Analyzing Bank

Performance

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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

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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

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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

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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

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Commercial Bank Financial
Statements
 Bank Assets
 Loans
 Real Estate
 Commercial

 Individual

 Agricultural

 Other loans in domestic offices

 Loans and leases in foreign offices

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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

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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

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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
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Commercial Bank Financial
Statements
 Bank Assets
 Investment Securities
 Held-to-Maturity
 Trading Account

 Available-for-Sale

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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

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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

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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
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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

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Commercial Bank Financial
Statements
 Bank Assets
 Other Assets
 Bank Premises
 OREO

 Often foreclosed property

 Banker’s Acceptances

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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
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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

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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

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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

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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
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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
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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

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

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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
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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 31
Commercial Bank Financial
Statements
 Income Statement
 Interest Income (II)
 minus

 Interest Expense (IE)

 equals

 Net Interest Income (NII)

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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)
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Commercial Bank Financial
Statements
 Income Statement
 Non-Interest Expense (OE)
 Includes:

 Personnel
 Occupancy
 Technology
 Utilities
 Deposit Insurance Premiums
 Intangible Amortizations
 Goodwill Imparement
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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 35
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
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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

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Commercial Bank Financial
Statements
 Income Statement
 Net Interest Income (NII)
 minus

 Burden
 minus

 PLL
 plus

 Realized Security Gains (Losses) (SG)

 equals

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Commercial Bank Financial
Statements
 Income Statement
 Pre-Tax Net Operating Income (te)
 minus

 Taxes (T)
 minus

 Extraordinary Items
 equals

 Net Income (NI)

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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

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Commercial Bank Financial
Statements
 Income Statement
 Total Operating Expense (EXP)
 Includes

 Interest Expense
 Non-Interest Expense
 PLL
 Analogous to COGS + Operating
Expenses

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

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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

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Relationship Between Balance
Sheet & Income Statement
n m

 A  L
i 1
i
j 1
j  NW
n
Interest Income   yi Ai
i  1
m
Interest Expense   c j L j
i  1

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

 Volume

n m
Net Interest Income   yi Ai   c j L j
i  1 i  1

n m
Net Income   yi Ai   c j L j  Burden - P LL  SG - T
i  1 i  1

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

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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

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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
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Return on Equity Model
 Expense Ratio and Asset Utilization
 Net Income/Average Total Assets

NI TR EXP Taxes
ROA    
aTA aTA aTA aTA

 ROA = AU – ER – TAX

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

Assets
 EXP/aTA

EXP IE OE PLL
ER    
aTA aTA aTA aTA

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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
EXP IE OE PLL
ER    
aTA aTA aTA aTA 51
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

EXP IE OE PLL
ER    
aTA aTA aTA aTA
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Return on Equity Model
 Income: Asset Utilization Components
 Total Revenue
 Includes:

 Interest Income (II)

 Non-Interest Income (OI)
 Realized Security Gains or Losses (SG)

TR II OI SG
AU    
aTA aTA aTA aTA

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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 TR II OI SG
AU    
aTA aTA aTA aTA 54
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

TR II OI SG
AU    
aTA aTA aTA aTA
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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

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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

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

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Managing Risks and Returns
 Risk Management
 Credit Risk
 Historical Loss Rate

 Gross Loan Losses (Charge-offs)

 Recoveries
 Net Losses
 Charge-offs - Recoveries

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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
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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

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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

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Managing Risks and Returns
 Risk Management
 Credit Risk
 Preparation for Losses

 Lack of Diversification
 High Loan Growth
 Country Risk

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Managing Risks and Returns
 Risk Management
 Liquidity Risk
 Funding Liquidity Risk

 Inability to liquidate assts or raise required

funding
 Market Liquidity Risk

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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
66
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
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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

68
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

69
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

70
Evaluating Bank Performance:
An Application
 Profitability Analysis for PNC in 2007

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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
77
Maximizing the Market Value of
Bank Equity
 CAMELS Ratings
 Capital Adequacy
 Asset Quality
 Management Quality
 Earnings
 Liquidity
 Sensitivity to Market Risk

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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

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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

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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

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Analyzing Bank
Performance

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