FINANCIAL ANALYSIS OF BANKS

Financial Analysis of Banks



Financial Analysis of Banks

Answer 1)

One of the main businesses of banks is the loan business, and thus credit risk management is a major activity to guarantee the business success of a bank. Those lenders that are best able to evaluate and price risks will be successful in the banking business. In order to be successful, lenders must rate those factors that influence the borrower's ability to repay the loan. This ability is dependent on the capital stock, the earnings or the liquidity of a borrower. In theory, these factors are called counterparty credit risks and have a main influence on the default risk of a borrower (Woodford, 2003, 11).

Our study is based on the assumption that environmental risks influence the counterparty risk. Theoretically, this risk is influenced by various borrower characteristics such as reputation, leverage, earnings and collateral. Different environmental risks and their influence on credit risks are described below. Thus borrowers with lower environmental performance will face higher risks and vice versa. In order to anticipate credit defaults caused by environmental risks, banks examine environmental credit risks of their borrowers. Empirical evidence for a correlation between environmental risks and credit risks has recently been presented, e.g. by Goss and Roberts (2011), Bauer and Hann (2010) or Weber et al..

Let us have a look at how environmental risks influence credit risks and how they have been integrated into the credit risk management of banks and financial institutions. At the end of the 1980s European and North American commercial banks were confronted by environmental risks for the first time. Under the US Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), the owner of a contaminated site was responsible for the decontamination and redevelopment of a site if the site was contaminated. Some banks were held liable under CERCLA because they participated in the management of a contaminating business and could have influenced the borrowers' compliance with environmental laws. In other countries a number of similar cases occurred as well. One reason for higher credit risks is contaminated sites used as collateral (Taylor, 2008, 25).

The contamination has a negative impact on the value of the collateral and thus the loss given default increases. Additionally, changes in environmental regulations often resulted in costs for the implementation of environmental technologies or other costs. This has an influence on the leverage and earnings of a borrower. Earnings and the liquidity of a borrower are influenced by market changes caused by changing environmental attitudes of clients as well. Also, the negative reputation of being connected with debtors that caused negative environmental impacts is seen as a major environmental credit risk.

Having said this, not only does the integration of environmental risks produce costs because of a more costly process of credit rating, but it increases the quality of the credit risk rating. Weber et al. (2010) demonstrated that the rate of correct credit default predictions improved about 7.7 percent if sustainability criteria were added to conventional credit risk ...