Day 3 and 4 Income Stmt and Risk Chap 2

7/31/2019 Day 3 and 4 Income Stmt and Risk Chap 2

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William Chittenden edited and updated the PowerPoint slides for this edition.

ANALYZING BANK

PERFORMANCE:

USING THE UBPR

Chapter 2

Bank Management, 6th edition.Timothy W. Koch and S. Scott MacDonaldCopyright 2006 by South-Western, a division of Thomson Learning


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The income statement

Interest income (II)

Interest expense (IE) Interest income less interest expense equals

net interest income (NII)

Loan-loss provisions (PL) represent management's estimate of potential

lost revenue from bad loans

Noninterest income (OI)

Noninterest expense (OE) noninterest expense usually exceeds

noninterest income such that the difference islabeled the bank's burden

Securities gains or losses (SG)

Taxes


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Interest incomethe sum of interest and loan fees earned

on all of a bank's assets.

Interest income includes interest from:

1. Loans and leases2. Deposits held at other institutions,

3. Investment securities

Taxable and municipal securities4. Trading account securities


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Noninterest incomehas increasedsignificantly and consists

of fees & other revenuesfor services

Fiduciary activities

Deposit service charges Trading revenue, venture cap., securitize inc.

Investment banking, advisory inc.

Insurance commissions & fees

Net servicing fees

Loan & lease net gains (losses)

Other net gains (losses)

Other noninterest income


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Noninterest expensecomposed primarily of:

Personnel expense:Salaries and fringe benefits paid to

bank employees

Occupancy expense :Rent and depreciation on equipment

and premises, and

Other operating expenses:Utilities

Deposit insurance premiums


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Noninterest expense

Expenses and loan losses directlyaffect the balance sheet.

The greater the size of loan portfolio,

the greater is operating overhead andPLL.

Consumer loans are usually smaller

and hence more costly (non-interest)per dollar of loans.


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Return on equity (ROE = NI / TE) the basic measure of stockholders returns

ROE is composed of two parts:

Return on Assets (ROA = NI / TA),

represents the returns to the assets thebank has invested in

Equity Multiplier (EM = TA / TE),

the degree of financial leverage

employed by the bank


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Expense ratio (ER = Exp / TA) the ability to control expenses.

Interest expense / TA Cost per liability (avg. rate paid)

Int. exp. liab. (j) / $ amt. liab. (j)

Composition of liabilities

$ amt. of liab. (j) / TA Volume of int. bearing debt and equity

Non-interest expense / TA Salaries and employee benefits / TA

Occupancy expense / TA Other operating expense / TA

Provisions for loan losses / TA

Taxes / TA


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Aggregate profitability measures

Net interest margin NIM = NII / Earning Assets (EA)

Spread

Spread = (Int Inc / EA) (Int Exp / Int bear. Liab.)

Earnings base EB = EA / TA

Burden / TA

(Noninterest Exp. - Noninterest Income) / TA Efficiency ratio

Non int. Exp. / (Net int. Inc. + Non-int. Inc.)


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Fundamental risks :

Credit risk

Liquidity risk

Market risk

Operational risk

Capital or solvency riskLegal risk

Reputational risk


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Credit riskthe potential variation in net income and

market value of equity resulting fromnonpayment or delayed payment on loans

and securities

Three Question need to be addressed:1. What has been the loss experience?

2. What amount of losses do we expect?

3. How prepared is the bank?


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Credit ratios to consider

What has been the loss experience? Net loss to average total LN&LS

Gross losses to average total LN&LS

Recoveries to avg. total LN&LS

Recoveries to prior period losses Net losses by type of LN&LS

What amount of losses do we expect?

Non-current LN&LS to total loans Total Past/Due LN&LS - including nonaccrual

Non-current & restruc LN&LS / Gross LN&LS

Current - Non-current & restruc/ Gr LN&LS

Past due loans by loan type


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Credit ratios to consider (continued)

How prepared are we?Provision for loan loss to: average

assets and average total LN&LS

LN&LS Allowance to: net losses andtotal LN&LS

Earnings coverage of net loss


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Liquidity riskthe variation in net income and market value ofequity caused by a bank's difficulty in obtaining cash

at a reasonable cost from either the sale of assets ornew borrowings

Banks can acquire liquidity in two distinctways:

1. By liquidation of assets Composition of loans & investments

Maturity of loans & investments

Percent of loans and investments pledged

as collateral2. By borrowing

Core deposits

Volatile deposits

Asset quality & stockholders equity


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Market riskthe risk to a financial institutions

condition resulting from adverse movementsin market rates or prices

Market risk arises from changes in: Interest rates

Foreign exchange rates

Equity, commodity and security prices

I t t t i k


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Interest rate riskthe potential variability in a bank's net

interest income and market value of equity

due to changes in the level of marketinterest rates

Example: $10,000 Car loan4 year fixed-rate car loan at 8.5%1 year CD at 4.5%

Spread 4.0%

But for How long?

Funding GAP

GAP = $RSA - $RSL,

where $RSA = $ amount of assets expected to reprice ina give period of time.

In this example:

GAP1yr = $0 - $10,000 = - $10,000This is a negative GAP.


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Foreign exchange risk the risk to a financial institutions

condition resulting from adverse movementsin foreign exchange rates

Foreign exchange risk arises from changesin foreign exchange rates that affect thevalues of assets, liabilities, and off-balancesheet activities denominated in currenciesdifferent from the banks domestic (home)

currency. This risk is also often found in off-balance

sheet loan commitments and guaranteesdenominated in foreign currencies; foreigncurrency translation risk


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Equity and security price riskchange in market prices, interest rates andforeign exchange rates affect the market values of

equities, fixed income securities, foreign currencyholdings, and associated derivative and other off-balance sheet contracts.

