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2019 Curriculum CFA Program Level II Financial Reporting and Analysis

Analysis of Financial Institutions

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Introduction

Financial institutions provide a wide range of financial products and services. They serve as intermediaries between providers and recipients of capital, facilitate asset and risk management, and execute transactions involving cash, securities, and other financial assets. 

Given the diversity of financial services, it is unsurprising that numerous types of financial institutions exist. Types of financial institutions include deposit-taking, loan-making institutions (referred to as banks in this reading), investment banks, credit card companies, brokers, dealers, exchanges, clearing houses, depositories, investment managers, financial advisers, and insurance companies. In many situations, overlap of services exists across types of institutions. For example, banks not only take deposits and make loans but also may undertake investment management and other securities-related activities and may offer such products as derivatives, which are effectively insurance against adverse effects of movements in the interest rate, equity, and foreign currency markets. As another example of overlap, life insurance companies not only provide mortality-related insurance products but also offer savings vehicles. This reading focuses primarily on two types of financial institutions: banks (broadly defined as deposit-taking, loan-making institutions) and insurance companies.

Section 2 explains what makes financial institutions different from other types of companies, such as manufacturers or merchandisers. Section 3 discusses how to analyze a bank. Section 4 focuses on analyzing insurance companies. A summary of key points concludes the reading.

Learning Outcomes

The candidate should be able to:

  1. describe how financial institutions differ from other companies;
  2. describe key aspects of financial regulations of financial institutions;
  3. explain the CAMELS (capital adequacy, asset quality, management, earnings, liquidity, and sensitivity) approach to analyzing a bank, including key ratios and its limitations;
  4. describe other factors to consider in analyzing a bank;
  5. analyze a bank based on financial statements and other factors;
  6. describe key ratios and other factors to consider in analyzing an insurance company.

Summary

  • Financial institutions’ systemic importance results in heavy regulation of their activities. 
  • Systemic risk refers to the risk of impairment in some part of the financial system that then has the potential to spread throughout other parts of the financial system and thereby to negatively affect the entire economy. 
  • The Basel Committee, a standing committee of the Bank for International Settlements, includes representatives from central banks and bank supervisors from around the world.
  • The Basel Committee’s international regulatory framework for banks includes minimum capital requirements, minimum liquidity requirements, and stable funding requirements. 
  • Among the international organizations that focus on financial stability are the Financial Stability Board, the International Association of Insurance Supervisors, the International Association of Deposit Insurers, and the International Organization of Securities Commissions. 
  • Another distinctive feature of financial institutions (compared to manufacturing or merchandising companies) is that their productive assets are predominantly financial assets, such as loans and securities, creating greater direct exposures to a variety of risks, such as credit risk, liquidity risk, market risk, and interest rate risk. In general, the values of their assets are relatively close to fair market values. 
  • A widely used approach to analyzing a bank, CAMELS, considers a bank’s Capital adequacy, Asset quality, Management capabilities, Earnings sufficiency, Liquidity position, and Sensitivity to market risk.
  • “Capital adequacy,” described in terms of the proportion of the bank’s assets that is funded with capital, indicates that a bank has enough capital to absorb potential losses without severely damaging its financial position.
  • “Asset quality” includes the concept of quality of the bank’s assets—credit quality and diversification—and the concept of overall sound risk management. 
  • “Management capabilities” refers to the bank management’s ability to identify and exploit appropriate business opportunities and to simultaneously manage associated risks. 
  • “Earnings” refers to the bank’s return on capital relative to cost of capital and also includes the concept of earnings quality. 
  • “Liquidity” refers to the amount of liquid assets held by the bank relative to its near-term expected cash flows. Under Basel III, liquidity also refers to the stability of the bank’s funding sources. 
  • “Sensitivity to market risk” pertains to how adverse changes in markets (including interest rate, exchange rate, equity, and commodity markets) could affect the bank’s earnings and capital position.
  • In addition to the CAMELS components, important attributes deserving analysts’ attention include government support, the banking entity’s mission, corporate culture and competitive environment, off-balance-sheet items, segment information, currency exposure, and risk disclosures. 
  • Insurance companies are typically categorized as property and casualty (P&C) or life and health (L&H). 
  • Insurance companies earn revenues from premiums (amounts paid by the purchaser of insurance products) and from investment income earned on the float (amounts collected as premiums and not yet paid out as benefits). 
  • P&C insurers’ policies are usually short term, and the final cost will usually be known within a year of a covered event, whereas L&H insurers’ policies are usually longer term. P&C insurers’ claims are more variable, whereas L&H insurers’ claims are more predictable. 
  • For both types of insurance companies, important areas for analysis include business profile, earnings characteristics, investment returns, liquidity, and capitalization. In addition, analysis of P&C companies’ profitability includes analysis of loss reserves and the combined ratio.

2.5 CE

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