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Eduzan / 04 Financial Statement Analysis

FSA 4 – Analysis of Financial Institutions

Published: 10 August 2026
Updated: 3 November 2026

Worked examples are fully visible. Check-yourself items are study aids you can reveal one at a time.

Most of the analytical machinery a candidate has met so far was built for manufacturers and retailers: firms that buy inputs, transform them, and sell the output. A bank does none of that. It buys money and sells money. Its inventory is a promise to repay, its cost of goods sold is interest, and its most important asset is a claim on somebody else’s future behaviour. Two features of that business model force a separate framework.

Systemic importance

The first feature is systemic importance. Banks sit between the providers of capital and the users of capital, and in doing so they weave a net of financial links across households, other banks, corporations and governments. Because the links run in every direction, the failure of one bank does not stop at that bank. It travels. The larger the institution and the denser its connections, the further the damage spreads, and the failure of a sufficiently large bank could in principle bring down the system that contains it.

Systemic risk is the formal name for that possibility: the risk that a disruption to financial services, caused by impairment of part or all of the financial system, produces serious negative consequences for the wider economy. Central to the idea is contagion, the spread of a shock from the institution, market or instrument where it started to other institutions, markets and places. Every kind of intermediary, market and piece of financial infrastructure can be systemically important to some degree. The 2008 global financial crisis pushed the problem onto the agenda of regulators in many countries at once, and a faltering economy can pass its difficulties on to healthier economies elsewhere.

Figure 1: Intermediation and the path of contagion

The intermediation function that makes a bank useful is the same function that transmits its failure outward, upward into the real economy and sideways into other institutions.

Two consequences follow. Financial institutions are heavily regulated, with rules covering how much capital must be held, how much liquidity must be maintained and how risky the asset base may be. And deposits, the bulk of most banks’ liabilities, usually carry insurance up to a fixed ceiling provided by the government of whichever country the bank operates in. In December 2016 deposits made up more than 80% of what domestically chartered commercial banks in the United States owed in total. The reason deposit insurance exists is not charity: even the suspicion that a bank might fail to honour deposits can start a bank run, and a large sudden withdrawal can turn suspicion into an actual failure.

Financial assets rather than tangible assets

The second distinguishing feature is the nature of the assets. A manufacturer holds plant, inventory and equipment. A bank holds loans and securities. Financial assets carry direct exposure to credit risk, liquidity risk, market risk and interest rate risk, and unlike most tangible assets they are frequently carried at fair value for reporting purposes. In general, therefore, the reported values of a financial institution’s productive assets sit relatively close to market values, which is both an advantage to the analyst and a source of earnings volatility for the institution.

The population of financial institutions

The term covers a wide range of businesses, and services overlap heavily across them. Banks take deposits and make loans, but many also run investment management arms and sell derivatives, which are in effect insurance against adverse moves in interest rates, equities and currencies. Life insurers sell mortality protection, but they also sell savings vehicles. The categories below are illustrative rather than exhaustive, and the structure of the industry differs by country, with state ownership more common in some jurisdictions than others.

A sampling of financial institutions by primary activity

FSA 4 – Analysis of Financial Institutions — table 1
Group	Institution type	Defining characteristic
Basic banking	Commercial banks	Deposit taking, lending and payments. Historic separation from insurance and investment banking has been eroding; a 1999 United States law allowed commercial banks broad securities and insurance activities, and French rules from the mid-1980s removed many restrictions.
Basic banking	Credit unions, cooperative and mutual banks	Depository institutions owned by their members rather than publicly traded, organised as non-profits and therefore not paying income taxes.
Basic banking	Building societies and savings and loan associations	Specialists in financing long-term residential mortgages.
Basic banking	Mortgage banks	Originate, sell and service mortgages; usually active in securitisation markets.
Basic banking	Trust banks (Japan)	Deposits take the form of money trusts, typically with three-year to five-year terms and one-year minimums, allowing long-term commercial lending and securities investment.
Basic banking	Online payment companies	Non-bank payment providers such as Paypal and Alipay, expanding rapidly into adjacent services.
Investment industry	Managers of pooled vehicles	Mutual funds of the open-end sort, closed-end funds, and exchange-traded funds. Regulation requires disclosure of investment policy, deposit and redemption procedures, fees and past performance.
Investment industry	Hedge funds	More complex strategies, less transparency, less liquidity, lighter regulation, higher fees and higher minimum investments than pooled vehicles.
Investment industry	Brokers and dealers	Facilitate securities trading for a commission or a spread.
Insurers	Property and casualty (P&C)	Protection against adverse events involving autos, homes and commercial activity.
Insurers	Life and health (L&H)	Mortality and health products, plus savings products.
Insurers	Reinsurance companies	Sell insurance to insurers, reimbursing claims paid rather than paying policyholders directly.

The list excludes supra-national organisations such as the World Bank, which brings together 189 member countries and lends via two arms, the International Bank for Reconstruction and Development and the International Development Association, because these are formed by member states for specific missions rather than offered as investments. Other examples are the Asian Development Bank and the Asian Infrastructure Investment Bank.

This reading concentrates on two of these groups: banks, defined broadly as deposit-taking and loan-making institutions, and insurers, split between property and casualty companies and life and health companies.

Banking and insurance are not systemically alike

The insurance market as a whole conducts a smaller share of its business across borders than banking does. The exception is reinsurance, which is largely international, and that exception matters: a reinsurer can be the link that ties institutions in different parts of the world together, which raises rather than lowers systemic vulnerability. A second structural difference is that the foreign branches of insurance companies are generally required to hold, inside a jurisdiction, assets sufficient to cover the policy liabilities written in that jurisdiction.

Beyond containing systemic risk, global and regional regulatory bodies exist to harmonise rules, standards and supervision. Consistency limits regulatory arbitrage, the practice by which a multinational exploits differences between jurisdictions to escape unfavourable regulation.

The Basel Committee and Basel III

Foremost among the global bodies working on financial stability stands the Basel Committee on Banking Supervision, set up in 1974 and hosted and supported by the Bank for International Settlements. Its members are central banks and the agencies responsible for supervising banks. The membership list as of July 2017 spans Argentina, Australia, Belgium, Brazil, Canada, the Chinese mainland, the European Union, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States, with Chile, Malaysia and the United Arab Emirates as observers. Many countries are represented twice, once by the central bank and once by a separate prudential supervisor, which is itself a useful reminder of how fragmented supervision is in practice.

The Committee produced Basel III, the successor to Basel I and Basel II. Its stated purposes are to improve the banking sector’s capacity to absorb shocks from financial and economic stress whatever their origin, to improve risk management and governance, and to strengthen bank transparency and disclosure. Three highlights matter for analysis:

Minimum capital. Basel III specifies the minimum share of risk-weighted assets that must be funded with equity capital. This prevents a bank from taking on so much leverage that it cannot survive loan losses.
Minimum liquidity. Holdings of high-quality liquid assets must be sufficient for the liquidity a 30-day stress scenario would demand, so that a bank survives losing part of its funding or facing an outflow set off by off-balance-sheet commitments.
Stable funding. A bank must hold a minimum amount of stable funding relative to its liquidity needs over a one-year horizon. Stability depends on the tenor of deposits, longer being more stable, and on the type of depositor, consumer deposits being more stable than interbank money.

By constraining leverage, Basel III pushed banks to focus on asset quality, to hold capital against operational and other risks, and to improve their risk assessment processes. It also changed the quality and composition of the capital base, strengthening its capacity to absorb losses so that losses are confined to the institution’s capital investors rather than passed to depositors, taxpayers or other institutions. That confinement is precisely what reduces contagion risk. Having written the framework, the Committee now monitors its adoption and implementation by member jurisdictions.

Several other international bodies work alongside it. The Financial Stability Board draws on supervisors and regulators from the G–20 countries together with Hong Kong SAR, Spain, Singapore and Switzerland, and aims to identify systemic risk and coordinate the responses of national authorities. The International Association of Deposit Insurers exists to make deposit insurance arrangements work better. Insurance supervision worldwide is the concern of the International Association of Insurance Supervisors (IAIS), and the International Organization of Securities Commissions (IOSCO) works towards fair and efficient securities markets. The IAIS and IOSCO sit with the Basel Committee in a Joint Forum addressing issues common to banking, insurance and securities.

National regulators and the compliance burden

Global bodies work through national regulators, and it is those national bodies that hold authority over specific aspects of an institution’s operations. The network is genuinely complex, with overlapping and sometimes differing mandates, and membership of the various global bodies only partly overlaps. The International Association of Deposit Insurers has 83 member organisations, some of which are also Basel Committee members, such as the United States Federal Deposit Insurance Corporation (FDIC), and some of which are not, such as Singapore Deposit Insurance Corporation Ltd, and Germany’s Bundesverband deutscher Banken. In some countries a single body oversees both banking and insurance, as Japan’s Financial Services Agency does; in others insurance has its own regulator, as with the National Association of Insurance Commissioners (NAIC) in the United States, and the China Insurance Regulatory Commission.

The practical consequence for a global institution is a compliance load that grows with geographic reach. HSBC Holdings, one of the most international banks in the world, discloses supervision by roughly 400 separate central banks and regulators across the jurisdictions holding its offices, branches or subsidiaries, each with its own requirements and controls.

Throughout this and the following sections, the word bank is used in its general sense: an entity whose primary business is taking deposits and making loans. The standard starting point for analysing one is CAMELS, an acronym for the six components of a bank rating approach originally developed in the United States for use by supervisory examiners.

The six CAMELS components

FSA 4 – Analysis of Financial Institutions — table 2
Letter	Component	What it asks
C	Capital adequacy	Is the proportion of assets funded with capital sufficient to absorb losses without severe damage to the bank’s financial position?
A	Asset quality	How good is the credit quality and diversification of the assets, and how sound is the risk management that produced them?
M	Management capabilities	Can management identify and exploit business opportunities while managing the risks that come with them?
E	Earnings sufficiency	Does the bank return more than its cost of capital, and are those earnings of high quality?
L	Liquidity position	Are liquid assets adequate relative to near-term expected cash flows, and under Basel III, is funding stable?
S	Sensitivity to market risk	How would adverse moves in interest rates, exchange rates, equities and commodities affect earnings and capital?

An examiner assigns each component a numerical rating from 1 to 5. A rating of 1 is the best available: best-practice risk management and performance, and the least regulatory concern. A rating of 5 is the worst: the poorest performance and practices, and the highest degree of concern. A composite rating for the whole bank is then built from the six component ratings.

The composite is not a simple arithmetic mean. Each component is weighted by the examiner conducting the study, and the weights reflect judgement. The practical implication deserves emphasis because it is examinable: two examiners can look at the same bank, assign identical ratings to all six components, and still arrive at different composite ratings, because they weighted the components differently.

Figure 2: Six ratings, one weighted composite

The six components are rated separately and then combined under weights the examiner chooses. Identical component ratings can still produce different composites.

CAMELS was built for supervisors, but it works as a framework for equity and debt investors in banks as well, and that is how the rest of this lesson uses it.

Capital adequacy: risk weighting

Adequate capital lets losses be absorbed without leaving the bank financially weak or insolvent. Losses reduce retained earnings, which are one component of capital, and losses large enough will exhaust it. A strong capital position lowers the probability of insolvency and supports public confidence, which for a deposit-funded institution is not a soft benefit but a funding input.

Capital adequacy is expressed as the proportion of a bank’s assets that is funded with capital. Crucially, the assets in the denominator are adjusted for risk before the comparison is made. Riskier assets receive a higher weight. National regulators set the weightings, typically with reference to Basel III. Cash carries a weight of zero, so cash contributes nothing to risk-weighted assets and requires no capital. Corporate loans carry a weight of 100%. A handful of riskier exposures go above 100%, among them high-volatility commercial real estate lending and loans over 90 days past due. Off-balance-sheet exposures are also assigned weights and included.

Each asset is multiplied by its regulatory risk weight and the products are summed.

A simple illustration makes the mechanics concrete. Take a balance sheet holding just three items: cash of $10, performing loans of $1,000, and non-performing loans of $10. The weights are 0%, 100% and 150%:

Risk-weighted assets of $1,015 against $1,020 of accounting assets.

Notice what has happened. The bank reports $1,020 of assets but $1,015 of risk-weighted assets. The cash disappeared from the base entirely and the small pool of non-performing loans was inflated by half. A bank that shifts its mix towards cash and government paper can shrink its risk-weighted assets without shrinking its balance sheet at all, which is why capital ratios can improve sharply in a year when nothing has been raised.

The tiers of capital

Capital itself is classified into a hierarchy. The most important layer is Common Equity Tier 1 Capital. In the FDIC’s description, Basel III treats it as the dominant form of bank capital, seen everywhere as the form that absorbs losses best, since it is permanent and puts shareholder money in the firing line if the bank becomes insolvent. Basel III also strengthens minimum capital ratio requirements and risk-weighting definitions, raises Prompt Corrective Action thresholds, establishes a capital conservation buffer and provides a mechanism for mandating counter-cyclical capital buffers.

Common Equity Tier 1 Capital covers common stock, the issuance surplus attaching to it, retained earnings and accumulated other comprehensive income, reduced by adjustments that include deducting intangibles and deferred tax assets.
Other Tier 1 Capital comprises further instruments meeting defined criteria: they must be subordinate to deposits and other debt obligations, carry no fixed maturity, and pay no dividend or interest except at the full discretion of the bank.
Tier 2 Capital comprises instruments subordinate to depositors and general creditors, with an original minimum maturity of five years, plus certain other requirements.

The Basel III minimums below are global reference points. Authority to set binding minimums for institutions in a jurisdiction rests with that jurisdiction’s regulator.

Figure 3: The three Basel III minimum capital ratios

Each successive minimum is measured against the same denominator, risk-weighted assets, and each admits a broader definition of capital in the numerator.

Example 1 · Worked

The excerpt below comes from HSBC Holdings plc’s annual report disclosure of its capital position. It shows the group’s capital ratios, the amount of capital by tier and risk-weighted assets by risk type.

HSBC Holdings plc: capital ratios at 31 December

FSA 4 – Analysis of Financial Institutions — table 3
Ratio	2016 (%)	2015 (%)
Common equity tier 1 ratio	13.6	11.9
Tier 1 ratio	16.1	13.9
Total capital ratio	20.1	17.2

HSBC Holdings plc: total regulatory capital and risk-weighted assets at 31 December

FSA 4 – Analysis of Financial Institutions — table 4
Item ($m)	2016	2015
Tier 1 capital, common equity	116,552	130,863
Tier 1 capital, additional	21,470	22,440
Capital, tier 2	34,336	36,530
Regulatory capital in total	172,358	189,833
Assets, risk weighted	857,181	1,102,995

HSBC Holdings plc: risk-weighted assets by risk type

FSA 4 – Analysis of Financial Institutions — table 5
Risk type	RWAs, $bn	Capital needed, $bn
Credit risk	655.7	52.5
Credit risk, counterparty	62.0	5.0
Market risk	41.5	3.3
Operational risk	98.0	7.8
At 31 December 2016	857.2	68.6

The capital required column is the Pillar 1 charge, set at 8% of RWAs. Taken from the 2016 HSBC Holdings plc annual report, page 127.

1. Did HSBC’s capital ratios strengthen or weaken in 2016?

Solution. They strengthened, and on all three measures. The Common Equity Tier 1 ratio rose from 11.9% of RWAs to 13.6%. The Tier 1 ratio rose from 13.9% to 16.1%. The Total Capital Ratio rose from 17.2% to 20.1%.

2. What was the primary reason for the change?

Solution. A reduction in risk-weighted assets, not an increase in capital. Total risk-weighted assets fell from $1,102,995 million to $857,181 million, a decline of about 22%. Regulatory capital actually fell over the same period, from $189,833 million to $172,358 million, and Common Equity Tier 1 capital fell from $130,863 million to $116,552 million. Verifying the arithmetic: 116,552 ÷ 857,181 = 13.6%, against 130,863 ÷ 1,102,995 = 11.9%. The denominator shrank far faster than the numerator, and that is what lifted every ratio.

3. Confirm that the capital required column is consistent with an 8% Pillar 1 charge.

Solution. Total RWAs of $857.2 billion multiplied by 8% gives $68.576 billion, which the disclosure presents as $68.6 billion. The four components also reconcile: 655.7 + 62.0 + 41.5 + 98.0 = 857.2, and 52.5 + 5.0 + 3.3 + 7.8 = 68.6. Credit risk alone accounts for 655.7 of the 857.2, so roughly three-quarters of HSBC’s regulatory capital requirement is driven by lending rather than by trading or operations.

Asset quality concerns the existing and potential credit risk attached to a bank’s assets, principally the financial ones. The concept reaches past the composition of the balance sheet to the strength of the risk management processes that generated and now manage those assets. A portfolio that looks conservative today but was produced by weak underwriting discipline is not a high-quality portfolio; it is a lucky one.

