Chapter 2 Analyzing Bank Performance

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1 Chapter 2 Analyzing Bank Performance

2 Balance Sheet It is a statement of financial position listing assets owned, liabilities owed, and owner s equity as of a specific date. Assets = Liabilities + Equity. Balance sheet figures are calculated at a particular point in time and thus represent stock values.

3 China Big Four Banks (12/31/2002) v.s. All US Banks (12/31/2002) Asset (%) Liabilities(%) CN US CN US Loans Deposits Investments Borrowings Cash Other Capital 3.8 Total Total

4 PNC Bank (12/31/2000, TA: 63 bn) ) v.s. Community National Bank (12/31/00, TA: 0.1bn) Asset (%) Liabilities(%) PNC CNB PNC CNB Loans Deposits Investments Borrowings Cash Other Capital 8.3 Total Total

5 Bank Assets: Loans Loans are the major asset in most banks portfolios and generate the greatest amount of income before expenses and taxes. They also exhibit the highest default risk and are relatively illiquid.

6 Loans: Categories Real estate loans Commercial loans Loans to individuals Agricultural loans Other loans in domestic offices Loans and leases in foreign offices Three adjustments Leases; Unearned income; Loss allowance

7 PNC and CNB: Loan portfolio (2000) PNC CNB Real estate Commercial Individuals Agricultural Domestic other International Unearned income Loss allowance Total

8 Bank Assets: Investment securities Investment securities are held to earn interest, help meet liquidity needs speculate on interest rate movements serve as part of a bank s dealer functions. The administration and transaction costs are extremely low.

9 Bank Assets: Investment securities Short-term investments Interest-bearing bank balances (deposits due from other banks) federal funds sold securities purchased under agreement to resell (RPs) Treasury bills municipal tax warrants Long-term investment: notes and bonds Treasury securities Obligations of federal agencies Mortgage-backed, foreign, and corporate

10 Bank Assets: Noninterest cash and due from banks It consists of vault cash, deposits held at Federal Reserve Banks deposits held at other financial institutions cash items in the process of collection These assets are held to meet customer withdrawal needs meet legal reserve requirements assist in check clearing and wire transfers effect the purchase and sale of Treasury securities

11 Bank Assets: Other assets Other assets are residual assets of relatively small magnitudes such as bankers acceptances premises and equipment other real estate owned and other smaller amounts

12 Bank Liabilities The characteristics of various debt instruments differ in terms of check-writing capabilities interest paid maturity whether they carry FDIC insurance whether they can be traded in the secondary market.

13 Bank liabilities: Deposits Demand deposits transactions accounts that pay no interest Negotiable orders of withdrawal (NOWs) and automatic transfers from savings (ATS) accounts pay interest set by each bank without federal restrictions Money market deposit accounts (MMDAs) pay market rates, but a customer is limited to no more than six checks or automatic transfers each month

14 Bank liabilities: Deposits Two general time deposits categories exist: Time deposits in excess of $100,000, labeled jumbo certificates of deposit (CDs). Small CDs, considered core deposits which tend to be stable deposits that are typically not withdrawn over short periods of time. Deposits held in foreign offices balances issued by a bank subsidiary located outside the U.S.

15 Deposit interest rate: Big banks v.s. Small banks

16 Core doposits Core deposits are stable deposits that are not highly interest ratesensitive. Core deposits are more sensitive to the fees charged, services rendered, and location of the bank. Core deposits include: demand deposits, NOW accounts, MMDAs, and small time deposits.

17 Borrowings (volatile funds) Large, or volatile, borrowings are liabilities that are highly rate-sensitive. Normally issued in uninsured denominations. Their ability to borrow is sensitive to the markets perception of their asset quality. Volatile liabilities or net non-core liabilities include: large CDs (over 100,000) deposits in foreign offices federal funds purchased repurchase agreements other borrowings with maturities less than one year

18 Capital: Subordinated notes and debentures Notes and bonds with maturities in excess of one year. Long-term uninsured debt. Most meet requirements as bank capital for regulatory purposes. Unlike deposits, the debt is not federally insured and claims of bondholders are subordinated to claims of depositors.

