THE CHANGING BANK ENVIRONMENT

Chapter 1

Bank ManagementBank Management, 6th edition.6th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2005 by South-Western, a division of Thomson Learning

The banking industry is consolidating and diversifying simultaneously. The traditional definition of a bank has been blurred

by new products and a wave of mergers, which have dramatically expanded the scope of activities and where products and services are offered. Formerly, a commercial bank was defined as both

accepting demand deposits and making commercial loans.

Today, these two products are offered by many financial services companies: including commercial banks, savings banks, credit unions, insurance companies, investment banks, finance companies, retailers, and pension funds.

What constitutes a bank, today is not as important as the products and services are offered and the geographic markets in which it competes.

While competition has increased the number of firms offering financial products and services, … the removal of interstate branching restrictions in the U.S. has dramatically reduced the number of banks but increased the number of banking offices (primarily branches).

Consolidation, in turn, has increased the proportion of banking assets controlled by the largest banks.

Not surprisingly, the same trends appear globally. The U. S. currently has several banks that operate

in all 50 states and many places outside the U.S. The largest foreign banks have significant

operations in the U.S. and throughout the world.

Increased competition… quickly changing the nature of commercial banking.

Competition also means geography no longer limits the trade area or the markets in which it competes. Individuals can open a checking account at:

a traditional depository institution, a brokerage firm, or a nonbank firm, such as GE Capital, State Farm Insurance, and

AT&T.

You can deposit money electronically, transfer funds from one account to another, purchase stocks, bonds and mutual funds, or even request and receive a loan from any of these firms.

Most allow you to conduct this business by phone, mail, or over the Internet.

Regulatory restrictions on products and services offerings worked effectively in promoting a safe banking system until the later half of the twentieth century.

Product innovations and technological advances of the late 1900s allowed investment banks to circumvent the regulations restricting their banking activities. In the late 1970s Merrill Lynch effectively created an

“interest bearing checking account,” something banks had not been legally allowed to offer.

Junk bonds became an alternative financing source for small business and other companies began to encroach upon the banks primary market.

Goals and Functions of Bank Regulation

To ensure Safety and Soundness

To provide an efficient and competitive system

Provide Monetary Stability

Maintain Integrity of payment systems

Protect consumers from potential abuses

Three separate federal agencies along with each state's banking department issue and enforce regulations

The Federal Reserve

The Federal Deposit Insurance Corporation (FDIC)

Office of the Comptroller of the Currency (OCC)

Most regulations can be classified in one of three basic categories:

1. supervision, examination, deposit insurance, chartering activity, and product restrictions are associated with safety and soundness

2. branching, mergers and acquisitions, and pricing are related to an efficient and competitive financial system

3. consumer protection.

Type of Commercial Bank

Type of Regulation National State member Insured state nonmember

Noninsured state nonmember

Bank holding companies

Safety and Soundness Supervision and Examination

Comptroller Federal Reserve

and state authority FDIC and state

authority State authority Federal reserve

Deposit Insurance FDIC FDIC FDIC State insurance

or none Not applicable

Chartering and Licensing OCC State authority State authority State authority Federal Reserve

and state authority Efficiency and Competitiveness

Branching Comptroller Federal Reserve

and state authority FDIC and state

authority State authority

Federal Reserve and state authority

Mergers and Acquisitions Comptroller Federal Reserve

and state authority FDIC and state

authority State authority

Federal Reserve and state authority

Pricing New Products Federal Reserve

and state authority

Federal Reserve and state authority

Federal Reserve and state authority

Federal Reserve and state authority

Not applicable

Consumer Protection Federal Reserve Federal Reserve

and state authority

Federal Reserve, FDIC, and state

authority

Federal Reserve and state authority

Not applicable

Depository institutions and their regulators

Supervision and Examination

Regulators examine banks for safety and soundness. Capital adequacy Asset quality Management quality Earnings quality Liquidity Sensitivity to Risk

1 to 5 rating in each category If deficient, regulators issue a MOU or a Cease

and Desist order

Regulation- New Charters

The U.S. System is a dual system with federal and state charters.

• OCC regulates federal (national) banks• States individually regulate state

chartered banks, with the FDIC acting as primary regulator

• The FDIC regulates insured banks too, even if not the primary regulator

• The Federal Reserve regulates state member banks and National banks that are required to be Fed members.

