1. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-1 Depository Institution Performance and Risk Analysis Chapter 4

2. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-2 Why Financial Analysis Is Important? Financial services industry is becoming more competitive Achieving financial goals is critical to survival and is aided by An affective planning process Establishing performance criteria Measuring progress towards those criteria It is required by the disclosures laws for publicly held firms

3. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-3 Sources of Industry Information Federal Financial Institutions Examination Council (FFIEC) Website Uniform Bank Performance Report ( UBPRs) National Information Center (NIC) Call Reports FDIC Bank Data & Statistics Website National Credit Union Administration Website Other Federal Reserve Bank Website Bank Rating Services Other Sources of Financial Information Enforcement Actions and Orders

4. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-4 Commercial Bank Report of Income Interest income Less Interest expense = Net Interest income (NII) Less Provision for loan losses (PLL) Less Burden (non-interest expenses – noninterest income) Equals Traditional Operating Profit, or Traditional Operating Profit = NII – PLL – Burden

5. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-5 Types of Assets and Liabilities Held by All FDIC - Insured Banks on Average

6. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-6 Types of Assets and Liabilities Held by All FDIC - Insured Banks on Average

7. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-7 Trends in Balance Sheet Composition: 1950 to 2003 Over this period Percent of assets held as loans has increased Percent of assets financed by deposits has decreased Banks lost deposits to money market funds and mutual funds Banks equity-to-asset ratio increased

8. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-8 Types of Bank Assets Cash and due Investment securities Fed funds sold & reverse repo agreements Assets in Trading Accounts Loans (as a percentage of assets) 58.28% Individuals09.36% Commercial & Industrial11.76% Real Estate30.41% Farm00.62% Other06.11%

9. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-9 Types of Liabilities & Equity Bank Liabilities Deposits66% Other liabilities25% ◦ Short term ◦ Long term Equity Capital 9% Common stock Surplus Undivided profits Other equity & reserves

10. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-10 Layout of the Income Statement Interest revenue Interest expense Net interest income (NII) Provision for loan losses (PLL) Noninterest revenue (NIR) Noninterest expense (NIE) Burden (BUR = NIE – NIR) Pretax net operating income (NII – PLL – BUR) Gains (Losses) on Securities and Net Extraordinary Items Net Income

11. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-11 ROA & ROE Effect on ROA of NIM, Provision for Loan Losses, and Burden NI=(NII – PLL – Burden) (1-t) ROA = (NIM – PLL% - Burden%) (1-t) ROE = ROA * EM

12. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-12 Figure 4.6 Page 145

13. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-13 Figure 4.7 Page 146

14. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-14 Forecasting NIM Based on a Target ROA Target ROA = (NIM – PLL% - Burden%)(1 – t) Pretax ROA = after-tax ROA/(1 – t) Pretax ROA = (NIM – PPL% - Burden%) Target NIM = [ROA/(1 – t)] + PPL% + Burden% NIM = IR% - IE% Given any two, you can solve for the remaining one.

15. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-15 Forecasting NIM Based on a Desired Target of ROE ROE = ROA * EM Target NIM = {[ROE/(1 – t)]/EM} + PPL% + Burden%

16. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-16 Analyzing Trends over Time Table 4.4 (page 148) NPM * AU = ROA ROA * EM = ROE Trends in ROA, EM, and ROE over time Components of ROA and ROE reveal ◦ Sources of change in performance measures ◦ Areas which need improvement

17. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-17 Table 4.4 Page 148

18. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-18 Overview of a Depository Institution’s Performance using a UBPR A More Detailed Analysis of a Depository Institution using UBPRS I.Overall Profitability Ratios II.Earnings and Profitability Analysis III.(NIM) Margin Analysis IV.Yield or Cost of Analysis V.Balance Sheet % Composition of Assets and Liabilities VI.Analysis of Noninterest Expenses as a Percent of Average Assets

19. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-19 UPBR Risk Ratios Credit Risk Composition of asset portfolio Net loan rates, net charge-offs, noncurrent loan rates Loan loss provision, earnings coverage, loan loss allowance Liquidity risk Capital risk Interest rate risk See Table 4.6

20. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-20 A Performance and Risk Evaluation Illustrated for Wells Fargo Wells Fargo Peer Comparison for 2002 and 2003: DuPont Analysis See Table 4.7 Earnings and Profitability Analysis: Peer Comparison 2002 and 2003 NIM Overview Yields to Assets Cost of (Interest Paid on) Liability Rates Asset and Liability Mix Analysis Asset Mix Liability Mix Analysis Burden

21. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-21 A Performance and Risk Evaluation Illustrated for Wells Fargo Risk Comparison with Peers See Table 4.8 Credit Risk Liquidity Risk Capital Risk Interest Rate Risk Off-balance-Sheet Activities That Reduce Interest Rate and Liquidity Risk Interest Rate Derivative Off-Balance-Sheet (OBS) Items State Peer Bank Comparison Summary of Analysis of Wells Fargo’s Performance and Risk Relative to the Peer Average

22. Copyright © 2004 by Thomson Southwestern All rights reserved. 4-22 Trend Analysis for Wells Fargo in 2002 and 2003 Explaining the Low ROA The Decline in the NIM Trends in Risk Ratios Summary of Trends