Improving credit quality as a result of post-recession recovery has led to a strong growth environment for financial institutions. Large banks such as Bank of China Limited (SEHK:3988), with a market capitalisation of HK$1.31T, have benefited from this momentum. Economic growth fuels demand for loans and affects a borrower’s ability to repay which directly impacts the level of risk Bank of China takes on. As a consequence of the GFC, tighter regulations have led to more conservative lending practices by banks, leading to more prudent levels of risky assets on their balance sheets. Since the level of risky assets held by a bank impacts its cash flow and therefore the attractiveness of its stock as an investment, I will take you through three metrics that are insightful proxies for risk. See our latest analysis for Bank of China
How Much Risk Is Too Much?
By nature, Bank of China is exposed to risky assets by lending to borrowers who may not be able to repay their loans. Total loans should generally be made up of less than 3% of loans that are considered unrecoverable, also known as bad debt. Bad debt is written off when loans are not repaid. This is classified as an expense which directly impacts Bank of China’s bottom line. A ratio of 1.41% indicates the bank faces relatively low chance of default and exhibits strong bad debt management.
Does Bank of China Understand Its Own Risks?
Bank of China’s ability to forecast and provision for its bad loans indicates it has a good understanding of the level of risk it is taking on. If the bank provisions for more than 100% of the bad debt it actually writes off, then it is considered to be relatively prudent and accurate in its bad debt provisioning. With a bad loan to bad debt ratio of 153.57%, the bank has cautiously over-provisioned by 53.57%, which illustrates a safe and prudent forecasting methodology, and its ability to anticipate the factors contributing to its bad loan levels.
Is There Enough Safe Form Of Borrowing?
Bank of China operates by lending out its various forms of borrowings. Customers’ deposits tend to carry the smallest risk given the relatively stable interest rate and amount available. The general rule is the higher level of deposits a bank holds, the less risky it is considered to be. Bank of China’s total deposit level of 77.47% of its total liabilities is within the sensible margin for for financial institutions which generally has a ratio of 50%. This indicates a prudent level of the bank’s safer form of borrowing and a prudent level of risk.