Numbers and types of institutions in June 2003

# instit. # Offices Deposits PrimaryRegulator

Commercial Banks 7831 73895 4.25 trillionNational Charter 2047 35238 2.30 trillion OCCState Charter 5784 38657 1.96 trillionFederal Res. Member 952 14890 962 billion FedFederal Res.nonmemb. 4832 23767 993 billion FDICSavings institutions 1410 13883 875 billion OTS/FedCredit Unions 9369 NA 477 billion NCUA

Federal Reserve bank regulations

The Riegle-Neal Interstate Banking and Branching Efficiency Act, 1994, mandates interstate branch banking, superseding state banking pacts

Nonbank banks

Edge Act corporations Edge Act corporations provide a full range of banking

services but, by law, deal only in international transactions

There are two types of Edge corporations: banks and investment companies

Loan production offices (LPOs) make commercial loans but do not accept deposits

Consumer banks outside their home state Consumer banks accept deposits but make only consumer

loans

Consumer Protection. State legislatures and the Fed have numerous laws

and regulations to protect the rights of individuals who try to borrow. Regs. AA, B, BB, C, E, M, S, Z, and DD apply specifically to

consumer regulation.

Equal credit opportunity (Reg. B)makes it illegal for any lender to discriminate against a borrower on the basis of race, gender, marital status, religion, age, or national origin.

Community reinvestment prohibits redlining in which lenders do not lend in certain geographic markets.

Reg. Z requires disclosure of effective rates of interest, total interest paid, the total of all payments, as well as full disclosure as to why a customer was denied credit.

Trends in federal legislation and regulation

The fundamental focus since 1970 has been to define and expand the product and geographic markets served by depository institutions, and to increase competition.

Subsequent problems with failed savings and loans and commercial banks raised concerns that only a few large organizations would survive and large firms would drive small firms out of business.

Deposit insurance…The FDIC insures the deposits of banks up to $100,000 per account holder while almost all CUs are insured by the National Credit Union Share Insurance Fund (NCUSIF), which is controlled by the NCUA. The FDIC was created by the Banking Act of 1933, in response to the large number of bank

failures after 1929. Originally the FDIC insured deposits up to $5,000. All newly chartered banks must obtain FDIC insurance.

The FDIC also acts as the primary federal regulator of state-chartered banks that do not belong to the Fed System. State banks who are members of the Federal Reserve System are regulated by the Fed. The FDIC also has backup examination and regulatory authority over national and Fed-

member banks.

The FDIC is also the receiver of failed institutions. The FDIC handles failed institutions by either liquidating them or selling the

institutions to redeem insured deposits.

Two insurance funds under the FDIC:

The Bank Insurance Fund (BIF) and the Savings Association Fund (SAIF).

The OCC and state banking authorities officially designate banks as insolvent, but the Federal Reserve and FDIC assist in closings.

The Federal Reserve also serves as the federal government's lender of last resort. When a bank loses funding sources, the Federal Reserve

may make a discount window loan to support operations until there is a solution.

The Central Bank …Congress created the Federal Reserve System in 1913 as the central bank of the U. S. and to provide the nation with a flexible and stable monetary and financial system The Fed's role in banking and the economy has

expanded over the years, but its primary focus has remained the same.

The Fed’s three fundamental functions are:1. conduct the nation’s monetary policy,2. an effective and efficient payments system, 3. supervise and regulate banking operations.

All three roles have a similar purpose, that of maintaining monetary and economic stability and prosperity.

The Federal Reserve System (The Fed) A decentralized central bank, with

12 districts reserve banks and branches across the country,

Coordinated by a Board of Governors in Washington, D.C.

The Board of Governors are appointed by the president of the United States and confirmed by the Senate for staggered 14-year terms.

The seven-members of the Board Governors are the main governing body of the Federal Reserve System.

The Board is charged with overseeing the 12 District Reserve Banks and with helping implement national monetary policy.

Monetary Policy

The Federal Reserve conducts monetary policy through actions designed to influence the supply of money and credit in order to promote price stability and long-term sustainable economic growth.

There are basically three distinct monetary policy tools:

1. open market operations,

2. changes in the discount rate, and

3. changes in the required reserve ratio.

Open market operations… are conducted by the Federal Reserve Bank of New York under the direction of the Federal Open Market Committee (FOMC). The sale or purchase of U.S. government securities in the “open market”

is the Fed’s most flexible means of carrying out policy objectives. Through the purchase or sale of securities, the Fed can adjust the level

of reserves in the banking system. Fed open market purchases increase liquidity, hence reserves in the banking

system, by increasing a bank’s deposit balances at the Fed. Fed open market sales of securities decrease bank reserves and liquidity by

lowering deposit balances at the Fed.

Changes in the discount rate …directly affect the cost of borrowing Banks can borrow deposit balances, or required

reserves, directly from Federal Reserve Banks (in its role as lender of last resort). The discount rate is the interest rate that banks pay.

When the Fed raises (decreases) the discount rate it discourages (encourages) borrowing by making it more (less) expensive.

Many economists argue that the Fed changes the discount rate primarily to signal future policy toward monetary ease or tightness rather than to change bank borrowing activity. Changes in the discount rate are formally announced and

market participants recognize that the Fed will likely be adding liquidity or taking liquidity out of the banking system.

Changes in reserve requirements …directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out. For example, a required reserve ratio of 10 percent means that a

bank with $100 in demand deposit liabilities must hold $10 in legal required reserves in support of the DDAs. The bank can thus lend only 90 percent of its DDAs.

