Practical analysis for investment professionals
11 June 2019

Global Financial Health Check-Up: What’s the Prognosis?

How healthy are the bank and non-bank sectors across the globe? How does their current status compare with the days preceding the global financial crisis (GFC)?

A recent study by AKRO investiční společnost, a.s., a Prague-based investment company, explored these questions in several major equity markets.

Our results are both encouraging and alarming. We found a dramatic improvement in the health of quoted banks since the 2008–2009 financial crisis as measured by the tangible common equity/risk-weighted assets ratio (TCE/RWA), demonstrating that global policymakers have successfully increased minimum capital requirements among financial institutions and limited leverage.

Banks Common Equity/Risk-Weighted Assets (%)

Source: AKRO investiční společnost/Bloomberg

But when we measured financial distress among non-financial companies using Edward Altman’s Z-score, we discovered several potentially alarming surprises.

As we await the next global downturn, the weak financial position of many non-banking firms, especially in Asia, is cause for concern.

Banking Health Check-Up

In the lead-up to the GFC, the TCE/RWA ratio, one of the most widely used yardsticks of bank distress, outperformed as a predictor of future financial difficulties. The table below shows median year-end TCE/RWA ratios for the banks included on four major global indices.

Annual Health Check-Up: Banks

Annual Health Check-Up: Banks

Source: AAKRO investiční společnost/Bloomberg

The data demonstrates that immediately prior to the GFC, many banks were operating with wafer-thin levels of equity. While this leveraged up their shareholders’ return on equity in good years, during a crisis, a relatively small write-down of assets — say, of commercial or residential property — or an increase in liabilities risked wiping out shareholder equity and rendering the bank insolvent. So the larger the equity buffer, the more likely the bank could survive a crisis. Post-GFC, this lesson was not lost on policymakers, regulators, and the bankers themselves.

Since 2008, the median TCE/RWA ratio for banks in all major equity markets has dramatically improved. Though individual banks still face challenges, the global banking sector is better equipped to weather a financial storm. Of the major markets reviewed, only Chinese banks, with a median TCE/RWA ratio of 9.4, score below 10, and they are still in much improved condition relative to where they were in the pre-GFC period.

Non-Financials Health Check-Up

The banking sector may be much healthier today, but what about non-financial companies? To answer this question, we applied the Altman Z-score, which uses multiple discriminate analysis (MDA) to identify firms in financial distress and combines measures of liquidity, profitability, leverage, solvency, and activity into a single measurement of financial health. This clever combination of metrics also captures the influence of “size.” When it comes to financial distress, size matters: Larger companies are far less likely to go bankrupt.

The lower the Z-score, the greater the potential for financial difficulties and bankruptcy.

Non-Financials: Altman Z-Score

Note: The jump in the Z-score for 2007 for the Shanghai-Shenzen Index reflected the surge in Chinese equity values in 2007 as the market value of equity is a component of the Z-score.

Source: AKRO investiční společnost/Bloomberg

A study examining 120 firms that defaulted on their publicly held debt between 1997 and 1999 found that the Z-score predicted default with 94% accuracy (113 out of 120) when it used a cut-off score of 2.67. A cut-off score of 1.81 anticipated 84% of defaults.

Median scores of 2.4 in Japan, 2.7 in China, and 3.1 in Europe imply that half of all quoted companies in these regions could be vulnerable should business conditions deteriorate. In stark contrast, the average quoted US company has a median Z-score of 4.3 and looks much better positioned to withstand the next economic downturn.

Why are scores low overall, and why are US companies financially stronger?

Our decomposition of the Z-score inputs demonstrates that US firms score well with respect to every aspect of the ratio. That many companies choose to take on a less-than-prudent amount of debt isn’t a surprise. The tax shield offered by debt rather than equity finance is a key consideration — debt interest is paid on pre-tax income, equity dividends on profits after tax.

Other considerations include leveraging balance sheets to boost short-term returns and differing index structures: Volatile tech companies, for example, often hold more cash than firms in more stable industries. The higher level of retained earnings/cash at many US companies isn’t a recent phenomenon and has been well covered in the press. It is probably due, in part, to tax planning: Many US firms are reluctant to repatriate profits for fear of raising their effective tax rate. The overall higher valuation multiples of US equities also may be reflected in higher Z-score for US companies.

Annual Health Check-Up: Non-Financials

Annual Health Check-Up: Non-Financials

Note: The jump in the Z-score for 2007 for the Shanghai-Shenzen Index reflected the surge in Chinese equity values in 2007 as the market value of equity is a component of the Z-score. Figures for the Nikkei 225 prior to 2008 are indicative only.

Source: AKRO investiční společnost/Bloomberg

Z-Score Decomposition

Z-Score Decomposition

Source: AKRO investiční společnost/Bloomberg

The recent inversion of the US yield curve, often a precursor to recession, has raised concerns about a global economic downturn. Our analysis shows that the health of the banking sector should reassure investors and regulators alike.

Nevertheless, since 2005, the median Z-score for non-financial companies in all the researched equity indices is virtually unchanged. Firms are managing their financial affairs no differently than they were before the crisis. Presumably, the impetus among firm managers to steer a responsible course has been offset by the temptation of super-low borrowing costs. Indeed, the median Z-score of non-financial firms in Asia is hovering near the edge, with more than half of the companies in the Japanese Nikkei 225 and Chinese Shanghai-Shenzen indices scoring below the bounds of what is considered financially wise. Based on the Z-score methodology and publicly available data, 27% of non-financial companies in the Nikkei 225 and 32% of those in the Shanghai-Shenzhen Index may have an elevated risk of financial distress.

Non-Financial Firms at Risk of Financial Distress

Non-Financial Firms at Risk of Financial Distress

Source: AKRO investiční společnost/Bloomberg


The increased financial strength of the banking sector reflects more than a decade of efforts by banks and regulators to improve the capital position and deleverage the sector. But the comparatively weak position among the median non-financial firms, particularly outside of the United States, is cause for concern. These alarming results are bound to reignite the debate about financial prudence and the optimum capital structure.

The fundamentally weak financial position of many firms post-GFC reflects a broken system of tax and monetary policy incentives that has encouraged many companies to take on more debt than they can handle. It is not sustainable.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/kencor04

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About the Author(s)
Jeremy Monk

Jeremy Monk is the Investment Director and lead portfolio manager at AKRO investiční společnost, a.s., an independent mutual fund group based in the Czech Republic. Prior to joining AKRO, Monk held portfolio management roles at Lombard Odier, M&G Investments (Prudential), and the Abu Dhabi Investment Authority (ADIA). Monk has an MBA and DIC from Imperial College, London, and also holds the ASIP designation.

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