Financial Analysis Of The Canadian Bank Report Sample
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Part 1 Introduction and Regulatory Challenges
The chain of recent financial and economic crisis has forced governments to implement new liquidity and regulatory requirements for the banking system. Authorities aim to make financial institutions more stable and accountable for their actions. Thus, according to Basel III, they require financial institutions to have a sufficient capital level in order to cover the major part of the costs and reduce risks. Basel III is an international law, which is called to regulate standards of the capital adequacy, stress testing and market liquidity of the financial institutions of all the members of the Basel Committee on Banking Supervision.
Canadian regulation already uses Basel III, even though, since 2011 there were many discussions, whether Canadian banking system is ready to implement new Basel III requirements. After numerous researches and supervisory examinations there was made a conclusion that most of the larger Canadian banks are ready to meet Basel III capital, leverage and liquidity standards.
BMO Bank of Montreal is one of the largest Canadian banks. It is a part of the BMO Financial Group with total assets level of $672 billion. This highly diversified financial services organization serves its clients since 1817. Among services provided by BMO there are personal and commercial banking business, wealth management and investment and corporate banking division.(BMO Financial Group, 2014, p 53)
Brief overview of the Canadian financial market
Total shareholder returns and limited credit losses are the main points that reflected in the high level of the return on equity (ROE), which is higher than two major competitors, USA and Australia achieved (Table 1). Over the past year Canadian banks have gained more than $20.5 billion annual return, which is the highest level achieved over the past five years. The resiliency of the housing markets has been a key contributor to these returns. (PWC. Canadian Banks 2015, 2015, pp 4-6)
Canadian banks continue to increase their capital base according to the Basel III standards. However, the low interest rate environment of previous years prevents many banks from charging on loans and earning on investments. At the same time, low interest rate allowed Canadian banks to get a high level of debts. Thus, the biggest impact on the efficiency level was made by operating costs and other expenditures that rose in a result of the implementation of new regulatory requirements.
As a result of unexpected failure of loan demand and tightening mortgage lending rules by the government, banks faced some difficulties in finding new customers and thus in increasing their portfolios. Nevertheless, general growing economy resulted in new financial institutions entering the market and therefore in increasing the competition in this area.
As one of the six biggest banks in Canada, BMO can easily benefit from the positive economic situation in the country. Thus, the bank has increased a strong client asset as well as enlarged transaction volumes. Furthermore, BMO has developed its investment climate and is currently focused on raising the client base, developing sales of innovative products and attraction of new investors. In case interest rates rise, BMO’s insurance business will develop faster. Increasing number of the retired people will continue to drive the North American wealth management industry. The bank has recently consumed the F&C. which strengthens BMO’s position on the global market. (BMO Financial Group, 2014, p 53)
Part 2 Regulatory Changes
The Office of the Superintendent of Financial Institutions (OSFI), which is now the prudential regulator of the Canadian financial sector, was established to regulate and supervise financial institutions and private pension plans. OSFI is responsible for implementing Basel III in Canada. Hence, bank regulation is divided among three institutions that cover almost 95% of all assets of the Canadian banking system. The rest 5% are held by deposit-taking institutions, which are not internationally active. (Basel Committee on Banking Supervision, 2014, pp.1-7)
One of the key prudential instruments, the Canadian Capital Adequacy Requirements Guideline (CAR Guideline) guides how the Basel III requirements should be met. The Canadian Basel III requirements are being gained according to the timelines. Moreover, according to the latest evaluation of the Canadian banking system, it is absolutely compliant to the Basel standards (Table 2). OSFI also expects all financial institutions to obtain so-called “all-in” target capital ratios equal to or greater than the 2019 capital ratios. (5, p.8)
Generally, Basel III requirements are connected with three important areas: capital, liquidity and systemic risk.
Basel III capital rules
Basel III accord requires banks to have capital that equals at least 10.5% of their total risk-weighted assets by 2019. Different types of banks have different extorts of the level of capital. Global systemically important banks (G-SIBs) the same as domestic systemically important banks (D-SIBs) have to hold additional capital. There are no G-SIB banks in Canada, and its six biggest banks remained to be D-SIBs. According to CAR all banks have to hold the capital of required level by 2019. Previously recognized as one of the best capitalizes banking system, Canadian banks did not ask about government finance help during the recent crisis. (Canadian Bankers Association, 2014, p 2)
Basel III liquidity requirements
According to the Basel accord there are two types of liquidity: the Liquidity Coverage Ratio (LCR) that has a 30-day horizon, and the Net Stable Funding Ratio (NSFR), 1 year horizon. OSFI prepared Liquidity Principles B6 Guideline for banks to hold high quality liquid assets as it bolsters bank’s resilience to internal and external shocks.( Canadian Bankers Association, 2014, p 4)
Basel III Management and Supervision rules
In order to maintain economic stability as well as the resiliency of any financial institutions an effective management of systematic risk has to be implemented. For this purpose, regulatory changes are being made. By these steps financial institutions will strengthen their capital, liquidity and leverage requirements.
