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8/6/2019 Assignment 1 MBL93EV St No. 71020438 Final
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Reviewed by C. J. Masina
Are bank stocks sensitive to risk management?
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Publication Information
The Authors
Rudra Sensarma,Department of Accounting, Finance, and Economics,
University of Hertfordshire Business School, Hatfield, UK
M. Jayadev,Indian Institute of Management, Bangalore, India
Article Type: Research paper
Journal: The Journal of Risk Finance
Year: 2009
Copyright Emerald Group Publishing Limited
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Purpose and Theoretical Review
The paper under review attempts to summarize the information contained in bank
financial statements on the risk management capabilities of banks and then ascertains
the sensitivity of bank stocks to risk management focusing on Indian Banks.
The paper under review interprets the selected accounting ratios as risk management
variables and attempts to gauge the overall risk management capability of banks by
summarizing these accounting ratios as scores through the application of multivariate
statistical techniques.
Finally, the paper analyzes the impact of these risk management scores on stock returns
through regression analysis.
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Topics to be Presentation
1. Du Pont identity
2. Return on Equity
3. Return on Assets
4. Risk Measurement Profit Margin
5. Risk Measurement - Interest Rate Risk6. Risk Measurement - Natural hedging strategy
7. Risk Measurement Credit Risk
8. Risk Measurement Solvency risk or capital risk
9. Risk management scores and data
10. Stock market response to risk management - Regression analysis
11. Conclusion
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Du Pont identity
Return On Investment
ROI = (Net Income /Sales Sales) x (Sales/Total Assets)
=Net Income/ Total Assets
Measures combined effects of profit margin and asset turnover
Various Textbooks and Journals
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Du Pont identity
ROE = (Net profit/Sales) (Sales/Assets) (Assets/Equity)
= (Profit margin) (Asset turnover) (Equity multiplier)
ROE = (Net profit/Equity)
=(Net profit/ Pre-tax profit ) x (Pre-tax profit/EBIT) x (EBIT/Sales)
x (Sales/Assets) x (Assets/Equity)
Various Textbooks and Journals
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Du Pont identity
The du Pont system is a financial analysis and planning tool designed to provide
an understanding of the factors that drive the return on equity (ROE) of the
firm using basic accounting relationships.
Various Textbooks and Journals
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Du Pont identity Ratios
Various ratios used in fundamental analysis.
Net profit Pretax profit = The company's tax burden.
This is the proportion of the company's profits retained after paying incometaxes.
Pretax profit EBIT = The company's interest burden.
This will be 1.00 for a firm with no debt or financial leverage.
EBIT Sales =The company's operating profit margin or return on sales
(ROS).
This is the operating profit per dollar of sales.Various Textbooks and Journals
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Du Pont identity Ratios
Sales Assets = The company's asset turnover (ATO).
Assets Equity = The company's leverage ratio, which is equal to thefirm's debt to equity ratio + 1.
This is a measure of financial leverage.
Return on sales x Asset turnover = The company's return on assets (ROA).
Interest burden x Leverage = The company's compound leverage factor.
Various Textbooks and Journals
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Modified Du Pont identity
Sensarma and Jayadev
(2009)
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Return on Equity
ROE = (Net Interest Margin + Non Interest MarginProvisions to Total Assets)
(Equity Multiplier) Sensarma and Jayadev (2009)
The equation tell us that a banking firm can achieve its objective of maximizing shareholder
returns by either of the following means: maximizing Net interest Margin (NETIM),
maximizing Non Interest Margin (NONIM), minimizing Provisions to Total assets (PROV),
maximizing equity-to-assets ratio (EM). In what follows, the authors suggested that each of
these four factors represents a bank's capability of managing various risks.
Sensarma and Jayadev (2009)
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Return on Equity
ROE = (Net Interest Margin + Non Interest MarginProvisions to Total
Assets) (Equity Multiplier)
= ((IIIE)/TA + (NIINIE)/TAProvisions/TA) x Assets/Equity
Sensarma and Jayadev (2009)
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Return on Assets
ROA = Net Interest Margin + Non Interest MarginProvisions to Total Assets
= (IIIE)/TA + (NIINIE)/TAProvisions/TA
In addressing the definition of return on assets, the differences in the way in which balance
sheets are laid out in various countries of the world must be investigated. These
differing approaches to balance sheet layout have their counterparts in the way in which
returns on assets can be defined.
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Return on Assets
Conceptually the ratio "return on assets" consists of a numerator derived from the income
statement and indicating a level of earnings of the firm, and a denominator derived from
the balance sheet and reflecting resources devoted to the generation of those earnings.
Bernstein (1993) notes that "care must be used in determining which elements enter the
computation as there exists a variety of views, which reflect different objectives, of how
these elements should be defined."
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Return on Equity
ROE = Tax burden x Interest burden x Margin x Turnover x Leverage
ROE = Tax burden x ROA x Compound leverage factor
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Risk MeasurementProfit Margin
Profit Margin = Net Interest Margin + Non Interest Margin
= (IIIE)/TA + (NIINIE)/TA
Therefore
Net Interest Margin = (IIIE)/TA
= (EBITTaxesInterest)/(EBITTaxes)
= Interest Rate Risk
Non Interest Margin = (NIINIE)/TA
= (EBITTaxes)/Sales
= Natural Hedging
Sensarma and Jayadev (2009)
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Risk Measurement - Interest Rate Risk
Interest Rate Risk refers to the risk of decline in net interest income of a bank due to
change in interest rates.
