Question

Detail and give two examples of two financial ratios often used to provide a direct measure of a commercial bank's credit risk exposure.

Answer 1

Financial ratios which are used to provide a direct measure of a commercial bank's credit risk exposure are 1.CAPITAL ADEQUACY:Recently, there is a rising interest toward capital adequacy of credit institutions, also because of Basel Committee's recent decisions (Basel Committee on Banking Supervision) to increase capital adequacy ratios. Why? Because the equity of the bank is the first cushion for eventual stress periods, as the Total Shareholder funds in a company.

The main ratio of this area is the Leverage ratio, calculated as Equity on Total Assets. It analyzes the portion of total assets financed by own resources. The higher the ratio the better the performance of the bank.

The following ratios are explicitly considered and determined by the Basel Committee and they are:

• Total Capital Ratio (Basel) = (Tier 1 Capital + Tier 2 Capital) / Risk Weighted Assets
• Tier 1 Ratio (Basel) = Tier 1 capital / Risk Weighted Assets.

Tier 1 Ratio and TCR are evaluated considering the following formula:

• Tier 1 Capital = Total equity - Revaluation reserves;
• Tier 2 Capital = Revaluation reserves + subordinated debt + Hybrid capital + provisions including deferred tax + total loan loss and other reserves

In the Basel standards, Tier 1 Ratio has to be higher than 6% (that will be 8% until 2019) and TCR higher than 8% (that will be 10.5% until 2019).

2. ASSET QUALITY:Another relevant problem could have an impact on bank creditworthiness is doubtful loans. Loans are the most important part in a bank balance sheet (above all in commercial, cooperative and saving banks). Deteriorated loans have been a relevant problem in the financial crisis: banks have accumulated too many bad loans to become unable to repay its debts, because total assets had lost value.

Asset quality ratio = Loan Impairment charges /Total assets,
analyses the entity of the annual expenses for impaired loans respect the total amount of asset.

Loans quality ratio = Reserves for impaired loans/Gross loans
in this case it is evaluated the weight of total doubtful loans on gross loans. The reserve comprehends the total amount of impaired loans, cumulated year after year.

Other ratios include Interest coverage ratio, debt service coverage ratio etc