How do you know if your bank is going bankrupt? What are the determinants of impending insolvency and how are they measured?
When a bank declares bankruptcy, it simply means, it is unable to pay its outstanding debts. It is a legal process that is often initiated by the banks themselves. Bankruptcy can damage your credit report because even though the debts are completely eliminated, they still stay on your credit report for years. The term “insolvency” is used to describe a situation where the company cannot pay for its debts as they become due even though it may have its asset may be worth more than its liabilities.
Between August 2017 and January 2020, several local banks were allowed to be taken over. Ghana’s banking sector went through a credibility crisis. The cracks in the financial sector started in 2015. A stress test conducted by the World Bank and IMF in 2019 revealed the sector’s serious infractions.
Signs Your Bank is Going Bankrupt
This post will help you to identify the signs of financial distress in a banking institution even if they appear to be doing really well;
1. Poor asset quality
Asset quality is simply an assessment of the risks associated with an asset. Any asset with a high return and a low chance of defaulting is said to have a high asset quality. Management of banks and other financial institutions invest very heavily into their loans portfolio and the whole process of credit administration. You can easily see how non-performing or impaired loans can undermine the profitability of banking institutions.
Asset Quality Ratio = Loan Impairment Charges / Total Assets
Asset quality is measured by comparing the total amount of doubtful loans with the gross loans given out. Evaluated as asset quality ratio, it is given by the total cost of loans impairment divided by total assets. So you can gauge your bank’s asset quality by analyzing its annual expenses on impaired loans with respect to the total assets. In fact, asset quality is a metric used in assessing the creditworthiness of banks in bank ratings.
2. Lack of profitability
In comparison to alternating investment and based on available resources, what would be the ability of a business to produce a return on investment? This is what financial managers call the profitability of a firm.
Simple cash flowers are insufficient in assessing the profitability of a firm, so financial managers use a metric called net margin, which is the ratio of the net profits to total revenues. It is basically how much of the bank’s income is actual profit.
Net margin = Net profit / Total revenue
You must understand that consistently failing to turn up adequate profits would mean the bank’s ability to fund its operations becomes hampered, it would not be able to attract investors, and it cannot remain in business for much longer.
3. Loss of capital
Loss of capital or capital loss is the loss in value of a firm’s capital. Capital assets are value investments like homes, stocks, bonds, cars, etc. In the banking sector, you can think of capital assets as an asset with a useful life beyond a year and are not meant to be offered for sale but for production purposes.
Capital loss is a loss is incurred when a capital asset decreases in value. often, capital losses are realized when the asset is sold. This is because they’re sold for a lesser price than the cost price of the asset.
Capital Loss = Purchase price – Sale price
Banks often hold capital as some kind of financial cushion against unexpected losses. Capital adequacy rations is a measure of a bank’s ability to absorb potential losses, like loan default.
4. Excessive leverage
Leverage is simply when a firm uses debt to increase the returns from an investment or project. This would ordinarily be a brilliant way to finance an investment and make a good return, just that things can quickly turn sour if the investment or project does not turn out as expected.
In an attempt to increase shareholder value, it is common to find many firms bypass the issue of stocks to raise capital, and rather resort to debt financing to invest in business operations. The idea here is just as a lever is used to move a heavy weight, leverage amplifies possible return on investment.
The term “highly leveraged” asset is used to refer to an asset that has more debt than equity. Companies in this position tend to acquire more and more debt until they go bankrupt.
5. Excessive risk exposure
Excessive risk exposure is a measure of the probability of different types of losses. It assesses the acceptability of different types of losses incurred by an entity’s strategy, program, project, or initiative
Risk exposure is a measure of how much loss can result from an investment or business activity. It is an estimate of the probability of a risk and its impact, or the probable cost. Losses like unexpected or low employee turnover, damage to property, legal liabilities are used to rank the risk exposure of a business operation.
Risk Exposure = Probability x Impact
The risk exposure of a bank is very important because the failure of a bank can impact millions of people and whole economies. As an investor, you should be interested in the ability of a bank to manage its risk. Regardless of how much revenue a bank makes, considerable amounts of non-performing loans can still cripple it financially. This is why government regulators assess the risk exposure of banks and encourage prudent risk management in decision-making.
6. Poor governance conduct
Corporate governance is the term used to describe the balance among participants in the corporate structure who have an interest in the way in which the corporation is run, such as executive staff, shareholders, and members of the community.
In all economies, banks play a critical role in driving economic growth by various activities that intermediate funds between depositors and borrowers in providing financing and supporting to enterprises. The corporate governance of a bank is, therefore, critical to the success of the banking sector and the whole economy.
As an investor, you should care about how a bank’s corporate governance directly impacts the profits and reputation of the company. Issues like poor policies can expose the company to lawsuits, fines, reputational damage, and loss of capital investment.
5 Problematic corporate governance issues
The following are four corporate governance problems you should look out for as an investor;
Oversight is a broad term that encompasses the executive staff reporting to the board and the board’s awareness of the daily operations of the company and the way in which its objectives are being achieved.
2. Conflict of interest:
A conflict of interest within the framework of corporate governance occurs when an officer or other controlling member of a corporation has other financial interests that directly conflict with the objectives of the corporation
3. Ethical Concerns:
Any corporation that neglects its ethical duty to protect the social welfare of others, including the greater community in which it operates, will soon be saddled with lawsuits and regulatory fines.
4. Lack of transparency:
A corporation must accurately report its profits and losses and make those figures available to those who invest in their company. A lack of transparency can also expose the company to fines from regulatory agencies.
7. Liquidity concerns
Liquidity management is the basic concept of the access to readily available cash in order to fund short-term investments, cover debts, and pay for goods and services.
Financial managers compare their most liquid assets (those that can be converted into cash easily and quickly), with short-term liabilities, or near-term debt obligations in order to keep a regular grasp of the firm’s liquidity risk, managers will monitor the liquidity ratio.
To maintain liquidity, banks must;
- Improve the average liquidity of assets
- Shorten asset maturities
- Liability maturities
- Issue more equity
- Reduce contingent commitments
- Obtain liquidity protection
These are the classic features of a bank that is insolvent or going bankrupt. Knowing these symptoms will guide your investing decisions.