Thus, six biggest banks in Canada will be asked to hold an additional 1% of capital and will be supervised with more intense. (Canadian Bankers Association , 2014, pp 3-4)A. Capital Adequacy of the BMO (capital structure & dividend policy) Capital Adequacy is measured in the Common Equity Tier 1 (CET1) Ratio. BMO’s CET1 Ratio was 10.1%, up from 9.9% in 2013 and continues to grow (Table 3), thus it is obvious that Tier 1 is strong and exceeds regulatory requirements. In 2014, the minimum Basel III CET 1 Ratio was a 4%, but OSFI requested Canadian banks to have at least 7%. One of the main reasons of CET 1 growth is the F&C acquisition. (1/14)
BMO’s total capital was $31.9 billion in 2014 that is $2.4 more than in 2013. Therefore, the Tier 1 was higher in 2014, especially considering the fact that Tier 2 is no longer qualified as capital as per Basel III. (1/56)
Legend for Figures 1-2
Figure 1. Total Shareholder Return (TSR), % (1/14)
Shareholders have earned the annual return higher for more than 5% in comparison with the previous year. BMO’s one-year TSR is 17.1% and the five-year 15.5%. Increasing dividend level will attract more investors and thus will allow BMO to develop and participate on international market. In 2014 BMO’s common shares provided a 3.8% annual dividend yield.(1/58)
Despite the growth in both earnings and adjusted earnings available to common shareholders, ROE, both reported and adjusted, have decreased for almost 1% in comparison with the previous year. (Figure 2) To have more clear view on this situation, all Big Six banks have been analyzed. (Table 4)
Figure 2. Return on Equity (ROE), % (1/14)
Canadian banks maintained to keep strong ROE level in 2014, however it was slightly reduced. Nevertheless, the total revenue of the Big Six rose from CA $18.9 billion to CA $20.5 billion. (PWC. Canadian Banks 2015, 2015, p 6)
B. Liquidity (working capital management)
BMO is highly responsible for the safety and soundness of the enterprise, depositor confidence and stability in earnings, therefore its policy is called to ensure that sufficient liquid assets and funding capacity are on the necessary level. (BMO Financial Group, 2014, p 95)
The Liquidity and Funding Risk Management is responsible for supervising and controlling limits and guidelines, policy requirements and the impact of market events on liquidity level on an ongoing basis. The Corporate Treasury group as well as other operating groups takes care about the ongoing management of liquidity and funding risk across the enterprise. (BMO Financial Group, 2014, p 95)
Measurement of liquidity and liquidity risk is a key component of liquidity risk management. Liquidity is being measured in the Net Liquidity Positions (NLP). It reflects the amount by which liquid assets exceed potential funding needs under a certain circumstances. Stress testing results as being considered in management decisions in order to maintain a net liquidity position under any conditions. This type of management includes required regulatory measures - the Liquidity Coverage Ratio (LCR) and Net Cumulative Cash Flow (NCCF). Essentially, about 75% of liquid assets are being held at the parent bank level in Canadian and U.S.-dollar. These are the supplemental liquidity pool or so called ‘denominated assets’ (BMO Financial Group, 2014, p 95) BMO’s portfolio of unencumbered liquid assets reached $171.0 billion in 2014, (Table 4). Raising amount of held-to-maturity securities will cause the increase of supplemental liquid assets that are held to bolster liability requirements. BMO’s supplemental liquid assets were reduced compared to the prior year. (BMO Financial Group, 2014, p 62) During the previous year BMO’s lending and deposit portfolios grew to 7% and 10%, respectively.
