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Bank of Qingdao Co Ltd’s (HKG:3866) profitability and risk are largely affected by the underlying economic growth for the region it operates in HK given it is a small-cap stock with a market capitalisation of HK$24.3b. Given that banks operate by reinvesting deposits in the form of loans, negative economic growth may lower the level of saving deposits and demand for loans, directly affecting those banks’ levels of cash flows. After the Financial Crisis in 2008, a set of reforms called Basel III was created with the purpose of strengthening regulation, risk management and supervision in the banking sector. These reforms target bank level regulation and aims to improve the banking sector’s ability to absorb shocks arising from economic stress which could expose financial institutions to vulnerabilities. Since its financial standing can unexpectedly decline in the case of an adverse macro event such as political instability, it is important to understand how prudent the bank is at managing its risk levels. Low levels of leverage coupled with sufficient liquidity may place Bank of Qingdao in a safe position in the face of adverse headwinds. We can measure this risk exposure by analysing three metrics for leverage and liquidity which I will take you through today.
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Is 3866’s Leverage Level Appropriate?
Banks with low leverage are better positioned to weather adverse headwinds as they have less debt to pay off. A bank’s leverage may be thought of as the level of assets it owns compared to its own shareholders’ equity. While financial companies will always have some leverage for a sufficient capital buffer, Bank of Qingdao’s leverage ratio of less than the suitable maximum level of 20x, at 11.32x, is considered to be very cautious and prudent. This means the bank exhibits very strong leverage management and is well-positioned to repay its debtors in the case of any adverse events since it has an appropriately high level of equity relative to the debt it has taken on to remain in business. If the bank needs to firm up its capital cushion, it has ample headroom to increase its debt level without deteriorating its financial position.
How Should We Measure 3866’s Liquidity?
As abovementioned, loans are quite illiquid so it is important to understand how much of these loans make up the bank’s total assets. Generally, they should make up less than 70% of total assets, consistent with Bank of Qingdao’s case with a much lower ratio of 37%. This means less than half of the bank’s total assets are tied up in the form of illiquid loans, leading to high liquidity, perhaps at the expense of generating interest income.