Better balance sheet management needed in banks
To mitigate a bank’s bad situation due to loan-related loss, banks need to manage its balance sheet properly
How much of a bank's deposits should be held in term form to avoid rate volatility? What percentage of its loans should be project finance? Should a bank hold most of its deposits in fixed terms? What may happen if it is the other way around, i.e., in current accounts? Should a bank be keeping a large amount in liquid form?
Why are good banks these days focusing more on cash management or transaction banking, popularly known as receivable and payable management?
London-based The Economist attributed a lot of credit to their better cash management as the reason for Citibank/Citigroup's surviving the global meltdown in 2008/09. Citi transaction services, earlier or later, also achieved a lot of accolades for helping the bank with better management of its assets and liabilities.
We have seen banks paying dearly for funding long-term assets by borrowing short-term or over-depending on call borrowing or short-term deposits to support their medium- or long-term loan book. Even today, we cannot claim all the banks have the right focus on balance sheet management in Bangladesh.
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Most of their time and resources are dedicated to loan management or term deposit mobilisation. Some banks are often being twisted into having too much dependency on call money or even long-term project finance.
The activities of a bank involve many types of risks, like reputation risk, financial crime risk, operational risk, fraud risk, people risk, credit risk, and others. One significant risk people generally blame for a bank's bad situation in Bangladesh and similar countries is loan-related loss.
My experience as a treasury manager or financial institution risk manager, spanning over a decade and a half in multiple large global and foreign banks, tells me that it is also about our failure to manage a bank's balance sheet properly.
The balance sheet of a commercial bank is significantly different from a typical company. The items in a bank's balance sheet are mostly money—money that its customers keep with the bank as deposits and money that its customers borrow as loans, i.e., liabilities and assets, respectively. In addition to loans, a bank also keeps money in various forms of investments, some of which are to be kept as per regulatory requirements.
While these activities seem simple, with the only risk being a borrowing client becoming a defaulter, in a real-life situation a bank typically has thousands of crores or even lakh crores of total deposits from hundreds of thousands of customer accounts in multiple currencies in addition to the domestic currency; things aren't simple at all, as each deposit and loan item comes with different maturity tenors.
On a large scale, a bank measures these as maturity mismatches for different future time periods.
Maximising returns while minimising risks related to alternative portfolio combinations are some of the competing aims of banks' balance sheet management.
Banks tend to have a huge sum of off-balance sheet exposures, such as contingent (e.g., letters of credit or guarantees) exposures or derivative positions.
We have seen during North America's financial sector meltdown that some large global banks have trillions of dollars worth of derivative positions, which only appear on their balance sheets after their debtors exercise the option to draw down the loan. Hence, simply the information published in a bank's balance sheet understates its riskiness, particularly the larger ones.
We have seen during North America's financial sector meltdown that some large global banks have trillions of dollars worth of derivative positions, which only appear on their balance sheets after their debtors exercise the option to draw down the loan. Hence, simply the information published in a bank's balance sheet understates its riskiness, particularly the larger ones.
The capital of a bank acts as a form of self-insurance while also providing a shield against unanticipated losses and the motivation to manage risk-taking mutually. Financing additional assets with capital increases the bank's leverage ratio.
A banking system's capital shortage may strain the economy in three ways.
It prevents the bank from lending to healthy borrowers. Moreover, these banks issue evergreen loans to indebted companies, which are also called "zombie firms." The bank adds unpaid interest to those loans to avoid undermining their already weak capital position.
Measuring a bank's capital can be tricky. Valuation of liquid instruments such as Treasury bonds is easy. But other securities, such as corporate and emerging market bonds, are notably less liquid than treasuries.
Therefore, determining the market prices of bank loans is difficult. A bank's asset becomes more difficult to value in times of financial strain. Liquidity aside, the solvency state of the bank is also an important determinant of their asset value.
We have seen during the Asian meltdown in the late nineties that unpredictable fluctuations in exchange rates lead to foreign exchange risks when banks hold assets or liabilities in foreign currencies. This uncertain movement impacts the earnings and capital of the bank.
As commercial banks deal with foreign currencies, they are constantly exposed to foreign exchange risk, which comes from their trade and non-trade services. This risk rises for any unhedged position—called an open position of a specific currency in a bank. The risk is mitigated through various hedging techniques.
Besides, banks are increasingly focusing on tenor mismatch, maturity ladder, and alignment between deposit/loan maturities.
Many commercial banks in Bangladesh have started to realise the importance of differentiating themselves from others through better balance sheet management. Better receivable and payable management, along with better tenor-based liquidity or balance sheet management, would soon become key to success for banks here.
Mamun Rashid is the Founding Managing Partner of PwC Bangladesh and Chairman of Financial Excellence Ltd.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.
