Analysis of Financial Institutions

Banks and insurers are judged by different yardsticks from industrial companies: they are highly leveraged, hold mainly financial assets and are shaped by regulation. This module explains the Basel III and insurance capital frameworks, applies CAMELS to bank analysis, adds the factors CAMELS leaves out, such as government support, bail-in rules and unrecognised losses, and covers the ratios that drive property and casualty and life insurer analysis. Level II item sets test multi-step ratio work and the judgement to see risk behind healthy-looking capital ratios.

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What you will learn

1. Explain what makes banks and insurers different from non-financial companies and outline the capital, leverage and liquidity rules they must meet.

Financial institutions are systemically linked, highly leveraged and hold mostly financial assets, so liquidity and market risk sit at the centre of the analysis.
Basel III minimums: CET1 4.5%, Tier 1 6% and total capital 8% of RWA, plus a 2.5% conservation buffer, a countercyclical buffer of up to 2.5% and G-SIB surcharges.
The leverage ratio (Tier 1 / total exposure, at least 3%) ignores risk weights and backstops them.
The LCR (30-day stress) and the NSFR (one-year funding structure) must both be at least 100%.
AT1 instruments count in Tier 1 but never in CET1; Tier 2 counts only in total capital.
Insurers face risk-based capital regimes such as Solvency II (EU) and NAIC risk-based capital (US).

2. Use the CAMELS framework and its main ratios to analyse a bank, and explain what the framework leaves out.

CAMELS = Capital, Asset quality, Management, Earnings, Liquidity, Sensitivity to market risk; 1 is best, 5 is worst.
NIM = net interest income / average interest-earning assets; cost-to-income = non-interest expenses / operating income, excluding provisions.
Coverage = allowance / NPLs; when provisions are below net charge-offs the allowance shrinks and earnings get a temporary lift.
IFRS 9 books 12-month expected losses on stage 1 loans; US GAAP CECL books lifetime losses from origination.
CAMELS misses systemic links, government support and economic losses that accounting has not yet recognised.

3. Identify factors outside CAMELS that matter in bank analysis, including government support, off-balance-sheet exposures and unrecognised losses.

Government support has often protected depositors and senior creditors, but bail-in rules push losses onto shareholders, AT1 holders and other junior creditors first.
Read instrument terms: AT1 can be written down or converted at a trigger or at the point of non-viability.
Undrawn commitments, guarantees and structured entities are off the balance sheet but can quickly become exposures.
Deduct after-tax unrealised losses on amortised-cost (HTM) securities, and on AFS securities excluded from capital, to estimate economic CET1.
A large stock of Level 3 assets relative to equity signals valuation uncertainty.

4. Describe the main risks of property and casualty and life insurers and calculate the ratios used to analyse them.

Insurer profit = underwriting result + investment result; a combined ratio above 100% can coexist with positive net income.
The loss and LAE ratio uses premiums earned; under the statutory convention the expense ratio uses premiums written.
Prior-year reserve releases lower the reported loss ratio, so look at the underlying (current-year) ratio too.
Long-tail P&C lines carry the most reserving uncertainty; life insurers carry interest rate, longevity and asset-liability mismatch risk.
IFRS 17 introduces the contractual service margin; US GAAP uses a different long-duration model.

Module at a glance

Banks and insurers are leveraged, systemically linked and hold mostly financial assets, so liquidity and market risk matter as much as profitability.
Basel III: CET1 4.5%, Tier 1 6% and total capital 8% of RWA plus buffers; leverage ratio at least 3%; LCR and NSFR at least 100%.
CAMELS covers capital, asset quality, management, earnings, liquidity and sensitivity to market risk; read all six, not just capital.
NIM = NII / average interest-earning assets; cost-to-income excludes provisions; coverage = allowance / NPLs, and the allowance rolls forward by provision minus charge-offs.
Deduct after-tax unrealised losses on HTM securities, and on AFS securities excluded from capital, to see economic CET1.
Government support and bail-in rules decide who bears losses; AT1 can be written off even while shareholders keep some value.
P&C insurers: combined ratio = loss and LAE ratio (on premiums earned) + expense ratio (on premiums written); life insurers face interest rate, longevity and asset-liability risk.
IFRS 9 books 12-month expected losses on stage 1 loans while CECL books lifetime losses; IFRS 17 and US GAAP measure insurance contracts differently.

This free module has 4 lessons, 16 practice questions with full explanations.

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