chapter 1 banking and the financial services industry

1

Chapter 1

Banking and the Financial Services Industry

2

Credit Crisis of 2007 - 2009 Lenders Made “Sub-Prime” Mortgages

Borrowers had insufficient income to make monthly payments

Many mortgages had “teaser” rates Low payments resulting in negative

amortization Multiple Mortgage Banks Fail

As the mortgages write-downs were recognized, the mortgage banks’ capital was depleted

3

Credit Crisis of 2007 - 2009 Collapse and/or Failure of:

Bear Stearns Lehman Brothers Countrywide Washington Mutual Wachovia

4

Credit Crisis of 2007 - 2009 Government Response

Fannie Mae and Freddie Mac placed into conservatorship

Loaned AIG over $150 billion Insured money market mutual funds Created Commercial Paper Funding

Facility Increased FDIC coverage to $250,000

Temporarily through 2009

5

Credit Crisis of 2007 - 2009 Government Response

Established Troubled Asset Relief Program – TARP

Established Term Asset-Backed Securities Loan Facility – TALF

Invested $125 billion in nine large U.S. banks

Promoted mortgage loan modifications

6

Credit Crisis of 2007 - 2009 Impact on Banks and the Banking

Environment Biggest impact of declining real estate

values concentrated in the areas that experienced the largest run-up in real estate values

Many large banks experienced large losses while many small banks did not

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Credit Crisis of 2007 - 2009

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Credit Crisis of 2007 - 2009 Impact on Banks and the Banking

Environment Largest Investment Banks

Goldman Sachs and Morgan Stanley Converted to Financial Holding Companies

Bear Stearns and Merrill Lynch Absorbed by other financial institutions

Lehman Brothers Failed

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How Do Banks Differ? Global Banks

Offer a wide array of products and services globally

Super-Regional Banks Similar to global banks but smaller in

size and market penetration Community Banks

Smaller trade area with total assets under $1 billion

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How Do Banks Differ?

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How Do Banks Differ? Bank Holding Companies

Owns controlling interest in one or more commercial banks

Parent Organization versus Subsidiaries

One-Bank Holding Companies Multibank Holding Companies

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How Do Banks Differ? Financial Holding Companies

The primary advantage to forming an FHC is that the entity can engage in a wide range of financial activities not permitted in the bank or in a BHC

Authorized to engage in: Underwriting and selling insurance and

securities Commercial banking Merchant banking Insurance company portfolio investment

activities

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Fed may not permit forming an FHC (or converting a BHC to an FHC) if any of its insured depository institution subsidiaries are:

not well capitalized, not well managed, did not receive at least a “Satisfactory”

rating in its most recent CRA exam

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An FHC can own a bank or BHC or a thrift or thrift holding company

Each of these companies owns subsidiaries, while the parent financial holding company also owns other subsidiaries directly

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How Do Banks Differ? Holding Company Financial

Statements The consolidated financial statements

of a holding company and its subsidiaries reflect aggregate or consolidate performance

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How Do Banks Differ? Holding Company Financial

Statements While the consolidated financial

statements of a holding company and its subsidiaries reflect aggregate performance, it is useful to examine the parent company’s statements alone

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How Do Banks Differ? Holding Company Financial Statements

The parent typically pays very little in income tax because 80 percent of the dividends from subsidiaries is exempt

Taxable income from the remaining 20 percent and interest income is small relative to deductible expenses

Under IRS provisions, each subsidiary actually pays taxes quarterly on its taxable income

With a consolidated tax return, however, the parent company can use taxable income from its subsidiaries to offset its loss

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Organizational Structure and Financial Services Business Model

S-Corporation Banks Have favorable tax treatment because a qualifying

firm does not pay corporate income tax The firm allocates income to shareholders on a pro

rata basis and each individual pays tax at personal tax rates on the income allocated to them

Given the opportunity to avoid double taxation at the firm and individual level, many closely held banks have chosen S-corporation status

The primary limitation to qualifying for S-corporation status is a requirement that the bank must have no more than 100 shareholders

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S-Corporation Banks

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Financial Services Business Models The principal advantage of being a depository

institution is access to FDIC deposit insurance The FDIC charges banks a premium for the

insurance, which ensures qualifying deposit holders that the FDIC will guarantee the principal amount of each deposit up to the maximum allowed

