fin 537 toolkit how do banks work? dr. ken cyree fall 2015

FIN 537 Toolkit

How do banks work?Dr. Ken Cyree

Fall 2015

What is a bank?• Banks are highly regulated financial

institutions that deal with money and provide financial services.– We will deal mostly with commercial banks

that accept deposits and provide loans• Banks are intermediaries between

borrowers and savers– Provide asset transformation– Provide financial transactions services

How did banks start?• In ancient times, wealth was stored in the

form of something valuable such as gold, cattle or grain. However, gold, cattle, and grain are hard to use for transactions.

• Innovators created paper “claims” or “receipts” against the gold/grain/cattle. Then, merchants and citizens started accepting these claim tickets as payment. Viola! Money was born.

How did banks start?

• Markets to trade money for a future payout (i.e., a loan) emerged around 3000 BC.

• In ancient times, either the government, goldsmiths, or religious authorities would provide “banking” services

• By the 1600s, a pre-runner to modern banking emerged. The first Central Bank started in 1668.


• Banks emerged to provide so-called “bank money” that were initially only good in a local area, such as North Mississippi– Many local panics led to bank runs– Eventually, the US created a National Bank in

1791– lots of history here. It’s charter expired in 1811.

– The Federal Reserve Bank was created in 1913 to be the Central Bank for the US


• Banks require a charter from either the Federal authorities (a national bank) or a state authority (a state bank).– They control access to the banking system

since not anyone can start a bank.– Why can’t just anyone start a bank?

• With the right credentials and capital (money invested) you can start a bank

What do banks do?

• Banks make a profit on the difference between loan and security interest income (and fees) and interest paid on deposits– They have other costs too, such as salaries– They are in business to make acceptable

profits. However, they have great impact on the economy at large.

• They provide “project evaluation” by determining if a businesses prospects are worthy of investing the bank’s money

How do banks work?

• Let’s look at a simple example of how a modern bank works.

• Suppose we start a new bank and provide $100,000 in capital. On day one, the bank’s financial position looks like this:

Assets Liabilities & Equity

Cash $100,000 Liabilities $0

Equity $100,000

How do banks work?• We decide to start making loans, and we

also create a deposit at the Federal Reserve known as a reserve account so we can offer demand deposits (checking).– We must hold at least 10% of demand

deposits in reserve accounts• Suppose we make a $20,000 loan and

deposit it into the recipient’s checking account. For now, we will use our own equity to fund it.

How do banks work?

• We have the following:

• Note that we transformed assets from cash to a loan.


Cash $70,000 Demand Deposits $20,000

Reserves $10,000 Equity $80,000

Loans $20,000

Total Assets $100,000 Total Liab. & Equity $100,000

• Note further that if we earned a whopping 10% on our loan, and even if we loaned out all we had, we would only have $10,000 in revenue:

• And we did not have any expenses!

Interest Income $10,000

Interest Expense $0

Salaries $0

Other Expenses $0

Net Profit $10,000

How do banks work?

• Next, we decide to start getting lots of demand deposits and we also create savings accounts. And, we loan all of it out except $10,000 in cash:


Cash $10,000 Demand Deposits $500,000

Reserves $10,000 Savings $500,000

Loans $1,060,000 Equity $80,000

Total Assets $1,080,000 Total Liab. & Eq. $1,080,000

• If we pay 1% on our savings and hire a teller for $20,000, we have the following, assuming we still earn 10% on loans:

• But we do not have a building or any other expenses! Making money is tough in a bank.


Interest Expense $5,000

Salaries $20,000

Other Expenses $0

Net Profit $81,000

How do banks work?• In our prior example, let’s review the

assumptions and see if there are any possible problems

1. We can earn 10% on loans. Is this realistic? If so, what kind of loans are they?

2. We had no other expenses than a teller’s salary and interest. Realistic?

3. All the savings and checking (DDs) stay put. Is this realistic?

• What if a $100,000 loan fails. We would lose the interest (an opportunity cost) and the investment in the loan:

• We would have to “pay” for it with our equity, and wipe out more than 1/3 of our investment in the start-up bank


Interest Expense $5,000

Loan Losses $100,000

Salaries $20,000

Other Expenses $0

Net Profit -$29,000

How do banks work?

• We have quite a few more problems to deal with too.

• For example, what happens when one of our checking account holders writes a $20,000 check to buy a car?


Cash $0 Demand Deposits $480,000

Reserves $0 Savings $500,000

Loans $1,060,000 Equity $80,000

Total Assets $1,060,000 Total Liab. & Eq. $1,060,000

How do banks work?

• In the first case with a bad loan, the bank experienced default risk.

• In the second case with a person writing a check, the bank experienced liquidity risk

• Note that the bank also had regulatory risk since they did not have at least 10% in their reserve account either.

• There are a few more types of risk we will look at during a later class.

How do banks work?

• So, rather quickly we ran into real trouble with the bank, and we have not even paid ourselves a salary.– What will happen if we use current market

rates on loans?– How many people will we need to operate the

bank? Certainly more than one teller.– Banking margins are very low. The average

pre-tax return on assets in March, 2015 was 1.43% for the US and 0.71% for Mississippi.

CSBS Case Competition Opportunity

• http://www.cvent.com/events/csbs-community-bank-case-study-competition/event-summary-09332b6031c2425da13caa2af42237fb.aspx

• We can create an elective class or have volunteers

• We need to complete the project, and the deadline is Oct. 29 for final names and final project is due May 2, 2016.

http://www.cvent.com/events/csbs-community-bank-case-study-competition/event-summary-09332b6031c2425da13caa2af42237fb.aspx




Chapter 1:Banking and the Financial Services Industry

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Global Financial Crisis of 2007 - 2009

• Economies began to weaken in mid-2007:• Series of crises related to problem mortgages and loans.

