THE recent developments in our local financial sector have once again caused the issue of risk and safety of our investments to resurface. As investors we frequently neglect to ask the important questions that are needed to assess the safety of our banks, pension savings, investment houses or insurance companies.

Assessing the safety of your bank/investment house

For the purpose of a financial institution, safety can be assessed by looking at the size of a company’s capital base relative to the size of its assets. This is an indication of the institution’s degree of leverage.

Leverage is simply the amount of money the institution has saved relative to the amount of money it owes. The amount of money an institution has saved is comprised of the portion of profits it keeps (its retained earnings) as well as the funds that have been injected by shareholders (its share capital). There are many other accounting technicalities that allow institutions to classify other monies or assets as part of their capital base. Generally, the capital base is what is left over after the liabilities are subtracted from the assets, so this figure is very important for investors who need to assess the stability and strength of the bank or investment house in which they are placing their money. The capital base is the cushion which will protect the institution’s clients in times of crisis.

The capital base of a financial institution is also important because it serves to protect the institution and its clients from changes in the value of the company’s assets. If the value of a bank’s assets falls drastically, the declines in value are usually written off against (ie subtracted from) its capital base. This risk is even higher in volatile environments and contracting economies. A sudden rise in interest rates, Government or customer loan defaults, or economic contraction can cause the value of the assets on a financial institution’s balance sheet to decline. If the amount of the decline is greater than the institution’s capital base, the institution becomes insolvent and unable to meet its obligations and continue doing business. In other words, the capital base acts as a buffer to absorb losses experienced by the institution, and if it is large enough it will allow the company to continue meeting its obligations to its clients and other creditors.

For this reason, regulators usually stipulate that a bank and other financial institutions keep a specified minimum percentage of its total assets as capital. The greater this percentage, the better it is for the institution and its clients. An institution with a capital base that is 6 per cent of its assets may be less financially flexible than an institution with a capital base that is 12 per cent of its assets. Instead of looking at the absolute value of the total assets or total capital that your bank or broker maintains, look at the size of its capital base in relation to its assets. This will give a good indication of the strength of the institution relative to its peers.

Regulators also make stipulations about the quality of the assets that are held as capital. The objective is to ensure that the institution not only has sufficient capital to withstand changes in the value of its assets, but also to ensure that the capital itself is invested in high-quality instruments that can be readily redeemed if the need arises. This quality is often measured by the risk-weighted capital adequacy ratio. Unfortunately, this ratio is not always published so the best thing to do is to scout for institutions with high-quality assets and a large capital base relative to the size of their total assets.

Marian Ross-Ammar is VP, Trading & investment at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm