As a financial institutions and markets analyst for More Gaine Securities, Inc.,

Question

As a financial institutions and markets analyst for More Gaine Securities, Inc., a highly reputable financial institutions' securities underwriter, you must prepare an analysis of the financial condition of a broad range of financial institutions of various sizes, localities, and product lines. Using the "probability of insolvency" model where E(ROA) is the expected value of after-tax earnings on assets, ?2 is the variance of ROA, and K/A is the firm's equity capital plus contingency and loan loss reserves to total assets, discuss, based upon your economic assumptions, what financial ratios you might use to assess the level and expected future course, over the next few years, of each of these indicators of financial soundness. As a preliminary to this discussion, clearly state your assumptions about general economic growth and cyclical movements, interest rates (level and term structure), and potential developments in individual industries and regional economies (e.g., agriculture, energy, Asian Markets). Primarily, discuss how the federal regulatory agencies' capital adequacy policy, in the form of risk-based capital adequacy standards and Prompt Corrective Action, might affect financial institution soundness, costs of moral hazard and portfolio choices.

NOTE: the maximum probability of insolvency = ?2/[E(ROA) + K/A]2

Explanation / Answer

The first step in estimating risks is to measure the expected variance in the returns to an individual Financial institute, given its selection of assets and liabilities. Ideally, this estimate should be made by applying a co-variance matrix for classes of assets to a Financial institute’s individual portfolio. In our study of Financial institute risks, a great deal of effort was devoted to attempts to measure the variance of specific activities. The greatest success was found in the study of interest rate risks. Because interest rate risks are closely related to movements in the risk-free interest rate and because such rates are set in a wellfunctioning market, it is not too difficult to measure the probability of movements in the risk-free rate applicable to assets with varying durations and maturities. With estimates of how movements of specific assets and liabilities of a Financial institute relate to those in the government bond market, it is possible to estimate the interest rate risk of a Financial institute as a whole. The data on credit and operating risks, while not as extensive, seem adequate for many purposes. These data consist of time series of loan losses and operating income changes for Financial institutes as a whole, and of similar information for large Financial institutes and Financial institute holding companies. These were analyzed through studies of the year-to-year movements of the cross-section of all individual Financial institutes. Information on the risks of mal-diversification and of moral hazards is far harder to obtain. There are records of the number of Financial institutes which have become insolvent for these and related reasons. The actual numbers are small. They give little indication of what would happen under a system of freer choices and minimal regulations. However, some measures for these risks can be obtained through simulations and examinations of related problems in other industries. Another sphere in which information is minimal is on the co-variances among risks. Here, however, data on a number of activities indicate that while an assumption of complete correlation among risks is conservative, it probably does not greatly distort the situation; that is, the co-variance term can be ignored. As a result, we conclude that currently the exact measurement of risks is not possible. However, the theories and available empirical estimates can show orders of magnitude and can pinpoint critical problems. Many types of risks can be quantified. The procedures point toward methods of reducing the remaining areas of uncertainty. With more detailed data from individual Financial institutes, the reliability of such estimates could be rapidly improved. Interest Rate Risks When interest rates move, Financial institutes are affected in at least four ways.

1. Their cash flows alter as the rate at which commitments are taken down changes, assets are paid off more or less rapidly, and deposit liabilities shift.

2. The interest rates paid and received on liabilities and assets tied to market rates move with those rates.

3. The term structure of interest rates shifts. If the term structure moves up, the value of future promises to pay becomes less.

4. The discounts for risk may widen. These changes will have the same effect as movements in the risk-free rate. We have tried to measure interest rate risks by two separate methods. The first calculates the probable variance in the risk-free rate of assets and liabilities at maturities from 3 months to 30 years. These estimates are based on the listing of actual month-to-month movements of government securities between 1951 and 1977. (McCulloch, 1975) These variances are combined into a weighted total variance depending on the duration of the activities conducted by typical Financial institutes. The second technique calculates the interest rate elasticity of net worth of specific institutions. Potential changes in capital values are estimated from econometric models of past lending and borrowing. Possible movements in interest rates are based on maximum past shifts in the term structure.

Federal statutes and regulations restrict the size of loans to a firm or individual in relation to the bank’s capital. While such rules are useful in guaranteeing a minimum, they fail to insure an adequate degree of diversification.

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