• Mortgages did not require large enough monthly payments to pay off loans.

• Borrowers had insufficient income to qualify for loans they received.

• Lenders made loans with the intent to sell them – the originate-to-distribute approach – so as not to retain the credit risk.

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• Multiple mortgage banks failures and defaults:• Home price declines led to losses from mortgage defaults.

• Many high-risk borrowers whose income did not cover payment amounts that would repay their loans.

• Subprime borrower loans with teaser rates and interest only payments resulted in negative amortization.

• Sustained drop in housing prices led to large write-downs.

• Credit availability was restricted and terms were increasingly strict.

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• Collapse and/or Failure of:• Bear Stearns, Lehman Brothers, Countrywide, Washington

Mutual and Wachovia

• Government Response:• Fannie Mae and Freddie Mac placed into conservatorship

• Loaned AIG over $150 billion

• Insured money market mutual funds

• Authorized Bank of America to acquire Merrill Lynch

• Approved Goldman Sacs, Morgan Stanley, MetLife and American Express to convert to bank holding companies



Government Response (cont’d)

• Authorized the Federal Reserve to purchase commercial paper directly from companies such as General Electric

• Increased FDIC coverage to $250,000 for domestic deposits and to unlimited coverage for business deposits

• Established Troubled Asset Relief Program – TARP

• Purchased $125 billion of preferred stock in nine large U.S. banks

• Loaned large amounts to large U.S. financial institutions

• Authorized the sale of FDIC-insured bonds

• Allowed hedge funds to borrow from the Federal Reserve




• Large institutions less willing to make unsecured loans to other institutions.

• Interbank interest rates, such as the London Interbank Offer Rate (LIBOR) rates rose sharply.

• Spread between LIBOR and Treasury rates at record highs.

• U.S. and other countries fell into a recession.• Housing values dropped and foreclosures reached

historically high levels in some markets.• Congress and FDIC promoted loan modifications for

troubled borrowers.



Impact on Banks and the Banking Environment

• Many of the largest banks that operate in national and international markets realized large losses:

• Subprime mortgages

• Private-label mortgage backed securities

• Loans to private equity firms involved in leverage buyouts

• Credit default swaps

• Speculative real estate loans

• Many small banks took significant losses on commercial real estate loans and write-downs.



Impact on Banks and the Banking Environment

• Dramatic change in the structure and operations of U.S. banks.

• Federal Reserve provided direct loans, guarantees, and lines of credit to financial institutions that exceeded $1 trillion.

• Asset write-downs and loan charge-offs in the U.S. led to similar problems in other countries.



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



Trends in the Structure of Banks• Banking industry has consolidated.

• Managers seek economies of scale and use technology to offer products and services across markets.

• FDIC insures commercial bank deposits and serves as one of the major bank regulatory organizations.

• An independent bank is a single organization that accepts deposits and makes loans.

• Thrifts are regulated by the OCC and were initially organized to emphasize mortgage lending to individuals.



Trends in the Structure of Banks – Bank Holding Companies (BHC)• Owns controlling interest in one or more

commercial banks.• Prior to the enactment of interstate branching,

primary motivation was to circumvent restrictions.• Primary motivation today is to broaden scope of

products that can be offered.• Holding company is the parent and operating

entities are the subsidiaries.• One-bank holding companies control only one bank.



Trends in the Structure of Banks – Bank Holding Companies (BHC)• Multibank holding companies control at least two

commercial banks.• Some treat subsidiaries like branches.

• Others allow subsidiaries to operate quasi-independently.

• Bank Holding Company Act of 1956 assigned regulatory responsibility to the Federal Reserve.

• Under current regulations BHC can acquire nonbank subsidiaries offering products and services closely related to banking.



Trends in the Structure of Banks



Trends in the Structure of Banks – Financial Holding Companies (FHC)

• Primary advantage is entity can engage in a wide range of financial activities not permitted in the bank or in a BHC including:

• Underwriting and selling insurance and securities

• Both commercial and merchant banking

• Insurance company portfolio investment activities

• Activities that are “complementary” to financial activities



Trends in the Structure of Banks – Financial Holding Companies (FHC)

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

• Not well capitalized or well managed

• Did not receive at least a “Satisfactory” rating in its most recent CRA exam

• FHC can own a bank, BHC, thrift or thrift holding company:

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



Trends in the Structure of Banks• Holding Company Financial Statements:

• Consolidated financial statements of a holding company and its subsidiaries reflect aggregate or consolidated performance.

• Useful to examine parent company’s statements alone.

• Parent typically pays little income tax because 80% of dividends from subsidiaries is exempt.

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

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



Holding Company Financial Statements



Organizational Structure – S-Corp Banks• Have favorable tax treatment because a qualifying

firm does not pay corporate income tax.• Firm allocates income to shareholders on a pro rata basis.

• Each individual pays tax at personal tax rates on the allocated income.

• Many closely held banks have chosen this status to avoid double taxation.

• Primary limitation to qualifying for S-Corp status is a requirement that the bank must have no more than 100 shareholders.



Organizational Structure – S-Corp Banks



Financial Services Business Models

• The principal advantage of being a depository institution is access to FDIC deposit insurance.

