BANK FINANCIAL STEMENTS Bank Assets Cash and due from banks Vault cash, deposits held at the Fed and other financial institutions, and cash items in the process of collection Investment Securities Bonds, notes, and other securities held to generate return and help meet liquidity needs Loans Commercial, consumer, RE, agricultural, etc. Generate most of interest income; highest default risk Other assets Bank premises and equipment, interest receivable, prepaid epenses, other real estate owned 4 2 The Balance Sheet Conceptually Assets Liabilities + Equity Most items epressed in book-value terms Balance Sheet: Record of what we own and how we financed whatever we have acquired Assets: What we own Liabilities: What we have borrowed (debt) Equity Capital: The shareholder s financial interest Bank Securities Types Treasuries; Agencies; Mortgage backed; Other asset backed; Corporate; State and local Balance Sheet Value Held to maturity securities recorded on the balance sheet at amortized cost Trading account securities actively bought and sold marked to market on balance sheet and gains and losses reported on income statement Available for sale recorded at market value on balance sheet with a corresponding change to stockholders equity as value changes; no income statement impact 5 Cash & Due from Banks Investment Securities Loans Other Assets Balance Sheet Deposits Non interest Bearing Interest Bearing Purchased Liabilities Fed Funds Repos Other S T Liab LT Sub. Debt Equity Accounts Types of Loans UBPR Classifications Real Estate Loans Commercial Loans Individual Loans Agricultural Loans Other Loans and Leases in Domestic Offices Loans and Leases in Foreign Offices 6 3 1
Complication: Accounting for Credit Risk Loans on the balance sheet are net loans Net loans gross loans loan loss reserve (LLR) LLR reserve is a balance sheet item (Contra Account on the asset side) Good news: LLR belongs to the shareholders Bad news: LLR is money the bank epects to lose 7 Role of Deposits Primary source of funding for banks 60+ percent of assets, and about 90 percent for community banks Stable relationship between interest bearing and non interest bearing Mi of deposits changes as the economy changes, but in largely unpredictable ways 10 Sources of Funding Core deposits Deposits of relationship driven customers Purchased funds Acquired in the money markets on an impersonal basis Competitive interest rates Long term funding Borrowing from the Federal Home Loan Banks Capital notes and debentures Equity 8 Other Borrowings Purchased liabilities (rate sensitive): Federal Reserve (discount window) borrowing Federal Funds Purchased Repurchase agreements Negotiable CDs and other borrowings Subordinated notes and debentures Historically, from least to most epensive Demand deposits Savings deposits Time deposits Purchased liabilities 11 Checking accounts Savings accounts Time Deposits Small time deposits Large time deposits Deposits Core Deposits Stockholders equity Ownership interest in the bank Common and preferred stock listed at par Surplus account represents the amount of proceeds received by the bank in ecess of par when it issued the stock Retained earnings equals accumulated net income not paid out as cash dividends 9 12 2
Common Size Financial Statements Initial comparison ratios Financial statements that display all items relative to a common base (such as total assets) Allows quick identification of differences Over Time Across Banks Across Groups 13 Noninterest income Fiduciary activities Managing and protecting a customer s property Recordkeeping for security transactions Managing pension and retirement plans Service charges Fees for maintenance, overdraft, stop payments Other Investment banking Venture capital revenue Insurance commission fees 16 Income Statement Interest Income Interest Epense Net Interest Income Provision for Loan Losses + Noninterest Income Noninterest Epense + Gains/Losses on Secs Preta Earnings Taes Net income 14 Noninterest Epense Personnel epense Salaries and benefits paid to bank employees Occupancy epense Rent and depreciation on equipment and premises, and Other operating epenses Utilities Deposit insurance premiums Burden Non Interest Epense Non Interest Income 17 Income Statement Items Net interest income is interest income minus interest epense Interest income: interest income and fees earned on loans and leases, deposits held at other institutions, securities, fed funds sold Interest Epense: interest paid on deposits, fed funds purchased, Repos, other borrowings, and sub. notes and debentures Provision for Loan Losses Noncash epense representing funds put aside to prepare for bad loans Why use ratios? Standardize numbers; facilitate comparisons The most common comparison norms are: Past performance Other banks (peer or target banks; industry (or peer group) average/median) Look at trends over time (trend analysis) for clues to whether a bank s financial condition is likely to improve or to deteriorate 15 18 3