19 Capital: Stockholders' equity Ownership interest in the bank. Common and preferred stock are listed at par Surplus account represents the amount of proceeds received by the bank in excess of par when it issued the stock.

20 Income Statement It is a financial statement showing a summary of a firm s financial operations for a specific period, including net profit or loss for the period in question. A bank s income statement reflects the financial nature of banking, as interest on loans and investments comprises the bulk of revenue. Net interest income made up approximately 77 percent of net revenue at a bank in 1981, but only about 58 percent of total net revenue at the end of 2001.

21 The Income statement + Interest income (II) - Interest expense (IE) = Net interest Income (NII) + Noninterest income (OI) =burden - Noninterest expense (OE) - Loan-loss provisions (PLL) = Operating income before securities transactions and taxes +(-) Realized gains or losses = Pretax net operating income - Taxes = Net income

22 Interest income the sum of interest and fees earned on all of a bank's assets. Interest income includes interest from: Loans Deposits held at other institutions Municipal and taxable securities Investment and trading account securities

23 Interest expense. the sum of interest paid on all interestbearing liabilities. It includes interest paid to transactions accounts (NOW, ATS, and MMDA) time and savings deposits short-term non- core liabilities long-term debt Interest income less interest expense is net interest income (NII)

24 Noninterest income Trust or fiduciary income reflects what a bank earns from operating a trust department Fees and deposit service charges reflect charges on checking account activity, safedeposit boxes, and many other transactions. Trading revenues reflect commissions and profits or gains from operating a trading account Other foreign transactions Other noninterest income

25 Noninterest expense Personnel expense: Salaries and fringe benefits paid to bank employees Occupancy expense : Rent and depreciation on equipment and premises Other operating expenses: Utilities and Deposit insurance premiums

26 Loan-loss provisions (PLL) Represent management's estimate of potential lost revenue from bad loans. It is subtracted from net interest income in recognition that some of the reported interest income overstates what will actually be received when some of the loans go into default. Charge-offs indicate loans that a bank formally recognizes as uncollectable and charges-off against the loss reserve.

27 Loan-loss provisions (PLL) The reserve s s maximum size is determined by tax. Provisions for loan losses Recoveries Tax Law Reserve for Loan Losses Charge offs

28 Realized securities gains (or losses) They arise when a bank sells securities from its investment portfolio at prices above (or below) the initial or amortized cost to the bank. Generally, securities change in value as interest rates change, but the gains or losses are unrealized (meaning that the bank has not sold the securities to capture the change in value).

29 Income statement: PNC &CNB, Interest income (II) 72% & 92% - Interest expense (IE) 38% & 27% = Net interest Income (NII) + Noninterest income (OI) 27% & 8% - Noninterest expense (OE) 35% & 46% - Loan-loss provisions (PLL) 2.1% & 1.7% = Operating income before securities transactions and taxes +(-) Realized gains or losses 0.3% & 0% = Pretax net operating income - Taxes 8.5% & 8.6% = Net income 16.3% & 16.0%

30 Relationship between balance sheet and income statement The composition of assets and liabilities and the relationships between different interest rates determine net interest income. The mix of deposits between consumer and commercial customers affects the services provided and thus the magnitude of noninterest income and noninterest expense. The ownership of nonbank subsidiaries increases fee income but often raises noninterest expense.

31 Relationship between balance sheet and income statement Expenses and loan losses directly effect the balance sheet. The greater the size of loan portfolio, the greater is operating overhead and PLL. Consumer loans are usually smaller and hence more expensive (non-interest) per dollar of loans.