How the assets are measured

Loans usually form the largest block of a bank’s assets. Their quality depends on the creditworthiness of borrowers and on whether the adjustment for expected losses is adequate. Loans are measured at amortised cost and shown net of allowances for loan losses.

Securities issued by other entities, often the second large block, are measured according to their category. Under IFRS 9, financial assets fall into one of three categories determined by the business model for managing the asset and by the contractual cash flows of the asset. The category dictates subsequent measurement and, where fair value applies, whether changes in value pass through other comprehensive income or through profit and loss.

Classification and measurement of financial assets

FSA 4 – Analysis of Financial Institutions — table 6
Framework	Category	Measurement
IFRS	Amortised cost	Amortised cost
IFRS	Fair value through other comprehensive income (FVOCI)	Fair value, changes to OCI
IFRS	Fair value through profit and loss (FVTPL)	Fair value, changes to profit and loss
US GAAP, debt only	Held to maturity	Amortised cost
US GAAP, debt only	Trading	Fair value through net income
US GAAP, debt only	Available for sale	Fair value through other comprehensive income
US GAAP, equity	All equity investments	Fair value with changes recognised in net income

Under US GAAP the three-category scheme applies only to debt securities. Equity investments are measured at fair value with changes in net income, except those accounted for under the equity method or resulting in consolidation of the investee, and except equity investments without a readily determinable fair value, which may be measured at cost minus impairment.

Two terminology traps

Before reading a bank balance sheet, two line-item conventions need clearing up.

Reverse repurchase agreements are loans. In a repurchase agreement a borrower sells a financial asset to a lender and commits to buy it back at a fixed price on a future date; the gap between sale price and the higher repurchase price is effectively interest. The borrower calls it a repurchase agreement, the lender calls it a reverse repurchase agreement. When a bank appears as the lender, the balance received is a collateralised loan and belongs with the loan book for analytical purposes. The repo market is large: the Office of Financial Research, part of the United States Department of the Treasury, estimates its size at $3.5 trillion.
Assets held for sale are not available-for-sale securities. Assets held for sale is a discontinued-operations term under IFRS 5, referring to long-term assets whose value is driven mainly by an intended disposal rather than by continued use. Available for sale is a securities classification. The words are similar; the meanings are unrelated.

Example 2 · Worked

The table gives the asset side of HSBC Holdings plc’s consolidated balance sheet, prepared under IFRS.

HSBC Holdings plc: consolidated balance sheet assets at 31 December

FSA 4 – Analysis of Financial Institutions — table 7
Assets ($m)	2016	2015
Cash and central bank balances	128,009	98,934
Items in course of collection, interbank	5,003	5,768
Hong Kong Government certificates	31,228	28,410
Trading assets	235,125	224,837
Financial assets at designated fair value	24,756	23,852
Derivatives	290,872	288,476
Loans and advances, banks	88,126	90,401
Loans and advances, customers	861,504	924,454
Reverse repos, non-trading	160,974	146,255
Financial investments	436,797	428,955
Assets held for sale	4,389	43,900
Prepayments, accrued income, other	59,520	54,398
Current tax assets	1,145	1,221
Associates and joint ventures	20,029	19,139
Goodwill and intangibles	21,346	24,605
Deferred tax assets	6,163	6,051
Total assets	2,374,986	2,409,656

Taken from the 2016 HSBC Holdings plc annual report.

1. Treating cash and balances at central banks, items in the course of collection and Hong Kong Government certificates of indebtedness as the most liquid items, what share of total assets was held in liquid form in each year, and did balance sheet liquidity rise or fall?

Solution. Liquidity increased.

2015: (98,934 + 5,768 + 28,410) ÷ 2,409,656 = 133,112 ÷ 2,409,656 = 5.5%.
2016: (128,009 + 5,003 + 31,228) ÷ 2,374,986 = 164,240 ÷ 2,374,986 = 6.9%.

Both the numerator and the denominator moved in helpful directions: liquid holdings grew by roughly $31 billion while the balance sheet shrank by about $35 billion.

2. Counting the trading assets, the designated fair value assets and the financial investments together, how did investments as a share of total assets move?

Solution. The share rose.

2015: (224,837 + 23,852 + 428,955) ÷ 2,409,656 = 677,644 ÷ 2,409,656 = 28.1%.
2016: (235,125 + 24,756 + 436,797) ÷ 2,374,986 = 696,678 ÷ 2,374,986 = 29.3%.

3. What proportion of HSBC’s assets are loans, remembering that reverse repurchase agreements are a form of collateralised lending?

Solution. The loan total takes in bank lending, customer lending and the reverse repos.

2015: (90,401 + 924,454 + 146,255) ÷ 2,409,656 = 1,161,110 ÷ 2,409,656 = 48.2%.
2016: (88,126 + 861,504 + 160,974) ÷ 2,374,986 = 1,110,604 ÷ 2,374,986 = 46.8%.

Reading the three answers together tells a single story. HSBC shifted out of lending and into liquid assets and investments over the year, which is exactly the sort of mix change that also reduces risk-weighted assets, and Example 1 showed the ratio consequences.

Credit quality and diversification

Assessing credit risk is fundamental to a bank’s lending decisions, but credit risk does not stop at the loan book. Securities investments carry it. Trading activity, including off-balance-sheet trading, creates counterparty credit risk. Guarantees, undrawn committed lines and letters of credit sit off the balance sheet as potential assets and potential liabilities simultaneously, and every one of them carries credit risk. Beyond credit risk, factors such as liquidity affect the value and marketability of a bank’s assets. Spreading credit exposure across the whole asset base and across counterparties, and avoiding concentration, is a central element of asset quality in its own right.

Example 3 · Worked

The disclosure below shows the distribution of HSBC’s financial instruments by credit quality. Seven balance sheet lines appear in full: central bank cash and balances, collection items, Hong Kong Government certificates, derivatives, bank lending, customer lending and non-trading reverse repos. Five appear only in part: trading assets, designated fair value assets, financial investments, assets held for sale, and the prepayments and accrued income line.

HSBC Holdings plc: financial instruments by credit quality at 31 December

FSA 4 – Analysis of Financial Institutions — table 8
Category	2016 ($m)	2015 ($m)
Not past due, not impaired: strong	1,579,517	1,553,830
Not past due, not impaired: good	313,707	331,141
Not past due, not impaired: satisfactory	263,995	293,178
Not past due, not impaired: sub-standard	26,094	26,199
Past due, not impaired	9,028	13,030
Impaired	20,510	28,058
Total gross amount	2,212,851	2,245,436
Impairment allowances	(8,100)	(11,027)
Total	2,204,751	2,234,409

Taken from the 2016 HSBC Holdings plc annual report, pages 88 and 89.

Common-size view and year-on-year change

FSA 4 – Analysis of Financial Institutions — table 9
Category	% of gross, 2016	% of gross, 2015	Change in dollar amount
Strong	71.4%	69.2%	1.7%
Good	14.2%	14.7%	−5.3%
Satisfactory	11.9%	13.1%	−10.0%
Sub-standard	1.2%	1.2%	−0.4%
Past due, not impaired	0.4%	0.6%	−30.7%
Impaired	0.9%	1.2%	−26.9%
Total gross amount	100.0%	100.0%	−1.5%
Impairment allowances	−0.4%	−0.5%	−26.5%

1. Did credit quality improve or deteriorate in 2016, and specifically how did the share of strong credit quality instruments move?

Solution. Credit quality improved. The share of the gross amount in strong credit quality instruments rose from 69.2% in 2015 to 71.4% in 2016: 1,553,830 ÷ 2,245,436 = 69.2% and 1,579,517 ÷ 2,212,851 = 71.4%. Every category below strong shrank in dollar terms, and the shift is not simply a denominator effect, because strong credit quality instruments grew by 1.7% while the gross total fell by 1.5%.

2. Does the change in impairment allowances reflect the change in the credit quality of the instruments, specifically the amount of impaired assets?

Solution. Yes. As a general expectation, the allowance should track the volume of impaired assets. Impairment allowances fell by 26.5% and impaired assets fell by 26.9%, which is close alignment. The coverage ratio confirms it directly: 11,027 ÷ 28,058 = 39.3% in 2015 and 8,100 ÷ 20,510 = 39.5% in 2016. Coverage held roughly constant, so the smaller allowance is explained by a smaller problem rather than by a change in provisioning stance.

Management capabilities

Much of what makes management effective at a bank makes management effective anywhere: identifying and exploiting profit opportunities while managing the associated risk, complying with laws and regulations, keeping governance strong through an independent board that steers clear of excessive pay and self-dealing, and running sound internal controls with transparent communication and high financial reporting quality. Across all entities, overall performance remains the most reliable single indicator of management effectiveness.

What differs for a financial institution is the weight placed on risk identification and control, spanning credit risk, market risk, operating risk, legal risk and others. Bank directors set overall guidance on acceptable risk exposure levels and on implementation policy, and supervise management. Senior managers then have to build procedures that measure and monitor risk consistently with that guidance. When an analyst assesses the M in CAMELS, the object of the assessment is largely whether that chain of responsibility functions.

Earnings: why estimates dominate

Ideally a financial institution earns enough to provide an adequate return on capital to its capital providers, rewarding shareholders through capital appreciation, distribution, or both. Ideally too, the earnings are of high quality and trending upward. High quality here means that accounting estimates are unbiased and that earnings arise from sustainable rather than non-recurring items.

For a bank, the single most important area of estimation is the loan impairment allowance. Estimating losses across a portfolio collectively can start with statistical analysis of historical loan losses, but history has to be supplemented by management judgement about how conditions may deviate in future. Estimating losses on individual loans requires assessments of the likelihood of borrower default or bankruptcy and of the value of any collateral. HSBC describes the difficulty candidly: the exercise of judgement requires assumptions that are deeply subjective and react sharply to the risk factors, above all to shifts in economic and credit conditions across a great many geographies. Because the factors are so interdependent, no single one of them drives the impairment allowances taken as a whole.

Estimates also enter the valuation of financial assets and liabilities carried at fair value. Where observable market prices exist, little judgement is required. Where they do not, judgement dominates, and both IFRS and US GAAP organise the resulting uncertainty through a fair value hierarchy based on the observability of the inputs used.

The fair value hierarchy

FSA 4 – Analysis of Financial Institutions — table 10
Level	Inputs	Analytical reading
Level 1	Quoted prices for identical assets or liabilities in active markets	Valuation requires almost no judgement; these are also the most liquid holdings
Level 2	Observable but not quoted prices for identical instruments in active markets: quoted prices for comparable instruments in active markets, quoted prices for the identical instrument where its market is not active, and observable data including rates, curves, credit spreads and implied volatility, all fed through a model	Less liquid than Level 1, but the valuation is anchored to observable market data
Level 3	Unobservable inputs, with fair value produced by one or more models	Subjective by construction; two modellers will produce different answers

Two Level 3 illustrations show why the level matters. An instrument might be valued using an option-pricing model that requires an unobservable and subjective estimate of market volatility. Another might be valued on estimated future cash flows discounted to present value, where nothing can be observed objectively, since the modeller determines the cash flows and the rate at which they are discounted alike.

In practice the Level 1, 2 and 3 labels get used three ways: for the inputs, for the valuation technique (a Level 3 technique being one that relies on one or more significant unobservable inputs, such as valuing a private equity holding from a model of estimated future cash flows), and for the assets or liabilities themselves. All three usages are common and the meaning is normally clear from context.

Other estimate-heavy areas are shared with non-financial companies. Judging whether goodwill is impaired requires estimating the future cash flows of a business unit. Recognising a deferred tax asset relies on assumptions about the probability of future taxes. Deciding whether and how much of a contingent liability to recognise, for litigation for example, usually depends on professional expert advice but still requires management judgement.

Earnings: the sustainability of the mix

Sustainability is read from the composition of earnings. Bank earnings typically comprise three general sources:

Net interest income, meaning interest received on loans less interest paid on the deposits that fund them.
Service income, which is fee based.
Trading income.

Of the three, trading income is typically the most volatile, so a mix weighted towards net interest income and service income is typically more sustainable. Within net interest income, lower volatility is also desirable: highly volatile net interest income can signal excessive interest rate risk exposure.

Example 4 · Worked

An analyst wants to judge how important each source of income is to HSBC.

HSBC Holdings plc: five-year summary of total operating income ($m)

FSA 4 – Analysis of Financial Institutions — table 11
Source	2016	2015	2014	2013	2012
Net interest income	29,813	32,531	34,705	35,539	37,672
Net fee income	12,777	14,705	15,957	16,434	16,430
Net trading income	9,452	8,723	6,760	8,690	7,091
Net result on designated fair value instruments	(2,666)	1,532	2,473	768	(2,226)
Net gains on financial investments	1,385	2,068	1,335	2,012	1,189
Dividend income	95	123	311	322	221
Insurance premium income, net	9,951	10,355	11,921	11,940	13,044
Disposal gains: US branch network, US cards, Ping An	–	–	–	–	7,024
Other operating income	(971)	1,055	1,131	2,632	2,100
Total operating income	59,836	71,092	74,593	78,337	82,545

Taken from the 2016 HSBC Holdings plc annual report, page 31.

Common-size statement: each line as a percentage of total operating income

FSA 4 – Analysis of Financial Institutions — table 12
Source	2016	2015	2014	2013	2012
Interest income, net	49.8%	45.8%	46.5%	45.4%	45.6%
Fee income, net	21.4%	20.7%	21.4%	21.0%	19.9%
Trading income, net	15.8%	12.3%	9.1%	11.1%	8.6%
Designated fair value instruments	−4.5%	2.2%	3.3%	1.0%	−2.7%
Financial investment gains	2.3%	2.9%	1.8%	2.6%	1.4%
Dividend income	0.2%	0.2%	0.4%	0.4%	0.3%
Insurance premiums, net	16.6%	14.6%	16.0%	15.2%	15.8%
Disposal gains (2012 only)	–	–	–	–	8.5%
Other operating income	−1.6%	1.5%	1.5%	3.4%	2.5%
Total operating income	100.0%	100.0%	100.0%	100.0%	100.0%

1. Which source dominates HSBC’s operating income, and how much did it contribute in 2016?

Solution. Net interest income, at 29,813 ÷ 59,836 = 49.8% of total operating income in 2016.

2. What share of total operating income came from trading in 2016?

Solution. 9,452 ÷ 59,836 = 15.8%.

3. Describe the trend in operating income across the five years.

Solution. Operating income declined in every year from 2012 to 2016, falling from $82,545 million to $59,836 million. Between 2012 and 2015 the mix barely moved, with roughly 46% coming from net interest income and 21% from fees. The 2016 figures break that pattern: net interest income rises to 49.8% of the total and trading income to 15.8%, but neither rose because the underlying business grew. Net interest income fell in absolute terms from $32,531 million to $29,813 million, and the shares moved because total operating income fell faster, helped down by a swing of the fair value designated line from $1,532 million positive to $2,666 million negative and by other operating income turning negative. A rising share of a shrinking pie is a different signal from a rising share of a growing one, and the common-size table alone would not have revealed the difference.

Every entity needs adequate liquidity. For a bank the stakes are higher because of what its current liabilities are. If a manufacturer cannot pay a current liability, the damage is largely confined to its own supply chain. Deposits are the primary component of a bank’s current liabilities, so failure to honour one can damage an economy in full. Government insurers cover deposits at most banks up to a stated amount, which makes liquidity a central concern of regulators rather than a private matter between a bank and its creditors.

The Basel III Regulatory Framework cites the sudden illiquidity that accompanied the 2008 financial crisis as the main motivation for a global liquidity standard. Several banks ran into difficulty despite holding an adequate capital base, because capital and liquidity are not the same thing. Basel III therefore introduced two minimum liquidity standards, both phased in over subsequent years.

The Liquidity Coverage Ratio

The Liquidity Coverage Ratio (LCR) fixes the smallest share of anticipated cash outflows a bank has to cover with highly liquid holdings. Sitting below the line are the liquidity needs projected for one stressed month; sitting above it are only those assets that turn into cash without difficulty. The floor is set at 100%.

A ratio below 100% signals an inability to meet stressed outflows from liquid holdings alone.

The Net Stable Funding Ratio

The Net Stable Funding Ratio (NSFR) fixes how much of the stable funding a bank requires has to be met out of the stable funding it actually has. What sits below the line, required stable funding, follows from what the asset base contains and how long it runs. What sits above it, available stable funding, follows from the make-up and tenor of the funding: capital, deposits and other liabilities. The target minimum is greater than 100%.

Available stable funding is the weighted sum of capital and liabilities after applying the ASF factors.

Available stable funding is computed by allocating capital and liabilities to one of five categories, multiplying each by its available stable funding (ASF) factor, and summing the weighted amounts.