When the Fed increases reserve requirements, it formally increases the required reserve ratio that directly reduces the amount of money a bank can lend. The reverse for reducing reserve requirements. Lower reserve requirements increase bank liquidity and lending

capacity while higher reserve requirements decrease bank liquidity and lending capacity.

There has been a fundamental shift in the structure of financial institutions over the past two decades.

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

1970 1975 1980 1985 1990 1995 2000

Year

Pe

rce

nt

of

To

tal,

All

Oth

ers

25.0%

30.0%

35.0%

40.0%

45.0%

50.0%

55.0%

60.0%

65.0%

Pe

rce

nt

of

To

tal,

De

po

sit

ory

In

sti

tuti

on

s

Monetary authority 5.1% 4.6% 3.5% 2.9% 2.4% 2.8% 2.4% 2.4%

Insurance Companies 16.8% 14.1% 13.9% 12.8% 14.6% 14.9% 11.6% 11.4%

Pension and Retirement Funds 7.0% 7.3% 8.2% 9.1% 8.6% 8.4% 7.2% 6.7%

Mutual Funds 0.6% 0.6% 1.7% 4.9% 7.6% 10.2% 11.8% 12.5%

Finance companies 4.5% 4.2% 4.9% 4.9% 4.7% 3.8% 4.0% 3.8%

Mortgage related 1.3% 2.2% 3.6% 6.3% 10.8% 11.8% 12.2% 12.8%

Other 4.2% 4.9% 5.3% 7.4% 8.6% 12.4% 18.8% 19.6%

Depository Institutions 60.5% 62.1% 58.9% 51.8% 42.8% 35.7% 31.9% 30.7%

Dec-70 Dec-75 Dec-80 Dec-85 Dec-90 Dec-95 Dec-00 Dec-01

Consolidations, new charters and bank failures

The number of failed banks increased sharply from 1980 through 1988 This period coincides with economic problems throughout various sectors

of the U.S. economy ranging from agriculture to energy to real estate.

As regional economies faltered, problem loans grew at banks and thrifts that were overextended and subsequent losses forced closings.

New charters representing the start-up of a new bank’s operations declined from 1984 to 1994, increased through 1998, and then decreased through 2001.

The major force behind consolidation has been mergers and acquisitions in which existing banks combine operations in order to cut costs, improve profitability, and increase their competitive position.

Bankers who either lose their jobs in a merger or choose not to work for a large banking organization often find investors to put up the capital needed to start a new bank.

Both mergers and new charters slowed dramatically in late 1998 as a result of a 25 percent fall in stock values at the largest bank holding companies and in 2001 with the continuing market decline.

Structural changes among FDIC-insured commercial banks, 1980–2001

0

100

200

300

400

500

600

700

1980 1983 1986 1989 1992 1995 1998 2001

Nu

mb

er

of

Ba

nk

s

New Charters

Mergers

Failures

Organizational form of the banking industry The organizational structure of banking has changed significantly

over the past two decades but changed most dramatically in the later half of the 1990’s due primarily to: the impact of interstate branching, the Federal Reserve System’s relaxation of securities powers restrictions

using a clause in the Glass-Steagall Act and most recently with the Gramm-Leach-Bliley Act of 1999.

Banks can now branch across state lines and acquire insurance and securities firms by forming a Financial Holding Company under the provisions of Gramm-Leach-Bliley.

Commercial banks are classified either as unit banks, with all operations housed in a single office, or as branch banks with multiple offices. Prior to the Riegle-Neal Interstate Banking and Branching

Efficiency Act of 1994, which allows nationwide interstate branching, state law determined branching for commercial banks.

Any organization that owns controlling interest in one or more commercial banks is a bank holding company (BHC). Control is ownership or indirect control via the power to vote more

than 25% of the voting shares in a bank.

Prior to interstate branching, the motivation to form a bank holding company was to circumvent branching and product restrictions.

Unit versus Branch banking…The current structure of the commercial banking system as well as the dramatic changes in the number of banks has been heavily influenced by historical regulations which prevent branching to one degree of another. One of the primary reasons the number of

banks has declined almost 50 percent since the mid 1980’s is the relaxation of branching restrictions provided by Riegle-Neal.

Since the mid 1980’s, the number of banks has fallen about 50 percent while the number of branches has increased by 50 percent.

Changes in the number of banks and bank branches, 1960 – 2001

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

Nu

mb

er

of

U.S

. B

an

kin

g

Off

ice

s

Branches 10,556 15,872 21,839 30,205 38,738 43,293 50,406 56,512 64,079 63,989

Banks 13,126 13,544 13,511 14,384 14,434 14,417 12,347 9,942 8,315 8,178

1960 1965 1970 1975 1980 1985 1990 1995 2000 2001*

Main Offices

Branches

All U.S. Banking Offices

(Main Offices plus Branches)

The number of interstate branches increased dramatically after interstate branching became fully effective in 1997.