32 Return on equity (ROE = NI / TE) the basic measure of stockholders returns ROE is composed of two parts: Return on Assets (ROA = NI / TA) represents the returns to the assets the bank has invested in. Equity Multiplier (EM = TA / TE) the degree of financial leverage employed by the bank. NI TA ROE = = ROA TA TE EM

33 Return on assets (ROA = NI / TA) can be decomposed into two parts: Asset utilization (AU) income generation Expense ratio (ER) expense control ROA = AU - ER = (TR / TA) - (TE / TA) TR = total revenue or total operating income = Int. inc. + non-int. inc. + SG(L) TE = total expenses = Int. exp. + non-int. exp. + PLL + Taxes

34 Bank Performance Model Returns to to Shareholders ROE = NI NI // TE TE INCOME Interest Non Interest Rate Composition (mix) Volume Fees and Serv Charge Trust Return to the Bank ROA = NI / TA EXPENSES Degree of Leverage EM = 1 / (TA / TE) Interest Overhead Prov. for LL Taxes Other Rate Composition (mix) Volume Salaries and Benefits Occupancy Other

35 Asset utilization (AU = TR / TA): the ability to generate income. Interest Income / TA Asset yields (rate) Interest income asset (i) / $ amount of asset (i) Composition of assets (mix) $ amount asset (i) / TA Volume of Earning Assets Earning assets / TA Non interest income / TA Fees and Service Charges Securities Gains (Losses) Other income

36 Expense ratio (ER = Exp / TA) the ability to control expenses. Interest expense / TA Cost per liability (rate) Int. exp. liab. (j) / $ amt. liab. (j) Composition of liabilities $ amt. of liab. (j) / TA Volume of debt and equity Non-interest expenses / TA Salaries and employee benefits / TA Occupancy expenses / TA Other operating expense / TA Provisions for loan losses / TA Taxes / TA

37 Other aggregate profitability measures Net interest margin NIM = NII / earning assets (EA) Spread Spread = (int inc / EA) (int exp / int bear. Liab.) Earnings base EB = EA / TA Burden / TA (Noninterest exp. - Noninterest income) / TA Efficiency ratio Non int. Exp. / (Net int. Inc. + Non int. Inc.)

38 Capital C: signals the ability to maintain capital commensurate with the nature and extent of all types of risk and the ability of management to identify, measure, monitor, and control these risks.

39 Asset A: reflects the amount of existing credit risk associated with the loan and investment portfolio as well as off balance sheet activities.

40 Management M: reflects the adequacy of the board of directors and senior management systems and procedures to identify, measure, monitor, and control risks.

41 Earnings E: reflects not only the quantity and trend in earnings, but also the factors that may affect the sustainability or quality of earnings.

42 Liquidity L: reflects the adequacy of the bank's current and prospective sources of liquidity and funds management practices

43 Sensitivity S: reflects the degree to which changes in interest rates, foreign exchange rates, commodity prices, and equity prices can adversely affect earnings.

44 Performance Characteristics of Different- sized Banks: Trend with Size Return on equity Return on assets <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b 0

45 Equity capital ratio <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

46 Core capital (leverage) ratio <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

47 Tier 1 risk-based capital ratio <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

48 Total risk-based capital ratio <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

49 Net interest margin <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

50 Yield on earning assets <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

51 Cost of funding earning assets <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

52 Earning assets to total assets <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

53 Efficiency ratio <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

54 Noninterest income to earning assets <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

55 Noninterest expense to earning assets <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

56 LN&LS loss provision to assets <0.1b 0.1~0.3b 0.3~0.5b 0.5~1b 1-10b >10b

57 US Banks: ROA (2002) All banks: 1.33% Ten largest Ranked Ranked Ranked

58 US Banks: ROE (2002) All banks: 14.51% Ten largest Ranked Ranked Ranked

59 US & Chinese Banks: ROA (2002) All U.S. Banks ICBC BOC ABC CCB

60 US & Chinese Banks: ROE (2002) All U.S. Banks ICBC BOC ABC CCB

61 Thank You Very Much for Your Kind Attention!

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

Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonald Copyright 2006 by South-Western, a division of Thomson Learning ANALYZING BANK PERFORMANCE: USING THE UBPR Chapter 2 William Chittenden