Categories of available stable funding and their ASF factors

FSA 4 – Analysis of Financial Institutions — table 13
ASF factor	Components
100%	Regulatory capital in total, apart from Tier 2 instruments maturing inside a year; further capital instruments and liabilities whose effective residual life reaches a year or beyond
95%	Retail and small business money that is stable: demand deposits without a maturity, plus term deposits running out inside a year
90%	The same retail and small business categories where the money is judged less stable
50%	Sub-year money from corporate customers outside finance; operational deposits; sub-year money from sovereigns, public sector bodies and development banks, whether multilateral or national; other balances running between six months and a year, central bank and financial institution funding included
0%	Every remaining liability and equity balance, undated liabilities included, subject to particular rules for deferred tax liabilities and minority interests; the excess of NSFR derivative liabilities over NSFR derivative assets; payables recorded on trade date for purchases of instruments, currencies and commodities

Adapted from the October 2014 Basel Committee paper setting out the net stable funding standard.

The logic behind the NSFR is that it ties the liquidity needs created by an institution’s assets to the liquidity provided by its funding. On the asset side, long-dated loans require stable funding while highly liquid assets do not. On the funding side, long-dated deposits and other liabilities count as more stable than short-dated ones, and retail deposits count as more stable than deposits of the same maturity from other counterparties.

Figure 4: The two Basel III liquidity standards cover different horizons

The LCR asks whether a bank can survive a month of stressed outflows. The NSFR asks whether the funding underneath its illiquid assets will still be there in a year.

Two further monitoring metrics

Basel III describes several liquidity-monitoring metrics beyond the two ratios. Two are worth knowing.

Concentration of funding. The proportion of funding obtained from a single source. Excessive concentration exposes a bank to the risk that one source is withdrawn.
Contractual maturity mismatch. The maturity dates of assets compared with the maturity dates of funding. In a normal upward-sloping yield curve environment, a bank maximises net interest income, all else equal, by borrowing short and lending long: it minimises what it pays depositors and maximises what it earns on loans. Carried to excess, that same structure creates liquidity risk, because the bank may have to return cash on maturing deposits before it receives repayment from borrowers.

Example 5 · Worked

HSBC discloses that management of liquidity and funding is undertaken locally by country within the group’s liquidity and funding risk management framework, under a general policy requiring every defined operating entity to fund what it does on its own. Asset and liability committees operate at group level, in the regions and in the operating entities, and primary responsibility for managing liquidity and funding sits with the local committees, the Holdings committee and the Risk Management Meeting.

On the LCR, HSBC reported a Group European Commission LCR at 31 December 2016 of 136%, against 116% at 31 December 2015, and stated that all principal operating entities were within the LCR risk tolerance level set by the Board. On the NSFR, it stated that at 31 December 2016 the principal operating entities were within the Board’s risk tolerance level. Each ratio presumes a stressed outflow drawn from a spread of depositors inside every deposit segment, and that presumption weakens where the spread is too narrow to avoid concentration. Entities are also exposed to term re-financing concentration risk if maturities are overly concentrated in a defined period. By 31 December 2016 every principal operating entity sat inside the tolerances set for concentration of depositors and for concentration of term funding maturities.

HSBC operating entities: liquidity measures (%)

FSA 4 – Analysis of Financial Institutions — table 14
Operating entity	LCR Dec-16	LCR Dec-15	NSFR Dec-16
HSBC UK liquidity group	123	107	116
Hongkong and Shanghai Banking Corp, Hong Kong branch	185	150	157
Hongkong and Shanghai Banking Corp, Singapore branch	154	189	112
HSBC USA	130	116	120
HSBC France	122	127	120
Hang Seng	218	199	162
HSBC Canada	142	142	139
HSBC China	253	183	49
HSBC Middle East (UAE branch)	241		141
HSBC Mexico	177		128
HSBC Private Bank	178		155

Taken from the 2016 HSBC Holdings plc annual report, pages 108, 143 and 144.

1. Which entity held the most liquid assets in 2016 measured against what a stress scenario would require of it?

Solution. HSBC Bank China. Its 2016 LCR of 253% is the highest of the eleven entities listed.

2. Which entity carried the most stable funding measured against the stable funding it needed?

Solution. Hang Seng Bank, whose 2016 NSFR of 162% is the highest reported.

3. Which entity is furthest from meeting the Basel III target for the NSFR?

Solution. HSBC Bank China. Its NSFR of 49% is the lowest of the group and less than half the Basel III standard of greater than 100%. The same entity therefore records both the highest LCR and the lowest NSFR, which is a useful reminder that the two ratios measure different things: an entity can be flush with 30-day liquid assets and still be funding long-dated assets with money that will not stay for a year. The disclosure does not explain the cause; renminbi capital controls or jurisdictional issues are plausible, but the information given is not sufficient to confirm any of them.

Nearly every entity has some exposure to interest rates, exchange rates, equity prices or commodity prices, and every company in the United States is required to provide quantitative and qualitative disclosures on market risk in its annual filings. What makes the S in CAMELS a first-order concern rather than a footnote is the structure of a bank’s business. Where loans and deposits differ in maturity, in how often they reprice, in their reference rate or in their currency, exposure to market moves follows automatically. Exposure arises not only from on-balance-sheet loans and deposits but also from off-balance-sheet positions such as guarantees and derivatives linked to interest rates, exchange rates, equities or commodities.

Why rising rates usually help

Consider interest rate sensitivity. Take the purely hypothetical case of a bank whose assets and liabilities are identical in interest rate, maturity and repricing frequency. Even then, a rise in interest rates increases net interest income, for the simple reason that banks have more assets than liabilities: the same rate change is applied to a larger base on the asset side.

Reality adds three further structural effects, all pointing the same way:

The yield on loan assets is presumed to exceed the rate paid to depositors, particularly consumer depositors.
In a typical yield curve environment, longer-dated assets carry a higher yield than shorter-dated funding sources, other things equal.
Where assets reprice more frequently than liabilities, earnings benefit in a rising rate scenario.

Many structural factors therefore drive interest rate sensitivity, and disclosures showing the earnings impact of an upward and downward rate shift are a direct window onto the existing structure of a bank’s balance sheet.

Example 6 · Worked

HSBC states that its objective is to manage and control market risk exposures while maintaining a market profile consistent with its risk appetite, using a range of tools including sensitivity analysis, value at risk and stress testing. The table below sets out the assessed impact on base case projected net interest income for 2016, excluding insurance, of four parallel quarterly shocks of 25 basis points, each applied at the start of a quarter from 1 January 2017 to the path of global interest rates that the market implies. The sensitivities assume all other non-interest rate variables remain constant and that no management action is taken. HSBC expects the measure to move with rates in both directions, up when they rise and down when they fall, because on balance its assets reprice faster and further than its liabilities do.

HSBC: net interest income sensitivity ($m)

FSA 4 – Analysis of Financial Institutions — table 15
Shift in yield curves	US dollar bloc	Rest of Americas	Hong Kong dollar bloc	Rest of Asia	Sterling bloc	Euro bloc	Total
+25 bps at the beginning of each quarter	605	47	504	280	61	212	1,709
−25 bps at the beginning of each quarter	−1,024	−41	−797	−292	−261	9	−2,406

Taken from the 2016 HSBC Holdings plc annual report, pages 78 and 117.

1. By how much would planned net interest income fall if yield curves shifted down by 25 basis points at the beginning of each of four quarters?

Solution. By $2,406 million. The six blocs sum to that total: −1,024 − 41 − 797 − 292 − 261 + 9 = −2,406.

2. Is the response symmetric, and where does the asymmetry come from?

Solution. No. The gain from a 25 basis point rise is $1,709 million while the loss from an equal fall is $2,406 million, so the downside is roughly 1.4 times the upside. Four of the six blocs lose more in the falling scenario than they gain in the rising one: the US dollar bloc (605 against −1,024), the Hong Kong dollar bloc (504 against −797), the rest of Asia bloc (280 against −292) and the sterling bloc (61 against −261). The rest of Americas bloc is close to symmetric at 47 against −41, and the euro bloc is the outlier, gaining in both directions with 212 in the rising scenario and 9 in the falling one. The likely reason is that deposit rates were already close to their floor, so a further cut reduces asset yields without a matching reduction in funding costs.

3. If falling interest rates hurt bank earnings, why did central banks cut rates so aggressively after the financial crisis to support the financial sector?

Solution. Because a sensitivity table of this kind is a static presentation. It holds the asset and liability structure standing at the reporting date fixed. Once the crisis passed, central bank policy pushed bank borrowing costs down to something close to zero, while the rates chargeable to loan customers, low though they were, stayed well clear of those costs. The spread therefore widened rather than narrowed. Beyond that, the intention was never solely to support bank earnings: the actions were also designed to provide liquidity and stimulus to the wider economy.

Value at risk

The second instrument HSBC applies to market risk, for measurement and monitoring alike, is value at risk (VaR), which estimates potential loss from simulations that incorporate historical pricing information. The parameters HSBC applies are a confidence level of 99%, a holding period of one day, and two years of past pricing observations covering currencies, rates, equities, commodities and the volatilities attaching to each. The parameters matter: a VaR figure is meaningless without the confidence level and holding period attached to it, and those choices differ enough across institutions to limit cross-company comparison.

CAMELS is reasonably comprehensive, but it is neither complete nor comprehensively integrated, and the order of the letters implies nothing about importance. Strong capital, the C, and strong liquidity, the L, are treated as equally important under the Basel III standards. Some bank-specific attributes are addressed weakly or not at all, and a further set of considerations applies to banks and non-banks alike.

Government support

Governments do not normally set out to rescue a company or an industry facing failure. In capitalist economies failure is an occasional by-product of risk-taking with capital, and bankruptcy law and courts exist to administer the consequences of failed capital allocation. Banking is different. A government has an interest in a healthy banking system, because a nation’s economy depends on bank lending and because a central bank needs healthy banks for monetary policy to transmit. A healthy system also supports commerce by providing payment processing and by giving depositors confidence that their money is safe.

Government agencies therefore monitor the health of the whole system, closing banks that might fail or arranging their merger with healthier institutions able to absorb them. This pruning removes problems that would otherwise weaken the system. Governments may also assist banks directly rather than closing them or arranging mergers. The 2008 financial crisis produced visible examples of both. Through the Troubled Asset Relief Program (TARP) the United States Treasury bought loans off bank balance sheets and injected equity, and over the same period it brokered a series of mergers among banking giants that produced still larger ones.

CAMELS produces no assessment of government support, so an investor must make a qualitative judgement. Two questions frame it:

Size of the bank. Is it large enough that its failure would damage a significant part of the economy? Is it too big to fail?
Status of the national banking system. Is the system healthy enough to absorb this particular bank’s failure, or would intervention with taxpayer funds be the better solution? The 2008–2009 crisis led the United States Federal Reserve to develop the concept of systemically important financial institutions (SIFIs), those whose failure would pose significant risk to the economy. Such institutions have faced increased regulation since.

Government ownership

Public ownership of banks may include a substantial stake held by the government of the home country, and it exists for competing reasons. A development view holds that government ownership aids the financial development of banks and thereby broad economic growth. The gloomier reading is that the domestic system could not stand unaided or draw capital in size, whether because ethical standards inside the industry are poor or because the public does not trust it, and the public supplies funds to every bank.

Whatever the reason, a government stake adds a dimension of security for a bank investor, because a government owner is likely to intervene on the bank’s behalf in distress. A government planning to reduce its stake may reduce that security, though not always. During the 2008–2009 crisis some governments became reluctant owners of banks that were ultimately supported by taxpayer funding, and when those stakes were reduced after the crisis ended, markets read the reduction as a signal of renewed strength rather than of lost protection.

Mission, culture and competition

Mission of the banking entity. Not all banks share a mission. A community bank serves the immediate community in which it operates, and that community’s welfare may rest on farming, mining or oil, or on a single large manufacturer. The fortunes of the bank, its borrowers and its depositors then depend on whatever affects the primary industry or employer. A global bank taking deposits worldwide and investing worldwide is more diversified against any single risk than any community bank can be. Mission shapes how a bank manages its assets and liabilities, and CAMELS does not capture it.
Corporate culture. A bank’s culture may be risk averse and cautious, making only loans it perceives as low risk, or risk seeking in pursuit of high returns, or somewhere between. Where caution runs too deep, shareholders may not be paid enough for the risk of owning the bank. A risk-hungry culture may produce boom, bust and volatility. Cultural differences matter especially for banks operating in several countries, where corporate culture and national culture may be at odds.
Competitive environment. A bank’s competitive position relative to peers affects how it allocates capital and assesses risk, and it feeds the cultural mindset. A regional bank with a near-monopolistic hold on its region may take few risks beyond defending that grip. A global bank is affected by the actions of other global banks, and its managers may chase market share with little regard for risk or may settle for slower but more profitable growth. The outcome depends on how managers perceive their competitive position and how they choose to react.

Four questions help an investor form a qualitative view of a bank’s cultural environment:

Has the bank produced recent losses from a narrowly focused investment strategy, such as an outsized exposure to one risky country or one area of the economy?
Has it restated its financial statements because of internal control failures in financial reporting?
Does it award above-average equity-based compensation to top managers, potentially encouraging risk-taking and short-termism?
What does its history with loss reserves suggest? Has it repeatedly been slow to provide for losses and then recorded large write-downs later?

Off-balance-sheet items

Off-balance-sheet assets and liabilities threaten an entity and its investors if they unexpectedly drain resources. Lehman Brothers going bankrupt accelerated the 2008 and 2009 crisis, and because that firm’s dealings in instruments like credit derivatives were so opaque, no concise analysis of the risks it carried was possible beforehand. Difficult to examine or not, off-balance-sheet exposures require consideration whenever a bank or other financial institution is analysed.

Not every off-balance-sheet item is exotic. Operating leases are a low-risk example: they are not a recognised liability, yet they give a creditor a claim on future cash flows, and the lease footnotes make the obligations easy for investors to see. Three categories deserve more attention.

Variable interest entities. A variable interest entity (VIE) is a form of special-purpose entity, usually created for a single purpose such as holding certain assets or assets financed with specific debt instruments. Before the accounting for VIEs was developed, companies sometimes arranged for outside parties to take a majority ownership stake in a special-purpose entity, ensuring the entity’s assets and liabilities did not have to be consolidated. Standard setters built the VIE model to capture the consolidation of such entities: a company that is the primary beneficiary of a VIE can be forced to consolidate it with no equity stake whatever, because the consolidation criteria are generalised and sit outside the sharply drawn ownership tests. A VIE can still produce off-balance-sheet assets and liabilities where the bank has an interest but is not required to consolidate. In that case the existence of the VIE and certain financial information must be disclosed, and those disclosures deserve scrutiny: whatever justification is offered for leaving the entity out deserves testing for reasonableness, and the scenarios that could hit the VIE deserve working through for what they would mean to the bank.
Benefit plans. These are not entirely off-balance-sheet, because net plan assets or obligations do appear, but the economics driving them differ from the bank’s own business. Shortfalls in plan assets caused by market performance can force rapid increases in required contributions, and falling interest rates, which push plan obligations higher, can drain cash just as quickly. The benefit plan footnotes are the place to gauge the risk.
Assets under management. One off-balance-sheet item is found only in financial companies and sometimes in banks: assets under management. A bank with a trust department earns management fees based on assets that belong to clients and are not consolidated onto the bank’s balance sheet, yet those assets drive the bank’s returns. Where such returns are material, the size and the growth or decline of assets under management should concern the investor.

Segments, currency, risk factors and disclosure

Segment information. Banks organise themselves in different ways: by domestic and foreign markets, along consumer or industrial lines, around financial services such as leasing or market making, and around related businesses such as trust operations. Whatever the structure, segment information should reflect the information used by the chief operating decision maker, and that is what allows an investor to judge whether capital is being allocated well among the bank’s internally competing operations.
Currency exposure. Floating exchange rates may not trouble a smaller regional bank operating in one currency, but they create problems for global banks. Banks finance and lend in several currencies, producing transaction exposure. Large banks trade currencies actively and hedge with foreign exchange derivatives, which can generate unforeseen gains or losses when world events move currencies unexpectedly, and not every bank is a successful currency trader. Global banks also face the translation issues that affect any multinational: when the home currency strengthens against the functional currencies of foreign subsidiaries, end-of-period translation of balance sheet accounts can produce currency translation adjustments that reduce capital.
Risk factors. The risk factors section of an annual filing is sometimes derided as a list of worst-case scenarios written by legal counsel, yet it can also close gaps in what an investor knows about legal and regulatory matters that surface nowhere else in the filing.
Basel III disclosures. Basel III attaches a wide disclosure regime to the quantitative rules, capital minimums included, in order to encourage market discipline by giving investors and other interested parties useful regulatory information on a consistent and comparable basis.