The existence of deposit insurance allows depository institutions to pay low rates on insured deposits and ensures that such deposits are relatively stable in times of crisis

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Financial Services Business Models The primary disadvantage of operating as a bank

(or BHC) is that the firm is subject to regulation as a bank

Prior to 2008, investment banks avoided regulation as banks, which allowed them to operate with substantially lower equity capital per dollar of risk assets and enter lines of business not generally available to commercial banks

The combined effect was greater financial leverage and business operations in many high-risk areas such as proprietary trading

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Transactions Banking Versus Relationship Banking Transactions Banking

Involves the provision of transactions services such as checking accounts, credit card loans, and mortgage loans that occur with high frequency and exhibit standardized features

Because the products are highly standardized, they require little human input to manage

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Transactions Banking Versus Relationship Banking Relationship Banking

Emphasizes the personal relationship between the banker and customer

For example, the key feature of a loan that is relationship driven is that the lender adds real value to the borrower during the credit granting process

In addition to the provision of funds, the lender may provide expertise in accounting, business, and tax planning

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Transactions Banking Versus Relationship Banking Relationship Banking

Lending institutions generally charge higher rates and often hold the loans in portfolio

Aggressively market noncredit products and services to such customers in order to lock in the relationship

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Transactions Banking Versus Relationship Banking Securitization

The process of pooling a group of assets with similar features—for example, credit card loans or mortgages—and issuing securities that are collateralized by the assets

The securities are sold to investors who receive the cash flows from the loans net of servicing, guarantee, and trust fees

The entire process adds liquidity to the market because the loan originators regularly repeat the process knowing that investors will demand the securities

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Transactions Banking Versus Relationship Banking Originate-to-Distribute (OTD)

When loan origination is separated from ownership

The flaw is that lenders who originated the loans knew they would not own the loans long term

They were, therefore, less concerned about the quality of the assets originated

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Transactions Banking Versus Relationship Banking Originate-to-Distribute (OTD)

In order to grow their business and continue originating loans, they increasingly made loans to less qualified borrowers

When the underlying assets defaulted at higher-than-expected rates, investors in the securities did not receive the promised payments

The net result is that liquidity largely dried up for most securitizations

37


Universal Banking Refers to a structure for a financial services

company in which the company offers a broad range of financial products and services

Combined traditional commercial banking that focused on loans and deposit gathering with investment banking

Underwrote securities, advised on mergers and acquisitions, managed investment assets for customers, took equity positions in companies, bought and sold assets for a speculative profit, offered brokerage services, and made loans and accepted deposits

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Universal Banking The presumed advantage of universal

banking is the ability to cross-sell services among customers

Participation in diverse products and services would presumably increase the information advantage and allow the bank to serve customers more efficiently and at better prices

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Universal Banking There is no consensus on whether

universal banking is successful U.S. firms that tried to achieve this goal

of a “one-stop financial supermarket” have not outperformed more traditional competitors

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Different Channels for Delivering Banking Services

Branch Banking Automated Teller Machines Internet (Online) Banking Call Centers Mobile Banking

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Chapter 2

Banking and the Financial Services Industry

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Government Policies and Regulation

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Historical Bank Regulation Glass-Steagall Act (1933-1999)

Created three distinct industries Commercial Banking Investment Banking Insurance

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Historical Bank Regulation Definition of a Commercial Bank Limitations on:

Geographic Scope Products and Services

Results: Large number of small banks Limited products and services banks

could offer Limited geographic area to operate

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Historical Bank Regulation Changes in:

Products and Services MMMFs LPOs Commercial Paper Junk Bonds Payment Methods

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Goals and Functions of Bank Regulation

Ensure the Safety and Soundness of Banks

Provide an Efficient and Competitive Financial System

Provide Monetary Stability Maintain the Integrity of the Payments

System Protect Consumers from Abuses

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Ensure Safety & Soundness and Provide an Efficient & Competitive System

Supervision and Examination FDIC OCC

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Supervision and Examination CAMELS

Capital Asset Quality Management Quality Earnings Quality Liquidity Sensitivity to Market Risk

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Supervision and Examination Memorandum of Understanding

Formal regulatory document Cease and Desist Order

Legal document Has legal standing

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New Charters Dual Banking System Office of the Comptroller of the

