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The Recent U.S. Bank Failures
Lessons Learned For Emerging Market Regulators
Posted on March 18, 2023
Bank regulators everywhere focus heavily on the quality of "risk-weighted assets" included in the balance sheet of a financial institution, as often mandated by national regulatory bodies as well as Basel III.
Government securities are usually rewarded a risk weighting of 100 percent (no risk) by national regulators, providing financial institutions with the incentive to include government securities as assets on their balance sheets, especially those issued by the contries where they're domiciled. As can be observed in the recent failures of two middle market American banks, there was too much focus on risk-weighted assets, but almost no focus on the tenor of those assets and the ability of a financial institution to sell those assets quickly.
In short periods of time, both Signature Bank and Silicon Valley Bank experienced explosive growth in their assets, almost exclusively government securities. As bank customers deposited cash into their accounts, the banks used the funds to buy government securities, all of which were given 100 percent risk weightings by the regulators. What happened? Why were these banks closed by the government?
- Silicon Valley Bank purchased longer-dated securities, but at a time when market interest rates were rising as a result of increased inflation, thus reducing the value of those securities.
- Regulators didn't change the risk weightings of those securities, from a 100% risk weighting, even though their actual value had been reduced as a result of higher interest rates.
- When Silicon Valley Bank needed to sell these securities in order to meet deposit withdrawel requests from their customers, the bank was forced to sell those securities at a loss, substantially wiping out their capital.
Regulators in Emerging Markets Can Have Even Greater Concerns about the quality of risk-weighted assets on the balance sheets of financial institutions they regulate and supervise, because:
- Regulators in Emerging Markets often regulate both deposit-taking and non deposit-taking financial institutions (non banks), frequently applying the same requirements on both types of institutions.
- In one country where we have worked, regulators apply a 100% risk waighting to government securities carried on the balance sheet of non-bank financial institutions, but Zero percent to outstanding loan and lease obligations, but without any regard to credit quality of payment history on those obligations. Any shift from government securities to extending credit to customers automatically increases the underlying risk of a given non-bank financial institution for requlatory purposes.
- As was the case with Silicon Valley Bank, there is little or no attention paid to the duration risk of the government securities carried on the books of regulated financial insitutions.
- Making matters potentially worse, in many countries there are only thin, or non-existant, public debt markets, where it is possible for a financial institution to sell goveernment securities, for example in the event that a financial institution needs funds, including as a result of regulators forcing mark-to-market requirements on that insitution.
- The use of government securities as risk-weighted assets, in an effort to ensure high quality of the balance sheet of financial institutions, won't reduce risk of default, and thus reduce risk, especially in cases of rising interest rates, because little or no attention is paid by regulators, to both duration risk and the ability to easily sell the securities.
- Assigning Zero risk weightings to ourstanding obligations that financial institutions carry on their books, reduces the incentives for financial institutions to lend to commercial customers, especially Small & Medium-Sized businesses (SMEs).
Aperio Associates has extensive experience working with regulators and supervisors in many emerging markets, with the objective of improving the ability of financial institutions to extend business credit, especially to Small & Medium-Sized Enterprises (SMEs), without reducing the underlying risk of the institution. For more information about our services, please contact us.
The Founders of Aperio Associates went to Ukraine in 2005 to work on a USAID technical assistance project. One of the sub projects was creating an organization for professionals who worked in the financial leasing business. The organization was called the Ukraine Certified Leasing Specialists Association, or CLS. To become a certified leasing specialist, one had to work in the industry for at least a year. You also had to attend training for three consecutive weekends, and each weekend was a different module. Then, you had to take three exams, one for each module, and if you passed all three, one becomes a certified leasing specialist. The certificates were jointly awarded by the Ukrainian Union of Lessors and the Certified Leasing Specialist Foundation, based in the US.
When we left the project, there were approximately 100 certified leasing specialists in both Ukraine and Moldova. It was then expanded to Belarus, and eventually there were approximately about 400 certified leasing specialists.
Aperio Associates looks forward to working with leasing companies and leasing associations in other countries, to develop certification programs in commercial finance, including leasing and other forms of commercial finance. For more information please contact us.
Posted on August 26, 2022
- Availability of both equity and debt capital are extremely limited.
- Lack of term debt (debt maturing in more than 12 months) is even more limited.
- Lack of public debt markets in many emerging markets, limiting lessors’ ability to borrow money at a reasonable cost.
- Lack of secondary market to facilitate sales of portfolios of existing leases.
- Lack of flexibility offered by discounting facilities offered by financial institutions such as warehouse lines.
- Limited profitability, resulting from lessor’s inability to borrow more than 100% of its equity.
Lease Funding Issues Faced by Lessors in ALL Markets:
- Interest rate risk resulting from funding medium term leases with short-term debt capital.
- Interest rate risk resulting from a lack of a local currency government bond market in all markets, limiting a lessor’s ability to accurately perceive risk and price lease transactions.