Unit banks each have their own board, officers, charters and technology. Expenses are usually higher for the parent that owns multiple independent

banks as compared to branches of the “lead” bank. Relaxation in branching restrictions and more efficiency are motivating factors

for a bank to form a BHC.

Risk is considered higher with restrictive branching because individual banks were less diversified. States with the highest bank failure rates historically restricted

branching.

Branching generally reduces competitors, lowers expenses, allows greater asset diversification, and expands each bank’s consumer deposit base Each of these factors decreases the chances of failure, everything else being

equal.

Like commercial banks, bank holding companies are heavily regulated by states and the federal government. The Bank Holding Company Act stipulates that the Board

of Governors of the Federal Reserve System must approve all holding company formations and acquisitions. One-bank holding companies (OBHCs) control only one

bank and typically arise when the owners of an existing bank exchange their shares for stock in the holding company.

Multibank holding companies (MBHCs) control at least two commercial banks.

The Gramm-Leach-Bliley Act of 1999 also gave regulatory responsibility over Financial Holding Companies to the Federal Reserve. The Glass-Steagall Act effectively separated commercial

banking from investment banking

Commercial banks were able to underwrite and deal in securities through Section 20 subsidiaries. The Fed resolved the issue of “principally engaged” by

allowing banks in 1987 to earn only 5 percent of the revenue in their securities affiliates. This was raised to 10 percent in 1989 and to 25 percent in March of 1997.

The Gramm-Leach-Bliley Act of 1999 repeals the restrictions on banks affiliating with securities firms The law creates a new financial holding company,

authorized to engage in: underwriting and selling insurance and securities, conducting both commercial and merchant banking, investing in and developing real estate and other "complimentary activities."

Financial holding companies (FHC) are distinct entities from bank holding companies (BHC). A company can form a BHC or a FHC or both.

Advantages in forming a FHC is that they can engage in a wide range of financial activities not permitted in the bank or in a BHC including:

insurance and securities underwriting merchant banking insurance company portfolio investment activities. activities that are "complementary" to financial activities also are

authorized.

The Fed may not permit FHC formation if any of its insured subsidiaries are not well capitalized and well managed, or did not receive at least a satisfactory rating in their most recent CRA exam.

Nonbank activities permitted bank holding companies The Federal Reserve Board regulates allowable nonbank

activities that are “closely related to banking” in which bank holding companies may acquire subsidiaries.

Restrictions came about for three reasons. 1. It was feared that large financial conglomerates would control

the financial system because they would have a competitive advantage.

2. There was concern that banks would require customers to buy nonbank services in order to obtain loans.

3. Some critics simply did not believe that bank holding companies should engage in businesses that were less regulated and thus relatively risky.

Organizational structure of financial services company

Bank Holding

Company

ThriftHolding

Company

SecuritiesSubsidiaries

InsuranceSubsidiaries

Real Estate

Subsidiary

NonbankSubsidiaries

Subsidiariesand ServiceCompanies

Financial ServicesHolding Company

Organizational structure of the OBHC

The bottom four levels have the same organizational form

as the independent bank.

Each subsidiary has a president and line officers.

One-Bank Holding Company

Board of Directors

Parent Company

Bank Subsidiary Nonbank Subsidiaries

Organizational structure of the MBHC.

MultiBank Holding Company

Board of Directors

Parent Company

Bank Subsidiaries Nonbank Subsidiaries Bank Subsidiaries

Key Legislation: 1970 - 1993 Depository Inst. Deregulation and Monetary Control Act of 1980

Garn-St. Germain Depository Institutions Act of 1982

The Tax Reform Act of 1986

Competitive Equality Banking Act of 1987

The Financial Inst. Reform, Recovery and Enforcement Act of 1989

The Federal Deposit Insurance Corp. Improvement Act of 1991

Market value accounting and FASB 115

Key Legislation: 1994 - 2004 Riegle-Neal Interstate Banking and Branching Efficiency

Act of 1994

The 1998 Credit Union Membership Access Act

Financial Services Modernization Act (Gramm-Leach-Bliley) of 1999)

USA Patriot Act of 2001

Sarbanes-Oxley Act 2002

Financial Services Modernization Act (Gramm-Leach-Bliley Act of 1999)

The repeal of restrictions on banks affiliating with securities firms clearly tops the list of provisions of Gramm-Leach-Bliley.

The Act, also addressed new powers and products of the financial services industry, functional regulation of the industry, insurance powers, the elimination of new charters for unitary savings and loan holding companies, and consumer privacy protection.

The privacy section of the bill that has some of the most far reaching beyond banking.

Banking business models…The business models followed by the majority of banks (small banks) is generally different that that of largest banks. Historically, small banks have been called independent

or community banks while large banks have been labeled large holding company banks, multibank holding companies, or even money center banks.

