Gearing Ratios: Trading Company vs Bank

[Snoopy]

The 'Gearing Ratio' is one of the simplest statistics to assess the underlying risk of a company you wish to invest in. An internet search for a definition of Gearing Ratio brings up ideas where 'long term debt' is compared to 'shareholders equity'. I prefer to use the term 'bank negotiated debt'. This is becauue long term agreements with a bank often have a portion of that debt maturing in the current period. It seems wrong to ignore the current portion of that bank debt, even if it is not strictly 'long term'.

All companies have company assets that are funded by a mixture of owners equity and debt. I have graphically represented this in my typical 'trading company' below:



Trading Company


DebtD


B


EquityA


AssetsA+(B+D)



In the table:

'B' represents the negotiated bank debt
'D' represents other debt, for example wages owed to employees and bills as yet unpaid to suppliers.
'A' represents the shareholders equity in the company.

Our particular company has no other positive equity apart from 'A'. This would be unusual. But complicating the model by bringing other kinds of assets into our model company would only serve to obfuscate the discussion.

The 'Gearing Ratio' for our Trading company is calculated very simply:

Gearing Ratio = B/A

The higher the 'Gearing Ratio', in general, the more risky is the company.

SNOOPY

[Snoopy]

The 'Gearing Ratio' for our Trading company is calculated very simply:

Gearing Ratio = B/A

The higher the 'Gearing Ratio', in general, the more risky is the company.


We now move on to our boutique bank which is still funded by a much larger parent bank. This is why 'B' is retained as a source of debt. However, we now have a new source of borrowings. Money handed over from customers at the counter in the form of debenture investments - C.

Another change is that our boutique bank lends to customers. From a bank perspective, this loan book is an asset, and is represented in the chart below as 'R' (for receivables).



Bank


DebtD


B


Customer Debentures


EquityA


Receivables (Loan Book)


Assets(A+R)+ (B+D+C)



The above looks complex. Yet the size of the loan book and the number of debentures written out for bank customers are largely independent of the underlying financial position of the bank. So when working out the 'Underlying Gearing Ratio' (the term 'Gearing Ratio' on its own is IMO largely meaningless when we are talking about a bank) the formula does not change from the Trading Company case.

The 'Underlying Gearing Ratio' for our Bank is calculated very simply:

Underlying Gearing Ratio = B/A

The higher the 'Underlying Gearing Ratio', in general, the more risky is the bank.

However, it would be a mistake to compare the 'Gearing Ratio' of a Trading Company, with the 'Underlying Gearing Ratio' of a bank in absolute numerical terms.

But like with like comparisons certainly are valid.

SNOOPY

[Snoopy]

The 'Underlying Gearing Ratio' for our Bank is calculated very simply:

Underlying Gearing Ratio = B/A

The higher the 'Underlying Gearing Ratio', in general, the more risky is the bank.

However, it would be a mistake to compare the 'Gearing Ratio' of a Trading Company, with the 'Underlying Gearing Ratio' of a bank in absolute numerical terms.

But like with like comparisons certainly are valid.


We now move on to the bit that I can't answer.

Suppose our Boutique Bank decided that taking in money from customers over the counter was just too hard. They had amassed a Receivables book that looked solid and a Parent Bank was willing to lend them money (I'll call it B2) in place of those over the counter customer debentures. So the balance sheet of our Boutique Bank is now represented as below:



Bank


DebtD


B


B2


EquityA


Receivables (Loan Book)


Assets(A+R)+ (D+B+B2)



Now what is the 'Underlying Gearing Ratio' of our Boutique Bank?

Is is B/A (as before)?

Or is it now (B+B2)/A ?

Comments appreciated, even along the lines that I have proposed the wrong question!

SNOOPY

[Snoopy]

Now what is the 'Underlying Gearing Ratio' of our Boutique Bank?

Is is B/A (as before)?

Or is it now (B+B2)/A ?

Comments appreciated, even along the lines that I have proposed the wrong question!


No-one has bitten on this. So I am going to continue my ramble and see where it leads.

A more general question is: How is risk reflected in the Gearing Ratio? Because if the Gearing Ratio is not a measure of risk, what is the point of measuring it? Now, a hypothetical situation.

Let's say the ANZ bank (the country's largest) announced tomorrow that all depositors funds would be unwound, and henceforth the domestic base of loan money would be replaced by a cash facility from the new Nikko-USA-Euro bank. All the new money would come from Tokyo Housewives, Belgian Dentists and Tea Party capitalists all desperate to improve on the zero interest rates being offerred on their banks at home. Naturally all this new money would be hedged to the New Zealand dollar to avoid wildly swingly exchange rates creating an uncertainty in the NZD cash available. How would this affect the risk profile of ANZ bank?

For starters nothing has changed on the loan book side of the business. But wouldn't it feel strange to be able to borrow for business expansion, yet not be allowed to run a cash account to manage daily cashflow, or be allowed to invest the proceeds of your business success back into the ANZ as your company grows? I sense there is something that I will term "crowd wisdom" that is in the back of the mind of bank customers. I am saying there is some comfort in the knowledge that tens of thousands of New Zealanders have put their own hard earned cash in a bank, and tens of thousands of New Zealanders, taken as a collective can't be wrong. OTOH, a triumvate conglomurate, headed by the Americans, Europeans and Japanese would seem distant, maybe without the best interests of New Zealand at heart? They would have creditworthiness. But could they really be trusted? For the average punter on the street, my instinct says no. My gut feeling is that taking out the "deposit side" of a bank would increase the risk. Depite the backing from the strongest economies on the planet, such a bank wouldn't be seen as a proper bank anymore. I can't rationalise that position. Yet, I would have a strong pull to close my accounts with the ANZ under this circumstance and move to another bank.

Anyone agree or disagree with my position?

SNOOPY

[Grunter]

A more general question is: How is risk reflected in the Gearing Ratio? Because if the Gearing Ratio is not a measure of risk, what is the point of measuring it? Now, a hypothetical situation.