Why the composite is not an arithmetic mean

Adding the six component ratings and dividing by six is the obvious way to build a composite, and it is exactly what an examiner does not do. The reason is that the six components are not equally informative for every user. A fixed-income investor in a bank cares far more about capital adequacy and liquidity than about earnings, because the downside case is default rather than a missed quarter. An equity investor cares far more about earnings and earnings quality, because the upside case runs through the income statement. The examiner’s weighting is a way of encoding whose question is being answered. When each component receives the same rating, the weighting is irrelevant and the two approaches coincide; the moment ratings differ, the weighted and unweighted composites can diverge, and Example 8 shows a case where they do.

The remaining three sections on banking work the CAMELS framework through the financial statements of a real institution, Citigroup, at the end of 2016. Two caveats belong at the front. First, the evidence an analyst gathers varies by analyst: an equity investor may care far more about earnings and earnings quality than about capital adequacy, while a fixed-income investor may care far more about capital adequacy and liquidity than about earnings, and the type of investor determines what analysis is performed for each component. Second, although CAMELS has quantitative elements it is not a formulaic approach. Judgement and discretion shape both the testing done to gather evidence and the rating assigned once the evidence is in. What follows is one plausible set of analyses, not an exhaustive one. Each component below closes with a rating, where 1 is the highest and 5 the lowest.

Capital adequacy

Capital adequacy compares the proportion of assets funded by capital, with assets given varying risk weights. The assets are sorted into risk classes and the capital behind them into tiers, namely Common Equity Tier 1, Total Tier 1 and Tier 2.

Citigroup: components of Common Equity Tier 1 Capital ($m), Basel III Advanced Approaches with transition arrangements

FSA 4 – Analysis of Financial Institutions — table 16
Item	31 Dec 2016	31 Dec 2015
Common stockholders’ equity	206,051	205,286
Add: non-controlling interests that qualify	259	369
Less: after-tax unrealised AFS gains and losses	(320)	(544)
Less: after-tax adjustment for defined benefit plan liability	(2,066)	(3,070)
Less: after-tax accumulated unrealised cash flow hedge losses	(560)	(617)
Less: after-tax cumulative own-credit fair value movement on liabilities	(37)	176
Less: goodwill after related deferred tax liabilities	20,858	21,980
Less: identifiable intangibles apart from MSRs, after related deferred tax	2,926	1,434
Less: net assets of the defined benefit pension plan	514	318
Less: DTAs on carry-forwards of operating losses, foreign tax credits and general business credits	12,802	9,464
Less: amounts above the 10% and 15% caps on other DTAs, certain common stock holdings and MSRs	4,815	2,652
Total Common Equity Tier 1 Capital	167,378	173,862
RWAs, credit risk	773,483	791,036
RWAs, market risk	64,006	74,817
RWAs, operational risk	329,275	325,000
Total risk-weighted assets	1,166,764	1,190,853
Common Equity Tier 1 Capital Ratio	14.35%	14.60%
Stated minimum	4.50%	4.50%

Citigroup sits well inside the required limits in both years. The ratio slipped from 14.60% to 14.35%, and the cause is mostly the increase in deferred tax assets disallowed in the computation: the carry-forward deduction rose from $9,464 million to $12,802 million and the excess-over-limitations deduction from $2,652 million to $4,815 million. The three risk categories reconcile to the total in both years: 773,483 + 64,006 + 329,275 = 1,166,764.

Citigroup: components of Total Tier 1 Capital ($m)

FSA 4 – Analysis of Financial Institutions — table 17
Item	31 Dec 2016	31 Dec 2015
Common Equity Tier 1 Capital	167,378	173,862
Perpetual preferred stock that qualifies	19,069	16,571
Trust preferred securities that qualify	1,371	1,707
Non-controlling interests that qualify	17	12
Less: after-tax cumulative own-credit movement	(24)	265
Less: pension plan net assets, defined benefit	343	476
Less: DTAs on operating loss and tax credit carry-forwards	8,535	14,195
Less: permitted holdings in covered funds	533	567
Less: regulatory capital minimums at insurance underwriting subsidiaries	61	229
Total additional Tier 1 Capital	11,009	2,558
Total Tier 1 Capital	178,387	176,420
Total risk-weighted assets	1,166,764	1,190,853
Tier 1 Capital Ratio	15.29%	14.81%
Minimum Tier 1 Capital Ratio	6.00%	6.00%

Total Tier 1 Capital includes instruments meeting criteria based on subordination to deposits and other debt obligations, absence of a fixed maturity, and no requirement to pay dividends or interest without the bank’s full discretion. Preferred stock can be structured to meet those criteria, and that is what drove the improvement here: the Tier 1 ratio rose from 14.81% to 15.29%, mostly because of additional perpetual preferred stock qualifying for inclusion in 2016, from $16,571 million to $19,069 million, together with a fall in the disallowed deferred tax assets from $14,195 million to $8,535 million. Additional Tier 1 Capital more than quadrupled, from $2,558 million to $11,009 million.

Citigroup: components of Tier 2 Capital and Total Capital ($m)

FSA 4 – Analysis of Financial Institutions — table 18
Item	31 Dec 2016	31 Dec 2015
Total Tier 1 Capital	178,387	176,420
Subordinated debt that qualifies	22,818	21,370
Trust preferred securities qualifying	317	0
Non-controlling interests qualifying	22	17
Eligible credit reserves above expected credit losses	660	1,163
Add: AFS equity unrealised gains admitted to Tier 2	3	5
Less: capital minimums at insurance underwriting subsidiaries	61	229
Total Tier 2 Capital	23,759	22,326
Capital in total	202,146	198,746
RWAs in total	1,166,764	1,190,853
Total Capital Ratio	17.33%	16.69%
Regulatory floor	8.00%	8.00%

Tier 2 Capital admits, within limits, part of the allowance for loan and lease losses along with other instruments ranking behind depositors and general creditors. The Total Capital Ratio improved from 16.69% to 17.33%, driven mostly by the increase in Total Tier 1 Capital and in qualifying subordinated debt. Checking the arithmetic: 178,387 + 23,759 = 202,146, and 202,146 ÷ 1,166,764 = 17.33%.

Assessment. Citigroup’s capital adequacy at the end of 2016 looks solidly positive. All three principal ratios exceed the minimums required to be considered well capitalised, and by a wide margin: 14.35% against 4.50%, 15.29% against 6.00%, and 17.33% against 8.00%. A rating of 1 could be justified.

Asset quality: composition

Asset quality matters greatly to a bank. As intermediaries, banks owe their existence to creating loans, and unsound credit policy can erode the capital base quickly in a downturn, straining liquidity and the ability to generate earnings, and making new lending difficult.

Bank assets rise in riskiness in three broad steps. One portion sits in highly liquid form: cash, balances at other banks, and holdings that turn into cash fast, repos and certain receivables among them. Little risk attaches to these. Next come investments made with cash deemed surplus to operating needs, classified under US GAAP and IFRS as available for sale, reported at fair value, or held to maturity, reported at amortised cost unless impaired. These are riskier than the liquid securities and reflect a management investment decision, but their value is fairly transparent and their reported value reflects realisability in cash, though establishing that takes more analytical effort for held-to-maturity securities. The riskiest and often largest class is the loan book, which embodies credit risk and management’s judgement in extending credit. The underwriting risks and those judgements are reflected in the allowance for loan losses.

This is where the external analyst is at a structural disadvantage. Some information is simply unavailable to an analyst or investor, whereas a supervisory examiner can see the bank from the inside, assess the soundness of loan and investment policies and procedures, review the construction and workings of internal controls, and examine how exceptions to credit policy are handled. The analyst is confined to circumstantial evidence that credit policies are sound and are being maintained, and that evidence sits in the financial statements without being obvious from the face of the balance sheet.

Citigroup: asset composition at 31 December ($m and % of total assets)

FSA 4 – Analysis of Financial Institutions — table 19
Item	2016 $	2016 %	2015 $	2015 %
Cash, and amounts due from banks	23,043	1.3%	20,900	1.2%
Deposits with banks	137,451	7.7%	112,197	6.5%
Federal funds sold, plus securities borrowed or bought under resale agreements	236,813	13.2%	219,675	12.7%
Brokerage receivables	28,887	1.6%	27,683	1.6%
Trading account assets	243,925	13.6%	241,215	13.9%
Total liquid assets	670,119	37.4%	621,670	35.9%
Securities available for sale	299,424	16.7%	299,136	17.3%
Securities held to maturity	45,667	2.5%	36,215	2.1%
Equity securities, non-marketable	8,213	0.5%	7,604	0.4%
Total investments	353,304	19.7%	342,955	19.8%
Consumer loans	325,366	18.2%	325,785	18.8%
Corporate loans	299,003	16.7%	291,832	16.9%
Loans, unearned income deducted	624,369	34.9%	617,617	35.7%
Allowance for loan losses	(12,060)	−0.7%	(12,626)	−0.7%
Total loans, net	612,309	34.2%	604,991	35.0%
Goodwill	21,659	1.2%	22,349	1.3%
Intangibles apart from MSRs	5,114	0.3%	3,721	0.2%
Mortgage servicing rights	1,564	0.1%	1,781	0.1%
Other assets	128,008	7.1%	133,743	7.7%
Total assets	1,792,077	100.0%	1,731,210	100.0%

Three observations follow from the composition. Liquid assets are the largest single group at 37.4% in 2016, slightly above the prior year, indicating greater liquidity. Investments at 19.7% of total assets are practically unchanged from 19.8%, and most of that money sits in available-for-sale paper measured at fair value. The consumer and corporate loan books carry the most risk, exceed a third of the balance sheet in each year, and rank second in size behind the liquid assets.

Asset quality: the investment portfolio

The analyst wants confidence that the investments, transparent in value though they are, reflect sound investment decisions, and that the loans came from similarly reasoned underwriting and are collectible at the stated amount.

Citigroup: available-for-sale securities at 31 December 2016 ($m)

FSA 4 – Analysis of Financial Institutions — table 20
Security class	Amortised cost	Gross unrealised gains	Gross unrealised losses	Fair value	Gains, % of cost	Losses, % of cost
Agency-guaranteed MBS, US government sponsored	38,663	248	506	38,405	0.6%	1.3%
Prime MBS	2	–	–	2	–	–
Alt-A MBS	43	7	–	50	16.3%	–
Residential MBS outside the US	3,852	13	7	3,858	0.3%	0.2%
Commercial MBS	357	2	1	358	0.6%	0.3%
MBS in total	42,917	270	514	42,673	0.6%	1.2%
Treasury paper	113,606	629	452	113,783	0.6%	0.4%
Agency paper	9,952	21	85	9,888	0.2%	0.9%
Treasury and federal agency paper, total	123,558	650	537	123,671	0.5%	0.4%
State and local government	10,797	80	757	10,120	0.7%	7.0%
Sovereign, non-US	98,112	590	554	98,148	0.6%	0.6%
Corporate	17,195	105	176	17,124	0.6%	1.0%
ABS	6,810	6	22	6,794	0.1%	0.3%
Debt securities, other	503	–	–	503	0.0%	0.0%
AFS debt securities, all	299,892	1,701	2,560	299,033	0.6%	0.9%
AFS equities, marketable	377	20	6	391	5.3%	1.6%
AFS securities, all	300,269	1,721	2,566	299,424	0.6%	0.9%

Drawn from Note 13 to the 2016 Form 10-K. The final two columns restate the gross unrealised amounts against the cost invested.

Fair value of $299,424 million is below amortised cost of $300,269 million, a net difference of $845 million. State and local government paper contributes most of it, at $757 million. Losing 7% of value, that class was alone in exceeding a 2% loss. Two observations follow. Citigroup has not produced a net winning strategy with its available-for-sale investments, but the losses do not suggest reckless abandon either. Separately, forthcoming US GAAP rules remove the AFS label from marketable equities. Fair value measurement continues exactly as at the end of 2016, but from 2018 the gains and losses on remeasurement will run through the income statement rather than other comprehensive income. At 31 December 2016 Citigroup’s unrealised gains on AFS equity investments of $20 million exceeded its unrealised losses of $6 million, so on those market values the reclassification would benefit reported income.

Note 13 also ages the losses, which matters because a loss position that persists is likelier to represent impairment that is other than temporary. Losses rarely sit unchanged for years and then reverse without warning.

Citigroup: aging of unrealised losses on AFS securities at 31 December 2016 ($m)

FSA 4 – Analysis of Financial Institutions — table 21
Security class	Fair value, less than 12 months	Losses, less than 12 months	Fair value, 12 months or longer	Losses, 12 months or longer	Total fair value	Total losses
Agency MBS, government sponsored	23,534	436	2,236	70	25,770	506
Prime MBS	1	–	–	–	1	–
Residential MBS, non-US	486	–	1,276	7	1,762	7
Commercial MBS	75	1	58	–	133	1
All MBS	24,096	437	3,570	77	27,666	514
Treasuries	44,342	445	1,335	7	45,677	452
Agency bonds	6,552	83	250	2	6,802	85
Treasuries and agency bonds together	50,894	528	1,585	9	52,479	537
Municipals	1,616	55	3,116	702	4,732	757
Sovereigns abroad	38,226	243	8,973	311	47,199	554
Corporate	7,011	129	1,877	47	8,888	176
Asset-backed paper	411	–	3,213	22	3,624	22
Other debt	5	–	–	–	5	–
Marketable AFS equities	19	2	24	4	43	6
Every AFS security	122,278	1,394	22,358	1,172	144,636	2,566

Just over half the losses, 54%, have existed for under 12 months, so they trouble an analyst less than the remainder. Of the $1,172 million of gross unrealised losses that are 12 months old or older, 60%, or $702 million, relate to state and municipal securities, which raises the worry that the biggest block of losses will end up being realised.

The same analysis can be run on the held-to-maturity portfolio, and although it is a much smaller share of total assets it still evidences the manager’s investment acumen. The result is consistent with the AFS review. Citigroup’s unrealised losses on HTM securities totalled $457 million, or 1.3% of the amount invested, and 82% of that, or $373 million, sat in positions whose losses had already run beyond 12 months, $180 million of it in state and local government paper. In dollar terms the HTM losses are far smaller than the AFS losses and in percentage terms they are minor, but their age is troubling. Problem assets do not usually improve with age, and a concentration of old losses may indicate management reluctance to report economic reality. Because HTM securities are carried at amortised cost, the classification obscures their fair value, and the age of the loss-making positions suggests impairment may be more severe than has been recognised.

Asset quality: the allowance for loan losses

Investments are neither as large nor as risky as loans, and loans cannot be assessed without working through the allowance for loan losses. Three accounts interact:

The allowance for loan losses is a balance sheet account, a contra asset to loans, directly analogous to the allowance for bad debts that offsets accounts receivable at a non-financial company.
The provision for loan losses is an income statement expense that increases the allowance.
Charge-offs net of recoveries, the actual losses, reduce the allowance.

Total loans minus the allowance is the expected value of the loans, which is why the allowance matters so much for judging loan quality. It is also discretionary by its very nature. Underestimating it overstates both assets and net income, and almost every bank discloses the allowance among its most critical accounting estimates.

The way to test a discretionary number is to compare it with a less discretionary one. Net charge-offs are less discretionary indicators of loan quality than the allowance, but they have the disadvantage of being a confirming event: by the time a loan is charged off it has already gone bad. They carry a second disadvantage, in that charge-offs can be used in good times to store away earnings for later release through recoveries. Non-performing, or non-accrual, loans are loans not currently paying their contractual amounts due, which makes them a more objective measure of portfolio quality. Three ratios follow, each comparing a discretionary measure to a more objective one:

Is the allowance being built ahead of loans that have already stopped paying?

How many years of recent loss experience does the standing allowance cover?

Is this year’s expense keeping pace with this year’s actual losses?

Example 7 · Worked

Citigroup stratifies both loans and the allowance between consumer and corporate. Because the two customer types differ greatly, each is analysed separately. The table gives five years of data selected from the management discussion and analysis of the relevant Forms 10-K, together with the resulting ratios.

Citigroup: loan loss analysis data at 31 December ($m)

FSA 4 – Analysis of Financial Institutions — table 22
Item	2016	2015	2014	2013	2012
Consumer allowance for loan losses	9,358	9,835	13,547	16,974	22,585
Corporate allowance for loan losses	2,702	2,791	2,447	2,674	2,870
Consumer provision	6,323	6,228	6,695	7,587	10,312
Corporate provision	426	880	133	17	146
Consumer charge-offs	7,644	8,692	10,650	12,400	16,365
Corporate charge-offs	578	349	458	369	640
Consumer recoveries	1,594	1,634	1,975	2,138	2,357
Corporate recoveries	67	105	160	168	417
Consumer net charge-offs	6,050	7,058	8,675	10,262	14,008
Corporate net charge-offs	511	244	298	201	223
Consumer non-accrual loans	3,158	3,658	5,905	7,045	9,136
Corporate non-accrual loans	2,421	1,596	1,202	1,958	2,394

Citigroup: resulting allowance for loan loss ratios

FSA 4 – Analysis of Financial Institutions — table 23
Ratio	2016	2015	2014	2013	2012
Allowance to non-accrual loans: consumer	2.96	2.69	2.29	2.41	2.47
Allowance to non-accrual loans: corporate	1.12	1.75	2.04	1.37	1.20
Allowance to net loan charge-offs: consumer	1.55	1.39	1.56	1.65	1.61
Allowance to net loan charge-offs: corporate	5.29	11.44	8.21	13.30	12.87
Provision to net loan charge-offs: consumer	1.05	0.88	0.77	0.74	0.74
Provision to net loan charge-offs: corporate	0.83	3.61	0.45	0.08	0.65

1. Reproduce the six 2016 ratios from the underlying data.

Solution. Net charge-offs first: consumer 7,644 − 1,594 = 6,050, corporate 578 − 67 = 511. Then:

Allowance to non-accrual, consumer: 9,358 ÷ 3,158 = 2.96.
Allowance to non-accrual, corporate: 2,702 ÷ 2,421 = 1.12.
Allowance to net charge-offs, consumer: 9,358 ÷ 6,050 = 1.55.
Allowance to net charge-offs, corporate: 2,702 ÷ 511 = 5.29.
Provision to net charge-offs, consumer: 6,323 ÷ 6,050 = 1.05.
Provision to net charge-offs, corporate: 426 ÷ 511 = 0.83.