Warning! Be careful not to infer too much from a ratio Changes often affect multiple ratios differently Accounting discretion makes a difference Approaches to loan loss epenses & write offs Calculating ratios is mechanical and their relationships are often mechanical, but interpreting underlying causes is not Ratios help you ask the right questions, but by themselves, they rarely give you all the answers Analyzing Return Commonly use system that decomposes changes in ROA/ROE Identifies drivers of profitability performance Illustrates connection between drivers and final performance results Useful at all levels of performance analysis Industry Bank Line of business 19 22 Key Notions Balance sheet helps drive income statement The drivers: - Earning assets growth - Net portfolio yield (net interest margin) - Asset quality Complement: High efficiency Icing on the cake: Capital gains 20 How Do We Measure Return? ROE NetIncome Equity Return on Equity Amount of net income generated by each book value dollar of shareholder equity ROA NetIncome Assets Return on Assets Amount of net income generated by each book value dollar of assets 23 Recipe for Increased Earnings Increase net interest income - Increase earning assets - Increase net interest margin Shrink the burden - Increase non interest income - Reduce non interest epense Reduce the loan loss provision Increase capital gains Pay less taes 21 Use Balance Sheet Averages The income statement represents the results over a period of time such as one year The balance sheet represents a point in time Use average balance sheet values from corresponding dates of the income statement For eample: Equityt Equityt 1 AverageEquity 2 24 4
Return on Equity ROE and ROA are related through degree of financial leverage (EM Equity multiplier) ROE Net Income Equity Alternative Breakdown of ROA Net Int Inc NII Int Inc Int Ep Burden Non IE Non II - (Net Non II) ROA Net Income Assets X EM Assets Equity ROA NII Burden PLL G/L + X EM Assets Equity 1 Equity ratio 25 28 Strategic Relationship Equity Equity Ratio Mult. Eq/ /Eq ROA ROE 5.00% 20.0 1.50% 30.0% 6.00% 16.7 1.50% 25.0% 7.00% 14.3 1.50% 21.4% 8.00% 12.5 1.50% 18.8% Higher financial leverage (lower equity) increases ROE 26 Net Interest Margin Int Inc EA ( EA Yield on Earning Assets NII to Breakdown NII NII Earning Assets EA Earnings Base Int Ep IBL ) ( IBL ) Cost Rate on Interest Bearing Liabilities 29 Net Income Income Statement Revenue Epense Interest Income Interest Epense Net Interest Income Provision for Loan Losses + Noninterest Income Noninterest Epense + Gains/Losses on Secs Preta Earnings Taes Net income 27 Net Interest Margin and Spread Net Interest Margin Spread Int Inc EA Int Inc EA Int Ep IBL Spread and NIM are important in evaluating a bank s ability to manage interest rate risk As rates change, interest income and epense change Variation in NIM and Spread indicate whether a bank positioned itself to handle rate changes Epected changes in NIM and Spread are eamined to access a bank s eposure to interest rate risk GAP and Earnings Sensitivity Analysis 30 Int Ep EA 5
Net Interest Income to If NII to is low, then: Yield on Earning Assets is low, and/or Earnings Base is low, and/or Cost Rate on IBL is high, and/or IBL/ is high If NII to is high, then: Yield on Earning Assets is high, and/or Earnings Base is high, and/or Cost Rate on IBL is low, and/or IBL/ is low PLL Provision for Loan Losses PLL Loans Provision for Loan Losses Funds put aside to prepare for bad loans Large PLL / Loans may indicate New risky loans Overall risk of loan portfolio (catch up) Safety conscious management Loans 31 34 Yield on Earning Assets Individual asset yields (average rate earned) Maturity/Repricing Timing Default risk Composition of assets (mi) Size of holdings across and within major categories Burden Burden Non Int Ep Non Int Inc Burden indicates the remaining epense that must be covered by income from other areas of the bank Taking the ratio of non interest epense and income items to average assets allows easier comparison 32 35 Interest Epense to Assets Cost per liability (average rate paid) Differences in risk premiums Timing of borrowing Maturity of borrowing Pricing epertise Composition of liabilities Size of holdings across and within various types of liabilities Burden Components Non Interest Epense Personnel Occupancy Technology Utilities Deposit Insurance Premiums Intangible Amortizations Goodwill Impairment 33 36 6
Non Interest Epense Personnel Personnel # Employees If Personnel / is high, then: Personnel / # employees is high, and/or # Employees / is high Occupancy Occupancy # Branches If Occupancy / is high, then: Occupancy / # Branches is high, and/or # Branches / is high # Employees # Branches G/L Gains/Losses on Securities G/L SEC Gains/Losses relative to level of securities and securities as percentage of assets Further breakdowns by category Importance of potential gains/losses? SEC Composition effects may eist More deposits then more overhead 37 40 Burden Components Non Interest Income 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) X X Taable Inc Taes If Taes/ is high, then: The ta rate may be high Increase over time could indicate ta rate changes or different ta rate environments Revenue may be high Good by itself Taable income may be high Less use of ta advantaged assets Taable Inc REV REV 38 41 Non II Non Interest Income Fid Fees + Dep Svc Fee income measured relative to asset categories or number of employees Deposit service charges to Deposits Other Breakdown of categories to reveal results of focus areas + Putting It All Together Ratios help you identify differences, eamine their origin, and ask the right questions to determine if there is a problem Analysis: Move from general to specific ROE is low Why? Profit Margin is low Why? Interest Epense/ is high Why?»Is this a problem that needs to be fied? Often goes in opposite direction for forecasts 39 42 7