SNOOPY

Snoopy, I think the first thing you need to consider is what "risk" is. From the firm's point of view, the risk you are considering is the risk of not being able to meet their debt obligations, or default risk.

It then makes sense that if a firm is at low risk of default, they could then afford to take on more debt to finance the business than a firm that is at a higher risk of default as they have the ability to to service higher levels of debt and/or can borrow more cheaply than the higher risk firm. Therefore the statement that higher gearing means more risk does not hold true, and in reality may mean the exact opposite - a high gearing ratio indicates less risk.

Next, we consider that the goal for any firm in terms of their capital structure is to maintain an optimal capital structure. This ensures they can deploy their capital most efficiently to maximise their returns on their capital and therefore maximise the share price of the firm. To do this, the firm needs to minimise their cost of capital, and this means altering the mix of debt and equity, and hence their gearing ratio. It may be that for certain firms, such as banks, their cost of borrowing is so significantly lower than their cost of equity, that their optimal capital structure is almost entirely debt, and thus they have very high gearing ratios.

The proper way of measuring the "risk" of a firm would therefore be to determine how far the firm is away from it's optimal capital structure, as a sub-optimal firm will not maximise it's value and thus not be operating in it's most efficient state. This means that the likelihood of the firm running into financial distress is higher than if the firm is optimised, and thus the firm is more "risky".

From the above, you can see that a firm's gearing ratio is not a good measure of risk at all. Comparing the gearing ratio of firms in the same industry may lend some insight, but this is only somewhat useful. Perhaps another method would be to measure the change in gearing ratio over time, and the effect of the change in the ratio on the firm's return on capital to gauge whether the firm has an optimal structure or not, and therefore whether the firm has become more or less risky over time. This would also only be useful if the cost of debt and cost of equity remains constant over time, but these are also dynamic, so complicates the analysis. This is also only an indirect observation though, rather than being a direct quantification of risk.

[Snoopy]

Snoopy, I think the first thing you need to consider is what "risk" is. From the firm's point of view, the risk you are considering is the risk of not being able to meet their debt obligations, or default risk.


Generally, I agree that the risk I am interested in is 'default risk'. However, I see a bank 'default risk' and a trading company 'default risk' as different.

A trading company is the much simpler case. A trading company have negotiated their own bank loan terms. A trading company knows all about trading in their own sphere. Thus a trading company uses their market knowledge to manage their profits and cashflows in light of their pre-negotiated bank loan obligation.

OTOH a bank must manage risk on two fronts.

FRONT 1: If a bank makes a loan to a trading company, then the bank is taking on a risk outside of their own sphere. Yes a bank will have industry knowledge. But this knowledge is gained from many customers, and thus represents an 'industry average knowledge', rather than 'customer specific knowledge'. Looking at one specific loan case , IMO it is the bank that is taking far more risk than the trading company taking out that loan from the bank. But of course the bank isn't just making one loan to one customer. The bank is making many loans to that same industry. And many loans in one industry portfolio lowers the overall portfolio risk (provided there is indeed diversification of conditions across the many loans).

FRONT 2: A bank is taking in funds from the public (term deposits), whereas a trading company does not (except for maybe long term company specific bonds that might be traded on the debt markets - not an issue in the day to day running of the trading company). Let's say our bank is making a loan to a company producing an automated production line for making fridges in China. Suddenly NZ gets foot and mouth disease, consumer confidence collapses, and consumers as group need their deposit money to pay down debt of other members of this consumer group. Now I think we can agree there is very likely no connection between building a production line for making washing machines in China and foot and mouth on New Zealand farms. But because these two have nothing in common, this introduces a 'funding risk' for the bank loans. A risk where one side wants out of the loan contract for reasons completely unrelated to the project the funds are being used for. I would argue there is no such equivalent risk for an ordinary trading company.

So a trading company must deal with a 'default risk' on one front. The trading company can reduce their risk by having fewer transactions in compatmentalised markets, in which they can use their expertise for better understanding of the business dynamics.

A bank must deal with a 'default risk' on two fronts, either subtley different (Front 1) or completely different (Front 2) from the trading company. The bank can reduce their risk by having many borrowing and lending contracts across many customers on different terms.

SNOOPY

[Snoopy]

Snoopy, I think the first thing you need to consider is what "risk" is. From the firm's point of view, the risk you are considering is the risk of not being able to meet their debt obligations, or default risk.

It then makes sense that if a firm is at low risk of default, they could then afford to take on more debt to finance the business than a firm that is at a higher risk of default as they have the ability to to service higher levels of debt and/or can borrow more cheaply than the higher risk firm. Therefore the statement that higher gearing means more risk does not hold true, and in reality may mean the exact opposite - a high gearing ratio indicates lessrisk.


I see your point Grunter, but I do not agree with your conclusion. IMO a higher gearing ratio always means more risk for any specific company.

However I do take your point that risk is not the same for all industries.

I want to introduce the concept of a "robust market" on one hand and a "fickle market" on the other hand.

A utility (for example) may have much more certain cashflows - operate in a 'robust market' - and so be able to take on more debt than a company with more volatile cashflows (operating in a 'fickle market') . So utilities, and some say a bank is a utility, generally might operate at higher debt levels and so have higher underlying gearing ratios. A bank operating on 'more debt' in a 'robust market' is therefore increasing their risk perhaps up to the level of a trading company operating in a 'fickle market' or even beyond. A 'robust market' may have an underlying lower risk. But operate at higher and higher gearing ratios in a 'robust market' and eventually you will increase our bank's risk to higher than that of a trading company operating in a 'fickle market'.

SNOOPY

[Snoopy]

Next, we consider that the goal for any firm in terms of their capital structure is to maintain an optimal capital structure. This ensures they can deploy their capital most efficiently to maximise their returns on their capital and therefore maximise the share price of the firm. To do this, the firm needs to minimise their cost of capital, and this means altering the mix of debt and equity, and hence their gearing ratio. It may be that for certain firms, such as banks, their cost of borrowing is so significantly lower than their cost of equity, that their optimal capital structure is almost entirely debt, and thus they have very high gearing ratios.