2. What do the allowance to non-accrual ratios say about the two loan books?

Solution. For consumer loans the 2016 ratio of 2.96 is the highest level in five years and has risen in each of the last two. The allowance, a discretionary amount, is growing faster than actual non-accrual loans, which gives an analyst confidence that reserves are being built in advance of loans turning bad. For corporate loans the reading of 1.12 is less definitive. Some volatility should be expected, because corporate lending is not homogeneous and individual credit failures can spike the ratio. Even allowing for that, the corporate ratio has fallen in each of the last three years, from 2.04 to 1.75 to 1.12, and 2016 is its lowest point in five years. That raises the concern that the allowance is a thin layer of protection against future corporate losses.

3. What do the other two ratio families add?

Solution. On allowance to net charge-offs, the consumer figure of 1.55 improves on 2015 and shows a cushion between the allowance and actual losses that has stayed fairly constant across five years, ranging from 1.39 to 1.65. The corporate figure of 5.29 still represents an ample cushion in absolute terms, but it fell sharply from 11.44 and is far below any other year in the five-year window.

On provision to net charge-offs, the provision is the amount added to the allowance each year and should broadly correlate with net charge-offs. For consumer loans, 2016 is the first year in five in which the provision exceeded net charge-offs, and although the ratio was below 1.0 in the previous four years it had been rising for three, from 0.74 to 0.77 to 0.88 to 1.05. The bank became more conservative in its consumer provisioning. For corporate loans the 2016 ratio fell sharply from the prior year and has been below 1.0 in four of the last five years, so the provision has trailed actual net charge-off experience. The large 2015 addition, at 3.61, has the appearance of an urgent catch-up adjustment rather than a steady policy.

Assessment. Citigroup’s asset quality at the end of 2016 was mixed. Investment policy looks fairly conservative, but the age of some positions carrying unrealised losses suggests a possible denial of impairment. On loan quality, the ratio analysis leaves the consumer book looking well reserved and the corporate book not. A rating of 2.5, near the midpoint of the scale, could be assigned given the mixed signals.

Management capabilities

External investors observe only circumstantial evidence of management quality, and a good deal of that evidence sits in the proxy statement. Three observations from Citigroup’s 2016 proxy are worth recording.

Citigroup aims for two-thirds independent board representation, where the New York Stock Exchange requires only a majority.
The roles of CEO and chairman have been separate since 2009, a practice often viewed as good governance because it avoids conflicts of interest.
Fourteen meetings of the Risk Management Committee took place in 2016, which shows attention being paid to one of the areas that matters most in a bank. The committee also created a subcommittee in 2016 to oversee data governance, data quality and data integrity, and that subcommittee met seven times in the year.

These are good practices, but they do not by themselves demonstrate strong management capability. What they demonstrate is that an environment exists in which strong management quality is permitted to flourish, which is a weaker claim and the correct one.

Related-party transactions are difficult to avoid at Citigroup’s scale. BlackRock and Vanguard each beneficially owned 5% or more of the outstanding common stock at 31 December 2016, and over 2016 Citigroup subsidiaries supplied both of them with lending, trading and other financial services in the ordinary course. The proxy states that the transactions were conducted on an arm’s-length basis with customary terms substantially the same as comparable transactions with unrelated third parties. Other related-party transactions are discussed in the Form 10-K and are routine for a company of this size.

On operational risk, the auditor issued an unqualified opinion on the effectiveness of the system of internal controls. That is evidence of a minimally satisfactory environment for management to operate in rather than a clear signal of competence; a qualified or negative opinion, by contrast, would be a serious concern for an investor.

Assessment. The board appears solidly constructed and appears to exert adequate control over managers, yet how the company actually performs also reports on the quality of its directors and managers, and asset quality was hardly a resounding result. A rating of 2 could be assigned.

Earnings: how much of the growth came from provisions

Earnings should be of high quality, and the main indicator of high quality is sustainability. Earnings are more sustainable when they do not depend on possibly opportunistic fine-tuning of discretionary estimates and are not reliant on non-recurring items or volatile revenue sources.

The allowance and the provision for loan losses are estimated amounts open to management discretion, and the provision can move a bank’s profitability sharply in a single year and steadily over many. The table sets Citigroup’s five-year change in pretax income against the change in total provisions for credit losses, which take in loan loss reserves alongside provisions for unfunded lending commitments and for policyholder benefits and claims.

Citigroup: historical pretax income and total provisions for credit losses ($m)

FSA 4 – Analysis of Financial Institutions — table 24
Item	5-year net change	2016	2015	2014	2013	2012	2011
Pretax income		21,477	24,826	14,701	19,802	8,165	15,096
Year-on-year move in pretax income	6,381	(3,349)	10,125	(5,101)	11,637	(6,931)	–
Credit loss provisions in total		6,982	7,913	7,467	8,514	11,329	12,359
Year-on-year move in those provisions	(5,377)	(931)	446	(1,047)	(2,815)	(1,030)	–
Net difference	1,004

Drawn from the five-year selected financial data in the 2016 and 2015 Forms 10-K.

Four observations follow, and they are uncomfortable ones.

2013 was the only year in which pretax income rose from the previous year while total provisions for credit losses fell. The $2,815 million decrease in the provisions drove 24% of the $11,637 million increase in pretax income.
In 2016, 2014 and 2012 pretax income declined from the previous year. Each of those declines would have been more severe had it not been buffered by a decrease in total provisions.
Across the five years, the change in total credit loss provisions contributed to improving pretax earnings in four of them. The single exception is 2015, when total provisions increased by $446 million, a negligible amount compared with the size of the decreases in the other four years.
On a longer view, the five-year net change in provisions of $5,377 million accounts for 84% of the $6,381 million net change in pretax income, which indicates that not much profit growth happened anywhere else. The residual, the net difference of $1,004 million, is all that five years produced from the underlying business.

Earnings: the revenue mix

The second indicator of sustainability is the extent to which trading income features in the revenue stream. Trading income tends to be volatile and is not necessarily repeatable, whereas net interest income and fee-based income provide returning streams. An analyst should examine the composition of the revenue stream both to see whether it is growing and to identify what is driving the growth or the decline.

Citigroup: five-year summary of revenue composition ($m)

FSA 4 – Analysis of Financial Institutions — table 25
Item	2016	2015	2014	2013	2012
Net interest revenue	45,104	46,630	47,993	46,793	46,686
Principal transactions, that is trading	7,585	6,008	6,698	7,302	4,980
Remaining non-interest revenue	17,186	23,716	22,528	22,629	17,864
Revenues after interest expense	69,875	76,354	77,219	76,724	69,530
Trading share of the total	10.9%	7.9%	8.7%	9.5%	7.2%
Net interest revenue share	64.5%	61.1%	62.2%	61.0%	67.1%
Remaining non-interest share	24.6%	31.1%	29.2%	29.5%	25.7%

Total revenues in 2016 of $69,875 million are almost unchanged from the 2012 level of $69,530 million. At 10.9% of total revenues, trading income has been trending upward as a proportion over the five years. Rather than growing its sustainable, non-volatile revenues, Citigroup’s principal transactions line is moving the other way, rising both in absolute dollars and in relative importance. All other non-interest revenue in 2016 is at its lowest representative level since 2012, and although the net interest revenue proportion improved in 2016 it remains below where it stood in 2012.

Earnings: reading the net interest margin

Net interest revenue is the product of two management activities: managing the interest earned on loans and other interest-bearing assets, and managing the interest paid on deposits and other interest-bearing liabilities. Banks can create value through maturity transformation, borrowing on shorter terms than they lend. Lending long at a higher rate than the cost of short-term funding creates value, but the same structure destroys value if short-term funding markets seize up or the yield curve unexpectedly inverts, which is why a bank’s risk management and diversification practices are integral to the process rather than incidental to it.

Citigroup: average balances, interest revenue and average rates on assets (condensed, $m)

FSA 4 – Analysis of Financial Institutions — table 26
Asset category	Avg volume 2016	Avg volume 2015	Interest revenue 2016	Interest revenue 2015	Avg rate 2016	Avg rate 2015
Deposits with banks	131,925	133,853	971	727	0.74%	0.54%
Federal funds sold and resales	232,876	234,353	2,543	2,516	1.09%	1.07%
Trading account assets, total	198,213	209,808	5,886	6,085	2.97%	2.90%
Investments, total	351,002	337,091	7,830	7,326	2.23%	2.17%
Loans in US offices	360,957	354,434	24,240	25,082	6.72%	7.08%
Loans booked outside the United States	262,715	273,064	15,578	15,465	5.93%	5.66%
Loans, total	623,672	627,498	39,818	40,547	6.38%	6.46%
Other interest-earning assets	56,398	63,209	1,029	1,839	1.82%	2.91%
Total interest-earning assets	1,594,086	1,605,812	58,077	59,040	3.64%	3.68%
Non-interest-earning assets	214,642	218,025
Total assets	1,808,728	1,823,837

Five observations come out of the asset side. The overall average rate earned slipped from 3.68% to 3.64%. One reason lies within loans, the single largest asset category: Citigroup sold its OneMain Financial subsidiary at the end of 2015, a United States consumer installment lending business with high yields, and that disposal pushed the rate earned in US offices down from 7.08% to 6.72%. Average US office loans nonetheless climbed from $354,434 million to $360,957 million after that sale, thanks to the Costco credit card book bought in mid-2016, which did not replace the OneMain interest income. Average loans outside the United States fell from $273,064 million to $262,715 million, partly on account of the sale, in the final quarter of 2015, of the Japanese retail banking and credit card operations. Trading account assets earned a better rate in 2016, 2.97% against 2.90%, but less capital was allocated to trading and less absolute interest income was earned from it. Finally, despite committing less capital to deposits with banks, $131,925 million against $133,853 million, the higher realised average rate lifted overall interest income, and the same pattern holds for the tax-exempt investments in US offices.

Citigroup: average balances, interest expense and average rates on liabilities (condensed, $m)

FSA 4 – Analysis of Financial Institutions — table 27
Liability category	Avg volume 2016	Avg volume 2015	Interest expense 2016	Interest expense 2015	Avg rate 2016	Avg rate 2015
Deposits, total	718,425	698,221	5,300	5,052	0.74%	0.72%
Federal funds purchased and repos	158,060	174,450	1,912	1,612	1.21%	0.92%
Trading account liabilities, total	74,150	69,963	410	217	0.55%	0.31%
Short-term borrowings, total	80,199	115,776	477	523	0.59%	0.45%
Long-term debt, total	181,768	189,989	4,412	4,517	2.43%	2.38%
Total interest-bearing liabilities	1,212,602	1,248,399	12,511	11,921	1.03%	0.95%
Total liabilities	1,579,544	1,604,647
Citigroup stockholders’ equity	228,065	217,875
Total equity	229,184	219,190

Citigroup: net interest revenue and net interest margin ($m)

FSA 4 – Analysis of Financial Institutions — table 28
Location	Avg interest-earning assets 2016	Avg interest-earning assets 2015	Net interest revenue 2016	Net interest revenue 2015	NIM 2016	NIM 2015	NIM 2014
US offices	859,311	923,309	27,929	28,495	3.25%	3.09%	2.88%
Offices outside the US	734,775	682,503	17,637	18,624	2.40%	2.73%	2.91%
Total	1,594,086	1,605,812	45,566	47,119	2.86%	2.93%	2.90%

Citigroup’s cost of funding rose in every category of liability in 2016, and the increase was more pronounced outside the United States with the exception of deposit liabilities. The divergence between domestic and foreign performance carries through to the net interest margin at the bottom of the table. The margin on assets in US offices improved to 3.25% from 3.09%, while the margin outside the United States fell from 2.73% to 2.40%. The overseas margin has fallen without interruption since 2014, the year the dollar started to strengthen, and adverse translation effects have run alongside it.

An investor might reasonably exercise increased caution when watching management’s future foreign investment decisions. Nothing here confirms that overseas capital is being allocated well or that currency exposure is under control. Weaker returns may equally stem from macroeconomic conditions, such as lower and even negative yield curves overseas producing fewer profitable opportunities, and an investor should weigh those possibilities too.

One methodological caution applies to the whole average-balance analysis. It explains what happened inside a bank over a period, but it is not necessarily useful for projecting future earnings, because what was earned or paid on an average balance in a past period need have no bearing on next period’s figures. End-of-period balances and their associated rates usually make a better starting point for a forecast than average balance information.

Assessment. The quality of Citigroup’s earnings is not exceedingly high. Decreases in the provision for loan losses drove 84% of the pretax earnings increase over five years, which does nothing to relieve quality concerns, and the rising share of trading income does not instil confidence either. The margin analysis adds a third concern, with net interest margin sliding across three years and the non-US offices doing most of the damage. Earnings quality can reasonably be rated 3.

A brief overview of accounting for derivatives

Derivatives accounting is extensive, and the points below are a compressed summary of a complex topic, broadly applicable under both IFRS and US GAAP. They matter here because derivative positions sit behind much of what follows on liquidity and market sensitivity.

At inception, many derivative contracts create neither an asset nor a liability on the balance sheet, and neither a gain nor a loss on the income statement. An interest rate swap, for example, can involve exchanging future cash flows of equivalent present value. At inception the only accounting record required for every derivative contract is disclosure of its notional amount in the notes to the financial statements.
Measuring the mark-to-market value of a contract creates an asset or a liability and thereafter increases or decreases the value of that asset or liability.
Changes in the value are recorded either in profit and loss or in comprehensive income, depending on the classification.
Two hedge classifications are available at this stage: a hedge of a cash flow, and a hedge of a net investment held in a foreign subsidiary. Either classification has to be supported by evidence of correlation with the risk hedged. Where a contract qualifies as one of these two hedge types, changes in its value go to other comprehensive income and are recognised in net income over the life of the hedged transaction.
If the contract fails to qualify as a hedge and is instead free-standing, or if it is classified as the third hedge type, a fair value hedge, then changes in fair value are reported as income or expense in each reporting period. Immediate recognition in earnings rather than in other comprehensive income can produce unexpected earnings volatility and missed earnings targets. Depending on the transaction, a secondary effect of failing hedge qualification may be a requirement to post additional collateral or cash.

Liquidity position

A bank’s liquidity matters for its own survival in stress, and because banks are interdependent through interbank deposits and derivative counterparty relationships, it matters for other banks and possibly for an entire economy. Capital alone does not assure liquidity: enough of that capital has to be available in cash or near-cash to meet obligations when they fall due. Basel III introduced two liquidity standards precisely to provide that assurance.

The Liquidity Coverage Ratio fixes the smallest share of projected outflows a bank has to hold in highly liquid form. The outflow figure is the liquidity requirement projected over 30 stressed days, and assets counted towards it must be of high quality and convertible into cash on the spot. Net outflows are built by applying prescribed factors to each liability category, then offsetting inflows from assets that mature within the 30-day window, and banks must add an amount to allow for possible maturity mismatches between contractual outflows and inflows during the period to reach total net outflows. The minimum threshold is 100%; anything below indicates an inability to meet liquidity needs.

Citigroup: Liquidity Coverage Ratio ($bn)

FSA 4 – Analysis of Financial Institutions — table 29
Item	31 Dec 2016	30 Sep 2016	31 Dec 2015
Liquid assets of high quality	403.7	403.8	389.2
Net outflows	332.5	335.3	344.4
Surplus of HQLA over net outflows	71.2	68.5	44.8
Liquidity Coverage Ratio	121%	120%	113%

The ratio improved over the last two years, from 113% to 121%. The 2016 figure means Citigroup can withstand cash outflows 21% higher than its 30-day stressed liquidity needs or, expressed differently, can absorb stressed outflows for 36.3 days, which is 121% applied to 30 days. Either reading indicates adequate liquidity even before allowing for the remedial management steps that would very likely be taken in a genuine stress event.