Currency Charters national banks

Office of Thrift Supervision Charters federal savings banks and

savings associations National Credit Union Administration

Charters federal credit unions

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New Charters State Banking Authorities

Charter state banks State Savings Authorities

Charter state savings banks State Credit Union Authorities

Charter state credit unions

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National versus State Charter All banks obtain FDIC deposit

insurance as part of the chartering process

National banks must join the Fed Primary regulator is the OCC

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National versus State Charter State banks may join the Fed

State banks are regulated by their state banking authority

State banks also have a primary federal regulator

Federal Reserve for member banks FDIC for non-member banks

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Commercial Banks, Savings Institutions, and Credit Unions Commercial Banks

Specialize in short-term business credit Savings Institutions

Specialize in real estate loans Stockholder versus Mutual Ownership “Qualified Thrift Lender” Unitary Thrift Holding Company

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Commercial Banks, Savings Institutions, and Credit Unions Credit Unions

“Common Bond” requirement Exempt from Federal Taxation

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Farm Credit System Farm Credit Administration 4 Farm Credit Banks 81 Agricultural Credit Associations 9 Federal land Credit Associations 1 Agricultural Credit Bank

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Farm Credit System Provides credit and other services to:

Agricultural producers and farmer-owned agricultural and aquatic cooperatives

Agricultural processing and marketing activities

Rural housing Farm-related businesses Rural utilities Foreign and domestic companies involved in

international agricultural trade

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Farm Credit System Not considered depository institutions

because they do not accept transactions deposits

Federal Farm Credit Banks Funding Corporation

Issues debt on behalf of the Farm Credit Banks

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Federal Deposit Insurance Currently full coverage for demand

deposit accounts until 12/31/2013 Currently coverage of at least $250,000

per depositor on interest-bearing accounts

Coverage will revert to $100,000 ($250,000 for retirement accounts) per depositor on 1/1/2014

Original limit in 1933 was $5,000

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Federal Deposit Insurance Goal is for fund to be 1.25% of deposits

Banks pay risk-based deposit insurance premium to the Deposit Insurance Fund

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Federal Deposit Insurance Federal Deposit Insurance Corporation

Receiver of failed institutions Liquidate Sell

Too Big to Fail Policy

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Product Restrictions: Depository Institutions versus Non-Depository Institutions Banks are restricted on what products

and services they can offer http://www.occ.treas.gov/corpapps/Ban

kAct.pdf

http://www.occ.treas.gov/corpapps/BankAct.pdf

http://www.occ.treas.gov/corpapps/BankAct.pdf

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Activities Permissible for a National Bank General Banking Activities

Branching Consulting and financial advice Corporate governance Correspondent service Finder activities Leasing Lending Payment services

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Activities Permissible for a National Bank Fiduciary, Insurance and Annuities

Activities General trust activities, employee

benefit accounts, and real estate brokerage

Insurance and annuities activities Securities activities

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Activities Permissible for a National Bank Technology and Electronic Activities

Digital certification Electronic bill payments Electronic correspondent services Electronic storage and safekeeping Internet access service Internet and PC banking Software development and production

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Activities Permissible for a National Bank Investments

Asset-backed securities Bank stock Bankers acceptances Corporate bonds Collateralized mortgage-related investments Commercial paper Money market preferred stock, Trust preferred securities State and local bonds

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Shortcomings of Restrictive Bank Regulation Does not prevent bank failure Cannot eliminate economic risk

Assumed markets for bank products could be protected

Discriminated against U.S. based firms Does not guarantee that bank

management will make good decisions

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Maintaining Monetary Stability and the Integrity of the Payments System

The Role of the Central Bank in the Economy: The Federal Reserve System Fundamental Functions

Conduct monetary policy Provide and maintain the payments

system Supervise and regulate banking

operations

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The Role of the Central Bank in the Economy: The Federal Reserve System Organization

Board of Governors 12 Federal Reserve District Banks

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The Role of the Central Bank in the Economy: The Federal Reserve System Monetary Policy

Open Market Operations Open market purchases (sales) increase

(decrease) reserves & the money supply

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Discount Rate Decreasing (Increasing) the discount rate

makes bank borrowing less (more) expensive, which leads to an increase (decrease) in the money supply