The proper way of measuring the "risk" of a firm would therefore be to determine how far the firm is away from it's optimal capital structure, as a sub-optimal firm will not maximise it's value and thus not be operating in it's most efficient state. This means that the likelihood of the firm running into financial distress is higher than if the firm is optimised, and thus the firm is more "risky".


I am familiar with the concept of 'optimal capital structure'. With such a concept a company can be sub optimal if it has either 'too much debt' or 'too little debt'. Clearly though, a company that has 'too little debt' is less likely to default, not more likely to default! So I can't agree with your proposal to use optimal capital structure to determine risk.

With a bank I think it is important to distinguish 'underlying debt' (total debt minus the customer loan book) verses 'underlying assets' (total equity less the customer deposit book) and 'total debt' verses 'total assets'. With a trading company the 'total gearing ratio' is important, while the 'underlying debt has no meaning. But with a bank it is IMO the underlying debt (or underlying gearing ratio) that is very important. The total gearing ratio is interesting, but I think that depends on 'net interest margin', (again a concept that has no meaning in a trading company being used for comparison).

If you have a 'high interest margin', that means that your customer deposit book can support more loans than otherwise might be expected. But 'interest margin' is IMO an undifferentiated financial commodity that is open to being undercut by competitors. So I would be careful assuming a 'high interest margin' bank or finance company will always be able to operate with those interest margins at the same high levels.

SNOOPY

[Snoopy]

You can see that a firm's gearing ratio is not a good measure of risk at all.


No one indicator is ever entirely satisfactory. Yet despite the limitations that I have acknowledged, I don't feel you have made the case for a firm's gearing ratio not being a good measure of risk.



Perhaps another method would be to measure the change in gearing ratio over time, and the effect of the change in the ratio on the firm's return on capital to gauge whether the firm has an optimal structure or not, and therefore whether the firm has become more or less risky over time. This would also only be useful if the cost of debt and cost of equity remains constant over time, but these are also dynamic, so complicates the analysis. This is also only an indirect observation though, rather than being a direct quantification of risk.


I think the fact that the cost of equity and debt changes with time is one of the reasons most (all?) companies taking out term loans have gearing covenants agreed to with their bankers. Manufacturing (for example) and banking markets are both dynamic. But this doesn't mean you should not use gearing ratios to measure risk. Indeed it is quite the opposite In my view. The gearing ratios are there because both banks and trading companies operate in markets that are dynamic, and the gearing ratios provides the risk buffer to offset that.

SNOOPY

[Snoopy]

We now move on to the bit that I can't answer.

Suppose our Boutique Bank decided that taking in money from customers over the counter was just too hard. They had amassed a Receivables book that looked solid and a Parent Bank was willing to lend them money (I'll call it B2) in place of those over the counter customer debentures. So the balance sheet of our Boutique Bank is now represented as below:



Bank


DebtD


B


B2


EquityA


Receivables (Loan Book)


Assets(A+R)+ (D+B+B2)



Now what is the 'Underlying Gearing Ratio' of our Boutique Bank?

Is is B/A (as before)?

Or is it now (B+B2)/A ?




After taking six weeks to reflect on my own question, I am prepared to put down an answer. I made a previous post about "Crowd Wisdom" affecting risk. It all sounded good when I wrote it, but I am not sure it is important in the context of this question.

My answer is that our boutique bank still has underlying gearing of B/A.

The problem with this answer is that if the parent bank:

1/ lends our boutique bank extra funds on top of the original loan, OR
2/ makes a new larger loan in place of the original loan plus

then the incremental requirement that 'we shareholders' know about is the new loan 'in total'. In terms of my 'letter model', the new loan is for 'B+B2'. But we shareholders only know the new 'B+B2' total. We don't know how much of the new loan is in the 'B' or 'B2' components. In fact it is not clear if the boutique bank itself knows this!

This means that as analysts we have to start using a 'rule of thumb' to determine 'B'.

SNOOPY

[Grunter]

I see your point Grunter, but I do not agree with your conclusion. IMO a higher gearing ratio always means more risk for any specific company.



Here is a paper that you may be interested in that demonstrates that there is no relationship between the gearing ratio and the risk of default in a bank.

http://www.szgerzensee.ch/fileadmin/Dateien_Anwender/Dokumente/working_papers/wp-0204.pdf

[Snoopy]

Here is a paper that you may be interested in that demonstrates that there is no relationship between the gearing ratio and the risk of default in a bank.

http://www.szgerzensee.ch/fileadmin/Dateien_Anwender/Dokumente/working_papers/wp-0204.pdf

Good on you for injecting some intellectual rigour into the debate Grunter.

The introduction to this paper contains the following sentence:

"It is largely undisputed that, everything else being constant, a bank's probability of default decreases with the level of capital - a simple buffer stock effect."

This is the point I was making, and the paper does not attempt to dispute it.

However, the paper goes on to talk about the case where: "everything else is not constant."

The main variation as I read it, talks about bank shareholder pressure to create competitive returns. While more capital supporting the same level of business will generate a lower ROE for the bank (everything else being equal) , a well capitalised bank may be incentivised to take on 'extra risky high profit deals' in an attempt to counteract the drag on profitability caused by having more equity on the books. Thus the net positive 'safety buffer'' effect of having more equity on the books, might be undone by the shady eighteenth floor ivory tower traders that the bank employs.

Critical in refuting or not this effect is how to measure 'risk'. The paper covers what happened to Swiss banks between 1990 and 2002. During that period there is no mention of any Swiss bank going bust. So the risk of going bust has to be measured indirectly by an indicator. Section 3 of the paper talks about how to measure risk. Risk is talked about as the 'volatility of bank assets' by valuation. There is an acknowledgment that his is difficult to measure directly, and that the study used 'a call option on the value of the assets of the bank' to measure it. Any option is simply a money weighted guess by market players, themselves most likely bank employees. This injects yet another layer of speculation over the true underlying data that you are trying to measure.