Peer and Trend Comparisons Compare your ratios to those of your peers Make sure you choose your peers carefully to get a meaningful comparison Be aware of differences in strategies that result in differences between you and your peers Compare your ratios this period to those for previous periods How and why did ratios change? Be aware of changes in strategy over time Decomposing ROE (ROE Tree) Net Int. Margin - Burden/EA Preta Return on EA * EA/ - LLP/EA -Income Taes/ ROA * /Eq ROE +Gain or Loss to EA 43 46 Avoiding Problems Make decisions with goals in mind Budgeting and planning built around model Short and long term objectives Short and long term strategies Respond to changes to create fleible strategies Quantify goals and eamine results Ratios can help give a quick summary of epected performance Are you headed in the direction you want? Financial Statement Shortcomings Off balance sheet activities Derivative contracts may have massive notional values that are not reflected in traditional measures Window dressing Timing of asset/liability adjustments may impact reported numbers Accounting Differences Leeway in accounting reporting rules often make comparisons difficult 44 47 Actual vs. Forecast/Budget Compare actual ratios to forecasted figures Are we doing what we thought we would? Why are there deviations? Are changes necessary? Provides a control mechanism (and reality check) that increases accountability Do not look at any ratio in isolation Change may solve one problem, but create another or not be consistent with overall strategy Consider interrelationships Do not forget risk! Risk Considerations Many times it is not difficult to increase epected return. However, the additional return may come at the cost of added risk. Is the risk return tradeoff reasonable? 45 48 8
Fundamental risks Credit risk Liquidity risk Market risk Interest rates Foreign echange rates Equity, commodity, and security prices Operational risk Capital or solvency risk Legal risk Reputational risk 49 Market Risk Risk to a financial institution s condition resulting from adverse movements in market rates or prices Market risk arises from changes in: Interest rates GAP; Duration GAP; Sensitivity Analysis Foreign echange rates Often off balance sheet Equity, commodity, and security prices Value at risk analysis 52 Credit Risk Potential variation in net income and market value of equity resulting from nonpayment or delayed payment on loans and securities What is the bank s loss eperience? Gross losses, net losses, and recoveries to average total loans and leases What future losses are epected/possible? Non current, total past due, and restructured loans to total loans Is the bank prepared? Provision for loan loss to average assets and loans Allowance for loan losses to net losses and total loans 50 Capital Risk Closely tied to asset quality and a bank's overall risk profile The more risk taken the greater is the amount of capital required Many capital measures are carefully monitored Tier 1 capital and total risk based capital to riskweighted assets Equity capital to total assets Dividend payout and growth rate in tier 1 capital 53 Liquidity Risk Variation in net income and market value of equity caused by difficulty in obtaining cash at reasonable cost from the sale of assets or new borrowings Liquidation of assets Composition of loans & investments Maturity of loans & investments Percent of loans and investments pledged as collateral Borrowing Core deposits Volatile deposits Asset quality & stockholders equity Operational Risk Cost efficiency of the bank's activities and whether proper procedures and systems eist Typical ratios focus on: Total assets per employee Total personnel epense per employee Non interest epense ratio There is really no meaningful way to estimate the likelihood of fraud or other contingencies from published data A bank s operating risk is closely related to its operating policies and processes and whether it has adequate controls 51 54 9
Legal Risk Potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of the banking organization Legal risk includes Compliance risks Strategic risks General liability issues 55 Reputational Risk Potential that negative publicity regarding an institution s business practices (whether true or not) will cause: Decline in customer base Costly litigation Revenue reductions 56 10