For banks, could an answer lie in better balance sheet management?

—Mamun Rashid—

London-based publication The Economist attributed a lot of credit to better cash management as the reason for Citibank/Citigroup surviving the global meltdown in 2008. Citi transaction services also received a lot of accolades for helping the bank for better management of its assets and liabilities.

We have seen banks paying dearly for funding long-term assets by borrowing short term, or over-dependency on call borrowing or short-term deposits, to support its medium- or long-term loan book. Even today, we can’t claim all the banks to have the right focus on balance sheet management in Bangladesh. Most of their time and resources are dedicated to loan management or term deposits mobilization. Some banks are often having their arms twisted for too much call money or even long-term project finance.

The activities of a bank involve many types of risks like reputation risk, financial crime risk, operational risk, fraud risk, people risk, credit risk, and others. One main risk people generally blame in Bangladesh, and similar cuntries, is the loan-related loss. My experience as a treasury manager, spanning over a decade and a half in multiple large global banks, tells me that it is also about our failure to manage a bank’s balance sheet properly.

The balance sheet of a commercial bank is significantly different from that of a typical company. The items in a bank’s balance sheet are mostly money — money that its customers keep with the bank as deposits and money that its customers borrow as loans, ie liabilities and assets respectively. In addition to loans, a bank also keeps money in various forms of investments, some of which are to be kept as per regulatory requirements.

While these activities seem simple with the only risk being a borrowing client becoming a defaulter, in a real-life situation a bank typically has thousands of crores, or even lakhs of crores, of total deposits from hundreds upon thousands of customer accounts in multiple currencies in addition to the domestic currency. Things aren’t simple at all as each deposit and loan item comes with different maturity tenors. On a large scale, a bank measures these as maturity mismatches for different future time periods.

Maximizing returns while minimizing risks related to alternative portfolio combinations are some of the competing aims of banks’ balance-sheet management.

Banks tend to have a huge sum of off-balance sheet exposures, such as contingent (eg letters of credit or guarantees) exposures or derivative positions.

We have seen during the North America financial meltdown how some large global banks have trillions of dollars’ worth of derivative positions, which only appear on their balance sheet after their debtors exercise the option to draw down the loan. Hence, simply the information published in a bank’s balance sheet understates their “riskiness,” particularly the larger ones.

The capital of a bank acts as a form of self-insurance whilst also providing a shield against unanticipated losses and the motivation to manage risk-taking mutually. Financing additional assets with capital increases the bank’s leverage ratio.

Shortage of capital in a banking system may strain the economy in several ways.

It prevents the bank from lending to healthy borrowers. Moreover, these banks issue evergreen loans to indebted companies, also called “zombie firms.” To avoid undermining their already weak capital position, the bank adds unpaid interest to those loans. Measuring a bank’s capital can be tricky. Valuation of liquid instruments such as treasury bonds is easy. But other securities such as corporate and emerging market bonds are notably less liquid than treasuries.

Therefore, determining market prices of bank loans is difficult. A bank’s asset becomes difficult to value in times of financial strain even more so. Liquidity aside, the solvency state of the bank is also an important determinant of their asset value. We have seen during the Asian meltdown in the late nineties how unpredictable fluctuations in exchange rates lead to Foreign Exchange risks when banks hold assets or liabilities in foreign currencies. This uncertain movement impacts the earnings and capital of the bank.

As commercial banks deal with foreign currencies, they are constantly exposed to Forex risk, which comes from their trade and non-trade services. Forex risk rises for any unhedged position — called an open position of a specific currency in a bank. The risk is mitigated through various hedging techniques. Additionally, banks are increasingly focusing on tenor mismatch, maturity ladder and alignment between deposit/loan maturities.

Many commercial banks in Bangladesh have started to realize the importance of differentiating from others through better balance sheet management. Better receivable and payable management along with better balance sheet management would soon become key to success for banks here.

(Mamun Rashid is the Founding Managing Partner of PwC Bangladesh and Chairman,Financial Excellence Ltd.)