Nevertheless, banks of the same size often pursue substantially different strategies

Business model structure of commercial banking The organizational structure of commercial banks can be characterized

as banks falling into one of the following categories based on the range of products and services offered and the different geographic markets served:

Global banks Nationwide banks Super Regional banks Regional banks Specialty banks

limited region limited product line

Specialty Community Banks…When many of us think of banks, we think of the largest banks in the country such as Bank of America, Citibank, etc.

Of the approximate 8,100 commercial banks operating in the United States, however, only about 80 are greater than $10 billion in assets.

The vast majority of banks are small banks (about 5,000), under $100 million in assets with a legal lending limit of less than $1 million.

In fact, almost 96% of all banks have total assets less than $1 billion.

Still, the largest banks (over $10 billion) hold almost 70 percent of all bank assets

A. Largest Commercial Banks

Rank Name State Total Assets 1 JP Morgan Chase Bank NY 628,662,000 2 Bank of America NA NC 617,962,335 3 Citibank NA NY 582,123,000 4 Wachovia Bank NA NC 353,541,000 5 Bank One NA IL 256,787,000 6 Wells Fargo Bk NA CA 250,474,572 7 Fleet National Bank RI 192,265,000 8 US Bank, NA MN 189,159,050 9 SunTrust Bank GA 124,453,567

10 HSBC Bank USA NY 92,958,123

The largest commercial banks: (thousands of dollars, 2003)

Historically, banks, savings associations, and credit unions each served a different purpose and a different market. Commercial banks mostly specialize in short-term

business credit, but also make consumer loans and mortgages, and have a broad range of financial powers.

Banks accept deposits in a variety of different accounts and invest these funds into loans and other financial instruments.

Their corporate charters and the powers granted to them under state and federal law determines the range of their activities.

Savings and loan associations and savings banks, have historically specialized in real estate lending; e.g., loans for single-family homes and other residential properties.

Savings associations are generally referred to as “thrifts” because they originally offered only savings or time deposits

They have acquired a wide range of financial powers over the past two decades, and now offer checking accounts, make business and consumer loans, mortgages, and offer virtually any other product a bank offers.

Savings institutions must maintain 65% of their assets in housing-related or other qualified assets to maintain their savings institution status. This is called the “qualified thrift lender” (QTL) test.

The number of thrifts has declined dramatically during the last two decades. The savings and loan crisis of the 1980s forced many institutions to close

or merge with others, at an extraordinary cost to the federal government.

Due to liberalization of the QTL, there was a resurgence in the thrift charter, and many insurance and securities firms, as well as non-financial, acquiring a unitary thrift holding company in order to bypass prohibitions in the Glass Steagall Act and the Bank Holding Company Act.

This resurgence stopped with the passage of Gramm-Leach- Bliley, which eliminated the issuance of new unitary thrift charters.

Credit unions are nonprofit institutions with an original purpose to encourage savings and provide loans within a community at low cost to their members.

A “common bond” defines their members, although this common bond can be loosely defined.

Members pool funds to form the deposit base and the members own and control the institution.

Credit unions accept deposits in a variety of forms. CUs have savings, checking, time deposits, with some offering and money market accounts.

Products and activities include almost anything a bank or thrift offers, including home loans, issuing credit cards, and even commercial loans.

CUs are exempt from federal taxation and sometimes receive subsidies, in the form of free space or supplies, from their sponsors.

C. Largest Savings Institutions

Rank Name State Total Assets 1 Washington Mutual WA 235,442,148 2 Golden West Financial Corp. CA 82,049,858 3 Sovereign Bancorp PA 43,610,071 4 Astoria Financial Corp NY 22,419,375 5 Telebanc Financial Corp VA 20,288,424 6 ING USA Holding Co. DE 19,145,012 7 Temple-Inland TX 17,275,395 8 Webster Financial Corp. CT 14,441,069 9 USAA Bancorp CA 13,721,232

10 Indymac Bancorp CA 13,189,979

D. Largest Credit Unions

Rank Name STATE Total Assets 1 Navy Federal CU VA 20,039,756 2 State Employees' CU NC 11,339,309 3 Pentagon Federal CU VA 6,057,833 4 Golden 1 CU CA 4,860,270 5 Boeing Employees WA 4,672,619 6 Orange County Teachers Fed. CU CA 4,562,145 7 United Airlines Employees' CU IL 4,352,392 8 Suncoast Schools Federal CU FL 3,935,904 9 American Airlines TX 3,924,129

10 Security Service Federal CU TX 3,185,393

Largest savings institutions and credit unions (thousands of dollars, 2003)

Five fundamental forces have transformed the financial services market

1. Deregulation/re-regulation2. Financial innovation3. Securitization4. Globalization5. Advances in technology.

The latter factors actually represent responses to deregulation and

re-regulation.