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Reserve Requirements Decreasing (Increasing) reserve

requirements increases (decreases) the money supply

Last changed April 1992

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The Federal Reserve’s Crisis Management Tools Term Auction Facility Term Securities Lending Facility Primary Dealer Credit Facility

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The Role of Depository Institutions and the Economy Banks are the primary conduit for

monetary policy Banks are the primary source of credit

for most small businesses and many individuals

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Efficient and Competitive Financial System Product restrictions, barriers to entry,

and restrictions on mergers and the degree of branching can clearly enhance safety and soundness, but they also hinder competition

Effective financial regulation requires a delicate balance between the system’s competitiveness and general safety and soundness concerns

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Efficient and Competitive Financial System Organizational Form of the Banking

Industry Bank Holding Companies

Parent Subsidiaries

One-Bank Holding Companies Mutli-Bank Holding Companies

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Efficient and Competitive Financial System Consumer Protection

Reg. B Equal Credit Opportunity

Cannot discriminate on the basis of sex, race, marital status, religion, age, or national origin

Reg. Z Truth-in-Lending

Requires disclosure of: Effective interest rates, total interest paid,

total of all payments Why credit was denied

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Efficient and Competitive Financial System Key Federal Legislation

Depository Institutions Deregulation and Monetary Control Act of 1980

DIDMCA Depository Institutions Act of 1982

Garn-St. Germain Competitive Equality Banking Act of

1987

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Financial Institutions Reform, Recovery, and Enforcement Act of 1989

FIRREA Federal Deposit Insurance Corporation

Improvement Act of 1991 FASB 115

Held-to-maturity Trading account securities Available-for-sale

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Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

Gramm-Leach-Bliley Act of 1999 USA Patriot Act (2001) Sarbanes-Oxley Act (2002) Check Clearing for the 21st Century

Act aka Check 21 (2004)

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Fair and Accurate Credit Transactions Act (FACT) of 2003

Servicemembers Civil Relief Act (SCRA) of 2003

Deposit Insurance Reform Act of 2005 Troubled Asset Relief Act (2008) TARP Capital Purchase Program (2008) Amended Reg. Z (Truth in Lending Act

of 1968)

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Housing and Economic Recovery Act (HERA) of 2008

Federal Housing Finance Regulatory Reform Act of 2008

Federal Housing Finance Agency (FHFA) HOPE for Homeowners Act of 2008 Treasury Emergency Authority Provisions Secure and Fair Enforcement of Mortgage

Licensing Act (SAFE) of 2008 Foreclosure Prevention Act of 2008 FHA Modernization Act of 2008

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Efficient and Competitive Financial System Current Unresolved Regulatory Issues

Capital Adequacy From a regulator’s perspective,

increased capital requirements make banks safer

Increasing capital requirements also has disadvantages

Equity is more expensive than debt Most banks do not have ready access to

the equity markets This can lead to more consolidation

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Regulatory Reform Regulation of depository institutions is

highly fragmented Federal Reserve OCC OTS FDIC NCUA

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Regulatory Reform Non-depository institutions are not

subject to the same regulatory burdens as depository institutions

Large investment banks Insurance companies Finance companies Hedge funds Credit card companies

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Regulatory Reform Since the Fed is willing and able to

assist financial players they do not directly supervise, the system appears to be at greater risk than it was before the most recent financial innovations

Chapter 3

Analyzing Bank Performance

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Analyzing Bank Performance In 2008, depository institutions

reported: Worsening asset quality leading to

higher charge-offs Shrinking net interest income Declining non-interest income

These factors led to lower profits, ROE, ROA, and bank failures

97

Analyzing Bank Performance Depository Institution Failures

Over 1,500 bank failures between 1985 and 1993

0 in 2005 or 2006 3 in 2007 Sharp increase in 2008 and 2009

26 in 2008 72 through mid-August 2009

98

Commercial Bank Financial Statements Most depository financial institutions

own few fixed assets and thus exhibit low operating leverage

Many bank liabilities carry short-term maturities. As a result, interest expense changes coincidentally with short-run changes in market interest rates

99

Commercial Bank Financial Statements Many commercial bank deposits are

insured by the FDIC. Insured deposits carry below-market interest rates

Banks operate with less equity capital than non-financial companies, which increases financial leverage and the volatility of earnings

