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DatabankDecember 21 2011

Are emerging market banks more transparent?

Banks in emerging markets appear to run greater risks to achieve greater returns. But they may just be more conservative in assessing their risks.
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Shares in emerging market banks have traditionally traded at a discount to those in developed markets, because they were considered less transparent and more volatile in their earnings. That discount has reversed over the past year, as many developed market banks – especially in Europe – have seen price to book values fall below one. Though by no means immune to the eurozone crisis, emerging market bank stocks proved more resilient.

And perhaps with good reason. We have calculated the top 10 banks by average return on risk for 2009 and 2010 – one very difficult year for global banking, the other a year of partial recovery. Return on risk measures pre-tax profits as a proportion of risk-weighted assets (RWAs), rather than total assets, for those banks where risk weighted assets data has been provided for both those years.

If the Basel principles are fulfilling their purpose, then banks with lower proportions of risk-weighted assets as a proportion of total assets should achieve lower, but more consistent returns. Those with higher RWAs should see higher return on assets in the good years, but more volatility in the bad years.

For 2009 to 2010, emerging market banks dominate the top 10 spots for return on risk (see chart return on risk above). Brazil contributes three banks, Singapore two more, while Turkey and South Africa have one each. The three exceptions are two investment banks – Goldman Sachs and Credit Suisse – plus US specialised consumer lender and transactions bank American Express.

Its credit card lending profile puts Amex in a similar bracket to the emerging market banks by one measure: average RWAs were almost 90% of total assets in 2009 to 2010. Emerging market banks also put most of their assets into higher risk buckets under Basel criteria, creating RWAs that are often around 70% or more of total assets. US auto lending specialist GMAC serves as a reminder of what, in theory, can happen to institutions that take higher risks – its average return on assets was negative 2.64% in 2009 to 2010, with RWAs at almost 90% of total assets.

Correlation breaks down

But for other loss-making banks, the correlation between risk and return seems to have broken down (see chart risk and return below). For these banks, all in Western Europe or Japan, low RWAs have not prevented losses. Many of these banks are undergoing restructuring, suffering legacy losses while theoretically deleveraging. But that deleveraging seems to take the form of so-called “risk weighted asset optimisation”, focusing on assets that incur low capital charges under Basel regulations.

Our chart suggests Basel’s risk calibration is not working. And with many of those 'low risk' assets consisting of eurozone sovereign bonds that have suffered severe price falls in 2011, we expect to see the correlation between risk and return further eroded when 2011 results are available. Instead of taking bigger risks, emerging market banks may simply be more conservative and transparent in the way they classify their risks. That in turn could help them to continue securing better and more predictable returns on risk in 2011 and beyond.

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