The most important capital that a bank has is the capital of trust and investor confidence. A small decline in a bank’s solvency likelihood can have a large negative effect on investor confidence, which in turn can impair the bank’s ability to conduct business. Therefore, more than any other business it is extremely important for banks to maintain a sufficiently high credit worthiness. While there are multiple dimensions of credit risk of a bank, our risk index consolidates them into one easy to interpret number. A higher safety index indicates relatively safe banks with very sound ability to pay back its liabilities in a timely manner. Such a bank can benefit tremendously in terms of lower cost of funds, lower deposit insurance premium, better trade terms in the inter-bank markets among other things. Eventually a sound safety rating should allow banks to compete aggressively in the lending market and capture market share away from its weaker counterparts.
Given its importance, it’s natural to think in terms of how to improve a bank’s safety ranking. Let’s first understand what are the ingredients of this index and how they are consolidated into one number. There are five key pieces of this index:
These along with the prevailing macro conditions determine the likelihood of a bank’s success. Our model gives the “best” predictor of a bank’s success based on these micro and macro factors at a given point in time. Since our model is forward looking, i.e., we predict the likelihood of success (or failure) on an ex-ante basis, it has rich applications for business decision making. Of all the banks that have failed so far this year, 80% have been ranked in the bottom 2% of our Safety Index before they actually failed.
A bank with low Safety Index has to closely look at the five components of this index as the starting point. In some cases the problem can be easy to identify. For example, a bank with rapidly deteriorating capital position should obviously focus on raising some capital to correct the situation. Our analysis of the sub-pieces of the Safety Index allows banks to detect where they are lacking as compared to their peer as well as their own historical past. In some cases, however, it may not be possible or desirable to quickly raise enough capital to correct the situation. In such cases, it maybe more meaningful to analyze what alternation in other components of the index may improve the bank’s Safety Index without requiring it to raise capital.
At times it’s some combination of two or more factors that pushes a bank to lower Safety Index level. Some of them may not be obvious if analyzed in isolation. But a comprehensive analysis of all pieces alongwith the overall Safety Index allows us to pin these problems down and suggest creative solutions. For example, a bank may have reasonable capital and liquidity positions, but its asset mix maybe too skewed in favor of one asset class. Should the bank change its asset mix or should it raise more capital leaving the asset mix intact? In other words, the low Safety Index can be either an asset side problem or a liability side problem or both. These business related questions can be analyzed more carefully using our analytical tools. In many cases a creative combination of changing the asset and liability mix can lead to more cost effective solution than perhaps the most obvious looking solution.
The starting point in any exercise aimed at improving the bank’s credit risk should be the measurement of its risk. Our Safety Index precisely measures that risk and its components provide guidance for corrective action. Our analytical tools are geared towards finding cost effective solutions for improving the banks risk profile – a key capital that every bank needs for success.
BankVega 