• Credit unions are ensured by the National Credit Union Association (NCUA).

• 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, even if the bank fails.

• This allows depository institutions to pay low rates on insured deposits and ensures that such deposits are relatively stable in times of crisis.



Financial Services Business Models

• Primary disadvantage of operating as a bank (or BHC) is the firm is subject to regulation as a bank.

• Subject to safety and soundness exams to address risk management and compliance exams which monitor appropriate customer service.

• Prior to 2008, investment banks avoided regulation, which allowed them to operate with 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



Transactions Banking versus Relationship Banking

• Transactions Banking:• High frequency transactions services (checking accounts,

credit cards, and mortgage loans) with standardized features that require little human input to manage.

• Lenders that generate sufficient volumes of these transactions can offer them globally with limited investment in human capital.

• Encourages the use of technology to offer products at prices low enough to discourage small competitors.

• These banks are generally large and compete across extensive geographic and product markets.

• Assets can be securitized if loan originators and rating agencies can successfully access underlying credit risk.




• Relationship Banking: • Emphasizes personal relationships between banker and

customers. • Lender adds value to the borrower during credit granting process

and may also provide expertise in other areas such as accounting, business and tax planning.

• Other services are aggressively marketed to ensure relationships.

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

• Borrowers pay for the assurance that funds will be advanced as needed with minimal repetitive negotiations.

• Customers often follow favorite banker to another bank.51



• 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.

• 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 loan originators regularly repeat it knowing investors will demand the securities.




• Originate-to-Distribute (OTD) approach:• Lenders who originated loans knew they would not own

them long term making them less concerned about the quality of assets originated.

• Loan originators paid based on volume and not penalized for defaults.

• Resulted in loans being made to less qualified borrowers and defaults that caused investors to not be paid.

• Net result is that liquidity largely dried up for most securitizations.

• Large institutions left with holding many of the low-quality loans that resulted in write-downs and losses that depleted capital.



Universal Banking• 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.



Universal Banking• Presumed advantage 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.

• No consensus on success.• U.S. firms that tried to achieve this goal of a “one-stop

financial supermarket” have not outperformed more traditional competitors.



Universal Banking



Too Big to Fail Banks

• Financial crisis led to Federal Reserve and U.S. Treasury providing emergency credit and injecting capital into banks.

• Generally nation’s largest institutions received the most help while some smaller banks were allowed to fail.

• Market participants and analysts labeled the firms receiving the most aid as “Too Big to Fail” (TBTF).

• Government argued failure of those firms would lead to global recession and that smaller organizations were less important economically.




• Congress passed the Dodd-Frank Act in 2010.• Attempts to address TBTF banks by creating a resolution

process by which troubled institutions will be liquidated.

• Many market analysts believe TBTF banks will never be allowed to fail through anything resembling liquidation.

• Since the crisis market share has increased for large banks and decreased for smaller ones.

• Numerous studies indicate TBTF firms have implicit government guarantees which produce lower borrowing and operating costs.



Different Channels for Delivering Banking Services

• Branch Banking:• Retail outlet in which customers can conduct banking

business either face to face or electronically.

• Automated Teller Machines (ATM)• Internet (Online) Banking:

• Primary appeal is convenience.

• Call Centers• Mobile Banking



Chapter 2:Government Policies and Regulation

62

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classroom use.

Historical Bank Regulation

• Federal Home Loan Bank Act of 1932• Securities Act of 1933• Banking Act of 1933 commonly known as the Glass-

Steagall Act• National Housing Act of 1934• Securities Exchange Act of 1934• Federal Credit Union Act of 1935• Banking Act of 1935



Goals and Functions of Depository Institution Regulation

• To ensure the safety and soundness of depository institutions and financial instruments.

• Primary purpose is to maintain domestic and international confidence, protect depositors and taxpayers and maintain financial stability.

• To provide an efficient and competitive financial system.

• Regulation is designed to prevent anticompetitive behavior while allowing firms to alter their product mix and delivery system to meet economic and market needs.



Goals and Functions of Depository Institution Regulation

• To provide monetary stability.• Fed attempts to control the nation’s money supply and

influence the general level of interest rates.

• To maintain the integrity of the nation’s payment system.

• Especially important given the trend towards electronic commerce and e-cash.

• To protect consumers from abuses by credit-granting institutions.

• All borrowers should have equal credit opportunities. 65


Ensure Safety and Soundness and Provide an Efficient and Competitive System• Supervision and Examination

• Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) assess the overall quality of a commercial bank’s condition according to a CAMELS system.

• CAMELS: capital adequacy, asset quality, management quality earnings quality, liquidity, sensitivity to market.

• Asset quality rating indicates the relative volume of problem loans and loan losses.

• Management quality is assessed in terms of senior officer awareness and control of policies and performance.



Ensure Safety and Soundness and Provide an Efficient and Competitive System• Supervision and Examination

• Sensitivity to market risk considers management’s ability to identify, measure, monitor and control price risk.

• Capital adequacy, earnings strength and liquidity are determined by key performance ratios.

• Results of the examination is a series of policy recommendations which may or may not be formal.

• A memorandum of understanding is a formal regulatory document identifying violations and corrective actions.

• A cease and desist order is a legal document that orders a firm to stop an unfair practice under penalty of law.



New Charters

• United States has a dual banking system in which individual states and the federal government issue bank and credit union charters.

• OCC charters national commercial banks, federal savings banks and savings associations.

• National Credit Union Administration (NCUA) charters federal credit unions.

• Individual states charter state institutions.