100

Commercial Bank Financial Statements Bank Assets

Loans Real Estate Commercial Individual Agricultural Other loans in domestic offices Loans and leases in foreign offices

101


Adjustment to Loans Gross Loans and Leases

minus Unearned Income Loan and Lease Loss (Allowance for

Loan Loss or ALL) equals

Net Loans and Leases

102


Investment Securities Short-Term Investments

One year or less Examples:

Interest-Bearing Deposits Due from Other Banks

Fed Funds Sold Reverse Repos T-Bills

103


Investment Securities Long-Term Investments

Over one year Examples:

T-Notes and T-Bonds Government Agency Issues Foreign and Corporate Bonds Mortgage-Backed Securities Municipal Securities: General Obligation Municipal Securities: Revenue

104


Investment Securities Held-to-Maturity Trading Account Available-for-Sale

105


Investment Securities Held-to-Maturity

Intent and ability to hold until maturity Recorded at cost (Book Value) Changes in value (unrealized gains or

losses) are NOT reflected on the balance sheet or income statement

May be a current or long-term asset, depending on maturity

106


Investment Securities Trading Account

Objective is to generate trading profits Marked-to-Market Changes in value (unrealized gains and

losses) ARE reflected on the Income Statement

Always a current asset, regardless of maturity of the underlying security

107


Investment Securities Available-for-Sale

For those securities that do not fall into the HTM or Trading categories

Market-to-Market Change in value (unrealized gains or losses)

ARE reflected on the Balance Sheet (Change to Shareholder’s Equity)

May be a current or long-term asset, depending on maturity

108


Non-Interest Cash and Due From Banks

Vault Cash Deposits held at the Federal Reserve Cash Items in Process of Collection

(CIPC) Largest component of this category

109


Other Assets Bank Premises OREO

Often foreclosed property Banker’s Acceptances

112

Commercial Bank Financial Statements Bank Liabilities and Stockholder’s Equity

Transaction Accounts Demand Deposits

Pays no interest Available to all customers

NOW Accounts Pays “market” interest rate Not available to for-profit corporations

ATS Accounts Pays “market” interest rate Not available to for-profit corporations

113

Commercial Bank Financial Statements Bank Liabilities and Stockholder’s

Equity Transaction Accounts

MMDAs Pays market interest rate Limited to six checks per month Available to all customers

114


Equity Savings and Time Deposits

Savings Deposits No Maturity

Time Deposits (CDs) “Large” or Jumbo CDs

Negotiable “Small” CDs

115


Equity Other Borrowings

Fed Funds Purchased Repurchase Agreements

Brokered Deposits Deposits Held in Foreign Offices

Issued by a bank subsidiary outside the U.S. Federal Home Loan Bank Borrowings Subordinated Notes and Debentures

116

Commercial Bank Financial Statements Bank Liabilities and Stockholder’s Equity

Core Deposits Deposits that are NOT very interest rate

sensitive Represent permanent funding base Made up of:

Demand Deposits NOW and ATS accounts MMDAs Savings Accounts “Small” Time Deposits

117


Equity Non-Core Deposits

Deposits that are very interest rate sensitive

AKA Volatile Liabilities Hot Money Purchased Liabilities Short-Term Non-Core Funding

118


Equity Non-Core Deposits

Consist of: Federal Funds Purchased Repos “Large” Time Deposits Brokered Time Deposits

119


Equity All Common and Preferred Equity

Preferred Stock Common Stock

123

Commercial Bank Financial Statements Income Statement

Interest Income (II) Includes interest and fees from:

Loans Deposits at other institutions Trading Account Securities Municipal Securities

Estimated Tax Benefit = Municipal Interest Rate/(1 – Marginal Tax

Rate) = Tax-Equivalent Municipal Interest Income

124


Interest Expense (IE) Includes interest paid on all interest-

bearing liabilities: NOW Accounts ATS Accounts MMDAs Savings Accounts Time Deposits Non-Core Liabilities Long-Term Debt

125


Interest Income (II) minus

Interest Expense (IE) equals

Net Interest Income (NII)

126


Non-Interest Income (OI) Includes:

