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The banking sector has been experiencing growth as a result of improving credit quality from post-GFC recovery. As a small-cap bank with a market capitalisation of US$406m, Financial Institutions, Inc.’s (NASDAQ:FISI) profit and value are directly affected by economic growth. This is because borrowers’ demand for, and ability to repay, their loans depend on the stability of their salaries and interest rates. Risk associated with repayment is measured by bad debt which is written off as an expense, impacting Financial Institutions’s bottom line. Today we will analyse Financial Institutions’s level of bad debt and liabilities in order to understand the risk involved with investing in the bank.
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Does Financial Institutions Understand Its Own Risks?
Financial Institutions’s forecasting and provisioning accuracy for its bad loans indicates it has a strong understanding of its own risk levels. If the level of provisioning covers 100% or more of the actual bad debt expense the bank writes off, then it is relatively accurate and prudent in its bad debt provisioning. Given its large bad loan to bad debt ratio of 432.55%, Financial Institutions excessively over-provisioned by 332.55% above the appropriate minimum, indicating the bank may perhaps be too cautious with their expectation of bad debt.
What Is An Appropriate Level Of Risk?
Financial Institutions’s operations expose it to risky assets by lending to borrowers who may not be able to repay their loans. Loans that cannot be recuperated by the bank, also known as bad loans, should typically form less than 3% of its total loans. Loans are written off as expenses when they are not repaid, which comes directly out of Financial Institutions’s profit. The bank’s bad debt only makes up a very small 0.26% to total debt which means means the bank has very strict bad debt management and faces insignificant levels of default.
How Big Is Financial Institutions’s Safety Net?
Financial Institutions profits from lending out its various forms of borrowings and charging interest rates. Deposits from customers tend to carry the lowest risk due to the relatively stable interest rate and amount available. Generally, the higher level of deposits a bank retains, the less risky it is deemed to be. Since Financial Institutions’s total deposit to total liabilities is very high at 90% which is well-above the prudent level of 50% for banks, Financial Institutions may be too cautious with its level of deposits and has plenty of headroom to take on risker forms of liability.