Movement of interest rates would affect a bank's NETIM and therefore ROA and finally
shareholder returns.
To manage Interest Rate Risk
introduced risk control measures based on value at risk techniques.
Banks also use derivative contracts like futures and swaps to mitigate interest rate risk.
NETIM would reflect the resilience of banks to interest rate risk. In this paper, the ratio
of net interest income to total assets, i.e. NETIM is taken an indicator of interest rate
risk management capabilities of a bank.
Sensarma and Jayadev (2009)
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Risk Measurement - Natural hedging strategy
Non-interest income is generated out of various activities, e.g. through services such as
transfer of funds or other payment services, letters of credit, usage of derivative
contracts such as forwards, futures, swaps, etc. which increase ROA without any
corresponding increase in risks.
Sustained increase in non-interest income of banks might indicate that the banks are
adopting natural hedging strategies to improve profitability and shareholder returns.
The proportion of net non-interest income to total assets, i.e. NONIM as an indicator ofnatural hedging strategy of a bank which is expected to have a positive bearing on the
ROA.
Sensarma and Jayadev (2009)
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Risk MeasurementCredit Risk
Asset turnover = Sales/Assets
= Provisions to Total Assets = Provisions/TA
= Credit risk
Sensarma and Jayadev (2009)
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Risk Measurement - Credit Risk
Credit risk indicates the failure of a bank to receive interest and/or the principal amount
from loans and non-treasury securities. Credit risk also arises when a bank gives
commitment or guarantees on behalf of customers.
Furthermore, credit risk is present in all counterparty exposures like interest rate swaps.
To manage credit risk on-balance sheet strategies for managing credit risk include
increasing provisions for all anticipated loan losses. Although, higher provisions reduce
the profitability of a bank but higher provisions as percentage of total assets also signal a
bank's efforts towards mitigating credit risk.
Provisions as percentage of total assets can provide an indication of the extent of credit
risk management.
Sensarma and Jayadev (2009)
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Risk MeasurementSolvency risk or capital risk
ROE = (Net profit/Sales) (Sales/Assets) (Assets/Equity)
Leverage ratio = Assets/Equity
= Equity Multiplier
= Capital Adequacy= Solvency risk or capital risk
Solvency risk is the risk that a creditor will lose his entire investment if a debtor cannotrepay him in full, even if all the debtors assets are liquidated to recover the creditorsinvestment. Solvency risk can also arise out of lack of sufficient funds to pay depositorsin the event of a run.
Capital to assets ratio indicates the cushion available to a bank against unexpected lossesand implicitly protects the interests of uninsured depositors. Higher capital to assetsratio builds confidence of bank depositors but may reduce shareholder value due to
reduction in ROE.
Sensarma and Jayadev (2009)
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Risk MeasurementSolvency risk or capital risk
Thus, maximization of ROE is often linked to a trade-off between ROA and the EM
(reciprocal of capital to assets ratio).
Higher EM may increase the ROE for shareholders but higher EM indicates low capital
to assets ratio and therefore higher solvency risk.
Capital to assets ratio as a measure of a bank's solvency risk management capabilities.
For this purpose we consider regulatory capital adequacy ratios, i.e. CAR of banks (a
proxy for the reciprocal of the EM.
Sensarma and Jayadev (2009)
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Risk management scores and data
Risk management scores were developed by the article authors for banks by
combining the identified four risk management variables into one measure and
applied the four alternative quantitative summaries of risk management capabilities,
which served as robustness checks for results whose corresponding values we use
as risk measurement score.
1.Risk management indicators: trends
2.Analysis of average risk scores
3.
Principal components analysis4.Discriminant analysis
Sensarma and Jayadev (2009)
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Stock market response to risk management
V =E (d)
r V is a stock's value (or price in an efficient market),E(d) is expected future dividends, and
ris the discount rate, which also incorporates
security risk.
Thus, for determining firm value, it is critical that value enhancing attributes in
E(d) and value reducing attributes in r are identified.
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Stock market response to risk management - Regression analysis
Stock market response to risk management was measured using regression analysis
RETit = + RETmarket (t) + UEit + RISKMGMTit + it
where RET itis returns on the i-th bank's stock in year t, RETmarket is returns on the market
which controls for systematic movements in the individual bank returns, UE is
unexpected earnings measured by change in profits, RISKMGMT is risk management
variable or score and is a random error. To proxy for the risk management term, they
returned to the four variables identified from the accounting framework discussed
before.
Results obtained suggest that
Banks with high-risk management scores were contributing to increase in shareholder'swealth. Thus, in all the specifications of their regression model it is revealed that
investors are attracted to banks which signal superior risk management capabilities
through their balance sheets.
Sensarma and Jayadev (2009)
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Conclusion
This paper attempts to makes several contributions.
First, it suggests a different way of looking at bank financial statements, viz from
the risk management perspective. To this end we demonstrate a decomposition of
ROE of commercial banks into risk management variables.
Second, the paper develops quantitative summaries of risk management capabilities
of banks by using several alterative multivariate techniques.
Third, risk management is shown to be an important determinant of stock returns of
banks, over and above standard factors used in the literature such as market returns
and earnings growth.
Fourth, the findings of the paper suggest that those banks that have better risk
management capabilities reward shareholders with enhanced wealth. Finally, this
exercise can be of value to all the different stakeholders in the banking system.
Sensarma and Jayadev (2009)
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End
Well!