Evaluating the quality of a bank’s assets is both the most important—and normally the most difficult—facet of bank analysis.
—Moody’s Investors Services, Global Credit Analysis1
Although the concept of asset quality is relevant to nonfinancial firms, particularly with regard to the valuation of inventory, it comes into its own in the realm of bank analysis. Because the vast bulk of a bank’s assets are financial assets backed by a comparatively small proportion of capital, any substantial discrepancy between the value of those assets at the time of acquisition and their reported value becomes a significant analytical concern. As hinted earlier, an increasing proportion of risk assets or risk transactions nowadays affect what is generally termed as asset quality without being earning assets such as plain loans or securities.
Not all of a bank’s customers will pay back the funds they have borrowed. Some will make repayments for a period of time and then default on the full payment of interest and principal. In other words, some loans that a bank makes will become nonperforming. Indeed, that a portion of a bank’s loans will become nonperforming loans, or NPLs, is practically certain and an inherent risk and cost of banking.2 Notwithstanding that earnings from non-interest-income-producing sources is becoming increasingly important to banks in many countries, in nearly all markets the majority of deposit-taking institutions still generate most of their operating ...