Reading the Balance Sheet Banks are For Profit, Revenue Generators Stockholders Want Return on Investments Progress must be monitored, measurements must be taken Measurements based on income and expenses Balance sheet is a document that reports on a company’s assets, liabilities, and stockholders’ equity.
Performance Ratios One way of measuring how well the business is doing is to use ratios. Ratio shows the relationship between two numbers that have the same unit of measurement. By comparing to others in industry, comparisons can be made 3 Common: net interest margin, return on assets, and return on equity
Net Interest Margin Interest received from loans/securities is major source of income for banks Interest paid on deposits is major expense for banks Loans and securities are called average earning assets when using this ratio
Net Interest Margin The difference between interest received and interest paid net interest income = total interest income - total interest expense NIM shows how much net income the bank is making on interest as a percentage of total assets. NIM = [interest income-interest expense/total assets] x 100 High NIM is GOOD. Banks have average 3.5%. Good is above 5%. Below 2.5% is cause for concern.
Return on Assets ROA represents how much money a business makes for each dollar of assets the company owns. Banks assets are primarily loans and securities High ROA indicates bank’s performing well Shows bank used assets effectively to generate profits
Return on Assets To calculate ROA, the net income must first be calculated Net income: the difference between the income and expenses of the business ROA = [net income (income – expenses)/total assets] x 100 Good ROA is over 1% Average has been lower, negative during crisis
Return on Equity Stockholders’ equity = total assets – total liabilities ROE applies to banks that have stockholders ROE tells how much profit was made for each dollar invested by stockholders ROE = [net income/stockholders’ equity] x 100 Good ROE has been above 10%. Currently, around 8%. During crisis, negative.
Spread Not a ratio. The difference between the average percentage rate the bank receives on loans made to customers and the average percentage rate that the bank pays on customer deposits. Spread = average interest rate on loans – average interest rate on deposits Larger the spread, more profit for bank. Good spread over 5%. During crisis, averaged at 3% Doesn’t account for all sources of income or expenses, but gives good overall picture of bank health.
Checkpoint 13.1 1.What two factors are used to evaluate a bank’s success? 2.Describe the difference between an asset and a liability. 3.What does a high net interest margin represent? 4.What is the historically average bank ROE? 5.Why is the spread useful if it does not consider all sources of income and expenses?
Research Activity Research what interest rate local banks and credit unions are offering on car loans and savings accounts. Calculate the average interest rates on car loans and savings accounts. Assuming these institutions only make car loans and only offer savings accounts, calculate the spread. Submit.
Assessing the Bank Describe how the CAMELS model is used to evaluate the strength of a bank. Explain the risks to profitability that are unique to banks.
CAMELS International bank-rating system used by the US to evaluate the overall financial condition of banks and other financial institutions. Each characteristics is rated on a scale of one to five One is outstanding, five is poor. Ratings of 6 factors are averaged for overall score. 4 or higher, problem bank
CAMELS Capital adequacy Asset quality Management Earnings Liquidity Sensitivity to market risk
Capital Adequacy Term used to describe having enough capital With enough capital, less likely to fail, can absorb losses Capital ratio shows how much capital the bank has relative to its assets Most common way capital adequacy is measured. Capital ratio = [total capital/total assets] x 100 Good is above 10%. Below 5%, seriously undercapitalized, low rating Undercapitalized bank doesn’t have enough capital to cover its expected risks.
Asset Quality Credit risk associated with the loans and investments held by a bank Good asset quality shows wise decisions and ability to continue generating revenue.
Management How the bank operates More difficult to measure than other CAMEL factors Past actions indicate how future situations will be handled More focus has been placed on making board of directors accountable for managers’ actions. Many blame executives and managers for bank failures
Earnings Banks fail when earnings are consistently negative. Regulators look for an upward trend in earnings One bad year won’t take a bank under Sources of bank’s earnings can be critical Regulators look for sources that can continue in the future Banks expected to earn most of income from loans, securities, and fees.
Liquidity Having enough cash available to meet normal withdrawals. The reserve requirement ensures banks will have a percentage of deposits in liquid assets. First step to measuring liquidity: examine bank deposits Can’t project with new customers, but long-time customers... After determining how much liquidity is needed based on deposits, sources of liquidity are examined. Banks can also borrow from Federal Reserve Banks (short term)
Sensitivity to Market Risk Market risk is the chance that the value of an asset will change due to market conditions. Market conditions are those that affect how buyers and sellers are able to profitably interact. Recently greatly affected by huge number of mortgage defaults Ability to manage risk is key to profitability.
Common Risks to Profitability Risk: Chance of an event occurring and the likely outcome of that event. Interest Rate Risk: chance bank may lose revenue due to a change in interest rates Credit Risk: possibility a borrower will not repay loan Liquidity Risk: chance a bank cannot sell its assets quickly enough to make a profit and meet the demand for cash (illiquid when cash going out exceeds cash coming in)
Risks Faced by Banks Interest Rate Risk Cause: changing rates in the market Reduced: interest rate forecasting Credit Risk Cause: loans or securities that default Reduced: careful credit analysis of customers Liquidity Risk Cause: insufficient cash for withdrawals Reduced: sufficient cash and liquid securities
Risk-return Trade-off The idea that if banks or other investors want a higher return, they must accept a higher degree of risk
Relationship Between Interest Rates and the Price of Securities Securities Prices Interest Rates
How does the money go? Current reserve requirement is 10%. Two main events cause cash to leave the bank: – Customer withdrawals – New bank loans
Checkpoint 13.2 1.What are the six factors that make up CAMELS ratings? 2.Which of the CAMELS ratings is the hardest to measure? 3.How do banks reduce interest rate risk? 4.What is the risk-return trade-off? 5.Name the two events that cause cash to leave the bank?
Research Activity There are many factors that can cause a bank to fail. Using the Internet, research the different things that can cause a bank to fail. Write a report (FBLA format guide) summarizing your findings. Submit via email.
Chapter 13 Exam Due to an increase in poor time management and the inability for several students to keep up with the exam packets, the exam will be given during class on Monday, April 7 th.
Bellringer What are the primary assets of a bank?
Bellringer: 5 minutes Why are performance ratios a more efficient way to make comparisons between bank profits? Submit your response.
Bellringer What is the most common way to measure capital adequacy?