Standard number two is the Net Stable Funding Ratio, which fixes how much of the required stable funding has to come out of what is available. Required stable funding depends on the composition and maturity of the asset base; available stable funding depends on the composition and maturity of the funding sources. The NSFR is in effect an inverted LCR: where the LCR evaluates short-term liquidity, the NSFR measures the available stable funding supporting longer-term, less liquid assets such as loans, and highly liquid assets do not enter the calculation at all. A ratio of 100% is again the minimum acceptable threshold.

The NSFR was not yet a required Basel III standard at the end of 2016, with final rules expected in 2017, so the table below is a rough calculation made without the various weightings for components of available and required stable funding that the final rules would introduce. It divides the estimated unweighted available stable funding by the estimated required stable funding, using Citigroup’s consolidated balance sheet amounts.

Citigroup: estimated Net Stable Funding Ratio ($bn)

FSA 4 – Analysis of Financial Institutions — table 30
Item	31 Dec 2016	30 Sep 2016	31 Dec 2015
Deposits in total	929.4	940.3	907.9
Long-term debt	206.2	209.1	201.3
Equity, common	205.9	212.3	205.1
Total available stable funding	1,341.5	1,361.6	1,314.3
Total investments	353.3	354.9	343.0
Total loans, net	612.3	626.0	605.0
Goodwill	21.7	22.5	22.3
Intangibles apart from MSRs	5.1	5.4	3.7
Mortgage servicing rights	1.6	1.3	1.8
Other assets	128.0	116.5	133.7
Total required stable funding	1,122.0	1,126.6	1,109.5
Net Stable Funding Ratio	120%	121%	118%

The estimated ratio has been relatively stable since the end of 2015, and available stable funding sits well above the minimum required funding. Confirming the arithmetic: 929.4 + 206.2 + 205.9 = 1,341.5, and 1,341.5 ÷ 1,122.0 = 120%.

Assessment. Citigroup’s liquidity position is very good on both ratios, and a rating of 1 is justifiable.

Sensitivity to market risk

Market risk works on a bank’s assets and liabilities without pause, and it reaches both earnings and liquidity, so an analyst has to work out how a hostile move in rates, currencies or other market variables would feed through. Required disclosures make several sensitivities assessable. The value at risk disclosure helps in assessing exposure to market factors, and VaR statistics can be effective indicators of trends in risk-taking within a company. Because calculation assumptions differ across companies, VaR is much less useful for comparing risk-taking between companies.

At a 99% confidence level Citigroup estimates how far a position or portfolio could fall in value over an assumed one-day holding period in normal market conditions, using a Monte Carlo simulation model to capture material risk sensitivities across asset classes and risk types. Its VaR includes positions measured at fair value but excludes investment securities classified as available for sale or held to maturity.

Citigroup: trading VaR at year end and on average, with the trading and credit portfolio measure ($m)

FSA 4 – Analysis of Financial Institutions — table 31
Risk factor	31 Dec 2016	2016 average	31 Dec 2015	2015 average
Interest rate	37	35	37	44
Credit spread	63	62	56	69
Covariance adjustment	(17)	(28)	(25)	(26)
Interest rate and credit spread, fully diversified	83	69	68	87
Foreign exchange	32	24	27	34
Equity	13	14	17	17
Commodity	27	21	17	19
Covariance adjustment	(70)	(58)	(53)	(65)
Trading VaR across all market risk factors, credit portfolios excluded	85	70	76	92
Specific risk-only component	3	7	11	6
Trading VaR on general market risk factors alone	82	63	65	86
Credit portfolio, incremental impact	20	22	22	25
Trading plus credit portfolio VaR	105	92	98	117
Continuing operations net income	15,033		17,386
Common equity	205,867		205,139
VaR against continuing operations net income	0.7%	0.6%	0.6%	0.7%
VaR against common equity	0.1%	0.0%	0.0%	0.1%

Because risks inside and between risk types are imperfectly correlated, the covariance adjustment pulls the daily total below the sum of its parts. Trading VaR covers mark-to-market and certain fair value option positions, sets aside certain hedges, and leaves out available-for-sale and accrual exposures. The specific risk component captures issuer-level equity and fixed income risk inside the measure, and the credit portfolio holds mark-to-market positions belonging to units outside trading.

Average trading VaR fell in 2016 to $70 million from $92 million, mainly because of changes in interest rate exposures from mark-to-market hedging activity, and average trading and credit portfolio VaR fell to $92 million from $117 million. Total trading and credit portfolio VaR did rise at year end, to $105 million from $98 million, yet that worst-case one-day number stays under 1% of continuing operations net income in each year, whether on an end-of-period basis at 0.7% or an average basis at 0.6%. Against equity the magnitude is smaller still, at 0.1% end-of-period and less than 0.1% on average. The important caveat is that VaR here is a single-day measure of a market shock, while market dislocations can persist for days, weeks or longer. VaR captures very short-term shocks well and says nothing about longer-lasting market damage.

A second disclosure estimates the sensitivity of Citigroup’s capital ratios to a $100 million change in each capital measure and to a $1 billion change in risk-weighted assets. These sensitivities consider only a single change at a time, and an event affecting more than one factor could have a far greater impact than the estimate suggests.

Citigroup: capital ratio estimated sensitivities at 31 December 2016 (basis points)

FSA 4 – Analysis of Financial Institutions — table 32
Measure	CET1 ratio: $100m capital change	CET1 ratio: $1bn RWA change	Tier 1 ratio: $100m capital change	Tier 1 ratio: $1bn RWA change	Total capital ratio: $100m capital change	Total capital ratio: $1bn RWA change
Advanced Approach	0.90	1.20	0.90	1.30	0.90	1.50
Standardized Approach	0.90	1.30	0.90	1.40	0.90	1.70
Actual capital ratio	14.35%	14.35%	15.29%	15.29%	17.33%	17.33%
Minimum capital ratio	4.50%	4.50%	6.00%	6.00%	8.00%	8.00%

Advanced Approaches risk-weighted assets rest mainly on models and cover credit, market and operational risk together. Under the Standardized Approach operational risk-weighted assets drop out and supervisory weights are applied wholesale to broad credit exposure categories, which leaves Advanced Approaches credit risk-weighted assets the more risk sensitive of the two. The market risk component is computed on much the same basis either way.

On either calculation, moving capital by $100 million or risk-weighted assets by $1 billion barely registers beside the ratios reported at year end: 0.90 to 1.70 basis points against ratios measured in whole percentage points. These remain static measures that adjust for one impact at a time.

Assessment. Citigroup’s sensitivity to market impacts appears controlled and provides circumstantial evidence of effective risk management. A rating of 1 is defensible.

Building the composite

Once every component has been analysed and rated, the composite assessment can be assembled. The simplest approach adds the six ratings. A bank earning the best rating of 1 on every component scores 6; a bank earning the worst on every component scores 30. Dividing the score by 6 converts it into a composite rating, which is the arithmetic mean of the component ratings. Note that where every component receives the same rating, weighting makes no difference at all.

The arithmetic mean nonetheless fails to reflect the fact that some components matter more to some analysts than others. Depending on the focus of the analysis, an analyst-weighted composite score and rating can differ appreciably from the unweighted mean.

Example 8 · Worked

Build the overall score for Citigroup as an equity analyst would, giving asset quality and earnings double the weight carried by the remaining four components. The component ratings assigned in the preceding sections were: capital adequacy 1.0, asset quality 2.5, management 2.0, earnings 3.0, liquidity 1.0 and sensitivity 1.0.

Citigroup: overall CAMELS score

FSA 4 – Analysis of Financial Institutions — table 33
Component	Rating	Weight	Weighted
Capital adequacy	1.0	1	1.00
Asset quality	2.5	2	5.00
Management	2.0	1	2.00
Earnings	3.0	2	6.00
Liquidity	1.0	1	1.00
Sensitivity	1.0	1	1.00
Total score	10.5	8	16.00
Divided by total weight	1.75		2.00

1. Compute the unweighted composite rating.

Solution. Sum the six ratings: 1.0 + 2.5 + 2.0 + 3.0 + 1.0 + 1.0 = 10.5. Divide by 6: 10.5 ÷ 6 = 1.75. That is not perfect, but it indicates a bank generally showing strong performance and risk management.

2. Compute the weighted composite rating.

Solution. Multiply each rating by its weight and sum: (1.0 × 1) + (2.5 × 2) + (2.0 × 1) + (3.0 × 2) + (1.0 × 1) + (1.0 × 1) = 1.00 + 5.00 + 2.00 + 6.00 + 1.00 + 1.00 = 16.00. The weights sum to 8, not 6, so the divisor changes: 16.00 ÷ 8 = 2.00.

3. Why does the weighted score come out worse, and what does the difference tell the analyst?

Solution. Because the two components receiving double weight are precisely the two with the worst ratings, asset quality at 2.5 and earnings at 3.0. Doubling their influence pulls the composite from 1.75 to 2.00. On the weighted reading the flaws management may have to deal with look a little more pronounced. The general lesson is the one stated at the outset: two analysts can agree on all six component ratings and still disagree on the composite, because the composite encodes whose priorities are being applied. A fixed-income investor doubling capital adequacy and liquidity instead, both rated 1.0, would compute (1.0 × 2) + (2.5 × 1) + (2.0 × 1) + (3.0 × 1) + (1.0 × 2) + (1.0 × 1) = 12.50 over total weights of 8, giving 1.56, a better composite than the unweighted 1.75 rather than a worse one.

Insurance companies provide protection against adverse events, and they earn revenue from two distinct activities. The first is premiums, the amounts paid by the purchaser of the insurance product. The second is the investment income earned on the float, being premium already collected but not yet paid out in benefits. The industry divides into property and casualty writers (P&C) and life and health writers (L&H), and their products differ on two dimensions: contract duration and variability of claims. P&C policies are usually short term, with the final cost usually known within a year of the insured event, whereas L&H policies are usually longer term. P&C claims arrive lumpier and less evenly, since accidents and comparable unforeseeable events cause them, whereas L&H claims can be anticipated with much greater confidence, since across large populations they track fairly steady actuarial mortality rates.

For both types, the important areas for analysis are business profile, earnings characteristics, investment returns, liquidity and capitalisation. For P&C companies two further areas apply: the analysis of loss reserves and the combined ratio, which is an indicator of overall underwriting profitability.

One reporting caveat frames everything that follows. Some countries, the United States among them, require insurers to prepare financial reports under statutory accounting rules that differ from US GAAP and IFRS and that place greater emphasis on solvency. In the United States the National Association of Insurance Commissioners has built a system of ratios and guideline values for solvency monitoring, the Insurance Regulatory Information System (IRIS), whose ratios are based on statutory reports. The analysis in this lesson is based on US GAAP and IFRS financial reports.

Why the float makes an insurer two businesses at once

A P&C insurer collects premiums at the start of the contract and pays claims later, sometimes much later. The gap creates a pool of money that belongs economically to future claimants but is under the insurer’s control in the meantime, and the insurer invests it. That is why an insurance company is simultaneously a risk manager and an investment company, and why an analysis that examines underwriting alone is incomplete. The point is visible in the revenue table below: net investment income is the second largest revenue source for Travelers after premiums earned, and it is significant relative to total revenues. It also explains why insurers can survive years of underwriting losses when investment returns are strong, and why a prolonged low-rate environment squeezes them even when underwriting is unchanged.

The Travelers Companies, Inc.: revenue composition ($m)

FSA 4 – Analysis of Financial Institutions — table 34
Source	2016	2016 %	2015	2015 %	2014	2014 %
Premiums	24,534	88.8%	23,874	89.0%	23,713	87.3%
Net investment income	2,302	8.3%	2,379	8.9%	2,787	10.3%
Fee income	458	1.7%	460	1.7%	450	1.7%
Net realised investment gains	68	0.2%	3	0.0%	79	0.3%
Other revenues	263	1.0%	99	0.4%	145	0.5%
Total revenues	27,625	100.0%	26,815	100.0%	27,174	100.0%

Operations, products and distribution

P&C insurers provide risk management services to insured parties. For the price of a premium they protect those parties against losses many times greater than the premiums paid. They try to minimise payouts by exercising care in underwriting and charging an adequate price for the risk they bear, and they diversify by avoiding excessive concentration in one type of policy, market or customer. They may also transfer policies, whole or in part, to reinsurers, who deal only with risks already insured by other insurers and do not originate primary policies.

The duty to perform is comparatively short compared with life insurance. Policies are often written annually and the covered event is often known with certainty inside the policy period, as with fire or weather. Some insured events take far longer to surface: environmental harm occurring during the policy period may not become obvious until well after the policy has expired.

Property insurance covers loss of or damage to property: buildings, motor vehicles, environmental damage and other tangible items of value. The causes of loss vary, from accident and fire to theft and catastrophe, and they determine which kind of policy applies.
Casualty insurance, which also goes by the name liability insurance, covers legal liability arising from an insured event, meaning liability owed to a third party: a passenger, an employee or a bystander.
Multiple peril policies arise because a single event can produce both kinds of loss. An automobile accident may destroy the car and injure the passengers at once.

Products may be sold as personal lines or commercial lines depending on the customer, and some products are sold in both. Types of P&C insurance run to motor property and liability cover, which is one product sold in both lines, plus homeowner cover, workers’ compensation, marine and reinsurance.

There are two distribution methods, and the difference matters for the cost structure. Direct writers employ their own sales and marketing people, and can also reach buyers online, by mail and other direct response routes, and through affinity groups bound by a common profession or interest. Agency writers sell through brokers and through agents who may be independent or exclusive. Because direct writers employ salaried sales and marketing staff, they carry higher fixed costs. Agency writers avoid that fixed cost and instead pay commissions to agents and brokers, which is a variable cost.

The underwriting cycle

Seen from a distance, the P&C business is cyclical. It is price sensitive, with many competitors willing to cut prices to win market share. According to A.M. Best, a United States insurance rating agency, there are approximately 1,200 P&C groups in the United States comprising approximately 2,650 P&C companies, and the largest 150 of those groups wrote roughly 92% of the consolidated industry net written premium in 2015.

The cycle runs as follows. Price cutting eventually destroys profitability, producing a soft pricing market, and insurers find themselves at an uncomfortably depleted level of capital. Competition then lessens and underwriting standards tighten, producing a hard pricing market. Premiums rise, profitability returns to more reasonable levels, the improved profitability attracts new entrants, and the cycle repeats.

Figure 5: The property and casualty underwriting cycle

Expenses drive the loop. A low industry combined ratio marks a hard market, which attracts entrants who cut prices; lower premiums raise the combined ratio and mark the soft market, and competitors leave either by choice or by failure.

The mechanism running the cycle is the combined ratio, the total insurance expenses divided by net premiums earned. When the industry ratio is low the market is hard, entrants arrive, prices are cut and the cycle turns down. The effect shows up beneath the line: lower premium prices reduce total net premiums earned, so the combined ratio rises, indicating a soft market. Competitors then leave, either because they choose to stop writing unprofitable business or because they fail.

The combined ratio and its components

For a single insurer, a combined ratio above 100% indicates an underwriting loss. Under Statutory Accounting Practices in the United States the combined ratio adds together two figures taken from statutory statements, one for underwriting losses and one for expenses. The first of these puts losses, defined as claims paid plus the change in loss reserves from beginning to end of period, divided by net premiums earned, and it indicates the quality of underwriting activity, meaning the decisions on whether to accept an application and what premium to charge. The expense ratio puts underwriting expenses, sales commissions and the related employee costs included, over net premiums written, and it reports operating efficiency in acquiring and managing underwriting business.

Companies sometimes report modified versions in their financial disclosures. Travelers, for one, puts net earned premiums below the line in its expense ratio, which follows US GAAP, and other companies present the calculation differently again. This is a real comparability trap, and it is worth checking the denominator before comparing two published combined ratios.

The distinction between the two premium measures is worth stating precisely, because several ratios turn on it. Net premiums written are direct premiums written after deducting whatever has been ceded away to other insurers. Billing normally happens in advance, twice a year say, and the premium is earned across the period the policy covers. Only the net premiums written that are earned over the relevant accounting period are net premiums earned.

A low reading says the underwriter judged the insured risks well.

Measures the efficiency of money spent obtaining new premiums; lower is better.

Overall efficiency of the underwriting operation; below 100 is considered efficient.

A measure of liquidity, relating the cash outflow of dividends to premiums earned in the same period.

A stricter efficiency measure that takes account of discretionary cash paid to policyholders or shareholders.

Figure 6: The combined ratio as two stacked components

A combined ratio below the 100% line means the underwriting operation made money before investment income; above it means the underwriting made a loss that investment income must cover.

Example 9 · Worked

The table applies the five ratios to a group of property and casualty insurers using their 2016 financial reports.

