Analysis of Commercial Bank Balance Sheet

"Banks and other deposit taking institutions are financial intermediaries whose assets consist overwhelmingly of loans to a wide variety of borrowers and whose liabilities consist overwhelmingly of deposits. ” A sound system of banking is very important for any economy. Commercial banks are directly related to the payment system of the economy. Generally most commercial banks are controlled by the central bank of that particular country.

The central bank can never allow the banking system to fail because if banks start to fail the payment system will fail. They may allow some banks to fail but the government will never allow big banks or the whole payment system to collapse. This is very evident from the recent where government have pumped in huge amount of money to save the so called “too big to fail” banks. Banks helps in the payment services through various kinds of deposits, debit cards and credit cards

ANALYSIS OF COMMERCIAL BANK BALANCE SHEET

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For my assignment I have picked up Lloyds TSB as my bank. Lloyds TSB is one of the four biggest bank in the UK.

I have taken 2007 annual report as the group has published only the 2008 interim report. The second item which we see in Lloyds TSB balance sheet is loan and advances to banks. It reflects the interbank relationship. This figure has fallen for most of the commercial bank and also for Lloyds TSB there is an decrease of 16. 50%. This is due to the financial crisis which has hit banking sector very badly and many banks have failed as a result. Llyods TSB gives loans to customer just like any other commercial bank and bank charge an interest for giving loans which is higher than the interest on deposit.

But there is always a default risk attached with the loan which the bank gives. Commercial Banks gives different kinds of loans starting from mortgage, education loan, overdraft facility etc. In case of Lloyds TSB mortgage comes out to be 48. 4% of loans to customer. And thing we should bear in mind is that mortgage are long term loan and it can be for 30 years as well. Customer Accounts got an increase of 11% and there is an increase of 11% from 2006 to 2007.

LIABILITIES OF LLOYDS TSB

Lloyds TSB is also having some fixed deposit like Certificates of deposit. In these deposits customers cannot withdraw there money before a specified time and they also receive some interest as well. Second are the commercial papers which are unsecured promissory notes to meet short term obligations. Certificate of Deposit comes to around 14,995 million GBP and commercial paper is 17,388 million GBP for Lloyds TSB. Lloyds TSB is also having reserves after paying reserves. This reserve can be used in case of emergency or any unexpected risks The main risks that commercial banks face due to their exposure to different kinds of assets and liabilities are liquidity risks, market risk and credit risk.

Lloyds TSB faces liquidity risk because of deposit in central bank. They have a deposit of 4330 million GBP. This means that they cannot give this amount as loans because it’s stuck with the central bank. This amount has increased considerably from 2006 to 2007. The bank faces liquidity risk because of their mismatch in assets and liabilities side. The group liquidity risk exposure is 33,185 million GBP. The main sources of liquidity risk for the bank are deposits from banks and customer accounts. As we seen above the assets of Lloyds TSB are long term whereas the liabilities are short term.

The commercial bank is the main source of payment service in any economy. Whenever bank gives loan they are exposed to default risk. Default risk arises whenever a company or individual is unable to meets its obligation on interest or principle payment of the loan. The bank faces asymmetric information problem as well. Though the bank does proper due diligence before giving out any loans but asymmetric information problem cannot be ruled out with any banks at all. Due to asymmetric information we have adverse selection and moral hazard problem.

Adverse selection problem comes to picture before entering into the transaction. In short the bank has to filter the good borrowers and the bad borrowers. Sometimes the bank may give loan to the bad borrowers and may suffer of this. Though banks have put checks like credit history before making out the loan but adverse selection problem cannot be neglected completely. The other problem which is created because of asymmetric information is moral hazard problem. The moral hazard problem starts after the bank has sanctioned the loan. Borrowers may get into undesirable activities.

The main objective for which the loan was sanctioned may never get fulfilled. The other side of the moral hazard problem is the conflict of interest between the borrower and the bank. Borrowers may try to act on their interests rather than the interests of the bank. Banks like Lloyds TSB can overcome the problems of adverse selection and moral hazards if they have proper checks and controls on their customers, but rarely does any bank achieve 100% success in these problems. These are the two most important risks that any financial intermediary faces in order to serve its most important duty, which is payment services to the economy. Just like any other financial institution, the group also faces credit risk.

"Credit risk is the risk due to uncertainty in a counterparty's (also called an obligor's or credit's) ability to meet its obligations. Because there are many types of counterparties—from individuals to sovereign governments—and many different types of obligations—from auto loans to derivatives transactions—credit risk takes many forms" (www.riskglossary.com). After the group's acquisition of Halifax of Scotland, the credit rating of the bank has come down. In order to counter credit risk, credit rating plays a very important role. The group's exposure to credit risk is 356,860 million GBP.