Historically, commercial banks have been the most heavily regulated companies in the United States

Regulations took many forms including : maximum interest rates that could be paid on

deposits or charged on loans, minimum capital-to-asset ratios, minimum legal reserve requirements, limited geographic markets for full-service

banking, constraints on the type of investments

permitted, and restrictions on the range of products and

services offered.

Banks and other market participants have consistently restructured their operations to circumvent regulation and meet perceived customer need

In response, regulators or lawmakers would impose new restrictions, which market participants circumvented again.

This process of regulation and market response (financial innovation) and imposition of new regulations (re-regulation) is the regulatory dialectic.

Increased competition

The McFadden Act of 1927 and the Glass-Steagall Act of 1933 determined the framework within which financial institutions operated for the next 50 years.

The McFadden Act sheltered banks from competition with other banks by extending state restrictions on geographic expansion to national banks.

The Glass-Steagall Act forbade banks from

underwriting equities and other corporate securities, thereby separating banking from commerce.

The fundamental forces of change… increased competition

Competition for deposits Competition for loans Competition for payment services Competition for other financial services

Discussion: What do you think is the result of this increased competition?

Competition for deposits

High inflation reduced the stable spread between asset yields and liability costs in the late 1970s.

In 1973, several investment banks created money market mutual funds (MMMFs). Without competing instruments, MMMFs

increased from $10.4 billion in 1978 to almost $189 billion in 1981.

Congress passed legislation enabling banks and thrifts to offer similar accounts including money market deposit accounts (MMDAs) and Super NOWs.

Competition for loans

Loan yields fell relative to borrowing costs, as lending institutions competed for a decreasing pool of quality borrowers.

High loan growth also raised bank capital requirements.

Junk bonds, commercial paper, auto finance companies, credit unions, and insurance companies compete directly for the same good quality customers.

Competition for loans (continued)

As bank funding costs rose, competition for loans put downward pressure on loan yields and interest spreads.

Prime corporate borrowers had the option to issue commercial paper (CP) or long-term bonds rather than borrow from banks.

Glass-Steagall prevented commercial banks from underwriting CP, banks lost corporate borrowers, who now bypassed them by issuing commercial paper at lower cost.

Competition for loans (continued) The competition for loans comes in many forms:

Commercial paper Captive automobile finance companies Other finance companies

The development of the junk bond market extended loan competition to medium-sized companies representing lower-quality borrowers.

The growth in junk bonds reduced the pool of good-quality loans and lowered risk-adjusted yield spreads over bank borrowing costs.

Today, different size banks generally pursue different strategies. Small- to medium-size banks continue to

concentrate on loans but seek to strengthen the customer relationship by offering personal service.

These same banks have generally rediscovered the consumer loan.

The largest banks, in contrast, are looking to move assets off the balance sheet. Regulatory capital requirements and the new

corporate debt substitutes often make the remaining loans too expensive and too risky.

Loan concentrations:Consumer and commercial credits

Credit Risk Diversification

69% 67% 65% 64% 62% 60% 58% 57% 55% 55% 57% 57% 59% 60% 60% 59%

31% 33% 35% 36% 38% 40% 42% 43% 45% 45% 43% 43% 41% 40% 40% 41%

0.0%

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20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Commercial borrowers

Consumer loans

Per

cent

of

loan

s

Captive automobile finance companies

The three largest U.S. automobile manufacturers as well as most foreign automobile manufactures are aggressively expanding in the financial services industry as part of their long-term strategic plans.

Competition for payment services

In an American Banker article, Diogo Teixeira comment that:

GE Capital has almost $300 billion of financial assets. GMAC has $12 billion of financial

services revenue, more than Microsoft's total corporate revenue. Microsoft has no leasing

subsidiary, takes no deposits, makes no loans, and offers not a single financial product -- in an age when everybody has financial products. Yet Microsoft is viewed as the threat, not GE

Capital or GMAC.

Competition for payment services…the impact of technology Once the domain of banks and other depository

institutions only, the payment system has become highly competitive.

The real challenge for the Federal Reserve System and the banking industry is in the delivery of payment processing services.

This competition is coming from emerging electronic payment systems, such as: smart and stored-value cards automatic bill payment bill presentment processing

It's not just electronic payment systems that are eroding the banks traditional markets

Cash can be acquired at any ATM machine all over the country.

You can open a checking account, apply for a loan and receive the answer and funds electronically.

Direct deposit of paychecks, credit cards, electronic bill payment, and smart cards means that competition for financial services goes well beyond the traditional banking services lines we think of from the recent past!