Figure 3. Average deposits. (BMO Financial Group, 2014, p 46)
Average BMO deposits increased $11.0 billion. Where personal deposits grew mainly due to growth in long term deposits, as well as growth in primary chequing accounts. (BMO Financial Group, 2014, p 46)
BMO states that their management obligatory uses secured and unsecured wholesale funding to sustain loans and less liquid assets is 2-10 years term. These steps are taken in order to match the term to maturity of these assets, as wholesale secured and unsecured funding are usually maturing in less than one year. Being one of the biggest Canadian banks BMO maintains a large and stable base of clients’ savings. This strong capital base is a key source that supports the maintenance of a sound liquidity position. The bank has got over $238.7 billion clients’ deposits in 2014, while in 2013 there were only $220.6 billion. Also in 2014 BMO received $28.2 billion deposits from corporate and institutional customers to maintain certain trading activities. (BMO Financial Group, 2014, p 98)
C. Market Risk (capital budgeting)
In order to calculate regulatory capital for trading and underwriting market risk the bank should have its internal model. BMO uses Value at Risk (VaR) results back-tested daily, and the 1-day 99% confidence level VaR at the local and consolidated BMO levels are compared. Elsewise, Profit & Loss (P&L) is changing daily. If the theoretical P&L is negative VaR, a back-testing exception occurs. (BMO Financial Group, 2014, p 104) Each case allows managers to monitor the situation and control the general risk level.
Models of analyzing and monitoring risks are different for products with scheduled term and for those, which do not have scheduled terms. For example mortgages and term deposits will be overviewed under the model of predicted prepayments or redemptions as they are equal to the actual observed outcomes. Credit card loans and chequing accounts do not have scheduled terms, thus they are modeled balance run-off profiles that are compared against actual balance trends. Before making any decision, the model has to be reviewed and parameter recalibration has to be taken in order to ensure variances are within the tolerance range. Tests, such as back-testing and sensitivity testing, are always taken when it is needed to analyze a model.(BMO Financial Group, 2014, p 104)
BMO has strong, independent risk management that monitor an extensive range of risk metrics, including Value at Risk, Stressed Value at Risk, stress and scenario tests, risk sensitivities and operational metrics. To meet Basel III standards BMO maintains its risk profiles of the trading and underwriting activities. All data, received from such reports, is undertaken in the independent valuation of financial assets and liabilities and compliance with a model risk. (BMO Financial Group, 2014, pp 91-94)
The Valuation Product Control (VPC) group within the Market Risk group is responsible for independent valuation of all trading and available-forsale (AFS) portfolios. (BMO Financial Group, 2014, p 71).
The Valuation Steering Committee is BMO’s senior management valuation committee, which creates, approves and implements new methodologies, as well as analyzes consolidated data, gathered previously. Four times a year the Valuation Steering Committee has a forum for discussing strategic questions and for financial reporting purposes. The following finance indexes are mentioned in the reports: appropriate valuation adjustments: credit valuation adjustments, closeout costs, uncertainty, funding valuation adjustments, and liquidity and model risk.
There are 3 levels of risk valuation management with different inputs: Level 1 inputs consist of quoted market prices, Level 2 inputs consist of models that use observable market information and Level 3 inputs consist of models without observable market information. (BMO Financial Group, 2014, p 92)
Thanks to the organized multilevel risk management in BMO, it was reported that in 2014 total Trading VaR decreased due to active portfolio rebalancing. The Total AFS VaR decrease was the reflection of position of reductions in a number of portfolios and from the impact of parameter recalibrations. Total Trading SVaR rose in 2014 compared to 2013 as the year was attributable to client facilitation activities across a range of businesses. (BMO Financial Group, 2014, p 92) If to analyze data from the Table 6 and Figure 4, it is shown that BOM has reduced the risk level, however, there are institutions among six largest Canadian banks, which have much lower market risk rate. Moreover, market risk has increased for $2 billion in the Q1 in 2015 (BMO Financial Group, 2015, p 9)
BMO Financial Group. (2014). Annual Report 2014. Retrieved February 26, 2015, from http://www.bmo.com/ar2014/downloads/bmo_ar2014.pdf
BMO Financial Group. (2015). Investor presentation. Retrieved February 28, 2015, from http://www.bmo.com/ir/qtrinfo/1/2015-q1/Q1%202015%20Analyst%20presentation.pdf
PWC. Canadian Banks 2015. (2015). Perspectives on the Canadian banking industry. Retrieved February 26, 2015, from http://www.pwc.com/ca/en/banking-capital-markets/publications/pwc-canadian-banks-2015-en.pdf
Canadian Bankers Association. (2014). Global Banking Regulations and Banks in Canada. Retrieved February 27, 2015, from http://www.cba.ca/contents/files/backgrounders/bkg_glb_reg_en.pdf
Basel Committee on Banking Supervision. (2014) Regulatory Consistency Assessment Programme – Canada. BIS.Retrieved February 27, 2015, from http://www.bis.org/bcbs/implementation/l2_ca.pdf
Where C is ‘Compliant’, LC – ‘Largely compliant’ and N/A – ‘to be assessed after the Basel Committee concludes the final Basel standards’
Figure 4. Market risk of the six biggest Canadian banks, CAD
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