Asset Liability Management

"The ALM group within a bank has been concerned with the control of interest rate risk on the balance sheet. For some banks, it may be equally important to manage interest rate risk arising from off-balance-sheet items, but it is instructive to look at the traditional methods and progress to the relatively new procedures" (Heffernan, Shelagh A. 2005). Moreover, banks have a mismatch in the maturity of their assets and liabilities. Banks use asset liability management to manage interest rate risk, market risk, and credit risk. Let's take an example where all deposits are on a fixed rate of interest, but all loans are made on a floating rate of interest. Commercial banks mainly use three types of markets to cover these risks. These are the money market, capital market, and derivative market. The capital market is generally used by large companies or governments to raise funds for a long period.

Capital markets can be divided into two types: the primary market, where securities are traded for the first time, and the secondary market, where securities are traded after they have already been traded in the primary market. Another subdivision of the capital market is the bond market and the stock market. There are various stock markets around the world, such as the London Stock Exchange, while the bond market includes different types of bonds such as government bonds (US Treasury bills), foreign bonds, etc. One of the most important changes in this market is the development of asset-backed securities. "Securitization is a financial transaction in which assets are pooled and securities representing interests in the pool are issued" (http://www.riskglossary.com/). When securitization is backed by any assets such as student loans or mortgages, it becomes an asset-backed security. Lloyds TSB also securitizes its assets to overcome liquidity problems. The process of securitization has become quite complex with the introduction of Collateralized Debt Obligation, Collateralized Loan Obligation, etc.

These complex securities are the heart of the financial crisis. Lloyds TSB does not have much exposure to these complex securities. Banks engage in off-balance-sheet activities to generate more profit, which helps the bank to earn fee income. Another advantage of off-balance-sheet activity is that it does not appear on the bank's balance sheet. Banks also use the derivative market to hedge their risks. "By their nature, derivative instruments can be used for hedging different types of risks. Owing to this, banks and insurance companies use derivatives in the management of their Asset Liability Management" (Cornelius Nandyal, 2001).

The derivative market is going through many new changes, and regulators are trying to introduce new regulations to increase transparency. Banks use interest rate swaps, credit default swaps, total return swaps, credit-linked notes, etc. However, different people have different views on derivatives. According to Warren Buffet, derivatives are weapons of mass destruction and can act as time bombs in the future, while Alan Greenp says, "Derivatives have permitted the unbundling of financial risks. Because risks can be unbundled, individual financial instruments can now be analyzed in terms of their common underlying risk factors, and risks can be managed on a portfolio basis."

Banks also use the money market for asset liability management. The most important organ of the money market is the interbank market, where banks with a surplus lend to banks with a deficit. This market was severely hit by the recent financial crisis. Banks do not know the financial soundness of the banks to which they are lending, which has increased the liquidity problem of the bank. Other types of markets are the gilt repo, commercial paper market, and the certificate of deposit market. As mentioned earlier, Lloyds TSB invests in commercial paper and certificate of deposit.

The recent crisis began with subprime mortgage loans that originated in the USA, but these loans were repackaged and sold all over the world. Thus, this crisis, which began in the USA, became a worldwide crisis. Securitization gives banks more leverage. The seeds of the recent crisis were sown when the Federal Reserve made interest rates around 1%, and the economy was flooded with a lot of cash. Banks started giving mortgage loans to subprime customers without any credit checks and at very easy terms and conditions.

Once interest rate started to increase in 2004, borrowers started to default on their loans. With the increase of interest rates house prices started to come down. Credit rating agencies who gave these securities AAA rating made these securities junk. The assumption on which these rating agencies were working was that house prices will keep raisingin the future as well. “The combination of low capital requirements imposed on AAA-rated assets and a commonly held perception that they were “safe,” allowed banks to hold on to any senior tranches that were not sold to investors.

But when the structured finance market collapsed in late 2007, the investment banks found themselves holding hundreds of billions of dollars of low-quality asset pools, many of which consisted of leveraged buy-outs loans, subprime mortgages, and bonds from CDO’s in process-that is, where the tranches had not yet been sold to other investors. ” (Coval et al, 2008) No one knows the worth of these complex securities which the banks are holding. Banks have stopped lending to each other because no one is sure of how much the other bank is holding. So interbank market is almost closed.

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