Improving credit quality as a result of post-GFC recovery has led to a strong environment for growth in the banking sector. The Bank of East Asia Limited (HKG:23) is a small-cap bank with a market capitalisation of HK$74.5b. Its profit and value are directly impacted by its borrowers’ ability to pay which is driven by the level of economic growth. This is because growth determines the stability of a borrower’s salary as well as the level of interest rates. Risk associated with repayment is measured by bad debt which is written off as an expense, impacting Bank of East Asia’s bottom line. Today we will analyse Bank of East Asia’s level of bad debt and liabilities in order to understand the risk involved with investing in the bank.
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How Good Is Bank of East Asia At Forecasting Its Risks?
Bank of East Asia’s understanding of its risk level can be estimated by its ability to forecast and provision for its bad loans. The bank has poorly anticipated the factors contributing to higher bad loan levels if it writes off more than 100% of the bad debt it provisioned for. This begs the question – does Bank of East Asia understand the risks it has taken on? With an extremely low bad loan to bad debt ratio of 49.61%, Bank of East Asia has significantly under-provisioned by -50.39% which is well below the appropriate margin of error. This may be due to a one-off bad debt occurence or a constant underestimation of the factors contributing to its bad loan levels.
What Is An Appropriate Level Of Risk?
Bank of East Asia is considered to be in a good financial shape if it does not engage in overly risky lending practices. So what constitutes as overly risky? Typically, loans that are “bad” and cannot be recuperated by the bank should comprise less than 3% of its total loans. Bad debt is written off when loans are not repaid. This is classified as an expense which directly impacts Bank of East Asia’s bottom line. Since bad loans make up a relatively small 0.91% of total assets, the bank exhibits strict bad debt management and faces low risk of default.
Is There Enough Safe Form Of Borrowing?
Bank of East Asia makes money by lending out its various forms of borrowings. Deposits from customers tend to bear the lowest risk given the relatively stable amount available and interest rate. Generally, the higher level of deposits a bank retains, the less risky it is deemed to be. Since Bank of East Asia’s total deposit to total liabilities is very high at 90% which is well-above the prudent level of 50% for banks, Bank of East Asia may be too cautious with its level of deposits and has plenty of headroom to take on risker forms of liability.