Although cash remains the dominate form of payment, the average payment size of cash is the smallest

2000

% Total

2000

% of

Cashless

Payments

2000

Growth:

1995-

2000 1995 2000

%

Total

2000

Growth:

1995-

2000

Cash 550,000 82.3% #N/A #N/A 2,200,000 0.3% 4.00$

Cheques issued 69,000 10.3% 58.2% 1.8% 73,515,000 85,000,000 10.9% 2.9% 1,231.88$

Electronic Transactions:

ACH 6,900 1.0% 5.8% 14.6% 12,231,500 20,300,000 2.6% 10.7% 2,942.03$

ATM 13,200 2.0% 11.1% 6.4% 656,600 800,000 0.1% 4.0% 60.61$

Credit Card 20,000 3.0% 16.9% 6.0% 879,000 1,400,000 0.2% 9.8% 70.00$

Debit Card 9,275 1.4% 7.8% 42.1% 59,100 400,000 0.1% 46.6% 43.13$

Total retail electronic 49,375 7.4% 41.7% 10.7% 13,826,200 22,900,000 2.9% 10.6% 463.80$

Chips 58 0.0% 0.0% 2.6% 310,021,200 292,147,000 37.4% -1.2% 5,037,017$

Fed Wire 108 0.0% 0.1% 7.3% 222,954,100 379,756,000 48.6% 11.2% 3,516,259$

Total wholesale electronic 166 0.0% 0.1% 5.5% 532,975,300 671,903,000 85.9% 4.7% 4,047,608$

Total Electronic 49,541 7.4% 41.8% 10.7% 546,801,500 694,803,000 88.8% 4.9% 14,025$

Volume of Transactions Value of Transactions

Average

Transaction

Size 2000

Competition for other bank services

Banks and their affiliates offer many products and services in addition to deposits and loans.

Trust services Brokerage Data processing Securities underwriting Real estate appraisal Credit life insurance Personal financial consulting

“Non-bank” activities of banks…the Gramm-Leach-Bliley Act.

Since the Glass-Steagall and Bank Holding Company acts, banks could not directly underwrite securities domestically.

Today, a bank can enter this line of business by forming a financial holding company through provisions of the Gramm-Leach-Bliley Act. A financial holding company owns a bank or

bank holding company as well as an investment subsidiary.

The investment subsidiary of a financial holding company is not restricted in the amount or type of investment underwriting.

Investment banking

Commercial banks consider investment banking attractive because most investment banks: already offer many banking services to prime

commercial customers and high net worth individuals and

sell a wide range of products not available through banks.

can compete in any geographic market without the heavy regulation of the FRS, FDIC, and OCC.

earn extraordinarily high fees for certain types of transactions and can put their own capital at risk in selected investments.

Investment banking

Investment banking encompasses three broad functions:

1. underwriting public offerings of new securities

2. trading existing securities3. advising and

financing mergers and acquisitions

Deregulation and re-regulation

Deregulation is the process of eliminating regulations, such as the elimination of Regulation Q (interest rate ceilings imposed on time and demand deposits offered by depository institutions.)

Deregulation is often confused with reregulation, which is the process of implementing new restrictions or modifying existing controls on individuals and activities associated with banking.

Efforts at deregulation and re-regulation generally address: Pricing issues

removing price controls on the maximum interest rates paid to depositors and the rate charged to borrowers (usury ceilings).

Allowable geographic expansion The Riegle-Neal Interstate Banking and Branching

Efficiency Act of 1994 has eliminate branching restrictions.

New products and services Gramm-Leach-Bliley Act of 1999 has dramatically

expanded the banks’ product choices; e.g., insurance, brokerage services, and securities underwriting.

Financial innovation

Financial innovation is the catalyst behind the evolving financial services industry.

Innovations take the form of new securities and financial markets, new products and services, new organizational forms, and new delivery systems.

Regulation Q brought about financial innovation as depository institutions tried to slow disintermediation.

Financial innovation (continued)

Banks developed new products to compete with Treasury bills, MMMFs, and cash management accounts.

Regulators typically imposed marginal reserve requirements against the new instruments, raising the interest rate ceiling, and then authorized a new deposit instrument.

Recent innovations take the form of new futures, options, options-on-futures, and the development of markets for a wide range of securitized assets.

Response of banks One competitive response to asset quality

problems and earnings pressure has been to substitute fee income for interest income.

Banks also lower their required capital and reduce credit risk by selling assets and servicing the payments between borrower and lender rather than holding the same assets to earn interest.

This process of converting assets into marketable securities is called securitization.

Securitization

Securitization is the process of converting assets into marketable securities.

It enables banks to move assets off-balance sheet and increase fee income.

It increases competition for standardized products such as: mortgages and other credit-scored loans

Eventually lowers the prices paid by consumers by increasing the supply and liquidity of these products.

The objectives behind securitization include the following: Free capital for other uses Improve ROE via servicing income Diversify credit risk Obtain new sources of liquidity Reduce interest rate risk

Generally, any loan that can be standardized can potentially be securitized.

Securitization allows nonbank firms to originate loans, package them into pools, and sell securities collateralized by securities in the pools. This increases the competition for the securitized asset and will eventually lead to lower rates.