- Interest rate risk resulting from the difference between high cost of borrowed funds and the yield on a lease transaction.
- Currency Risk faced by lessors when acquiring equipment in a foreign currency and extending lease payment terms denominated in local currency.
Regulatory Issues Faced by Lessors in Emerging Markets that Affect Capitalization and Funding:
- Mandated limitations on yield, reducing spreads to unacceptable levels.
- Unrealistic capitalization requirements, including mandated debt/equity ratios.
- For bank-affiliated lessors, limitations on use of depositors’ money to fund lease transactions.
Building a Suite of Commercial Finance Products
Posted on May 21, 2022
Result - The financial institution extends credit with two products that are complementary to each other. The customer improves its profitability. A "win-win" for both borrower and lender.
Aperio Associates provides advisory services and workshops designed to show financial institutions and their professionals on how to best assist their customers in taking maximum advantage of the available products. We offer assistance in marketing & sales, product development, and underwriting & credit, all designed to increase the profitability of the financial institution and the skills of their professionals.
Posted on February 18, 2022
Applying the extensive experience of its Principals, Aperio offers workshops and seminars, both for groups and individually, for commercial finance professionals, on how to prepare an effective credit package for larger transactions. For smaller transactions, where financial institutions require limited financial information, please visit "New Products & Services."
What is a Credit Package? - A credit package clearly describes how the financial institution will be repaid. A credit package contains all the necessary information for a credit officer to approve a request for financing from a business customer. A credit package should contain the following elements:
Summary information is designed to give a credit officer important information about the prospective borrower as well as information about the transaction. Summary information is similar to a well-wrotten newspaper article - "Who/why/when/where/how." Summary information should include:
- Borrower information - Name, and contact information of the borrower/lessee, and the name(s) of the responsible officer(s) of the borrower and, as applicable, the names(s) of all additional guarantors.
- Corporate Governance - Legal organization of the borrower, and the jurisdiction where the borrower is located, tune in business.
- Brief transaction information - the amount requested, and the reason(s) for the request.
- Requested Terms - Type of loan or lease, requested repayment term, amount and frequency of repayments.
Summary information will likely include the financial institutions's standard credit appliction, signed by an authorized representative of the potential borrower/lessee, authorizing the financial instituton to verify all the information provided by the potential borrower/lessee.
The narrative provides more detail about the propsective borrower/lessee, simplar to the body of a well-written newspaper article. The narrative provides a credit officr with A narrative should contain the following information:
- History - Brief history of the potential borrower/lessee, including corporate governance, description of products or services, and major customers.
- Justification - Why is the prospective borrower/lessee is requesting the loan or lease. For a lease, the narrative should describe the equipment, the reason why the equipment is needed such as a business expansion or replacing old equipment, the benefits including increase revenues, cost savings, or both. For short-term transactions, such as a working capital loan, benefits might include the ability to take trade discounts, make bulk purchases of raw materials, and other benefits. Benefits from extending the loan or lease is the borrower/lessee's primary source of repayment.
- Financial Summary - Summary information from the potential borrower/lessee's financial statements, a summary of the amount of cash going through the business, from bank references, statements of electronic payments such as M-Pesa in Kenya, and supplier references (especially from suppliers offering credit terms).
- Address Potential Questions - For every transaction, a good credit officer will raise questions on events that could effect the ability of the borrower/lessee to repay the obligation. A good narrative anticipates these questions, and directly addresses them, rather than waiting for the credit officer to ask them.
Detailed Financial Information
All information required by the financial institution, likely including:
Business financial statements and tax returns.
- Financial statements on all guarantors (individual and corporate)
- Information about the equipment supplier.
Considering Cashflow as a Primary Source of Repayment
Posted on January 28, 2022
Many lessors, especially in emerging markets, consider the value of additional collateral, owned and pledged to the financial institution, to be the primary source of repayment of an obligation. This is an incorrect and often dangerous approach for the following reasons:
Discriminates against service business that do not normally use capital equipment or own real property.
- Over-reliance on estimates of re-sale value of pledged collateral as a source of repayment.
Consider the Following Example (from an actual transaction):
A company makes chocolate covered crackers, for sale at retail outlets.
- An enrober, costing approximately $200,000, is required to place chocolate on the crackers.
- The company sells both milk and dark chocolate crackers.
- Without a second enrober, the company must shut down, to shift from milk to dark chocolate.
- The company incurs $6,682/mo. in direct labor costs from shifting from milk to dark chocolate.
- Lease payment for a 2nd enrober is $3,804/mo.
- Net savings from direct labor costs, after lease payments - $2,878/mo.
Lesson Learned - The primary source of repayment are the economic benefits gained from using the leased equipment, not from the value of collateral, either the leased equipment or additional collateral offered by the lessee to the lessor as additional security.
Aperio Associates provides comprehensive seminars and workshops, given individually and in groups, covering all aspects of credit, underwriting and pricing.