National Versus State Charter• All banks obtain FDIC deposit insurance as part of the

chartering process.• National banks are regulated only by federal agencies.• State-chartered banks have a primary federal regulator.

• Federal Reserve if the bank is a member of the system.

• FDIC if the bank is not a member of the Federal Reserve System.

• Regulatory agencies conduct periodic on-site examinations to assess a bank’s condition and monitor compliance with banking law.



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National Versus State Charter


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National Versus State Charter


• Commercial Banks• Specialize in short-term business credit, make consumer

loans and mortgages, have a broad range of financial powers.

• Savings Institutions• Specialize in real estate loans and now offer virtually any

other product a commercial bank offers.

• Must maintain 65% of their assets in housing-related or other qualified assets to maintain their status (called the “qualified thrift lender” QTL test).

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Commercial Banks, Savings Institutions, and Credit Unions


• Savings Institutions• Liberalization of QTL resulted in many unitary thrift

holding companies which allowed a company to own a depository institution while bypassing prohibitions.

• Gramm-Leach-Bliley eliminated the issuance of new charters.

• Credit Unions• Non-profit institutions whose members have a “common

bond” which can be very loosely defined today.

• Differences between credit unions and other depository institutions are disappearing.

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• Created in 1916 to support the credit needs to agriculture in rural America. Composed of:

• Farm Credit Administration

• 4 Farm Credit Banks

• 79 Agricultural Credit Associations

• 3 Federal Land Credit Associations

• 1 Agricultural Credit Bank

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Farm Credit System (FCS)


• Provides credit and other services to agricultural, rural, and farm-related businesses.

• Not depository institutions because they do not accept transactions deposits.

• Range of acceptable activities by Farm Credit Banks have increased and, due to strategic alliances with commercial banks, the number of banking-type products have increased.

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Farm Credit System (FCS)


• Currently insures customer deposits up to $250,000 per depositor per insured commercial bank and savings institution.

• Similar arrangement for credit unions under the National Credit Union Insurance Fund (NCUSIF).

• Depository institutions pay premiums for insured deposits into the Deposit Insurance Fund based on risk assessment.

• Amount depends on the size of the FDIC’s reserve and the perceived quality of the institution.

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Federal Deposit Insurance


• FDIC acts as the primary federal regulator of state- chartered banks that do not belong to the Federal Reserve System.

• FDIC is the receiver of failed institutions.• Declares an institution insolvent and either liquidates or

sells it to redeem insured deposits.

• Historically have not allowed largest institutions to fail.

• OCC and state banking authorities officially designate banks as insolvent, but the Federal Reserve and FDIC assist in closings.

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Federal Deposit Insurance


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Product Restrictions: Depository Institutions v. Non-Depository Institutions


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• Does not prevent bank failure.• Cannot eliminate economic risk.• Does not guarantee good management decisions.• Three drawbacks:

• Assumes market for bank products could be protected and not encroached on by other firms.

• Discriminated against U.S. versus foreign firms.

• Penalizes customers without convenient access to range of products demanded .

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Shortcomings of Restrictive Bank Regulation


Maintaining Monetary Stability and the Integrity of the Payments System

• Role of the Central Bank in the Economy - The Federal Reserve System fundamental functions:

• Conduct nation’s monetary policy.

• Provide and maintain an effective and efficient payment system.

• Supervise and regulate banking operations.

• Decentralized central bank with Reserve Banks and branches in 12 districts across the country.

• Serves as the lender of last resort.




• Fed conducts monetary policy through actions designed to influence the money supply and credit.

• Original permanent monetary policy tools:• Open market operations is the most flexible means of

carrying out policy objectives.• Fed can adjust the level of reserves thereby influencing short-

term interest rates and the growth of the money supply.

• Changes in discount rate affect cost of reserve borrowing.

• Changes in the reserve requirements adjusts the amount of funds an institution can lend out.




• The Federal Reserve’s Crisis Management Tools• Term auction facilities introduced in late 2007 in response

to the liquidity crisis due to subprime mortgage problems.

• Three programs - Term Auction Facility, Term Securities Lending Facility and Primary Dealer Credit Facility.

• Created to provide additional funding during the 2007 – 2009 crisis and discontinued in 2010.

• Differed in terms of collateral, loan duration and costs.




• The Role of Depository Institutions in the Economy• Banks play an important role in facilitating economic

growth.

• Banks are the primary conduit of Federal Reserve monetary policy.

• Banks are the primary source of credit for most small businesses and many individuals.

• Fundamental shift since 1980 that includes competition from less regulated financial firms that compete in the same general product lines.



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• Product restrictions, barriers to entry, merger and branching restrictions enhance safety and soundness, but also hinder competition.

• Effective regulation requires a balance between the competitiveness and safety and soundness concerns.

• Numerous laws and regulations to protect borrower’s rights including:

• Restricting deceptive advertising and practices.

• Prohibiting discrimination and equal credit opportunity.

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Efficient and Competitive Financial System


• Community Reinvestment Act (1977) prevents a depository institution from acquiring another if the parent receives a poor CRA evaluation.

• Depository Institutions Deregulation and Monetary Control Act of 1980 removed interest rate ceilings and authorized checking account interest.

• Depository Institutions Act of 1982 expanded FDIC power to assist troubled banks.

• Competitive Equality Banking Act of 1987 expanded the FDIC’s authority over open bank assistance transactions.

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Key Federal Legislation: 1970 - 1993



• Financial Institutions Reform, Recovery, and Enforcement Act of 1989 put FDIC in charge of industry insurance and created insurance funds.