Ths problem with this study, as I see it, is that the risk being measured is not the risk I am concerned with. If, as a banker, my underlying loan portfolio suddenly had an increase in value of 20% of the underlying assets, then this would be a very good thing. Suddenly my loan would be backed by a much more valuable hard asset. Yet under the 'risk' is 'volatility' prescription, such an sudden increase in assets would be very bad because it would increase asset valuation volatility!

I put it to you Grunter that the chosen measure of risk talked about in the paper doesn't reflect actual 'shareholder risk' or 'bank default' risk. The 'employee behavioural angle' of risk taking behaviour being incentivised is interesting. But the conclusion that volatility in the asset portfolio is a useful indicator of the likelihood of a bank loan defaulting over its term is IMO flawed. Consequently the conclusions drawn by the authors of the paper must be open to question.

SNOOPY

[Grunter]

Good on you for injecting some intellectual rigour inot the debate Grunter.

The introduction to this paper contains the following sentence:

"It is largely undisputed that, everything else being constant, a bank's probability of default decreases with the level of capital - a simple buffer stock effect."



You will note the paper reaches this conclusion:

"we do not find a significant relationship between the default probability and the capital ratio"

You argue that the method of quantifying risk is flawed and point to volatility not being an appropriate measure of risk? Volatility is the very definition of risk. If the assets appreciate, yes, they have increased in value suddenly, but that does not mean volatility has increased. Volatility comes about when values jump around (up AND down) about a mean. If prices are only going one way (up), the mean is moving upwards as well and the time series of asset values are said to be trending. It's just like a stock price - volatility only increases when the price is moving around more, rather than in one particular direction.

The paper argues that the best approximate for the volatility of the bank's assets is the volatility of the bank's returns and hence reflected in the stock price. Unless you work in the bank and calculate the probability of default on each and every loan in the bank's portfolio, I don't think you are going to get a better indicator. In fact, you may see that the distribution of default risk may in fact be normal, so that you can make an overall assumption of default risk from the bank's returns anyway.

I think you get yourself into trouble when you attempt to granulise your analysis by considering a single loan situation, rather than looking at the overall loan book.

[Snoopy]

Snoopy, I think the first thing you need to consider is what "risk" is. From the firm's point of view, the risk you are considering is the risk of not being able to meet their debt obligations, or default risk.


Grunter, this is the first comment on risk that you made on this thread, I comment that I agree with.



You argue that the method of quantifying risk is flawed and point to volatility not being an appropriate measure of risk? Volatility is the very definition of risk. If the assets appreciate, yes, they have increased in value suddenly, but that does not mean volatility has increased. Volatility comes about when values jump around (up AND down) about a mean. If prices are only going one way (up), the mean is moving upwards as well and the time series of asset values are said to be trending. It's just like a stock price - volatility only increases when the price is moving around more, rather than in one particular direction.

I think you get yourself into trouble when you attempt to granulise your analysis by considering a single loan situation, rather than looking at the overall loan book.


I contend that there are many possible definitions of risk. Volatility is but one definition of risk. "Volatility= Risk" is favourable in a mathematical sense becasue it is (relatively) easy to deal with if you are working within the mathematics of risk. But I want to go back to your first statement Grunter, talking about 'default risk'.

Now let's take an example. Rather than a 'single example', for which you have criticised me examining in the past, let's talk about a wider NZ based risk that has been in the bankers sights of late: dairy farm risk.

Dairy farm risk is not the same for every dairy farmer. The consensus though, is that with typical levels of borrowing and typical production yield, the NZD payout price per kg of milk solids needs to be about $NZ5.50 for our 'average farmer' to break even, and meet 'debt obligations'. We can discuss this dairy industry case with some confidence, because unlike the Swiss bank study, we have a direct and widely published indicator of output receipts: the monthly Fonterra Milk Auction Results. There is also a milk futures market that is an industry and speculator view of where milk solid prices might be headed in the future.

Based on these auction results Fonterra issues its 'best guess' as to what the milk payout will be for the season. The price received is largely out of farmers hands. Farmers can control their input costs though. And you can measure how good a farmer is, in a financial sense, by measuring how well they can control their input costs, and therefore calculate a farmers margin by taking the projected annual farm payout and subtracting from that those input costs. Input costs include a farmers debt obligations.

My contention is that the best measure of 'dairy farm risk' (the risk of a dairy farm not being able to meet theri debt obligations) is to measure dairy farm input costs.

Your contention is that "risk = volatility". So can you please explain to me how 'volatility' is used to measure dairy industry default risk?

SNOOPY

[Snoopy]

You argue that the method of quantifying risk is flawed and point to volatility not being an appropriate measure of risk? Volatility is the very definition of risk. If the assets appreciate, yes, they have increased in value suddenly, but that does not mean volatility has increased. Volatility comes about when values jump around (up AND down) about a mean. If prices are only going one way (up), the mean is moving upwards as well and the time series of asset values are said to be trending. It's just like a stock price - volatility only increases when the price is moving around more, rather than in one particular direction.






I contend that there are many possible definitions of risk. Volatility is but one definition of risk.

Your contention is that "risk = volatility". So can you please explain to me how 'volatility' is used to measure dairy industry default risk?


I hope Grunter is just on holiday and he (or anyone!) will soon return with the answer to my question. Perhaps not though, because to answer my question I think will be difficult.

The situation as I see it is as follows.

A banker lending to the dairy industry today will want to see dairy revenue become greater than dairy input costs. Of most concern is the milk price trend, or more exactly the future milk price that can be extrapolated from that trend. If the input costs exceeds the revenue received, then long term the industry is not sustainable. Farming commodities have a long history of price 'ebb and flow' though. So the smart banker will not immediately foreclose on a farm just because input costs exceed revenue. Instead, such farms will go on a 'watch list'. If the milk price trend is down, and revenue received is below the cost of sales, then this is the worst situation. The banker will be looking for the commodity price to bottom. Once a commodity price has stabalised, then our banker will be able to assess how long the farm has got until its banking covenants are broken. Where there is some certainty, a banker will feel comfortable lending. Not having certainty is what bankers don't like!

