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Chapter 1 Banking and the Financial Services Industry 1.

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1 Chapter 1 Banking and the Financial Services Industry 1

2 Credit Crisis of 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 2

3 Credit Crisis of Collapse and/or Failure of: Bear Stearns Lehman Brothers Countrywide Washington Mutual Wachovia 3

4 Credit Crisis of 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

5 Credit Crisis of 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 5

6 Credit Crisis of 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 6

7 7 Credit Crisis of

8 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 8

9 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 9

10 How Do Banks Differ? 10

11 How Do Banks Differ? 11

12 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 12

13 How Do Banks Differ? 13

14 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 14

15 How Do Banks Differ? Financial Holding Companies 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 15

16 How Do Banks Differ? Financial Holding Companies 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 16

17 How Do Banks Differ? 17

18 How Do Banks Differ? Holding Company Financial Statements The consolidated financial statements of a holding company and its subsidiaries reflect aggregate or consolidate performance 18

19 How Do Banks Differ? 19

20 How Do Banks Differ? 20

21 How Do Banks Differ? 21

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23 How Do Banks Differ? 23

24 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 24

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26 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 26

27 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 27

28 Organizational Structure and Financial Services Business Model S-Corporation Banks 28

29 Organizational Structure and Financial Services Business Model 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 29

30 Organizational Structure and Financial Services Business Model 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 30

31 Organizational Structure and Financial Services Business Model 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 31

32 Organizational Structure and Financial Services Business Model 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 32

33 Organizational Structure and Financial Services Business Model 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 33

34 Organizational Structure and Financial Services Business Model 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 34

35 Organizational Structure and Financial Services Business Model 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 35

36 Organizational Structure and Financial Services Business Model 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 36

37 Organizational Structure and Financial Services Business Model 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 37

38 Organizational Structure and Financial Services Business Model 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 38

39 Organizational Structure and Financial Services Business Model 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 39

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41 Different Channels for Delivering Banking Services Branch Banking Automated Teller Machines Internet (Online) Banking Call Centers Mobile Banking 41

42 Chapter 2 Banking and the Financial Services Industry 42

43 Government Policies and Regulation 43

44 Historical Bank Regulation Glass-Steagall Act ( ) Created three distinct industries Commercial Banking Investment Banking Insurance 44

45 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 45

46 Historical Bank Regulation Changes in: Products and Services MMMFs LPOs Commercial Paper Junk Bonds Payment Methods 46

47 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 47

48 Ensure Safety & Soundness and Provide an Efficient & Competitive System Supervision and Examination FDIC OCC 48

49 Ensure Safety & Soundness and Provide an Efficient & Competitive System Supervision and Examination CAMELS Capital Asset Quality Management Quality Earnings Quality Liquidity Sensitivity to Market Risk 49

50 Ensure Safety & Soundness and Provide an Efficient & Competitive System Supervision and Examination Memorandum of Understanding Formal regulatory document Cease and Desist Order Legal document Has legal standing 50

51 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 51

52 Ensure Safety & Soundness and Provide an Efficient & Competitive System New Charters State Banking Authorities Charter state banks State Savings Authorities Charter state savings banks State Credit Union Authorities Charter state credit unions 52

53 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 53

54 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 54

55 Ensure Safety & Soundness and Provide an Efficient & Competitive System 55

56 Ensure Safety & Soundness and Provide an Efficient & Competitive System 56

57 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 57

58 Ensure Safety & Soundness and Provide an Efficient & Competitive System Commercial Banks, Savings Institutions, and Credit Unions Credit Unions “Common Bond” requirement Exempt from Federal Taxation 58

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60 Ensure Safety & Soundness and Provide an Efficient & Competitive System Farm Credit System Farm Credit Administration 4 Farm Credit Banks 81 Agricultural Credit Associations 9 Federal land Credit Associations 1 Agricultural Credit Bank 60

61 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 61

62 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 62

63 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 63

64 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 64

65 Ensure Safety & Soundness and Provide an Efficient & Competitive System Federal Deposit Insurance Federal Deposit Insurance Corporation Receiver of failed institutions  Liquidate  Sell Too Big to Fail Policy 65

66 Ensure Safety & Soundness and Provide an Efficient & Competitive System Product Restrictions: Depository Institutions versus Non-Depository Institutions Banks are restricted on what products and services they can offer nkAct.pdf nkAct.pdf 66

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68 Ensure Safety & Soundness and Provide an Efficient & Competitive System Activities Permissible for a National Bank General Banking Activities Branching Consulting and financial advice Corporate governance Correspondent service Finder activities Leasing Lending Payment services 68

69 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 69

70 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 70

71 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 71

72 Ensure Safety & Soundness and Provide an Efficient & Competitive System 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 72