• Federal Deposit Insurance Corporation Improvement Act of 1991 increased FDIC authority, mandated prompt corrective action for failing banks and established new bank capital requirements.

• FASB 115 addressed the market value accounting of equity security investments with readily determinable fair values and debt securities.

• Held-to-maturity, trading account and available-for sale



• Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 permits adequately capitalized bank holding companies to acquire banks in any state.

• Gramm-Leach-Bliley Act of 1999 repealed the Glass-Steagall Act and modified the Bank Holding Company Act to create a new financial holding company authorized to engage in insurance, securities, banking, real estate, and other activities “complementary” to banking.

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• Title III of the USA Patriot Act to prevent terrorists from using the U.S. financial system illegally.

• Check Clearing for the 21st Century Act (Check 21) created a framework to eliminate of paper checks.

• Fair and Accurate Credit Transactions Act of 2003 and Servicemembers Civil Relief Act of 2003 enhanced consumer credit rights and provided specific relief to active-duty military.

• Deposit Insurance Reform Act of 2005 merged insurance funds and removed restrictions on risk-based insurance premiums.




• Troubled Asset Relief Program (2008) created a fund to allow the U.S. Treasury to purchase distressed assets from financial institutions.

• TARP Capital Purchase Program (2008) allowed the Treasury to invest in bank’s preferred stock.

• Housing and Economic Recovery Act of 2008:• Federal Housing Finance Regulatory Reform Act of 2008

addressed problems of certain government-sponsored entities (GSEs) and created the Federal Housing Finance Agency.




• Housing and Economic Recovery Act of 2008:• Hope for Homeowners Act of 2008 created a new

discount program at the FHA to allow lenders to provided deep discount loans to prevent foreclosures.

• Treasury Emergency Authority authorized the Treasury to purchase GSE’s debt securities and common stock.

• Secure and Fair Enforcement for Mortgage Licensing Act of 2008 established national standards for lenders.

• Foreclosure Prevention Act of 2008 and FHA Modernization Act of 2008 provided new requirements.




• Regulation Z (Truth in Lending ACT of 1968) amendment to protect borrowers:

• Prohibits a lender from making a mortgage loan without considering income, total assets and ability to repay.

• Requires lenders to verify income and assets

• Restricts prepayment penalties.

• Requires escrow accounts for insurance and taxes for all first-lien mortgages.

• Prohibits lenders from other practices and requires good-faith estimates of costs and repayment schedules.




• Emergency Economic Stabilization Act of 2008 authorized the Treasury to supply banks with cash though the purchase of distressed assets including mortgage-backed securities.

• Helping Families Save Their Homes Act of 2009 included provisions intended to prevent mortgage foreclosures, enhance mortgage credit availability, and protect renters living in foreclosed homes.

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Key Federal Legislation: Dodd-Frank

• Sweeping legislation that is over 3,000 pages and contains 398 rules.

• As of November 2013, only 162 of the rules have been finalized, 121 have been proposed, and 115 have not yet been proposed.

• Created the Financial Stability Oversight Council and the Office of Financial Research.

• Gives federal regulators the ability to take over and liquidate large bank holding companies and nonbank financial institutions if a threat to the country’s financial stability.

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• Requires certain hedge and private equity fund managers to register as SEC advisors.

• Requires complex financial institutions to have “funeral” plans in place.

• Created the Consumer Financial Protections Bureau to inform and protect consumers.

• Created the Office of National Insurance.• Created the Office of Credit Rating Agencies and

created a mandate to standardize credit ratings.

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• Eliminated the Office of Thrift Supervision.• Requires mortgage securitizers to retain 5% of the

credit risk if the mortgage does not meet the Ability to Repay and Qualified Mortgage standards.

• Prohibits banking entities from engaging in proprietary trading.

• Requires companies to ask shareholders to have a nonbinding vote on executive compensation.

• Repealed Re. Q which prohibited interest on demand deposits.

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• Requires regulation of credit default swaps.• Eliminates “Too-Big-To-Fail” bailouts.• Mitigates systemic risk by requiring creation of rules

for Financial Market Utilities.• Authorizes the SEC to impose a fiduciary duty on

brokers who give investment advice to clients.• Permanently extended maximum deposit insurance to

$250,000.• Created national underwriting standards for

residential mortgages.

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• Capital Adequacy:• Banks subject to minimum requirements since 1992.

• Regulators follow the “capital is king” approach with advantages to well-capitalized institutions.

• Ramifications of greater requirements are enormous.• Equity is more expensive than debt.

• Increased requirement restrict growth and make it difficult to compete as a small entity, leading to consolidations.

• Regulatory Reform:• Regulation of depository institutions is highly fragmented.

105

Current Unresolved Regulatory Issues


• Creates two classes of banks: • Large: Creditors and depositors have defacto protection.

• Small: Creditors and uninsured depositors may incur loss.

• Creates moral hazard or the lack of incentive to guard against risk when there are no consequences.

• Solution is not to let large banks fail as a collapse could hinder the economy.

• Need to mitigate risk, reduce moral hazard and level the playing field between large and small banks.

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Too Big To Fail


Chapter 3:AnalyzingBankPerformance

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classroom use.

Analyzing Bank Performance

• FDIC closed 335 banks between 2008 and 2010.• Net operating income of FDIC insured institutions

fell from $37.55 billion in 2nd quarter 2006 to a $36.97 billion loss in 4th quarter 2008.