Large banks must conduct value-at-risk analysisto assess the risk of losswith their trading account portfolios.


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Capital risk closely tied to asset quality and a bank's

overall risk profile

The more risk taken, the greater is theamount of capital required.

Appropriate risk measures include all therisk measures discussed earlier as well asratios measuring the ratio of: Tier 1 capital and total risk based capital to

risk weighted assets Equity capital to total assets Dividend payout, and growth rate in tier 1

capital


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Legal riskthe potential that unenforceable contracts,

lawsuits, or adverse judgments can disrupt orotherwise negatively affect the operations or

condition of the banking organization

Legal risk includes:Compliance risks

Strategic risks

General liability issues


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Reputational risk

Reputational risk is the potential thatnegative publicity regarding aninstitutions business practices,

whether true or not, will cause adecline in the customer base, costlylitigation, or revenue reductions.

St t i f M i i i


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Strategies for Maximizing

Shareholder Wealth

Asset Management Composition and Volume

Liability Management

Composition and Volume

Management of off-balance sheet activities

Net interest margin management

Credit risk management

Liquidity management

Management of non-interest expense

Securities gains/losses management

Tax management


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CAMELS

Capital AdequacyMeasures banks ability to maintain

capital commensurate with the banksrisk

Asset QualityReflects the amount of credit risk with

the loan and investment portfolios

Management QualityReflects managements ability to

identify, measure, monitor, and controlrisks


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CAMELS (continued)

EarningsReflects the quantity, trend, and quality

of earnings

LiquidityReflects the sources of liquidity and

funds management practices

Sensitivity to market riskReflects the degree to which changes

in market prices and rates adversely

affect earnings and capital


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CAMELS Ratings

Regulators assign a rating of 1 (best)to 5 (worst) in each of the sixcategories and an overall composite

rating 1 or 2 indicates a fundamentally sound

bank

3 indicates that a bank shows someunderlying weakness that should becorrected

4 or 5 indicates a problem bank

Average Performance Characteristics of


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Average Performance Characteristics of

Banks by Business Concentration and Size

ROE and ROA (up to $10 billion in assets)increases with bank size

Employees per dollar of assets decreaseswith bank size

Larger banks have lower efficiency ratiosthan smaller banks

Smaller banks: have proportionately more core deposits and

fewer volatile liabilities than larger banks have a proportionately larger earnings base

than larger banks

have proportionately lower charge-offs than

larger banks


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Bank Performance Measure by Size

Assets Size < $100M

$100M -

$1B

$1B -

$10B > $10B

Trend

with Size

All

Commercial

Banks

Number of institutions reporting 3,655 3,530 360 85 7,630

% of unprofitable institutions 9.80 2.00 1.90 1.20 5.70

% of institutions with earn gains 59.30 70.70 71.90 68.20 then 65.30

Performance ratios (%)

Return on equity 8.46 12.88 13.48 14.24 generally 13.82Return on assets 0.99 1.28 1.46 1.30 then 1.31

Pretax ROA 1.24 1.73 2.21 1.93 then 1.92Equity capital ratio 11.52 10.00 10.90 9.95 10.10

Net interest margin 4.18 4.22 4.00 3.43 3.61

Yield on earning assets 5.65 5.73 5.39 4.83 5.02

Cost of funding earn assets 1.47 1.51 1.39 1.40 1.41

Earning assets to total assets 91.86 91.93 91.01 84.39 86.18

Efficiency ratio 69.54 62.22 55.54 57.42 57.96

Burden ratio 2.60 2.07 1.21 0.82 1.06

Noninterest inc to earn assets 1.03 1.54 2.46 2.93

2.66Noninterest exp to earn assets 3.63 3.61 3.67 3.75 3.72Net charge-offs to LN&LS 0.27 0.31 0.43 0.73 0.63LN&LS loss provision to assets 0.22 0.26 0.34 0.34 0.33


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Bank Risk Measures by Size

Assets Size < $100M

$100M -

$1B

$1B -

$10B > $10B

Trend

with Size

All

Commercial

Banks

Asset Quality

Net charge-offs to LN&LS 0.27 0.31 0.43 0.73 0.63

Loss allow to Noncurr LN&LS 151.5 196.2 206.0 168.0 then 174.6

LN&LS provision to net charge-offs 134.2 125.7 125.5 83.0 89.9

Loss allowance to LN&LS 1.44 1.39 1.47 1.53

1.50Net LN&LS to deposits 72.67 82.11 92.82 86.68 then 86.38

Capital Ratios

Core capital (leverage) ratio 11.31 9.47 9.36 7.23 7.83

Tier 1 risk-based capital ratio 16.83 12.85 12.34 9.11 10.04

Total risk-based capital ratio 17.93 14.06 13.92 12.07 12.62

Structural Changes

New Charters 118 2 1 1 122

Banks absorbed by mergers 102 125 30 7 264

Failed banks 3 0 0 0 3


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Fi i l St t t M i l ti


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Securities gains and lossesBanks often classify all investment

securities as available for sale,

overstating any true gains or lossesNon-recurring sales of assets

This type of transaction is not part ofthe banks daily activities and typically

cannot be repeated; thus it overstatesearnings

Financial Statement Manipulation(continued)

B k M t 6th diti


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William Chittenden edited and updated the PowerPoint slides for this edition

ANALYZING BANKPERFORMANCE:

USING THE UBPR

Chapter 2

Bank Management, 6th edition.Timothy W. Koch and S. Scott MacDonaldCopyright 2006 by South-Western, a division of Thomson Learning

Documents

Day 3 and 4 Income Stmt and Risk Chap 2