73 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 73

74 Maintaining Monetary Stability and the Integrity of the Payments System The Role of the Central Bank in the Economy: The Federal Reserve System Organization Board of Governors 12 Federal Reserve District Banks 74

75 Maintaining Monetary Stability and the Integrity of the Payments System 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 75

76 Maintaining Monetary Stability and the Integrity of the Payments System The Role of the Central Bank in the Economy: The Federal Reserve System Monetary Policy Discount Rate  Decreasing (Increasing) the discount rate makes bank borrowing less (more) expensive, which leads to an increase (decrease) in the money supply 76

77 Maintaining Monetary Stability and the Integrity of the Payments System The Role of the Central Bank in the Economy: The Federal Reserve System Monetary Policy Reserve Requirements  Decreasing (Increasing) reserve requirements increases (decreases) the money supply  Last changed April

78 Maintaining Monetary Stability and the Integrity of the Payments System The Federal Reserve’s Crisis Management Tools Term Auction Facility Term Securities Lending Facility Primary Dealer Credit Facility 78

79 Maintaining Monetary Stability and the Integrity of the Payments System 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 79

80 Maintaining Monetary Stability and the Integrity of the Payments System 80

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82 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 82

83 Efficient and Competitive Financial System Organizational Form of the Banking Industry Bank Holding Companies Parent Subsidiaries One-Bank Holding Companies Mutli-Bank Holding Companies 83

84 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 84

85 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

86 Efficient and Competitive Financial System Key Federal Legislation 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 86

87 Efficient and Competitive Financial System Key Federal Legislation 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) 87

88 Efficient and Competitive Financial System Key Federal Legislation 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) 88

89 Efficient and Competitive Financial System Key Federal Legislation 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

90 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 90

91 Efficient and Competitive Financial System Current Unresolved Regulatory Issues Regulatory Reform Regulation of depository institutions is highly fragmented  Federal Reserve  OCC  OTS  FDIC  NCUA 91

92 Efficient and Competitive Financial System Current Unresolved Regulatory Issues 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 92

93 Efficient and Competitive Financial System Current Unresolved Regulatory Issues 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 93

94 Chapter 3 Analyzing Bank Performance 94

95 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 95

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97 Analyzing Bank Performance Depository Institution Failures Over 1,500 bank failures between 1985 and in 2005 or in 2007 Sharp increase in 2008 and in through mid-August

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 98

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 99

100 Commercial Bank Financial Statements Bank Assets Loans Real Estate Commercial Individual Agricultural Other loans in domestic offices Loans and leases in foreign offices 100

101 Commercial Bank Financial Statements Bank Assets 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 101

102 Commercial Bank Financial Statements Bank Assets Investment Securities Short-Term Investments  One year or less  Examples:  Interest-Bearing Deposits Due from Other Banks  Fed Funds Sold  Reverse Repos  T-Bills 102

103 Commercial Bank Financial Statements Bank Assets 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 103

104 Commercial Bank Financial Statements Bank Assets Investment Securities Held-to-Maturity Trading Account Available-for-Sale 104

105 Commercial Bank Financial Statements Bank Assets 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 105

106 Commercial Bank Financial Statements Bank Assets 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 106

107 Commercial Bank Financial Statements Bank Assets 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 107

108 Commercial Bank Financial Statements Bank Assets 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 108

109 Commercial Bank Financial Statements Bank Assets Other Assets Bank Premises OREO  Often foreclosed property Banker’s Acceptances 109

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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 112

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 113

114 Commercial Bank Financial Statements Bank Liabilities and Stockholder’s Equity Savings and Time Deposits Savings Deposits  No Maturity Time Deposits (CDs)  “Large” or Jumbo CDs  Negotiable  “Small” CDs 114

115 Commercial Bank Financial Statements Bank Liabilities and Stockholder’s 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 115

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 116

117 Commercial Bank Financial Statements Bank Liabilities and Stockholder’s Equity Non-Core Deposits Deposits that are very interest rate sensitive AKA  Volatile Liabilities  Hot Money  Purchased Liabilities  Short-Term Non-Core Funding 117

118 Commercial Bank Financial Statements Bank Liabilities and Stockholder’s Equity Non-Core Deposits Consist of:  Federal Funds Purchased  Repos  “Large” Time Deposits  Brokered Time Deposits 118

119 Commercial Bank Financial Statements Bank Liabilities and Stockholder’s Equity All Common and Preferred Equity Preferred Stock Common Stock 119

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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 123

124 Commercial Bank Financial Statements Income Statement 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 124

125 Commercial Bank Financial Statements Income Statement Interest Income (II) minus Interest Expense (IE) equals Net Interest Income (NII) 125