'Volatility in milk price' will be the most unsettling thing for a banker. If the milk price crashes, then suddenly recovers before going down, only to recover again, then our banker will not be able to make any decision. What our banker needs to know is:

1/ where the milk price is today AND
2/ whether the milk is trending up or down. AND
3/ how the current price matches the breakeven cost for the dairy industry.

If our banker knows the three things above, then he can assess industry risk.

However, if the price is bouncing around seemingly with no direction, typically what you see with volatility then our banker can't detect a trend, can't detect a likely bottoming or peaking of price and therefore can't assess how long a dairy business can use its equity to ride out the bad times. Volatility is largely useless to our banker in assessing default risk at any level. Volatility is not measuring any of the factors that determine the future viability of the dairy industry. Thus when the previously mentioned academic study suggests that 'high volatility', what Grunter refers to as jumping up AND down, is not correlated with 'default risk' this is exactly what I would expect. If your chosen indicator (volatility) is measuring something completely unconnected to 'default risk', of course there will be no correlation observed!

This doesn't mean you can't measure default risk though. It just means that IMO volatility is completely the wrong tool with which to do the measuring!

SNOOPY

[Grunter]

Snoopy, again, respectfully I don't think you properly understand the definition of risk.

I've included another paper that talks about how default risk is measured. From it, you should see how volatility and the risk of default are inextricably linked.

http://www.econ2.jhu.edu/People/Duffee/rfs.pdf

[Snoopy]

Snoopy, again, respectfully I don't think you properly understand the definition of risk.

I've included another paper that talks about how default risk is measured. From it, you should see how volatility and the risk of default are inextricably linked.

http://www.econ2.jhu.edu/People/Duffee/rfs.pdf

Grunter, if I read the paper correctly, the authors are studying corporate bonds, the vast majority investment grade. In particular the study looks at the market interest rate of those bonds as it varies in time with a one month sampling frequency for the data. Attempts are then made to see if this data can be used to correlate with the default risk of the assiciated individual company for each bond considered.

A default is a default after it has happened. But there is a long standing practical problem of determining the mathematical boundaries for when a default happens - the covenant that triggers the default can vary between companies in practice. This paper attempts to get around this problem by defining default as a "two-factor square-root diffusion model."

A "two-factor square-root diffusion model", from what I can figure, is in general terms, modelling (equations 3a and 3b) a kind of 'decay behaviour' (By this I mean you start with a constant value and subtract a time series function around variable 's'). The 'initial state' dissipates in proportion to the function of 's' entities decaying, plus a variable term related to the square root of 's' multipled by the standard deviation from some central condition. In mathematical terms the form is:

Change = [Constant - Decay Function] + [Standard Deviation] x [Square Root of Decay Function] x [Another Constant]

This equation form is entirely selected by the authors, and already includes a 'variability term'. Thus far from 'proving' that variability and its triigger of volatility is related to company default, the paper appears to set up this prospect by 'definition' at the outset.

Then, in a 'huge surprise' ;-), this 'defintion of default' is best actuated by another function, the bouncing up and down of bond interest rates which introduces a 'volatility' that satisfies the variability trigger of the model! I may have interpreted all this incorrectly. But it looks to me Grunter, like a circular argument you are running. Define a 'default' as a 'function of variabilty', then introduce a 'volatility' that triggers the 'variabilit'y that 'proves' your case.

I am struck by the following comment in the introduction to the reference paper

"Much of the literature follows Merton (1974) by explicitly linking the risk of a firm’s de-fault to the variability in the firm’s asset value. Although this line of research has proven very useful in addressing the qualitatively important aspects of pricing credit risks, it has been less successful in practical applications."

Have you considered that the reason many of these studies have 'failed to work in practice' (for individual companies) is that the underlying premise of the model being studied is wrong?

Are you able to articulate, without referencing an academic paper, exactly why you feel 'volatility' is related to the 'risk of bankruptcy' for any particular investment?

SNOOPY

[Grunter]

Grunter, if I read the paper correctly, the authors are studying corporate bonds, the vast majority investment grade. In particular the study looks at the market interest rate of those bonds as it varies in time with a one month sampling frequency for the data. Attempts are then made to see if this data can be used to correlate with the default risk of the assiciated individual company for each bond considered.

A default is a default after it has happened. But there is a long standing practical problem of determining the mathematical boundaries for when a default happens - the covenant that triggers the default can vary between companies in practice. This paper attempts to get around this problem by defining default as a "two-factor square-root diffusion model."

A "two-factor square-root diffusion model", from what I can figure, is in general terms, modelling (equations 3a and 3b) a kind of 'decay behaviour' (By this I mean you start with a constant value and subtract a time series function around variable 's'). The 'initial state' dissipates in proportion to the function of 's' entities decaying, plus a variable term related to the square root of 's' multipled by the standard deviation from some central condition. In mathematical terms the form is:

Change = [Constant - Decay Function] + [Standard Deviation] x [Square Root of Decay Function] x [Another Constant]

This equation form is entirely selected by the authors, and already includes a 'variability term'. Thus far from 'proving' that variability and its triigger of volatility is related to company default, the paper appears to set up this prospect by 'definition' at the outset.

Then, in a 'huge surprise' ;-), this 'defintion of default' is best actuated by another function, the bouncing up and down of bond interest rates which introduces a 'volatility' that satisfies the variability trigger of the model! I may have interpreted all this incorrectly. But it looks to me Grunter, like a circular argument you are running. Define a 'default' as a 'function of variabilty', then introduce a 'volatility' that triggers the 'variabilit'y that 'proves' your case.

I am struck by the following comment in the introduction to the reference paper

"Much of the literature follows Merton (1974) by explicitly linking the risk of a firm’s de-fault to the variability in the firm’s asset value. Although this line of research has proven very useful in addressing the qualitatively important aspects of pricing credit risks, it has been less successful in practical applications."

Have you considered that the reason many of these studies have 'failed to work in practice' (for individual companies) is that the underlying premise of the model being studied is wrong?