2016 ratios for selected property and casualty insurers ($m)

FSA 4 – Analysis of Financial Institutions — table 35
Item	Travelers Companies	Hartford Financial Services Group	W. R. Berkley Corp.	CNA Financial Corp.	Markel Corp.
Loss and loss adjustment expense, dollars	15,070	11,351	3,846	5,270	2,051
Premiums earned, net	24,534	13,811	6,293	6,924	3,866
Loss and loss adjustment expense ratio	61.4%	82.2%	61.1%	76.1%	53.1%
Underwriting expense, dollars	8,139	5,156	2,396	2,787	1,437
Premiums written, net	24,958	10,568	6,424	6,988	4,001
Underwriting expense ratio	32.6%	48.8%	37.3%	39.9%	35.9%
Combined ratio	94.0%	131.0%	98.4%	116.0%	89.0%
Dividends paid to policyholders or shareholders	757	334	184	813	0
Dividends ratio	3.1%	2.4%	2.9%	11.7%	0.0%
Combined ratio after dividends	97.1%	133.4%	101.3%	127.7%	89.0%

Markel’s combined ratio of 89.0% follows from the unrounded components, 53.05% plus 35.92% equalling 88.97%. Adding the rounded figures shown gives 89.0% only when the loss ratio is displayed to one decimal as 53.1%; the source exhibit shows 53.0% in its combined ratio block, which is a display artefact of rounding rather than a different figure.

1. Reproduce Travelers’ and Hartford’s ratios from the underlying dollar amounts.

Solution. Travelers: 15,070 ÷ 24,534 = 61.4% and 8,139 ÷ 24,958 = 32.6%, giving a combined ratio of 94.0%. Dividends: 757 ÷ 24,534 = 3.1%, so the combined ratio after dividends is 97.1%.

Hartford: 11,351 ÷ 13,811 = 82.2% and 5,156 ÷ 10,568 = 48.8%, giving a combined ratio of 131.0%. Dividends: 334 ÷ 13,811 = 2.4%, so the combined ratio after dividends is 133.4%. Note that Hartford’s expense ratio is computed on net premiums written of 10,568, which is well below its net premiums earned of 13,811; using earned premiums instead would give 37.3% and a materially different combined ratio. The denominator convention is not a detail.

2. Rank the group and place Travelers within it.

Solution. There is wide variation. Markel performed the best with a combined ratio of 89.0%, and Hartford performed relatively poorly at 131.0%. Hartford’s high loss and loss adjustment expense ratio of 82.2% combined with an underwriting expense ratio of 48.8% suggests its underwriting business requires additional management attention.

Across the five companies, Travelers is the median on the loss and loss adjustment expense ratio: the five values sorted are 53.1%, 61.1%, 61.4%, 76.1% and 82.2%, and Travelers sits third at 61.4%. On the underwriting expense ratio and the combined ratio Travelers is below median, meaning better than median, at 32.6% and 94.0% against medians of 37.3% and 98.4%. Its operations are therefore in the better-performing half of the group. After allowing for the dividend distribution policy in the combined ratio after dividends, Travelers remains in the better-performing half at 97.1%, second only to Markel.

3. CNA has the second worst combined ratio after dividends despite a loss ratio better than Hartford’s. What drives that?

Solution. The dividends ratio. CNA distributed $813 million against net premiums earned of $6,924 million, a dividends ratio of 11.7%, which is roughly four times the ratio of any other company in the group. Its combined ratio of 116.0% is already above 100%, and adding 11.7 points takes it to 127.7%. The stricter measure exists precisely to capture this: dividends are discretionary cash outlays, and folding them into the ratio gives a fuller description of the total cash requirement of the underwriting operation.

Loss reserves

One critical expense for a P&C insurer comes from managing its loss reserves. Proper estimation of liabilities is essential to pricing policies, because underestimating loss reserves leads to undercharging for the risks assumed. Development of the reserves is based on historical information but also incorporates estimates about future losses, so it is a material account subject to management discretion whose improper estimation carries real consequences. If the reserves and the annual adjustments to them are too optimistic, policy pricing may be insufficient for the risk borne and insolvency may follow.

A second problem is duration. The longer the insurer’s obligation runs, the harder it becomes to estimate the loss reserve properly. Asbestos cover illustrates the point. Those policies were written well before the courts began handing down larger awards, so what insurers now experience bears little resemblance to what they priced for, and awards grew fast enough to make the matching reserves extremely hard to set.

The Travelers Companies, Inc.: loss reserve balances and activity ($m)

FSA 4 – Analysis of Financial Institutions — table 36
Item	2016	2015	2014
Opening gross reserves for claims and claim adjustment expense	48,272	49,824	50,865
Deduct recoverables on unpaid losses	(8,449)	(8,788)	(9,280)
Opening net reserves	39,823	41,036	41,585
Estimate for claims arising this year	15,675	14,471	14,688
Estimated reduction on claims arising in earlier years	(680)	(817)	(885)
Total increases	14,995	13,654	13,803
Paid on this year’s claims	(6,220)	(5,725)	(5,895)
Paid on earlier years’ claims	(8,576)	(8,749)	(8,171)
Total payments	(14,796)	(14,474)	(14,066)
Acquisition	–	2	–
Unrealised currency gain	(74)	(395)	(286)
Closing net reserves	39,948	39,823	41,036
Add back recoverables on unpaid losses	7,981	8,449	8,788
Closing gross reserves for claims and claim adjustment expense	47,929	48,272	49,824
Share of reserves ceded to reinsurers	16.7%	17.5%	17.6%
Releases on earlier-year claims	680	817	885
Income before income taxes	4,053	4,740	5,089
Those releases as a share of pretax income	16.8%	17.2%	17.4%

Drawn from the insurance claims footnote in Travelers’ 2016 financial statements. The roll-forward is denominated in reserves net of reinsurance recoverables expected to reduce the ultimate liability; beginning and ending balances are shown gross and then reduced by recoverables to reach net reserves.

Four observations come out of the roll-forward.

The liability is mostly short tail. Claims paid in 2016 for current-year events of $6,220 million are 39.7% of the $15,675 million of estimated current-year claims and claim adjustments, so most of the exposure runs off quickly. The pattern in the two earlier years is much the same.
Reinsurance is used substantially. Reinsurance means one insurer handing part of its risk to another for a premium, with the cedant expecting the reinsurer to reimburse the losses. Travelers has passed on somewhere between 16.7% and 17.6% of gross loss reserves.
Reserve increases dominate the income statement. Reserve additions, after netting the releases on earlier-year claims, weigh on the income statement more heavily than any other expense line. The $14,995 million added in 2016 equals 63.6% of the $23,572 million of total claims and expenses reported for the year.
Downward revisions matter more than they look. The company reduced its prior-year claims estimates by $680 million in 2016, $817 million in 2015 and $885 million in 2014. Downward revisions indicate that initial recognised reserves are being estimated conservatively, but aggressive revisions can equally be a tool for managing earnings. Against total increases of roughly $15 billion the revisions look minor; against income before taxes they are not. They contributed 16.8% of income before income taxes in 2016, 17.2% in 2015 and 17.4% in 2014.

Investment returns and liquidity

P&C insurers face much uncertainty in the risks they insure and compete hard when pricing enters its hard stage. To counteract that uncertainty they invest the collected premiums conservatively, favouring steady-return, low-risk assets and avoiding low-liquidity investments.

The Travelers Companies, Inc.: investment portfolio composition ($m)

FSA 4 – Analysis of Financial Institutions — table 37
Holding	2016	2016 %	2015	2015 %
Fixed maturities held available for sale, at fair value; cost $59,650 and $58,878	60,515	85.9%	60,658	86.1%
Equities held available for sale, at fair value; cost $504 and $528	732	1.0%	705	1.0%
Real estate holdings	928	1.3%	989	1.4%
Short-dated securities	4,865	6.9%	4,671	6.6%
Investments, other	3,448	4.9%	3,447	4.9%
Total investments	70,488	100.0%	70,470	100.0%

Investments represent 70% of total assets in both 2016 and 2015. Fixed-maturity holdings run at roughly 86% of the portfolio in both years, with almost a further 7% in short-dated paper that stands in for cash. Equities account for just 1% each year, and real estate barely registers. Concentrations merit attention as they would for any company: for a P&C insurer, concentration by type, maturity, credit quality, industry, geographic location or single issuer should each be evaluated.

Dividing total investment income by invested assets, cash plus investments, gives an estimate of performance. The metric can be computed on two bases, with and without unrealised capital gains, and the difference between the two shows how much of the total investment result depends on unrealised gains.

Because P&C insurers must stand ready to meet policy payouts, and because the timing of those payouts is uncertain, liquidity is a priority in selecting assets. The typical low-risk, steady-return instruments they hold are liquid by nature, but an analysis should still consider the overall quality of the investments and the ease with which they can be converted to cash without affecting their value. The fair value hierarchy provides direct evidence: Level 1 values are based on readily available prices from liquid markets and indicate the most liquid securities; Level 2 values are based on less liquid conditions, with prices unavailable from a liquid market and inferred instead from similar securities trading in an active market; Level 3 values rest on models and assumptions because no active market exists, implying illiquidity.

Example 10 · Worked

Below is how Travelers classified its investment securities within the fair value hierarchy at the end of 2016.

The Travelers Companies, Inc.: portfolio composition by fair value hierarchy ($m)

FSA 4 – Analysis of Financial Institutions — table 38
Security	Total	Level 1	Level 2	Level 3
Treasury paper and obligations of US agencies and authorities	2,035	2,035	0	0
State, municipal and political subdivision obligations	31,910	–	31,898	12
Foreign government debt	1,662	–	1,662	–
MBS, CMOs and pass-through obligations	1,708	–	1,704	4
Corporate bonds, all other	23,107	–	22,939	168
Preferred stock, redeemable	93	3	90	–
Total fixed maturities	60,515	2,038	58,293	184
Percentage of security class	100.0%	3.4%	96.3%	0.3%
Public common stock	603	603	0	0
Non-redeemable preferred stock	129	51	78	–
Total equity securities	732	654	78	0
Percentage of security class	100.0%	89.3%	10.7%	0.0%

1. What proportion of the combined fixed-income and equity portfolio is classified as Level 1?

Solution. (2,038 + 654) ÷ (60,515 + 732) = 2,692 ÷ 61,247 = 4.4%. Travelers holds very little of its portfolio in Level 1 assets. The great majority is Level 2, which implies less liquidity than Level 1 but does not imply illiquidity.

2. Does the fair value footnote give assurance that the Level 2 assets are liquid?

Solution. Not absolute assurance, but persuasive evidence that the reported values are fair. Travelers states that a pricing service produced the fair value estimates covering roughly 98% of fixed maturities at the end of both 2016 and 2015. The service uses market quotations for securities with quoted prices in active markets, and because fixed maturity paper other than Treasuries does not usually change hands every day, it builds estimates from proprietary pricing applications drawing on whatever relevant market information exists, on benchmark curves, on comparison against similar securities, on sector groupings and on matrix pricing. An option adjusted spread model generates its prepayment and rate scenarios, and each asset class is assessed on the market and credit information available, on where markets appear to be moving, and on sector news. Ranked roughly by priority, the market inputs used are benchmark yields, trades reported, quotes from brokers and dealers, spreads by issuer, two-sided markets, benchmark securities, bids, offers, reference data, and events in the industry and the economy.

The analytical value lies in the composition of that list. Reported trades, broker and dealer quotes, issuer spreads and two-sided markets are all liquidity information, so the fact that the pricing service weighs them increases confidence that the recognised values approximate what Travelers would have achieved on liquidation at year end 2016. It is evidence about the reliability of the marks, not a guarantee of constant liquidity.

3. Is the fixed maturity portfolio more or less liquid than the equity portfolio on this evidence?

Solution. Less liquid, and by a wide margin. Only 3.4% of fixed maturities are Level 1 against 89.3% of equity securities, and 96.3% of fixed maturities are Level 2. That said, the fixed maturity portfolio is roughly 83 times the size of the equity portfolio (60,515 against 732), so the combined figure of 4.4% is dominated by the bond book. Level 3 exposure is negligible in both: $184 million of fixed maturities, or 0.3%, and nothing at all in equities.

Capitalisation

Unlike banking, where international risk-based capital standards have existed since 1988, no global standard existed for the insurance sector as of mid-2016, though the IAIS was then at work on a global risk-based capital standard for the sector. It is expected to carry a target capital adequacy floor, computed by setting qualifying capital over the risk-based capital that is required.

Capital standards nonetheless exist in individual jurisdictions. Europe adopted Solvency II in 2014. Among much else it sets capital floors, and an insurer that drops beneath one obliges the supervisor in that country to step in. The NAIC risk-based capital rules in the United States, which date from the 1990s, fix a capital floor that depends on how large an insurer is and what risks it runs. For a P&C writer the formula weighs asset risk, credit risk, underwriting risk and whatever else is relevant.

An L&H company earns its revenue by writing life and health cover, and at many firms by selling investment products and services alongside it. The second main revenue source is investment income. The five areas that framed the P&C discussion apply here too: business profile, earnings characteristics, investment returns, liquidity and capitalisation. What changes is the weight given to each, because the liabilities behave differently. L&H policies run longer and their claims are more predictable, and both facts flow through to how the assets are invested and how much capital the regulator demands.

Products and distribution

Life insurance products vary widely. At the simplest end, a premium buys coverage and the beneficiary receives payment when the insured dies. Under a term life policy a benefit falls due should the insured die inside the contract’s fixed term, and the policy lapses worthless if the insured outlives it. Other products combine a death benefit with a savings vehicle. Life insurers may also offer investment products such as annuities, with fixed payments or with variable payments linked to market returns.

Health-related products vary primarily by the type of coverage. Certain products meet named medical expenses and treatments, and others pay an income where the policyholder falls ill or is injured.

Distribution runs either directly to consumers through electronic media or through agents, and the agents may be employees of the company, exclusive agents or independent agents. Distribution through independent agents is more expensive for the insurer, but it minimises fixed costs and increases the flexibility to pursue growth opportunities, which is the same fixed-versus-variable trade-off that separates direct writers from agency writers in the P&C business.

Understanding where a company’s revenue comes from, and how that has changed, is the starting point of the business profile. Diversification lowers risk, and an L&H company can spread itself across the sources of its revenue, the products it offers, the territories it covers, the channels it sells through and the assets it invests in.

Example 11 · Worked

The tables present selected income statement information for Aegon N.V., reported under IFRS in euros, and for MetLife, Inc., reported in US dollars.

Aegon N.V.: selected consolidated income statement information (EUR millions)

FSA 4 – Analysis of Financial Institutions — table 39
Item	2016	2015	2014	2013	2012
Premium income	23,453	22,925	19,864	19,939	19,049
Investment income	7,788	8,525	8,148	7,909	8,413
Fees, commissions, other	2,414	2,452	2,145	1,957	1,865
Total revenues	33,655	33,902	30,157	29,805	29,327

MetLife, Inc.: selected income statement information ($m)

FSA 4 – Analysis of Financial Institutions — table 40
Item	2016	2015	2014	2013	2012
Premiums	39,153	38,545	39,067	37,674	37,975
Investment income, derivative gains included	13,358	19,916	22,273	19,154	19,713
Policy fees on universal life and investment-type products, and other	10,965	11,490	11,976	11,371	10,462
Total revenues	63,476	69,951	73,316	68,199	68,150

Several MetLife income statement lines have been grouped here so the two presentations can be compared. For anything beyond this illustration, work from the audited statements themselves.

Common-size revenue and year-on-year change

FSA 4 – Analysis of Financial Institutions — table 41
Measure	2016	2015	2014	2013	2012
Aegon: premium income, % of total revenues	69.7%	67.6%	65.9%	66.9%	65.0%
Aegon: investment income, % of total revenues	23.1%	25.1%	27.0%	26.5%	28.7%
Aegon: fees, commissions, other, % of total revenues	7.2%	7.2%	7.1%	6.6%	6.4%
Aegon: premium income, year-on-year change	2.3%	15.4%	−0.4%	4.7%
Aegon: investment income, year-on-year change	−8.6%	4.6%	3.0%	−6.0%
Aegon: fees, commissions, other, year-on-year change	−1.5%	14.3%	9.6%	4.9%
MetLife: premiums, % of total revenues	61.7%	55.1%	53.3%	55.2%	55.7%
MetLife: investment income, % of total revenues	21.0%	28.5%	30.4%	28.1%	28.9%
MetLife: policy fees and other, % of total revenues	17.3%	16.4%	16.3%	16.7%	15.4%
MetLife: premiums, year-on-year change	1.6%	−1.3%	3.7%	−0.8%
MetLife: investment income, year-on-year change	−32.9%	−10.6%	16.3%	−2.8%
MetLife: policy fees and other, year-on-year change	−4.6%	−4.1%	5.3%	8.7%

1. Using the 2016 data, compare the two companies on diversification across revenue sources.

Solution. MetLife appears more diversified, because it generates only about 62% of total revenues from premiums (39,153 ÷ 63,476 = 61.7%) against nearly 70% for Aegon (23,453 ÷ 33,655 = 69.7%). The qualification matters, though: premium income can be a more stable source of revenue than investment income, so greater diversification of revenue sources should be weighed against the potentially greater variability that comes with it. MetLife is less concentrated but its second largest source fell 32.9% in a single year, which is not a picture of stability.