126 Commercial Bank Financial Statements Income Statement 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) 126

127 Commercial Bank Financial Statements Income Statement Non-Interest Expense (OE) Includes:  Personnel  Occupancy  Technology  Utilities  Deposit Insurance Premiums  Intangible Amortizations  Goodwill Imparement 127

128 Commercial Bank Financial Statements Income Statement 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 128

129 Commercial Bank Financial Statements Income Statement 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 129

130 Commercial Bank Financial Statements Income Statement 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 130

131 Commercial Bank Financial Statements Income Statement Net Interest Income (NII) minus Burden minus PLL plus Realized Security Gains (Losses) (SG) equals 131

132 Commercial Bank Financial Statements Income Statement Pre-Tax Net Operating Income (te) minus Taxes (T) minus Extraordinary Items equals Net Income (NI) 132

133 Commercial Bank Financial Statements Income Statement Total Revenue (TR) or Total Operating Income (TOI) Includes:  Interest Income  Non-Interest Income  Realized Security Gains (Losses) Analogous to Net Sales 133

134 Commercial Bank Financial Statements Income Statement Total Operating Expense (EXP) Includes  Interest Expense  Non-Interest Expense  PLL Analogous to COGS + Operating Expenses 134

135 Commercial Bank Financial Statements Income Statement NI = NII – Burden – PLL + SG – T 135

136 Relationship Between Balance Sheet & Income Statement A i = Dollar magnitude of the i th asset L j = Dollar magnitude of the j th liability NW = Dollar magnitude of equity y i = Average pre-tax yield on the i th asset c j = Average pre-tax cost on the j th liability 136

137 137 Relationship Between Balance Sheet & Income Statement

138 Net Interest Income Changes with changes in: Composition Volume 138

139 Return on Equity Model Profitability Analysis Return on Equity (ROE) Return on Assets (ROA) 139

140 Return on Equity Model Profitability Analysis Return on Equity Net Income/Average Total Equity ROA x EM  Net Income/Average Total Assets x Average Total Assets/Average Total Equity 140

141 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

142 Return on Equity Model Expense Ratio and Asset Utilization Net Income/Average Total Assets ROA = AU – ER – TAX 142

143 Return on Equity Model Expense Ratio and Asset Utilization Expense Ratio (ER) Total Operating Expense/Average Total Assets  EXP/aTA 143

144 Return on Equity Model Expense Ratio and Asset Utilization Expense Ratio (ER) IE can change due to changes in:  Volume  Different levels of liabilities versus equity  Composition  Different mix of liabilities  Rates 144

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 145

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) 146

147 Return on Equity Model Income: Asset Utilization Components 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 Rates 147

148 Return on Equity Model Income: Asset Utilization Components Non-Interest Income (OI) OI can change due to changes in:  Fees  Trust Activities  Service Charges  Other Non-Interest Income 148

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 149

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 150

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152 Managing Risks and Returns Risk Management Credit Risk Liquidity Risk Market Risk Operational Risk Reputation Risk Legal Risk 152

153 Managing Risks and Returns Risk Management Credit Risk Historical Loss Rate  Gross Loan Losses (Charge-offs)  Recoveries  Net Losses  Charge-offs - Recoveries 153

154 Managing Risks and Returns Risk Management Credit Risk Expected Future Losses  Past-Due Loans  Interest and Principal has not been paid but it is still accruing interest  days  90 days and over  Non-Performing Loans  90 days or more past-due  Non-Accrual Loans  Not accruing interest 154

155 Managing Risks and Returns Risk Management 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 155

156 Managing Risks and Returns Risk Management 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 156

157 Managing Risks and Returns Risk Management Credit Risk Preparation for Losses  Lack of Diversification  High Loan Growth  Country Risk 157

158 Managing Risks and Returns Risk Management Liquidity Risk Funding Liquidity Risk  Inability to liquidate assts or raise required funding Market Liquidity Risk 158

159 Managing Risks and Returns Risk Management 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 159

160 Managing Risks and Returns Risk Management 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 160

161 Managing Risks and Returns Risk Management Market Risk Equity and Security Price Risk Foreign Exchange Risk  Foreign Currency Translation Risk  Commitments and Guarantees denominated in a foreign currency 161

162 Managing Risks and Returns Risk Management Operational Risk Business Interruptions Transaction Processing Inadequate Information Systems Breaches in Internal Controls Client Liability Legal Risk Reputation Risk 162

163 Managing Risks and Returns Risk Management 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 163

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

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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 170

171 Maximizing the Market Value of Bank Equity CAMELS Ratings Capital Adequacy Asset Quality Management Quality Earnings Liquidity Sensitivity to Market Risk 171

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 172

173 173

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 174

175 175

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 176

177 Analyzing Bank Performance 177


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