific levels of credit
substantiates these business needs by presenting
historical audited financial statements and
projections of future needs.
• Historical financial statement analysis can be
useful in determining whether cash flow and
profit projections are plausible on the basis of
the history of the applicant and in highlighting
the applicant’s risks.
• Calculation of financial ratios is useful when
performing financial statement analysis on a
mid-market corporate applicant
 Sample Cash Flow Analysis
Change Assets 2013 2014 Liabilities & Equity 2013 2014 Change

($60) Cash $170 $110 Accounts payable $135 $120 ($15)

$200 Accounts rec. 500 700 Notes payable 1,200 1,400 $200

($240) Inventory 1,240 1,000 Total current liabilities 1,335 1520

Total current 1,910 1810 Long-term debt 2,005 2,620 615

$1,500 Fixed assets 2,000 3,500 Common stock 100 200 100

Retained earnings 470 970 500

Total assets $3,910 $5,310Total liab. & equity $3,910 $5,310

Income Statement 2014 Summary Cash Flow Statement 2014

Sales $8,800.00
Costs ($5,600.00) A: Cash Flow From Operations $ 2,464.50
Depreciation ($900.00)
EBIT $2,300.00 ($ 2,400.00)
B. Cash Flow From Investing
Interest ($350.00)
Expense
EBT $1,950.00 C. Cash Flow From Financing ($ 124.50)
Taxes ($760.50)
Net Income $1,189.50
Dividends $689.50 D. Change in Cash ($ 60.00)
Change RE $500.00
McGraw-Hill/Irwin 20-9
 Credit Analysis
 Mid-market C&I lending (cont.)
 Common ratio analysis includes:
 liquidity ratios
 current ratio
 quick ratio (i.e., the acid test)
 asset management ratios
 number of days in receivables
 number of days in inventories
 sales to working capital
 sales to fixed assets
 sales to total assets (i.e., the asset turnover ratio)

McGraw-Hill/Irwin 20-10
 Credit Analysis
 Mid-market C&I lending (cont.)
 debt and solvency ratios
 debt-to-assets ratio
 times interest earned ratio
 cash-flow-to-debt ratio
 profitability ratios
 gross margin
 operating profit margin
 return on assets (ROA)
 return on equity (ROE)
 dividend payout ratio

McGraw-Hill/Irwin 20-11
 Sample Ratio Analysis
Change Assets 2013 2014 Liabilities & Equity 2013 2014 Change
($60) Cash $170 $110 Accounts payable $135 $120 ($15)
$200 Accounts rec. 500 700 Notes payable 1,200 1,400 $200
($240) Inventory 1,240 1,000 Total current liabilities 1,335 1520
Total current 1,910 1810 Long-term debt 2,005 2,620 615
$1,500 Fixed assets 2,000 3,500 Common stock 100 200 100
Retained earnings 470 970 500
Total assets $3,910 $5,310 Total liab. & equity $3,910 $5,310

Income Statement 2014

Sales $8,800.00
Costs ($5,600.00)
Depreciation ($900.00)
EBIT $2,300.00
Interest ($350.00)
Expense
EBT $1,950.00
Taxes ($760.50)
Net Income $1,189.50
Dividends $689.50
Change RE $500.00
McGraw-Hill/Irwin 20-12
 Liquidity ratios (2014)
Current ratio = Current Assets / Current Liabilities = 1.19
Quick ratio (acid test) = (Cash + Cash equivalents + Receivables) / Current Liabilities = 0.53
Asset management ratios (2014)
Days sales in receivables = (Receivables  365) / Credit Sales = 29
Days in inventory = (Inventory  365) / Cost of Goods Sold = 65
Sales to fixed assets = Sales / Fixed Assets = 2.5
Asset turnover = Sales / Total Assets = 1.66
Debt (long term solvency) ratios (2014)
Debt to asset or total debt ratio = Total Liabilities / Total Assets = 78%
Times Interest Earned: EBIT / Interest Expense = 6.57
Cash flow to debt ratio = (EBIT + Depreciation ) / Debt = 77.3%
EBIT is earnings before interest and taxes, EAT is earnings after taxes
Profitability ratios (2014)
Gross margin = Gross profit / Sales = 36%
Operating profit margin = Operating profit / Sales = 26%
Net profit margin = EAT / Sales = 13.5%
Return on assets = EAT / total assets = 22%
Return on equity = EAT / Total equity = 101.7%
Dividend payout = Dividends / EAT = 57.9%