Chapter 1 Banking and the Financial Services Industry

Credit Crisis of 2007 - 2009 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

Credit Crisis of 2007 - 2009 Collapse and/or Failure of: Bear Stearns Lehman Brothers Countrywide Washington Mutual Wachovia

Credit Crisis of 2007 - 2009 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 2009

Credit Crisis of 2007 - 2009 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

Credit Crisis of 2007 - 2009 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

Credit Crisis of 2007 - 2009

Credit Crisis of 2007 - 2009 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

How Do Banks Differ? Global Banks Super-Regional Banks Community 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

How Do Banks Differ?

How Do Banks Differ?

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

How Do Banks Differ?

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

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

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

How Do Banks Differ?

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

How Do Banks Differ?

How Do Banks Differ?

How Do Banks Differ?

How Do Banks Differ?

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

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

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

Organizational Structure and Financial Services Business Model S-Corporation Banks

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

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

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

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

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

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

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

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

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

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

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

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

Chapter 2 Banking and the Financial Services Industry

Government Policies and Regulation

Historical Bank Regulation Glass-Steagall Act (1933-1999) Created three distinct industries Commercial Banking Investment Banking Insurance

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

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

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

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

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

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

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

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

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

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

Ensure Safety & Soundness and Provide an Efficient & Competitive System

Ensure Safety & Soundness and Provide an Efficient & Competitive System

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

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

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

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

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

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

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

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

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 http://www.occ.treas.gov/corpapps/BankAct.pdf

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

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

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

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

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

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

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

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

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

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 1992

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

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

Maintaining Monetary Stability and the Integrity of the Payments System

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

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

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

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 1987

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

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)

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)

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 2008

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

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

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

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

Chapter 3 Analyzing Bank Performance

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

Analyzing Bank Performance Depository Institution Failures Over 1,500 bank failures between 1985 and 1993 0 in 2005 or 2006 3 in 2007 Sharp increase in 2008 and 2009 26 in 2008 72 through mid-August 2009

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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)

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

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

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 Recoveries Equals Ending ALL

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

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

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

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

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

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

Relationship Between Balance Sheet & 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

Relationship Between Balance Sheet & Income Statement

Relationship Between Balance Sheet & Income Statement Net Interest Income Changes with changes in: Composition Volume

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

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

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

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

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

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

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

Return on Equity Model Income: Asset Utilization Components Total Revenue Includes: Interest Income (II) Non-Interest Income (OI) Realized Security Gains or Losses (SG)

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

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

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

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)

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

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

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 30-89 days 90 days and over Non-Performing Loans 90 days or more past-due Non-Accrual Loans Not accruing interest

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

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

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

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

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

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

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

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

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

Evaluating Bank Performance: An Application Profitability Analysis for PNC in 2007

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

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

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

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

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

Analyzing Bank Performance