Topic 2: Measuring And Analysing The Performance Of Banks

Front 1

Assets

Back 1

• Cash and deposits
• Securities
• Loans and leases
• Miscellaneous assets

Front 2

Liabilities

Back 2

• Deposits (demand, NOWs, money market, savings, and time)
• Non-deposit borrowings
• Equity capital from shareholders (stock, surplus, retained earnings.

Front 3

Basic Equation

C+ S + L + MA = D + NDB + EC

Back 3

C =Cash AssetsS =Security HoldingsL =LoansMA =Miscellaneous Assets

D =DepositsNDB =Nondeposit Borrowings EC =Equity Capital

*Cash assets = primary reserves

*Securities = secondary reserves

Front 4

Securities

Back 4

Liquid Securities (secondary reserves):

• Short-term Govt. securities (T-bills)
• Other money market securities, e.g. Commerical Paper (CP).

Investment Securities

• US Govt. Notes (T-bills), Corporate Bonds & Municipal Bonds.

Trading Account Assets

• Securitiespurchased to Provide Short-Term Profits from Short-Term Price Movements.
  

Front 5

Loan Accounts

Back 5

Themajor Asset category: many types:

• Commercialand Industrial Loans
  
• ConsumerLoans (Loans to Individuals)
  
• RealEstate Loans
  
• FinancialInstitution Loans, Leases etc
  

Front 6

Federal Funds Sold and Reverse Repurchase Agreements

Back 6

• AType of Loan Account covering interbank lending
  
• GenerallyOvernight Loans
  
• FederalFunds Sold - Funds Come from the
  
• Deposits at the Federal Reserve
  

Front 7

Liabilities:

Non Deposit Borrowings

Back 7

• Fed Funds Purchased
• Other Borrowed funds
  
• Subordinated Debt
• Limited Life Preferred Stock
• Other Liabilities (e.g. Deferred tax)
  

Front 8

Equity Capital:

•Perpetual Preferred Stock

Back 8

–perpetual (as opposed to preferred stockwith a given maturity which would be treated as a liability)

Front 9

Equity Capital:

CommonStock

Back 9

• Common Stock
• Capital surplus
• Retained earnings
• Treasury stock
• Contingency reserve

Front 10

Banks value assets and liabilities at original (historical, book-value) cost. Problem?

Back 10

Assumed A or L held to maturity and ignores changing risk and therefore valuation.

“Gains trading” sellassets that appreciate, hang on to those that deprecate = accumulation of risk

Front 11

Off-Balance Sheet Items

Back 11

• Unused commitments
• Standby credit agreements
• Derivative contracts:

- Future contracts

- Options

- Swaps

OBStransactions expose a firm to counterparty risks.

OBSitems have grown so rapidly that, for the banking industry as a whole, theyexceed total bank assets many times over.

Front 12

Secondary Mortgage Market:

FinancialInstitutions remove mortgages from their balance sheets through one of twomechanisms:

Back 12

Pooling recently originated mortgages togetherand selling them in the secondary market.

Securitizing mortgages (i.e. by issuing securities backed bynewly originated mortgages)

Front 13

Advantagesof securitization

Back 13

• Financial Institutions can reduce theliquidity risk, interest rate risk, and credit risk of their loan portfolios.
  

• Institutions generate income fromorigination and service fees.
  

Front 14

Income Statement

Back 14

Net Interest Income

- Provision for Loan Loss

Net Income After PLL

+/- Net Non-interest Income

Net Income Before Taxes

Taxes

Net Income

- Dividends

Undivided profits

Front 15

Net Interest Income=

Interest Income - Interest Expenses

Back 15

Interest Income

• Interest and Fees on Loans
• Taxable Securities Revenue
• Tax-Exempt Securities Revenue
• Other Interest Income

Interest Expenses

• Deposit Interest Costs
• Interest on Short-Term Debt
• Interest on Long-Term Debt

Front 16

Net Non-Interest Income=

Non-interest Income - Non-interest Expenses

Back 16

Non-Interest Income

• Feeds Earned from Fiduciary Activities fees for managing or protecting a customer's property/ pension/ retirement.
• Service Charges on Deposit Accounts
• Trading Account Gains and Fees
• Additional Non-interest Income

Non-Interest Expense

• Salaries and Employee benefits
• Premises and equipment expenses
• Other operating expenses

Front 17

Commercial vs. Investment Banks:

Balance Sheet

Back 17

Liabilities: Investment banks have Less deposits evident & more wholesale funding of the business (Eurodollar,interbank market, repo market)

Assets: Fewerloans and more securities as assets.