2. Describe how revenue diversification has moved at each company, focusing on premium income.

Solution. At both companies premiums account for a larger slice of total revenue in 2016 than in any of the four preceding years: 69.7% for Aegon against a range of 65.0% to 67.6%, and 61.7% for MetLife against a range of 53.3% to 55.7%.

The causes differ. For Aegon the rise in the premium share came partly from genuine growth in premium income, up 15.4% in 2015, together with a decline in investment income of 8.6% in 2016. For MetLife the rise came primarily from the fall in investment income in 2015 and 2016, of 10.6% and 32.9% respectively, while premiums moved little, up 1.6% in 2016 after a fall of 1.3% in 2015. In both cases the concentration in premiums increased, but Aegon reached it partly by growing and MetLife almost entirely by shrinking elsewhere.

Earnings characteristics

The major components of an L&H insurer’s expenses are benefit payments to policyholders under life insurance, other insurance policies, annuity contracts and other contracts. Some products that accumulate a cash value let the holder end the contract ahead of its stated maturity and take out the cash value built up. Such early cancellation is a contract surrender, and surrenders may create additional expense for the insurer.

As with P&C insurers, earnings reflect a number of accounting items requiring significant judgement and estimation.

Future policyholder benefits and claims must be estimated on actuarial assumptions, for example about life expectancy. The amounts expensed in any period are affected both by the benefits actually paid and by interest on the estimated liability for future policyholder benefits.
Acquisition costs for new and renewal business go onto the balance sheet and are then written off against the profits that business actually and prospectively earns, which ties reported earnings to a forecast.
Securities valuation is a third area where accounting judgement can materially affect earnings, and it is discussed under investment returns below.

General profitability measures apply: return on assets, return on equity, growth and volatility of capital, and book value per share, along with pre-tax and post-tax operating margin, meaning operating profit as a percentage of total revenues, and pre-tax and post-tax operating return on assets and on equity. Most analysis goes further than these general measures, because L&H earnings are complex and because operational distortion and accounting estimates matter so much to reported results. Sector-specific metrics help. A.M. Best, for instance, works with benefits paid measured against the sum of net premiums written and deposits, and with commissions and expenses measured the same way.

Return on equity: US L&H sector and MetLife, Inc.

FSA 4 – Analysis of Financial Institutions — table 42
Measure	2011	2012	2013	2014	2015	2016
US L&H sector return on average equity	4.70%	12.60%	12.90%	11.00%	11.20%	not available
US L&H sector pretax operating return on average equity	9.10%	18.70%	19.10%	14.30%	15.10%	not available
MetLife, Inc. return on average equity (from Form 10-K)	12.20%	2.00%	5.40%	9.40%	7.50%	1.00%
MetLife, Inc. pretax operating return on average equity (calculated)	9.00%	9.30%	9.90%	9.80%	7.80%	7.50%

Sector figures are drawn from the Federal Insurance Office industry report of September 2016.

In 2011 MetLife earned a higher return on average equity than the industry average, 12.20% against 4.70%, and a similar pretax operating return on average equity, 9.00% against 9.10%. After 2011, MetLife did not perform as well as the industry on either measure. Two questions follow from the table and neither is answered by it. The first is what caused the differences between MetLife and the industry. The second is why the pretax operating return on average equity and the return on average equity were similar for MetLife in 2014 and 2015, at 9.80% against 9.40% and 7.80% against 7.50%, when the two measures diverge widely in other years. Both require further investigation.

Earnings can also be distorted by accounting treatment. Mismatches between the valuation approach used for assets and that used for liabilities introduce distortion when interest rates move. In some cases significant distortions to reported earnings have arisen because assets are reported at current market values while liabilities are reported at fixed historical costs reflecting assumptions in place when the liabilities were booked.

Investment returns

For an L&H company the investment result is an important source of income, and three things dominate the evaluation: how far the portfolio is diversified, how it performs, and what interest rate exposure it carries. Portfolio liquidity matters too and is taken separately below.

Diversification starts with the allocation across asset classes and with an evaluation of how well that allocation corresponds to the insurer’s liabilities to policyholders. Because L&H claims are relatively predictable, these companies can more often seek the higher returns offered by riskier investments than P&C companies can. The cost is volatility: higher-yielding assets such as equity or real estate fluctuate in valuation more than debt investments. Returns have also been hard to come by through the decade of low interest rates, which narrowed the opportunity set and made an adequate risk-adjusted return on financial assets more difficult to earn. Concentration by type, maturity, low credit quality, industry, geographic location or single issuer can be a concern, particularly to rating agencies.

Performance is gauged as it would be for any portfolio, by setting investment income over invested assets, which means cash plus investments, and the measure can be computed using investment income plus realised gains and losses either with or without unrealised capital gains and losses. The usual gauge of interest rate risk sets asset duration alongside liability duration.

Example 12 · Worked

Below are the portfolio and the investment result reported by AIA Group. Financial investments make up 82% of the group’s total assets, rising to 84% once investment properties are counted.

AIA Group Limited: investment portfolio (US$m)

FSA 4 – Analysis of Financial Institutions — table 43
Holding	30 Nov 2016	% of total	30 Nov 2015	% of total
Deposits and loans	7,062	4.6%	7,211	5.1%
Debt securities	113,618	73.3%	104,640	73.3%
Equity securities	30,211	19.5%	27,159	19.0%
Derivatives	107	0.1%	73	0.1%
Financial investments, all	150,998	97.5%	139,083	97.4%
Investment property	3,910	2.5%	3,659	2.6%
Total	154,908	100.0%	142,742	100.0%

AIA Group Limited: investment income at 30 November 2016 (US$m)

FSA 4 – Analysis of Financial Institutions — table 44
Investment return	Amount
Interest	5,290
Dividends	654
Rent	140
Investment income subtotal	6,084
Gains and losses	1,471
Investment return in total	7,555

Roughly $127 million of the $1,471 million gains and losses line arose on debt holdings.

1. Describe AIA’s investment allocation in 2016 and the change from the prior year.

Solution. The portfolio is mainly invested in debt securities, at 73.3% of the total in both years. Between the two dates there is a very small shift from loans and deposits, down from 5.1% to 4.6%, into equity securities, up from 19.0% to 19.5%. Everything else is essentially unchanged, with derivatives at 0.1% and investment property moving from 2.6% to 2.5%. In absolute terms the portfolio grew from $142,742 million to $154,908 million, so every category except loans and deposits grew in dollars.

2. Estimate the return on average fixed-income assets, treating loans and deposits together with debt securities as a single fixed-income class.

Solution. The return is investment income on fixed-income securities divided by the average investment in fixed-income securities.

Numerator: interest income plus gains on debt securities = 5,290 + 127 = 5,417.

Denominator: average the two year-end fixed-income totals.
[(7,062 + 113,618) + (7,211 + 104,640)] ÷ 2 = (120,680 + 111,851) ÷ 2 = 232,531 ÷ 2 = 116,265.5.

Return: 5,417 ÷ 116,265.5 = 4.7%.

Note what is deliberately excluded. Dividend income of $654 million and rental income of $140 million belong to equities and property, not to fixed income, and the remaining $1,344 million of gains and losses ($1,471 million less the $127 million on debt securities) is likewise not attributable to the fixed-income book. Matching the numerator to the denominator is the whole discipline of this calculation.

Liquidity

An L&H company’s liquidity requirements are driven by its liabilities to creditors and, primarily, by its liabilities to policyholders, which include both benefits and policy surrenders. Historically liquidity mattered less to life insurers because traditional life products were long term, but it has become more important as new products have been introduced. Liquidity arrives from operating cash flow and from how readily the investment assets convert, so any liquidity work has to take in the portfolio as a whole. Sub-investment-grade bonds and equity real estate holdings usually convert to cash less readily than investment-grade fixed income does.

Broadly, a liquidity measure sets the readier assets, cash and marketable securities among them, against the obligations falling due soonest. More elaborate measures, such as the liquidity model used by Standard & Poor’s, compare assets individually adjusted for assumptions about ready convertibility to cash against obligations individually adjusted for assumptions about the potential for withdrawals, with the adjusted amounts computed under both normal market conditions and stress. One familiar tool does not transfer. The ordinary current ratio cannot be applied straightforwardly here, since an L&H balance sheet frequently carries no split between current and non-current items in the first place.

Capitalisation

Just as for P&C writers, no worldwide risk-based capital rule governs L&H companies. Individual jurisdictions do specify the amount of capital an insurer must hold based on its risk profile, and if capital falls below the minimum a supervisory authority generally intervenes.

The differences between the two insurance businesses show up in the differences between their capital requirements, and both differences follow directly from the nature of the liabilities.

Since claims at an L&H writer are regarded as more foreseeable than those at a P&C writer, the equity buffer required is smaller and the capital requirement correspondingly lighter.
Life products frequently generate substantial interest rate exposure, so an L&H company’s risk-based capital calculation folds that exposure in. The P&C formula, organised around asset risk, credit risk and underwriting risk, does not have to weight it the same way.

That pair of adjustments is a good place to end, because it closes the circle the lesson opened with. A financial institution is analysed differently from a manufacturer because its liabilities determine what its assets must look like, how much capital must sit behind them and how quickly they must be convertible into cash. CAMELS for banks, the combined ratio and reserve analysis for P&C insurers, and duration matching and surrender behaviour for L&H insurers are all the same question asked in three settings: can this balance sheet meet its promises when the promises come due?

Check yourself

1. A bank holds $50 in cash, $2,000 in performing corporate loans and $40 in loans more than 90 days past due, weighted at 0%, 100% and 150% respectively. Compute risk-weighted assets and the minimum Common Equity Tier 1 Capital required under Basel III.

Risk-weighted assets are (50 × 0%) + (2,000 × 100%) + (40 × 150%) = 0 + 2,000 + 60 = $2,060. The Common Equity Tier 1 minimum is 4.5% of risk-weighted assets, or 2,060 × 0.045 = $92.70. Note that the $2,090 of accounting assets never enters the calculation, and that shifting $500 of the corporate loans into cash would cut required capital by $22.50 without changing the size of the balance sheet.

2. A bank’s Common Equity Tier 1 ratio rises from 11.9% to 13.6% while its Common Equity Tier 1 capital falls. Explain how, and say whether this is unambiguously good news.

Risk-weighted assets must have fallen proportionally faster than capital. HSBC did exactly this in 2016: capital fell from $130,863 million to $116,552 million while risk-weighted assets fell from $1,102,995 million to $857,181 million. It is not unambiguously good. The bank is better capitalised against a smaller book of risk, but the shrinkage in risk-weighted assets can come from selling profitable lending, from reclassification, or from a change in risk-weight models, and only the first of those is visible on the face of the ratio. The direction of the numerator is the warning sign worth noting.

3. Why are the ratios of allowance for loan losses to non-accrual loans and provision for loan losses to net charge-offs more informative than the allowance figure on its own?

Because each ratio sets a discretionary number against a less discretionary one. The allowance and the provision are management estimates and can be flexed to smooth reported income. Non-accrual loans are loans that have already stopped paying, and net charge-offs are losses already realised, so neither can be adjusted by assumption alone. Reading the estimate against the fact reveals whether the estimate is being built ahead of trouble or is lagging it. A ratio of allowance to non-accrual loans that falls for three consecutive years, as Citigroup’s corporate ratio did from 2.04 to 1.75 to 1.12, says something the allowance balance alone does not.

4. A bank reports an LCR of 121% and an NSFR of 49%. Is the bank liquid? What is the distinction the two ratios are drawing?

It is liquid over 30 days and badly funded over one year. The LCR asks whether high-quality liquid assets cover expected net cash outflows in a 30-day stress scenario, and 121% means it can absorb outflows 21% above that requirement. The NSFR asks whether available stable funding covers the stable funding required by the composition and maturity of the asset base over one year, and 49% means barely half of the requirement is met. Highly liquid assets do not enter the NSFR calculation at all, which is why a bank can score well on one and poorly on the other. HSBC Bank China reported precisely this pair in 2016.

5. Two analysts assign identical CAMELS component ratings to a bank and arrive at composite ratings of 1.75 and 2.00. Explain how, and which analyst is right.

Neither is wrong. The composite is not an arithmetic mean; each component is weighted by the person performing the analysis. Using Citigroup’s ratings of 1.0, 2.5, 2.0, 3.0, 1.0 and 1.0, the unweighted composite is 10.5 ÷ 6 = 1.75. An equity analyst who double-weights asset quality and earnings, the two weakest components, computes (1.0 × 1) + (2.5 × 2) + (2.0 × 1) + (3.0 × 2) + (1.0 × 1) + (1.0 × 1) = 16.00 over total weights of 8, giving 2.00. The weighting encodes whose question is being answered, and a fixed-income analyst double-weighting capital and liquidity would produce 12.50 ÷ 8 = 1.56 from the same six ratings.

6. An insurer reports a loss and loss adjustment expense ratio of 76.1% and an underwriting expense ratio of 39.9%, and pays $813 million of dividends against net premiums earned of $6,924 million. Compute the combined ratio and the combined ratio after dividends, and interpret them.

The combined ratio is 76.1% + 39.9% = 116.0%, which is above 100% and therefore signals an underwriting loss: the underwriting operation is consuming more in losses and expenses than it collects in premiums, and investment income must make up the difference. The dividends ratio is 813 ÷ 6,924 = 11.7%, so the combined ratio after dividends is 116.0% + 11.7% = 127.7%. These are CNA Financial’s 2016 figures. The second measure is stricter because dividends are discretionary cash outlays, and including them gives a fuller picture of the total cash the underwriting operation has to support.

7. A P&C insurer reduces its estimate of prior-year claims by $680 million in a year when income before income taxes is $4,053 million. Why should an analyst care, and what are the two competing interpretations?

Because the revision contributed 680 ÷ 4,053 = 16.8% of income before income taxes, even though it looks small against total reserve increases of $14,995 million. The first interpretation is favourable: the company estimates its initial recognised reserves conservatively, so prior-year estimates are routinely released. The second is unfavourable: aggressive revisions are a tool for managing earnings. Travelers released $680 million, $817 million and $885 million in 2016, 2015 and 2014, contributing 16.8%, 17.2% and 17.4% of pretax income. The consistency of the contribution is the thing to notice, and it cuts both ways.

8. Why do life and health insurers typically face lower capital requirements than property and casualty insurers, and what risk enters the L&H formula that does not sit at the centre of the P&C one?

Because claims at an L&H writer are held to be more foreseeable, tracking fairly steady actuarial mortality rates once large populations are involved, while P&C claims come lumpier and spring from accidents and similar unforeseeable events. Less variable claims need a smaller equity cushion. The risk that enters the L&H calculation is interest rate risk, because many life products create material exposure to it. The NAIC formula for minimum risk-based capital for P&C insurers is built around asset risk, credit risk, underwriting risk and other relevant risks.

End of lesson.

Back to 04 Financial Statement Analysis

FSA 4 – Analysis of Financial Institutions

Why financial institutions are analysed differently

Systemic importance

Financial assets rather than tangible assets

The population of financial institutions

Banking and insurance are not systemically alike

The Basel Committee and Basel III

National regulators and the compliance burden

The CAMELS framework and capital adequacy

Capital adequacy: risk weighting

The tiers of capital

Asset quality

How the assets are measured

Two terminology traps

Credit quality and diversification

Management capabilities and the quality of earnings

Management capabilities

Earnings: why estimates dominate

Earnings: the sustainability of the mix

Liquidity under the Basel III standards

The Liquidity Coverage Ratio

The Net Stable Funding Ratio

Two further monitoring metrics

Sensitivity to market risk

Why rising rates usually help

Value at risk

What CAMELS leaves out

Government support

Government ownership

Mission, culture and competition

Off-balance-sheet items

Segments, currency, risk factors and disclosure

CAMELS applied: Citigroup capital adequacy and asset quality

Capital adequacy

Asset quality: composition

Asset quality: the investment portfolio

Asset quality: the allowance for loan losses

CAMELS applied: Citigroup management, earnings and the net interest margin

Management capabilities

Earnings: how much of the growth came from provisions

Earnings: the revenue mix

Earnings: reading the net interest margin

CAMELS applied: Citigroup liquidity, market sensitivity and the composite score

A brief overview of accounting for derivatives

Liquidity position

Sensitivity to market risk

Building the composite

Analysing property and casualty insurers

Operations, products and distribution

The underwriting cycle

The combined ratio and its components

Loss reserves

Investment returns and liquidity

Capitalisation

Analysing life and health insurers

Products and distribution

Earnings characteristics

Investment returns

Liquidity

Capitalisation

Related lessons