Are you able to articulate, without referencing an academic paper, exactly why you feel 'volatility' is related to the 'risk of bankruptcy' for any particular investment?

SNOOPY

Snoopy,

Most banks are listed, and also have debt issuances. In sophisticated markets, most also have Credit Default Swaps on these bonds. This is the best way to price the risk of default in the bank.

You seem to think that Banks are an entirely different beast - they are not.

You also seem to not know what parts of the paper to read - you don't read what the paper is proposing - just read the theory parts. I'm not trying to propose ways of measuring risk - I post the papers so they explain the theoretical underpinnings of the argument to make clearer to you.

Essentially volatility is related to the risk of bankruptcy as the risk of bankruptcy is defined as when the value of the bank's assets fall to a defined amount (zero/below solvency requirements whatever). As the value of the assets fluctuates through time, this means that the value of the assets is volatile. Therefore it is easy to see that low volatility means that it is less likely the bank's assets will drop below the bankruptcy benchmark, and more volatility means that it is more likely the benchmark will be reached.

I fail to see how you haven't grasped this concept?

[Snoopy]

You also seem to not know what parts of the paper to read - you don't read what the paper is proposing - just read the theory parts. I'm not trying to propose ways of measuring risk - I post the papers so they explain the theoretical underpinnings of the argument to make clearer to you.


You may be right here Grunter. Those papers you referenced are very 'information dense'. If you wanted to point be to a particular part of the paper then you should have felt free to do so. I will have a look at it again. But I reckon that if I was looking for the 'theoretical underpinnings', then just reading the theory parts should have been a good place to start!



Essentially volatility is related to the risk of bankruptcy as the risk of bankruptcy is defined as when the value of the bank's assets fall to a defined amount (zero/below solvency requirements whatever). As the value of the assets fluctuates through time, this means that the value of the assets is volatile. Therefore it is easy to see that low volatility means that it is less likely the bank's assets will drop below the bankruptcy benchmark, and more volatility means that it is more likely the benchmark will be reached.

I fail to see how you haven't grasped this concept?


Thanks for the more explicit explanation. But the one point you haven't answered is the one you put so well yourself previously.



You argue that the method of quantifying risk is flawed and point to volatility not being an appropriate measure of risk? Volatility is the very definition of risk. If the assets appreciate, yes, they have increased in value suddenly, but that does not mean volatility has increased. Volatility comes about when values jump around (up AND down) about a mean. If prices are only going one way (up), the mean is moving upwards as well and the time series of asset values are said to be trending. It's just like a stock price - volatility only increases when the price is moving around more, rather than in one particular direction.


I totally get the bit about when a bank's assets fall below a defined amount, there is a problem. But as you so eloquently hinted at above, this is a problem if it happens at the end of a 'trend' (a downward trend being the potential problem). If a bank's assets go below a certain value due to 'volatility' (could be a problem), then you can expect those assets to bounce back up in value again due to that same 'volatility' (actually not a problem).

So while I agree with you on the issue at stake:

"bank's assets fall to a defined amount"

I don't agree that the threat here is 'volatility'. And quoting from your previous comments above, from 21st September 2016, it seems you agree with me!

SNOOPY

[Snoopy]

Let's say our bank is making a loan to a company producing an automated production line for making fridges in China. Suddenly NZ gets foot and mouth disease, consumer confidence in NZ collapses, and NZ consumers as group need their deposit money to pay down debt of other NZ members of this consumer group. Now I think we can agree there is very likely no connection between building a production line for making washing machines (or fridges ;-) )in China and foot and mouth disease on New Zealand farms. But because these two have nothing in common, this introduces a 'funding risk' for the bank loans. A risk where one side wants out of the loan contract for reasons completely unrelated to the project the funds are being used for.


'Liquidity', the mismatch between the needs of depositors and borrowers (such as in the example above) , is a side issue in the overall context of this thread. Yet I feel it is worthy of some comment.

In a contractual sense, banks tend to have enormous liquidity problems. In a practical sense they tend to have no problems. This is because depositors tend to:

1/ Roll over their debenture investments AND/OR
2/ Not suddenly pull out all their cash funds that are on call.

Furthermore the banks can influence depositor behaviour by offering higher interest rates that correspond to periods where the bank wants to retain more funds.

There is further 'fund relief' available too. A bank can simply raise more equity through something as simple as a dividend reinvestment plan. So despite the dire contractual picture on most bank books, in reality getting more funds to pay out depositors is not an issue. A extension of that argument is that studying bank liquidity is a waste of time.

No bank CEO knowingly makes a loan that he/she knows will be difficult to repay in a timely manner. Yet we do know that often the first step in a bank loan going bad is a problem with liquidity. Liquidity issues are often resolved by bringing in new capital from somewhere else. This is what I call a 'sideways solution', because bringing in new capital does not necessarily solve the underlying liquidity problem. Rather, the new capital usurps the original problem so the original underlying liquidity issue becomes redundant.

Here then is the enigma for investors concerned with bank liquidity. If the most common way to fix an emergency 'liquidity issue' has nothing to do with manipulating the timing of cashflows of depositors and lenders, does it make sense to study liquidity at all?

SNOOPY

[Snoopy]

No bank CEO knowingly makes a loan that he/she knows will be difficult to repay in a timely manner. Yet we do know that often the first step in a bank loan going bad is a problem with liquidity. Liquidity issues are often resolved by bringing in new capital from somewhere else. This is what I call a 'sideways solution', because bringing in new capital does not necessarily solve the underlying liquidity problem. Rather, the new capital usurps the original problem so the original underlying liquidity issue becomes redundant.

Here then is the enigma for investors concerned with bank liquidity. If the most common way to fix an emergency 'liquidity issue' has nothing to do with manipulating the timing of cashflows of depositors and lenders, does it make sense to study liquidity at all?