• Depository institutions reported:• Worsening asset quality leading to higher charge-offs

• Shrinking net interest income

• Declining noninterest income due to record trading losses and larger numbers of nonperforming loans.

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• A high-performance firm is one that makes an exceptional return to shareholders while maintaining an acceptable level of risk.

• High performance is more than just high returns.

• Includes the ability to generate high returns while carefully assessing and pricing the level of risk assumed.

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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. • Interest expense changes create significant asset

allocation and pricing problems.

• Many commercial bank deposits are FDIC insured and carry below-market interest rates.

• Banks operate with less equity capital than nonfinancial companies which increases financial leverage and volatility of earnings.



The Balance Sheet: Bank Assets

• Bank assets fall into four general categories:• Loans are the major asset and generate the greatest

amount of income before expenses and taxes.

• Investment securities are held to earn interest, help meet liquidity needs, speculate on interest rate movements, meet pledging requirements and serve as part of a bank’s dealer function.

• Noninterest cash and due from banks consists of vault cash, deposits held at Federal Reserve Banks and other institutions and cash items in the process of collection.

• Other assets are residual assets of relatively small amounts.

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• Bank assets fall into four general categories:• Loans are the major asset and generate the greatest

amount of income before expenses and taxes.

• Investment securities are held to earn interest, help meet liquidity needs, speculate on interest rate movements, meet pledging requirements and serve as part of a bank’s dealer function.

• Noninterest cash and due from banks consists of vault cash, deposits held at Federal Reserve Banks and other institutions and cash items in the process of collection.

• Other assets are residual assets of relatively small amounts.

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• Loans are negotiated with borrowers and have various maturities, interest rates and repayment terms. There are six major categories:

• Real Estate

• Commercial

• Individual

• Agricultural

• Other loans in domestic offices

• Loans and leases in foreign offices

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• Two adjustments are made to gross loans and leases to obtain the net loan amount.

• Unearned income is income that has been received but not yet earned

• The loan and lease allowance is a contra asset reserve account that recognizes some loans will not be repaid.

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• Investment Securities• Short-term securities have maturities of one year or less

and are held primarily to meet liquidity needs.• Returns vary quickly which changes in money market conditions.

• Lower risk and short maturity results in significantly less interest than could be earned on longer-term securities.

• T-bills, municipal securities and money market instruments.

• Long-term securities have maturities of more than one year and may generate non-taxable interest.

• U.S. Treasury and agency securities, mortgage-backed securities and small amounts of foreign and corporate bonds.

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• Accounting for Investment Securities:• Held-to-maturity securities are recorded at amortized

cost reflecting the objective to hold until maturity.

• Trading account securities are actively bought and sold and are reported at current market value on the balance sheet. Unrealized gains and losses are reported on the income statement.

• Available-for-sale securities are all other securities. They are recorded at market value on the balance sheet with a corresponding change to stockholders’ equity as unrealized gains and losses.

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• Non-Interest Cash and Due From Banks• Vault cash is held to meet customer withdrawals.

• Deposits held at the Federal Reserve are demand balances used to meet legal reserve requirements, assist in check clearing and wire transfers or effect the purchase and sale of Treasury securities.

• Balances at other financial institutions are held primarily to purchase services.

• Cash items in process of collection (CIPC) are generally the largest component of cash, representing checks that have been presented but not yet credited to accounts.

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• Other Assets• Residual assets of small amounts including bank premises

and equipment, other real estate owned (OREO), investment in unconsolidated subsidiaries and other assets.

• OREO is substantial for problem banks because it represents collateral on unpaid loans.

• Commercial banks own relatively few fixed assets.

• Banker’s acceptances are negotiable instruments guaranteeing payment to the owner that are often used in trading goods.

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The Balance Sheet: Liabilities and Stockholders’ Equity

• Transaction Accounts• Demand deposits pay no interest.

• Negotiable orders of withdrawal (NOW) and automatic transfers from savings (ATS) pay interest and are only available to noncommercial customers.

• Money market deposit accounts (MMDA) pay market rates but limit the number of checks and automatic transfers to no more than six each month.

• Exempts depository institutions from holding reserves against MMDAs because they are technically savings, not transaction accounts.

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• Savings and Time Deposits• Time deposits below insurance limit are called small CDs

and carry early withdrawal penalties.

• Time deposits above insurance limit are called jumbo CDs and are negotiable.

• Can be bought and sold in the secondary market.

• Maturities range from one month to five years

• Typically $1 million in size

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• Other Borrowings• Fed funds purchased and securities sold under agreement

to repurchase

• Brokered deposits

• Deposits held in foreign offices

• Federal Home Loan Bank borrowings

• Subordinated notes and debentures

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The Balance Sheet: Liabilities and Stockholders’ Equity• Core deposits consist of demand deposits, NOW and

ATS account, MMDAs, other savings and time deposits less than FDIC limits.

• Stable deposits not usually withdrawn over the short term.

• Most valuable and stable source of institutions’ funding.

• Volatile (noncore) liabilities are asset-quality sensitive borrowings and consist of jumbo CD’s, deposits in foreign offices, federal funds purchased, repurchase agreements, FHLB borrowings and commercial paper.

• If bank gets in trouble, customers willing to move deposits.

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• Common and preferred stock are listed at par value while the surplus account represents proceeds in excess of par.

• Retained earnings represent cumulative net income minus all dividends paid to shareholders.

• Other equity usually reflects capital reserves.• Minority interest in consolidated subsidiaries is the

non-controlling interest in minority subsidiaries.

