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CHAPTER 20 Bank Performance

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Copyright 2002 Thomson Publishing. All rights reserved. OUTLINE OF INCOME STATEMENT Interest Income (from loans & investments) - Interest Expense =Net Interest Income (spread or margin) +Non-interest Income - Non-interest Expense - Loan Losses (Bad Debt Expense) +/- Security Gains/Losses - Income Tax =Net Income Performance Evaluation of Banks

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Copyright 2002 Thomson Publishing. All rights reserved. Exhibit 20.2

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Copyright 2002 Thomson Publishing. All rights reserved. Ch 20, Problem (10e, p. 529; 11e, p.563) Managing in Financial Markets INCOME STATEMENT FOR HAWAII BANK % of Avg Assets Interest Income (from loans & invest.) ?% - Interest Expense ?% =Net Interest Income (spread or margin) ?% +Non-interest Income ?% - Non-interest Expense ?% - Loan Losses (Bad Debt Expense) ?% = Net Income before Tax ?% - Income Tax ?% =Net Income ?% ROA = (Net Inc / Avg Assets) = ?% ROE = (Net Inc / Equity) ?% / ?% = ?% or ROE = ROA * (Avg Assets/Equity) = ?%

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Copyright 2002 Thomson Publishing. All rights reserved. Performance Evaluation of Banks Interest income and expenses Gross interest income = interest income generated from all interest-bearing assets Affected by market rates Impacted by composition of bank assets (loans provide higher rate than liquid investments) Gross interest expenses = interest paid on deposits and borrowed funds Affected by market rates Impacted by the composition of bank liabilities (demand accounts are less costly than time deposits) Net interest income = gross interest income interest expenses

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Copyright 2002 Thomson Publishing. All rights reserved.

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Gross Interest Income/Expense

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Copyright 2002 Thomson Publishing. All rights reserved.

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Performance Evaluation of Banks Noninterest income and expenses Noninterest income results from fees charged on services Lockboxes, overdraft fees, ATM fees, bankers acceptances fees, cashier check fees, foreign exchange transactions, investment banking and other advisory fees Loan loss provision is a reserve account established in anticipation of future losses Noninterest expenses include salaries, office equipment Securities gains and losses

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Copyright 2002 Thomson Publishing. All rights reserved.

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Performance Evaluation of Banks Return on assets (ROA) Net income as a percent of total assets Net Income / Total Assets = ROA Usually lower for large banks (money center banks) because they obtain funds from large deposits (CDs) that pay higher interest rates. Small banks usually get funds from demand deposits (zero interest) and small savings accounts (low interest).

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Copyright 2002 Thomson Publishing. All rights reserved. How to Evaluate a Banks Performance Examination of Return on Assets (ROA) Will usually reveal poor performance, but will not indicate the source of the problem Possible reasons for a low ROA: Excessive interest expenses (e.g too many CDs) Low interest received on loans and securities Too conservative with loansexcessive short-term securities Insufficient noninterest income Service fees too low (should raise NSF fees, etc.) High provision for loans losses

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Copyright 2002 Thomson Publishing. All rights reserved. Performance Evaluation of Banks Return on equity (ROE) The return on capital invested Net Income / Capital = ROE ROE = ROA x leverage multiplier (inverse of capital ratio) ROE for large banks has been lower than for small banks for the same reasons that their ROA has been lower

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Copyright 2002 Thomson Publishing. All rights reserved.

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Exhibit 20.11 Breakdown of Performance Measures

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Copyright 2002 Thomson Publishing. All rights reserved. Influence of Bank Policies and Other Factors on a Banks Income Statement

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Copyright 2002 Thomson Publishing. All rights reserved. Zager Bank Example Application: Example of Zager Bank l Zager bank is a medium size bank l Aggressive management style can be viewed as risky due to limited collateral and cash flow situation. l The bank charges high interest rates on loans because the borrowers do not have alternative lenders. l Strategy was successful during strong economic conditions. l When economy weakened in 2008, borrowers had trouble repaying their loans.

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Copyright 2002 Thomson Publishing. All rights reserved. Zager Bank Example

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Copyright 2002 Thomson Publishing. All rights reserved. Risk Evaluation of Banks No consensus measurement exists that would allow for comparison of various types of risk among all banks Some analysts measure a firms risk by its beta, which measures the sensitivity of stock returns to the market as a whole, but Beta ignores firm-specific characteristics Examples: look up BofA (BAC) or Banner Bank (BANR).

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Copyright 2002 Thomson Publishing. All rights reserved. Beta measures non-diversifiable risk

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Copyright 2002 Thomson Publishing. All rights reserved. Betas During Financial Crisis Feb-08 / Today 0.19 / ? (BAC - Bank of America) 1.14 / ? (C - Citibank) 0.5 / ? (JPM - JP Morgan Chase) 0.04 / ? (WFC - Wells Fargo) 1.17 / ? (BANR - Banner Bank)

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Copyright 2002 Thomson Publishing. All rights reserved. History of U.S. Bank Failures # of banks failed 3 in 2007 30 in 2008 148 in 2009 157 in 2010 92 in 2011 51 in 2012 24 in 2013 3 so far in 2014 See FDIC website for details http://www.fdic.gov/bank/individual/failed/banklist.htmlhttp://www.fdic.gov/bank/individual/failed/banklist.html

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Copyright 2002 Thomson Publishing. All rights reserved. Bank Failures Historical reasons for bank failure Fraud from poor internal controls Embezzlement of funds No separation of personnel dutiesesp. at small banks High loan default percentage Excessive reliance on a specific industry (such as oil, defense, or agriculture) or a specific geographic location. Recession periods Liquidity crisis Bank runs, panics Loss of confidence of financial markets Increased competition (very tight margins) Under-capitalization / over-leverage (too much debt)

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Copyright 2002 Thomson Publishing. All rights reserved. Bank Failures Study by the Office of the Comptroller of the Currency reviewed 162 national banks that have failed since 1979 and found that: 81% did not have a loan policy or did not closely follow their policy 59 % did not use an adequate system to identify problem loans 63% did not adequately monitor key bank officers or departments 57% allowed one individual to make major corporate decisions Since these are all controllable, must conclude major reason is poor management.