Improving the bank gearing ratio by recapitalisation is a 'big picture solution' to liquidity questions. Recapitalisation under these circumstances though, often means that those existing holders of bank equity are disadvantaged, because any new capital must be issued at a greatly discounted price. So although a bank liquidity event is very unusual, the fact that the consequences are extremely severe means I think bank liquidity is worth studying.

From a bank perspective, New Zealand was largely insulated from GFC wash down effects because of the well capitalised Australian parent banks that dominate the NZ banking market. The second tier NZ finance industry, by contrast, was almost wiped out. But just because the NZ Banks survived the last GFC, this should not lead to a complacency that they will automatically survive the next.

The 'headline worry' is that bank customers will lose access to their bank deposits for a while, and even take a 'haircut' on their bank investments. In fact, this is exactly what happened with NZ investors trying to recover their capital from debenture investments in finance companies that went bad. So the idea that this could happen between a customer and their bank while incredible (to those who were around before the GFC) is at least on the horizon as an unwelcome possibility. But is there another loosely connected worry that no-one speaks about and which hides behind a cloud because no-one in the last twenty years has experienced it?

SNOOPY

[Snoopy]

But is there another loosely connected worry that no-one speaks about and which hides behind a cloud because no-one in the last twenty years has experienced it?


My oblique reference above, comes from the idea that:
"the amount of money a bank has on deposit, or can borrow from a 'parent bank', does not affect the size of that individual bank's loan book."

Now I admit that statement sounds a bit wacky. And the internet is full of wacky economic theories that do not increase their credibility by people reading them. But the above 'wacky theory' is the theory promoted by the 'Bank of England', which follows a model very similar to our own 'Reserve Bank of New Zealand'. A forum member has sent me a 'reference link' that explains this idea in great detail.

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf#page=1

The idea that a 'loan book' is the creator of deposits, not the saving behaviour of bank customers, will be too much of a shock to many and will bring comprehension of this post to a full stop. So I will leave it at that.

SNOOPY

[Snoopy]

The idea that a 'loan book' is the creator of deposits, not the saving behaviour of bank customers, will be too much of a shock to many and will bring comprehension of this post to a full stop. So I will leave it at that.


Now to carry on, for those that have got over the shock....

From a shareholder perspective in a single bank, I am not sure that 'loan books create the bank deposits' is the most useful way of looking at things. I have long been of the view that 'bank customers create their own deposits.' However, I can't dismiss the explanations of the 'Reserve Bank of England' either. After reading that bank of England article I came to the conclusion that:

1/ 'loan books create the bank deposits' AND
2/ 'bank customers create their own deposits.'

could amount to two different ways of looking at what turns out in the end to be the same thing. However, this thinking does challenge my long held view that, to run a bank, it is the quality and quantity of customer deposits (and money borrowed from 'parent banks') that matters most. Maybe it is equally valid to think of the quality and maturity of bank receivables as the primary driver of any individual banking business?

If you follow the 'receivables matter most' perspective, that means the substantive liquidity risk for banks is not: "Bank depositors may have a problem getting their loan money back.".

Instead the primary bank liquidity risk is that "Banks will not be able to get enough loan customers to fully cover the payout of their broad spectrum of depositors." Effectively the banks would become 'undergeared' due to a collapse in market demand for their loans.

To be honest, this still seems like a weird consequence to me. I can't recall a bank ever being in this position. But just because I can't recall it though, doesn't mean it didn't happen, or it couldn't happen.

SNOOPY

[Snoopy]

If you follow the 'receivables matter most' perspective, that means the substantive liquidity risk for banks is not: "Bank depositors may have a problem getting their loan money back.".

Instead the primary bank liquidity risk is that "Banks will not be able to get enough loan customers to fully cover the payout of their broad spectrum of depositors."


To take this further, I think it is useful to look at a specific example. I am tempted to call our hypothetical example "Bank A". But to be slightly less predictable, I will call it "Bank H".

The 'contracted position' for "Bank H's" receivables verses deposits, is significantly altered when the 'human factor' is added in on top. I have already talked about the 'human factor' of depositors leaving money in "Bank H" for longer than they signed up to do so.

The "human factor" that is less discussed is that those who take out loans, have an 'historical statistical tendency' to repay some loans early. How early? In the case of "Bank H', take the current term loans due as one figure, and add to that figure 32% of that short term loan total. More loans being 'cashed in early' is an indicator that there is more pressure to create extra new loans than many shareholders in "Bank H" realise.

Before the GFC, I could scarcely imagine a bank customer's deposit not being repaid in full.

Yet even now I find it hard to imagine that a reverse mortgage customer (for example) would not want to take out a new loan at any price. I suppose if house prices went into a profound slump, a houseowner might suffer the combined effect of a compounding interest reverse mortgage bill aggressively eating away the value of the family home asset that is simultaneously falling in value. A double whammy!

In another example, one might imagine a sharemilker with a herd of cows that has slumped in value, with no means to buy any more cows at any price.

In both these examples, the worst thing the owner of these assets could do is to rush to "sell at the bottom of the market". If I was such an owner, I would attempt to 'hang on' until house/cow prices recovered a bit before voluntarily exiting my loan. So I can now imagine a situation where demand for 'new loans' dries up. Reducing the corresponding 'on call' deposit interest rate might be a way for "Bank H" to lose some 'on deposit' funds quickly. "Bank H" would not want to be in a position of paying interest on deposited funds, while having no customer on the other side to "on loan" these funds to.

When a loan customer enquires about repaying their loan early, a bank can be proactive in seeking new loans to replace those being repaid early. In the short term some 'borrowing headroom' in the parent bank facility can be used to accelerate the new loan process, until the loan to be repaid early is 'actually repaid', or new offsetting debenture deposits come on board. What I have described here is a very short term fix. But this example nevertheless shows that "Bank H"'s 'borrowing headroom' can assist as a bridge in both:

1/ 'paying out depositors' AND
2/ 'setting up new finance receivables'.

