Analysis of Financial Institutions

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.