Fiduciary (Trust) Income Deposit Service Charges Trading Revenues Investment Banking Fees and Commissions Insurance Commission Fees and Income Net Servicing Fees Net Gains (Losses) on Sales of Loans Other Net Gains (Losses)

127


Non-Interest Expense (OE) Includes:

Personnel Occupancy Technology Utilities Deposit Insurance Premiums Intangible Amortizations Goodwill Imparement

128


Non-Interest Expense (OE) minus

Non-Interest Income (OI) equals

Burden Non-interest expense is typically larger

than non-interest income Reducing the Burden will increase bank

profitability

129


Provision for Loan and Lease Losses (PLL) Estimate of potential losses on loans Relationship between PLL and ALL

Beginning ALL (from Balance Sheet) plus

This year’s PLL (from Income Statement) minus

Charge-offs plus

Recoveries Equals

Ending ALL

130


Provision for Loan and Lease Losses (PLL)

Relationship between PLL and ALL Recall, ALL is a contra-asset account

When a loan is charged off, Gross Loans and the ALL account are decreased by the same amount

131


Net Interest Income (NII) minus

Burden minus

PLL plus

Realized Security Gains (Losses) (SG) equals

132


Pre-Tax Net Operating Income (te) minus

Taxes (T) minus

Extraordinary Items equals

Net Income (NI)

133


Total Revenue (TR) or Total Operating Income (TOI)

Includes: Interest Income Non-Interest Income Realized Security Gains (Losses)

Analogous to Net Sales

134


Total Operating Expense (EXP) Includes

Interest Expense Non-Interest Expense PLL

Analogous to COGS + Operating Expenses

135


NI = NII – Burden – PLL + SG – T

136

Relationship Between Balance Sheet & Income Statement Ai = Dollar magnitude of the ith asset Lj = Dollar magnitude of the jth liability NW = Dollar magnitude of equity yi = Average pre-tax yield on the ith

asset cj = Average pre-tax cost on the jth

liability

NWLAm

jj

n

ii

11

n

iii Ay

1

IncomeInterest

m

ijj Lc

1

ExpenseInterest

137

Relationship Between Balance Sheet & Income Statement

138

Relationship Between Balance Sheet & Income Statement Net Interest Income

Changes with changes in: Composition Volume

SG - T LLBurden - PLcAyNet Incomem

ijj

n

iii

11

m

ijj

n

iii LcAy

11

IncomeInterest Net

139

Return on Equity Model Profitability Analysis

Return on Equity (ROE) Return on Assets (ROA)

Return on Equity Model Profitability Analysis

Return on Equity Net Income/Average Total Equity ROA x EM

Net Income/Average Total Assets xAverage Total Assets/Average Total Equity

140

Return on Equity Model Expense Ratio and Asset Utilization

Asset Utilization (AU) Total Revenue/Average Total Assets

TR/aTA Expense Ratio (ER)

Total Operating Expenses/Average Total Assets

EXP/aTA Tax Ratio (TAX)

Taxes/Average Total Assets

141


Net Income/Average Total Assets

ROA = AU – ER – TAX

142

aTATaxes

aTAEXP

aTATR

aTANIROA

143


Expense Ratio (ER) Total Operating Expense/Average Total

Assets EXP/aTA

aTAPLL

aTAOE

aTAIE

aTAEXPER

144


Expense Ratio (ER) IE can change due to changes in:

Volume Different levels of liabilities versus

equity Composition

Different mix of liabilities Rates

aTAPLL

aTAOE

aTAIE

aTAEXPER

145

Return on Equity Model Expense Ratio (ER)

Non-Interest Expense OE can change due to changes in:

Personnel Expenses Occupancy Expenses Technology Expenses Other Overhead Expenses

aTAPLL

aTAOE

aTAIE

aTAEXPER

146

Return on Equity Model Income: Asset Utilization Components

Total Revenue Includes:

Interest Income (II) Non-Interest Income (OI) Realized Security Gains or Losses (SG)

aTASG

aTAOI

aTAII

aTATRA U

147


II can change due to changes in: Volume

Different levels of earning assets to total assets

Earnings Base (EB) = Average Earning Assets/aTA

Composition Different mix of earning assets

RatesaTASG

aTAOI

aTAII

aTATRA U


Non-Interest Income (OI) OI can change due to changes in:

