Weak Performance Bankruptcy Zone

Published Date: 02 Nov 2017

This paper explores whether the risk possessed by the European banks is greater than that of the U.S banks for the period 2002-2007. A contrasting evaluation of the banking risk of the European and the U.S Banks are carried out and is off much interest as when considered with the current economic situation. Even though there have had been many failures in the financial system in the U.S banking sector during the financial crisis which had let to closures of a numerous banks, yet the Euro zone is at riskier position. My foremost pronouncement is that the bank risk faced by the European banks is higher than that of U.S Banks.

INTRODUCTION

Banks are the major source for any economy as they are engaged in performing simultaneously both activities of which one involves with the function of accepting deposits and the other is the activity lending these deposits to the deficit units. In particular they perform the function of a financial intermediary. This paper discusses whether the European banks are riskier than the U.S banks for the period 2002-2007. The analysis and the forecasting of bank risk or the financial stability of any bank have been of great concern for the banking sector all over. The measurement of bank risk is important for the Euro zone as there is an ever increasing level of banking industry since 1985 (ECB, 2007). Whereas, the U.S banking sector is more distinct when compared with other European countries. The U.S bank held U.S $9.88 trillion in the assets and U.S $5.98 trillion on the total loans dated on 30th September 2004.

LITERATURE REVIEW

According to a report published by the GFSR, the financial system of the U.S banks is still very complex and the global financial system has increased in nominal terms from 2002 -2007. Prior to the crisis period, the profitability of the banks in USA was extremely high and these profits were not utilised to support bank’s capital bases and thus forming a reason for the crisis. Since independence in the early 1990’s by Warsaw Pact and the former Sovient Union, the European banks bought major banks at a lower price. Moreover, the risk were being overcome as the U.S cuts out the interest rates during the 2002 stock crisis which led to dropping down of interest rates of foreign banks that in turn led to gaining easy loan resulting to higher risk. According to the report issued by Morgan Stanley, the Eastern Europe has borrowed a total of $1.7 trillion from Western European Banks of which most are short term borrowings.

Prior to the eruption of the subprime mortgage crisis, they have been flourishing all over the world. As they were booming, their lending activities were also increasing within the country as well as international home markets which were induced by low cost bounteous financing, accumulating profits and economic expansion. During this period these banks have become more conditioned to short-term funding and thus prone to complete surprises forcing them to compress their balance sheet (Graph 1 & Graph 2). While these banks are flourishing, the amount of risk is also increasing and has been spreading to the other parts of the world.

More interestingly as the financial crisis triggered the U.S housing market, they had a double side effect on the European economy. The one way was through European banks that had direct exposure to the U.S debt related financial products (1/3rd of mortgage was held by Europe banks) and the other way was the increase in risk premium which resulted in a fear of insolvency. There were other recent studies carried out on the risk characteristics in cost or profit functions estimation, such as the liquidity risk exposure (Altunbas et al., 2000;

Demirguc-Kunt and Huizinga, 2004; Brissimis et al., 2008; Fiordelisi and Molyneux, 2010); insolvency risk exposure (Lepetit et al., 2008); credit risk (Athanasoglou et al., 2008; Brissimis et al. 2008; Fiordelisi and Molyneux, 2010); capital risk exposure (Dietsch and Lozano-Vivas 2000, Lozano-Vivas et al. 2002, Altunbas et al. 2000, Athanasoglou et al. 2008, Brissimis et al. 2008, Lepetit et al. 2008); market risk exposure (Fiordelisi and Molyneux 2010); and the off-balance risk exposure (Casu and Girardone, 2005).

METHODOLOGY & DATA

Our empirical analysis is based on a balance sheet data of banks of both in the U.S and the Europe, collected for the period 2002 – 2007. Our data sample gathered here is of secondary in nature. In this study we apply the method of Z-score in order to measure the risk of these banks used for the research. Z-score is a critical tool used by business managers to analyse the financial stability of the business. According to Altman 2000, who invented the Z-score model for predicting bankruptcy, gave the following criteria for classifying bank as weak, healthy and very healthy. The table below shows a standard Z-score model which has been very effective in different countries. The model states that when the Z-score is below 1.80 the bank is said to weak and will led to bankruptcy, the second category states that when the value is between 1.8 and 3.00, the bank performance is healthier and the final category states that when the Z-score value is above 3.00 the performance is very healthy.

Table1: Z-score model

CATEGORY

Z-score VALUE

IMPLICATIONS

I

Below 1.80

Weak Performance/Bankruptcy zone

II

1.80 – 3.00

Healthy Performance

III

Above 3.00

Very Healthy/Sound Performance

The formula for Z-score is as follows

C:\Users\hp\Desktop\fism\bfm zscore.png

Where; 1.PNGis the capital asset ratio at time t and 2.PNG is the return on asset ratio for time t by Lepetita & Laetitia, 2013. In our sample, since we are calculating risk of a set of European and U.S banks, so we classify the data into two sets one set is the U.S banks and the other set is the European banks on which we then calculate the Z-score using the STATA tool. This classification is made in order to make the calculation simplified and further to undergo a comparison study on the risk.

RESULTS

Since we have divided our data set into two categories, one into European banks and the other into U.S banks, we can see that we have got 4326 U.S banks and12095 European Banks as our observation for analysis. First, in order to carry out the Z- score analysis we see if the data is normally distributed or skewed distributed or kurtosis distributed. This test is carried out by using SPSS; we can see that the data is of normal distribution. Secondly, the Z-score is calculated. From table 2 we can interpret that the Z-score for the U.S banks is 0.5225163 and the Z-score for the European banks 0.4203826. Finally, apart from the calculation of the Z-score we have also calculated the ln of the Z-score for both European banks and U.S banks. The following are the results of the ln Z-score for the European and the U.S banks -.9789052 and -.747414 respectively.   

Table 2 Z-score Values

U.S Banking

   Variable |       Obs        Mean    Std. Dev.       Min        Max

-------------+--------------------------------------------------------

      ZScoreUS |      4326    .5225163    .6138629  -9.434726   16.25799

European banking

Variable |       Obs        Mean        Std. Dev.       Min        Max

-------------+--------------------------------------------------------

 ZScoreEU     |  12095    .4203826    .6552341  -18.81603     28.094

Table 3 Log of Z-score

European Banking

    Variable |       Obs        Mean    Std. Dev.       Min        Max

-------------+--------------------------------------------------------

LnZscoreEu |     11805   -.9789052    .6040086  -10.58738   3.335556

U.S Banking

    Variable |       Obs        Mean    Std. Dev.       Min        Max

-------------+--------------------------------------------------------

LnZcoreUS |      4155    -.747414    .5947385  -6.537374   2.788584

CONCLUSION

It has been concluded here that the European banks are more risky than the U.S banks. This is based on the results provided above. We can see in the second step after checking the whether the data is normally distributed, that the Z-score value for U.S banks is higher than that of the European Banks. From this analysis we can conclude that the higher the Z-score the less risky the bank and is less prone to bankruptcy and vice-versa. This can be further proven by our third step calculation where we have taken the ln of Z-score which is provided in Table 3. As we can see that the ln of Z-score of the European banks is negatively higher than the Z-score of the U.S banks. Based on this analysis we can analyse that the ln of Z-score is negatively proportional to a higher constraints of the log odds of insolvency. In other words we can say that as the ln of the Z-score is negatively higher the weaker the banks are and the more prone they are to bankruptcy zone. So finally we can conclude that the European Banks are more risky and more prone to bankruptcy than the U.S banks.