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The Income Statement

• Interest income (II) is the sum of interest and fees earned on all assets.

• Estimated tax benefit for loan and lease financing and tax-exempt securities income is the estimated dollar tax benefit from not paying taxes on these items.

• Interest expense (IE) is the sum of interest paid on all interest bearing liabilities.

• Gross interest income minus gross interest expense is labeled net interest income (NII).

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The Income Statement• Non-Interest Income (OI) includes:

• Fiduciary activities

• Deposit service charges

• Trading, venture capital and securitization income

• Investment banking, advisory, brokerage and underwriting fees and commissions

• Insurance commission fees and income

• Net servicing fees

• Net gains (losses) on sales of loans

• Other net gains (losses)

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• Non-Interest Expense (OE) consists of:• Personnel, occupancy and other operating expenses

• Intangible amortizations and goodwill impairment

• Provision for loan and lease losses (PLL)• Realized securities gains or losses (SG)• Pretax net operating income (te)• Applicable income taxes (T)• Net income (NI):

• Operating profit less all taxes +/- extraordinary items

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• Total Revenue (TR):• Total interest income, noninterest income and realized

securities gains (losses)

• Comparable to net sales for a nonfinancial firm

• Total Expense (EXP):• Interest expense, noninterest expense and provision for

loan losses

• Comparable to cost of goods sold and operating expenses

• NI = NII – Burden – PLL + SG - T

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Relationship Between the Balance Sheet and 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

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NWLAm

1jj

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1ii

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1iiiAyIncomeInterest

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ijjLc

1

ExpenseInterest

141© 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a

license distributed with a certain product or service or otherwise on a password-protected website for classroom use.



• Net interest income changes when the: • composition or mix of assets change.

• rate earned on assets or paid on liabilities changes.

• Volume of interest earning assets or interest bearing liabilities change.

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ijj

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11

IncomeInterest Net



• Two lines of business at commercial banks:• Retail line focuses on individual customer banking

relationships.

• Wholesale line deals with larger commercial customers.

• Net income varies with the magnitude of assets and liabilities and the associated cash flows:

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SG - T LLBurden - PLcAyNet Incomem

1ijj

n

1iii

The Return on Equity Model

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Profitability Analysis

• Return on Equity (ROE)• Net income/Average total equity

• Return on Assets (ROA)• Net income/Average total assets

• ROE is linked to ROA by an equity multiplier (EM)

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Interpreting Financial Ratios and the Use of Average Balance Sheet Data

• Rule 1: Use Average Balance Sheet Data when Comparing Income Statement Data with Balance Sheet Data

• Rule 2: Compare Individual Ratios over Time• Rule 3: Accounting Data May Not Reflect Accepted

Accounting Procedures and May Be Manipulated

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Expense Ratio and Asset Utilization

• Net Income = Total Revenue – Total Operating Expenses - Taxes

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Expense Ratio and Asset Utilization• Asset Utilization (AU)

• Total Revenue/Average Total Assets

• Expense Ratio (ER)• Total Operating Expenses/Average Total Assets

• Tax Ratio (TAX)• Taxes/Average Total Assets

• The greater the AU and the lower the ER and TAX, the higher the ROA.

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Expense Ratio and Asset Utilization• Interest expense ratio

• Interest Expense/Average Total Assets

• Noninterest expense ratio • Noninterest Expense/Average Total Assets

• Provision for loan loss ratio• Provision for Loan Losses/Average Total Assets

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aTA

PLL

aTA

OE

aTA

IE

aTA

EXP ER


• Interest expense may vary for three reasons:• Rate effects means interest costs differ between banks.

• Banks pay different risk premiums indicating how the market perceives their asset quality and overall risk.

• Banks time their borrowings differently which impacts rates.

• Banks use different maturities which impacts rates.

• Composite effects because the mix of liabilities differ.

• Volume effects recognizes that interest expense is based on the amount of liabilities.

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• Noninterest Expense• Measures of personnel, occupancy and other operating

expenses as a percentage of total overhead indicate cost efficiencies or comparative disadvantages.

• Ratios are constructed to allow comparisons between different sized banks.

• May also vary based on composition of liabilities

• Banks with large amounts of transaction deposits have greater relative overhead costs.

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• Asset utilization (AU) is a measure of the institution’s ability to generate total revenue.

• The greater the AU, the greater the bank’s ability to generate income from the assets it owns.

• Interest income differs between banks for the same three reasons as interest expense: rate, composition and volume.

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aTA

SG

aTA

OI

aTA

II

aTA

TR UA


• Noninterest Income (OI)• Fees, fiduciary activities, service charges, trading

revenues and other noninterest income.

• May be skewed by substantial nonrecurring items.

• Tax payments also impact ROA.

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Aggregate Profitability Measures

• Net Interest Margin (NIM) is a summary measure of the net interest return on income-producing assets:

• Net Interest Income/Average Earning Assets

• Spread (SPRD) is a measure of the rate spread or funding differential on balance sheet items that earn or pay interest.

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

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Aggregate Profitability Measures

• Burden ratio measure the amount of noninterest expense covered by fees, service charges, securities gains and other income as a fraction of total assets.

• (Non-Interest Expense – Non-Interest Income)/Average Earning Assets

• Efficiency ratio measures a bank’s ability to control noninterest expense relative to total revenue net of interest expense.

• Non-Interest Expense/(Net Interest Income + Non-Interest Income)

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Managing Risks and Returns

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

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Credit Risk• Potential variation in net income from loan nonpayment

or deferred payment.• Net losses = gross losses (charge-offs) – recoveries (dollar

loans that were previously written off and collected).