Fees Trust Activities Service Charges Other Non-Interest Income

148

aTASG

aTAOI

aTAII

aTATRA U

149

Return on Equity Model Aggregate Profitability Measures

Net Interest Margin (NIM) Net Interest Income/Average Earning

Assets Spread

Interest Income/Average Earning Assets - Interest Expense/Average Interest-Bearing Liabilities

150

Return on Equity Model Aggregate Profitability Measures

Burden (Non-Interest Expense – Non-Interest

Income)/Average Earning Assets Lower numbers are better

Efficiency Ratio Non-Interest Expense/(Net Interest

Income + Non-Interest Income) Lower numbers are better

152

Managing Risks and Returns Risk Management

Credit Risk Liquidity Risk Market Risk Operational Risk Reputation Risk Legal Risk

153


Credit Risk Historical Loss Rate

Gross Loan Losses (Charge-offs) Recoveries Net Losses

Charge-offs - Recoveries

154


Credit Risk Expected Future Losses

Past-Due Loans Interest and Principal has not been paid but it

is still accruing interest 30-89 days 90 days and over

Non-Performing Loans 90 days or more past-due

Non-Accrual Loans Not accruing interest

155


Credit Risk Expected Future Losses

Total Non-Current Loans Non-Performing + Non-Accrual Loans

Restructured Loans Classified Loans

Regulations force management to set aside reserves for loans that are clearly not going to be paid back

156


Credit Risk Preparation for Losses

Provision for Loan Loss IRS versus FASB and Regulators

Earnings Coverage of Net Losses (Net Interest Income – Burden)/Net Loan

and Lease Losses Management can manipulate by

delaying the recognition of bad loans

157


Credit Risk Preparation for Losses

Lack of Diversification High Loan Growth Country Risk

158


Liquidity Risk Funding Liquidity Risk

Inability to liquidate assts or raise required funding

Market Liquidity Risk

159


Liquidity Risk Holding Liquid Assets

Pledging Requirements Cash Assets

Not a good source of liquidity for a bank Ability to Borrow for Liquidity

Volatile Liabilities “Hot Money” versus Core Deposits

Large CDs Fed Funds Purchased Repos

160


Market Risk Interest Rate Risk

Asset or Liability is considered “rate sensitive” if it can be re-priced during a particular time period

GAP/Earnings Sensitivity Analysis Changes in spread/NIM due to changes

in rates Duration GAP

Market Value of Equity Sensitivity

161


Market Risk Equity and Security Price Risk Foreign Exchange Risk

Foreign Currency Translation Risk Commitments and Guarantees

denominated in a foreign currency

162


Operational Risk Business Interruptions Transaction Processing Inadequate Information Systems Breaches in Internal Controls Client Liability

Legal Risk Reputation Risk

163


Capital or Solvency Risk Risk of becoming insolvent

Liabilities > Assets Off-Balance Sheet Risk

Tier 1 Capital Common Equity + Non-cumulative

Preferred Stock Risk-Weighted Assets

164

Evaluating Bank Performance: An Application Profitability Analysis for PNC in 2007

170

Maximizing the Market Value of Bank Equity Effective Management of:

Assets Liabilities Off-Balance Sheet Activities Interest Rate Margin Credit risk Liquidity Non-Interest Expense Taxes

171

Maximizing the Market Value of Bank Equity CAMELS Ratings

Capital Adequacy Asset Quality Management Quality Earnings Liquidity Sensitivity to Market Risk

172

Maximizing the Market Value of Bank Equity CAMELS Ratings

Ratings from 1 (best) to 5 (worst) 1 & 2

Sound banks 3

Some underlying problems 4 & 5

Problem banks

174

Maximizing the Market Value of Bank Equity Performance Characteristics of Banks

by Size Large Banks versus Small Banks

Higher ROE Lower NIM Higher Charge-offs Lower Capital

176

Financial Statement Manipulation Off-Balance Sheet Activities

Window Dressing Preferred Stock Non-Performing Loans Allowance for Loan Losses Securities Gains and Losses Non-Recurring Extraordinary Items

Analyzing Bank Performance

177

chapter 1 banking and the financial services industry

Documents

small banks

financial holding companiesfed

mortgage banks capital

subsidiaries directly16how

large losses

mortgages writedowns

global banksoffer

monthly paymentsmany