SNOOPY

[macduffy]

I'm not sure where you're going with this, Snoopy, but the "primary bank liquidity risk" is surely that the subject bank loses the confidence of the financial "world"; depositors withdraw funds; liquid assets are insufficient to cover further withdrawals; other banks refuse to lend to it; borrowers, naturally enough, don't rush to repay their loans. Unless the central bank/govt comes to the party either with temporary funding or an arranged sale, subject bank folds. Consequences ensue for the rest of the financial system.............

[Snoopy]

I'm not sure where you're going with this, Snoopy, but the "primary bank liquidity risk" is surely that the subject bank loses the confidence of the financial "world"; depositors withdraw funds; liquid assets are insufficient to cover further withdrawals; other banks refuse to lend to it; borrowers, naturally enough, don't rush to repay their loans. Unless the central bank/govt comes to the party either with temporary funding or an arranged sale, subject bank folds. Consequences ensue for the rest of the financial system.............

Macduffy, your explanation of a liquidity crisis corresponds more or less to how I thought the financial system worked, before I read the "Bank of England" explanation that I have previously referenced. Except your explanation is more succinct and clear than I could have managed! The first thing you mention in your chain of events is that 'depositors withdraw funds'. The Bank of England seems to have a different take on all of this though, even if The Bank of England document was talking about the economy in general, whereas this thread is based around what happens from a 'single bank perspective'.

Yet the Bank of England states that it is the 'loans of individual banks' that create external deposits in the accounts of bank customers. And it is these new external to the bank deposits that cause the growth in money supply of a country. From the sole perspective of "Retail Bank H" though, "Bank H" needs to attract some of the already existing money sloshing around in the economy to be 'new' deposits in "Bank H" (even though the money in those 'new' deposits is not new to the country's economy in total). If "Bank H" did not attract a 'new deposit' of 'old money', then Bank H's balance sheet could not support the "finance receivable' that it is creating as part of the process of creating 'genuinely new money' outside of the bank's walls.

The Bank of England seems quite adamant that a potential collapse in the demand for loans is the real threat to the liquidity of the economy, not 'depositors withdrawing funds'. From the perspective of "Bank H" though, 'Bank H' must still manage that balance between 'finance receivables' and 'customer term deposits'. Yet from an overall perspective, the economy does not care if "Bank H" has those term deposits, or if those same term deposits are deposited in another bank that I will call "Bank J". This goes to the heart of looking at the same problem from different angles.

Is a liquidity problem for "Bank H" 'caused' by:

1/ a reduction in people willing to put deposits in "Bank H", (as you assert Macduffy). OR
2/ Does "Bank H" and "Bank J" not loaning people money, so not creating new money in the borrowers account, mean that eventually and indirectly there is no new money for depositors to put more money on deposit in "Bank H".

OR do 1/ and 2/ really amount to the same thing for "Bank H", but from different perspectives? That is the conclusion I came to.

So, if you then accept there is more than one way to explain the same money flows (or lack of) then I think you also must accept that you can explain any liquidity crisis from at least two perspectives. And seeing something like this from both perspectives is actually a really hard thing to do if you were only brought up with one of the explanations.

This in turn explains why I am having difficulty completing my post 24. Time to lie down again as my head is hurting.

SNOOPY

[Baa_Baa]

It is confusing and takes a while to get ones head around it. The Reserve Bank of England report is also tough reading, which doesn't help.

These people http://www.positivemoney.org.nz are NZ's arm of a worldwide movement that are opposed to the practices that enable banks to literally create money out of thin air, ergo create liquidity in the economy (which many/most think that only the country's Reserve Bank can do), all by creative accounting.

It's a consequence of fractional reserve banking and is endemic worldwide. It is also extremely profitable for banks. It is seen by some to be a root cause of many financial issues.

They put the problem quite succinctly: http://www.positivemoney.org.nz/Site/Problem/default.aspx

And because they think it is a terrible system that has caused no end of trouble, they also have ideas as to a solution: http://www.positivemoney.org.nz/Site/Solution/Overview/default.aspx which they go into a great more detail if one wishes to understand the finer points.

But here are some easy to understand and very informative other sources here: http://positivemoney.org/our-proposals/

I'm inclined to believe all this is correct. As long as it is not illegal it is not in the interests of the banks to disclose precisely how 'money is created' and how they profit from it, or how it affects liquidity in the economy and indebtedness.

Frankly I'm less interested in how it affects the banks' liquidity. They seem to have it figured out any which way.

[Snoopy]

They put the problem quite succinctly: http://www.positivemoney.org.nz/Site/Problem/default.aspx

And because they think it is a terrible system that has caused no end of trouble, they also have ideas as to a solution: http://www.positivemoney.org.nz/Site/Solution/Overview/default.aspx which they go into a great more detail if one wishes to understand the finer points.


I didn't expect to propose a solution many of the ills of financial system when I started this thread This thread has exceeded my expectations.



Frankly I'm less interested in how it affects the banks' liquidity. They seem to have it figured out any which way.

Call me small minded Baa-Baa, but I still think liquidity within individual banks is very much a live issue. There haven't been any recent bank collapses in Oceania (don't mention NZ's post GFC finance company sector though). But post GFC there are many overseas banks that only exist now because of the support of their respective countries' government's bail outs. Liquidity issues were only fixed by massive capital injections from those governments.

SNOOPY

[Baa_Baa]

I didn't expect to propose a solution many of the ills of financial system when I started this thread This thread has exceeded my expectations.

Call me small minded Baa-Baa, but I still think liquidity within individual banks is very much a live issue. There haven't been any recent bank collapses in Oceania (don't mention NZ's post GFC finance company sector though). But post GFC there are many overseas banks that only exist now because of the support of their respective countries' government's bail outs. Liquidity issues were only fixed by massive capital injections from those governments.

SNOOPY

Certainly wouldn't call you anything of the sort, apologies if I have shifted a bit off topic bringing up the notion of banks being a source of new money in the economy. No doubt the banks need liquidity to survive, it's how they create money out of thin air and their accounting practices that enable that, which subverts the role of the reserve bank that most think is the sole source of money:

http://www.positivemoney.org.nz/Site/Emails/Newsletter_72.aspx

BAA