Front 18

Commercial vs. Investment Banks:

Income statement

Back 18

Non-interest income would be moreprominent due to: Tradingactivities and the offering of Investment and Financial services

The costs of investment banks are alsodistinct. Investmentbanks have high technology, communications and physical capital costs. Alsohigh staff costs which can include some very large bonus payments.

Front 19

The value of the financial firm’s stockwill tend to rise if:

Back 19

1. Dividends are expected to increase
2. The financial organization’sperceived level of risk falls.
   
3. Market interest rates decrease, reducing shareholders’ acceptablerates of return via the risk-free rate of interest component of all marketinterest rates

Front 20

Dividend Discount Model

Back 20

Front 21

Return On Equity (ROE)

Back 21

Net Income

Total Equity Capital

Front 22

Return on Assets (ROA)

Back 22

Net Income

Total Assets

Front 23

Net Interest Margin

Back 23

Interest Income - Interest Expense

Total Assets

Front 24

Net Non-interest Margin

Back 24

Net Non-interest Income

Total Assets

Front 25

Earnings Spread

Back 25

Total Interest Income - Total Interest Expense

Total Earning Assets Total Interest Bearing L

Measures the effectiveness of a financial firm's intermediation function in borrowing and lending money andalso the intensity of competition in the firm’s market area.

Ifother factors are held constant, the spread will decline as competitionincreases.

Front 26

Net Bank Operating Margin

Back 26

Operating Revenues - Operating Expenses

Total Assets

Front 27

Earnings per share (EPS)

Back 27

Net Income After Taxes

Number of common shares outstanding

Front 28

ROE = NPM x AU x EM

Net Profit Margin (NPM) =

Back 28

Net Income

Net Operating Revenue

* Effectiveness of Expense Management (cost control)

Front 29

Asset Utilization Ratio (AU) =

Back 29

Total Operating Revenue

Total Assets

* Portfolio Management Policies (the mix and yield of assets).

Front 30

The Equity Multiplier (EM) =

Back 30

Total Assets

Total Equity Capital

* Leverage of Financing Policies: the choice of sources of funds (debt or equity).

Front 31

Interest Rate Risk

Back 31

Danger that shifting interest rates may adversely affect a bank's net income or value of its assets or equity.

Front 32

Credit Risk

Back 32

The probability that some of the financial firm's assets will decline in value or become worthless, because a debtor defaults

Front 33

Liquidity Risk

Back 33

Probability the Firm will not have sufficient cash and borrowing capacity to meet withdrawals and other cash needs.

Front 34

Insolvency/ Capital Risk

Back 34

Probability of the value of the bank's assets declining below it's level of total liabilities.

when A < L

(often subject to regulation)

Front 35

Market Risks

Back 35

Market risk considers movement in the market prices of the banks assets and liabilities.

Price movements arise due to changes in supply, demand, interest rates, exchange rates and other asst prices and other factors.

Becoming increasingly important as banks continue to trade more.

Front 36

Foreign Exchange Risks

Back 36

Foreign exchange risks arise from changes in the exchange rate between two currencies.

This may adversely affect the value of the banks assets and liabilities and its profits (value of income from subsidiaries).

- Could diversify

- Use derivatives to hedge against exchange rate movements.

Front 37

Off-balance sheet (OBS) risk

Back 37

•TheVolatility in Income and Market Value of Bank Equity that May Arise fromUnanticipated Losses due to OBS Activities (activities that do not have abalance sheet impact until a transaction is affected)

Front 38

Operational Risk

Back 38

UncertaintyRegarding a Financial Firm’s Earnings Due to Failures in Computer Systems,
Errors, Misconduct by Employees, Floods, Lightening Strikes and Similar Eventsor Risk of Loss Due to Unexpected Operating Expenses.

Front 39

Reputation Risk

Legal and Compliance Risk

Back 39

1. Risk associated with Public Opinion.

2. Risks to Earnings resulting from actions taken by the legal system.

Front 40

Country or Sovereign risk

Back 40

Risk that repayments from foreign borrowers may be interrupted because of interference from foreign governments.

Front 41

Two Ratios to measure operating efficiency:

Back 41

Operating efficiency ratio =Total Operating Expenses / Total Operating Revenues

lower ratio is better

Employee productivity ratio = Net Operating income / Number of employees