• Expected future losses:• Past-due loans are still accruing interest.• Nonperforming loans are more than 90 days past due.• Nonaccrual loans are not currently accruing interest.• Restructured loans have modified payments or interest.• Classified loans have reserves for recognized losses.

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Credit Risk• Preparation for losses

• Ideally loan loss reserve should equal noncurrent loans.• GAAP and call reporting guidelines require adequate reserve to

cover the known and inherent risk in the portfolio.

• For taxes reserve is set by IRS rules which could lead to a conflict.

• Banks that lend in a narrow geographic area or to a certain industry risk concentration risk if economic conditions adversely affect the area of concentration.

• Institutions in high loan growth areas may assume greater risk due to less rigorous loan procedures.

• Country risk refers to risk of making international loans.

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Liquidity Risk

• Risk to earnings and equity from the bank’s inability to timely meet payments or obligations.

• Funding liquidity risk is the inability to liquidate assets or raise required funding.

• Market liquidity risk is the inability of the institution to easily unwind or offset specific exposures without significant losses from inadequate market depth or market disturbances.

• Liquid assets are costly to hold because they pay very low rates of interest.

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Liquidity Risk

• Banks attempt to minimize cash holdings due to the cost of holding.

• Liquid assets consist of unpledged, marketable short-term securities classified as available for sale plus federal funds sold and securities purchased under agreement to resell.

• Pledged securities cannot be sold without a release.

• Banks with large amounts of funding from core deposits have better liquidity than banks without them.

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Market Risk

• Risk to earnings and equity from adverse movements in market rates or prices.

• Interest rate risk is the potential variability in an institution’s net interest income and market value of equity due to changes in market interest rates.

• Analyzed using GAP and earnings sensitivity analysis.

• More comprehensive approach uses duration gap and economic value of equity sensitivity analysis.

• An asset or liability is rate sensitive if management expects it to be repriced (rate change) within a certain time period.

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Market Risk

• Equity and security price risk is the potential risk of loss associated with trading account portfolios.

• Large banks often conduct value-at-risk analyses to assess risk. Small banks conduct sensitivity analysis.

• Foreign exchange risk is the risk to an institution from adverse movements in foreign exchange rates.

• Most banks measure this risk by calculating measures of net exposure by each currency.

• Net exposure is the amount of assets minus the amount of liabilities denominated in the same currency.

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Operational Risk

• Possibility that operating expenses might vary significantly from what was expected.

• May occur as the result of:• Business interruptions

• Transaction processing

• Inadequate information systems

• Breaches in internal controls

• Client liability

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Legal and Reputation Risk

• Legal risk:• Risk that unenforceable contracts, lawsuits or adverse

judgments could disrupt or negatively affect the operations, profitability, condition or solvency of the institution.

• Reputation risk:• Risk that negative publicity, true or untrue, can adversely

affect a bank’s customer base or bring forth costly litigation that negatively affects profitability.

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Capital or Solvency Risk

• Not considered a separate risk because all of the other risks affect a bank’s capital and solvency.

• Capital risk refers to the potential decrease in the market value of assets below the market value of liabilities.

• A firm is formally insolvent when its net work is negative.

• Fundamentally a bank fails when it cash inflows are insufficient to meet mandatory cash outflows.

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Off-Balance Sheet Risk

• Refers to volatility in income and market value of equity from unanticipated losses due to off-balance sheet liabilities.

• Risk-based capital requirements oblige a bank to covert off-balance sheet activities to “on-balance” sheet equivalents and hold capital against them.

• Tier 1 (or core) capital is total common equity capital plus noncumulative preferred stock plus minority interest in unconsolidated subsidiaries less ineligible intangibles.

• Risk-weighted assets are the total of risk-adjusted assets.

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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

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The Fall in Bank Profitability During the Great Recession

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CAMELS Ratings

• Capital Adequacy:• Ability to maintain capital commensurate with the nature

and extent of all types of risk and management ability to identify, measure, monitor and control those risks.

• Asset Quality:• Reflects existing credit risk associated with the loan and

investment portfolio and off-balance sheet activities.

• Management Quality:• Adequacy of the board of directors and management

systems and procedures in managing risk.

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CAMELS Ratings

• Earnings:• Reflects the quality and trends in earnings and factors tha

may affect their sustainability.

• Liquidity:• Reflects the adequacy of current and prospective sources

of liquidity and funds-management practices.

• Sensitivity to Market Risk:• Reflects the degree to which changes in interest rates,

foreign exchange rates, commodity prices and equity prices can adversely affect earnings or economic capital.

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Performance Characteristics of Banks by Size• Commercial banks of different sizes exhibit sharply

different operating characteristics.• Some reflect government regulations.

• Some are associated with differences in markets served.

• Larger banks hold a larger % of assets in loans relative to deposits but a smaller % of earning assets.

• Smaller banks operate with proportionately more core deposits and fewer volatile liabilities.

• Lower earnings base of largest banks reflect de-emphasis of lending and increased emphasis on products and services and the generation of fee income.

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Financial Statement Manipulation• Off-Balance Sheet Activities

• Window Dressing

• Preferred Stock

• Nonperforming Loans

• Allowance for Loan Losses

• Securities Gains and Losses

• Nonrecurring Sale of Assets

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Chapter 3:AnalyzingBankPerformance

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classroom use.

fin 537 toolkit how do banks work? dr. ken cyree fall 2015

Documents

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