Off-balance sheet activities, asset sales and Enron Enron engaged in questionable activities including

not reporting losses from business activities that the firm inappropriately moved off-balance sheet.

Enron hid losses on the business activities and/or

used its off-balance sheet activities to artificially inflate reported earnings.

Many banks also enter into agreements that do not have a balance sheet impact until a transaction is effected. An example might be a long-term loan commitment to

a potential borrower. Off-balance sheet positions generate noninterest

income but also entail some risk as the bank must perform under the contracts.

Globalization

Gradual evolution of markets and institutions so that geographic boundaries do not restrict financial transactions.

Financial markets and institutions are becoming increasingly global in scope.

Firms must recognize that businesses in other countries as well as their own are competitors, and that international events affect domestic operations.

Increased consolidation

The dominant trend of the structure of financial institutions is that of consolidation.

With the asset quality problems of Texas banks in the 1980, regulators authorized acquisitions by out-of-state banks.

By 1998, effectively all interstate branching restrictions had been eliminated this has lead to

consolidation frenzy in which we have almost half as many banks as compared to the 1980’s

The later half of the 1990s saw not only a large number of bank mergers but also several of the largest bank consolidations: Citicorp merges with Travelers Chase Manhattan acquires Chemical Banking Chase Manhattan acquires J.P. Morgan Mellon Bank acquires Dreyfus NationsBank acquires BankAmerica Bank of New York acquires Irving Bank Corp Fleet Financial Group acquires BankBoston Bank One acquires First USA Southern National acquires BB&T Financial

The removal of restrictive branching laws as well as “merger mania” of the late 1990s has dramatically reduced the number of banks.

The primary factor leading the reduction in the number of banks from a high of 14,364 in 1979 to about 8,000 at the beginning of 2002 can be attributed to the removal of branching restrictions provided by Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994

GE Capital Services is the financial subsidiary of General Electric GECS divides its operations into two segments, Financing and

Specialty Insurance. The operations of GECS Financing are divided into four areas: Consumer services provides products such as private-label and bank

credit card loans, personal loans, time sales and revolving credit and inventory financing for retail merchants, auto leasing and inventory financing, mortgage servicing, consumer savings and insurance services .

Equipment management provides leases, loans, sales, and asset management services for equipment.

Mid-market financing provides loans and financing and operating leases for middle-market customers for a variety of equipment.

Specialized financing provides loans and leases for major capital assets, commercial and residential real estate loans, and investments; and loans to and investments in management buyouts and corporate recapitalizations.

Specialty insurance provides U.S. and international property and casualty reinsurance; specialty insurance and life reinsurance; financial guaranty insurance (principally on municipal bonds and structured finance issues); private mortgage insurance; and creditor insurance covering international customer loan repayments.

EVALUATING BANK PERFORMANCE

Chapter 2

Bank ManagementBank Management, 6th edition.6th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2005 by South-Western, a division of Thomson Learning

Balance Sheet

Assets = Liabilities + Equity.

Balance sheet figures are calculated at a particular point in time and thus represent a “snapshot” of bank values.

Bank Assets

Cash and due from banks vault cash, deposits held at the Fed and other financial

institutions, and cash items in the process of collection. Investment Securities

assets held to earn interest and help meet liquidity needs. Loans

the major asset, generate the greatest amount of income, exhibit the highest default risk and are relatively illiquid.

Other assets bank premises and equipment, interest receivable, prepaid

expenses, other real estate owned, and customers' liability to the bank

http://www2.fdic.gov/ubpr/UbprReport/SearchEngine/Default.asp

Balance Sheet PNC National Bank PNC BANK NATIONAL ASSOCIATION

—— HISTORICAL—— —— HISTORICAL——12/31/03 % of 12/31/04 % of

BALANCE SHEET % Cha $ 1,000 Total % Cha $ 1,000 Total

ASSETSLoans:

Real estate loans 1.2% 15,639,089 25.2% 32.4% 20,701,894 28.0%Commercial loans -8.4% 11,879,285 19.2% 23.8% 14,707,458 19.9%Individual loans -4.4% 2,501,847 4.0% 52.6% 3,816,861 5.2%Agricultural loans 9.2% 984 0.0% 57.0% 1,545 0.0%Other LN&LS in domestic off. -20.5% 3,022,795 4.9% -0.8% 2,999,113 4.1%LN&LS in foreign off. 15.6% 1,190,025 1.9% 2.8% 1,222,904 1.7%

Gross Loans & Leases -4.6% 34,234,025 55.2% 26.9% 43,449,785 58.9%Less: Unearned Income 8.0% 44,867 0.1% 0.2% 44,949 0.1%Loan & Lease loss Allowance -5.8% 606,886 1.0% -3.8% 583,915 0.8%

Net Loans & Leases -4.5% 33,582,272 54.1% 27.5% 42,820,921 58.0%Investments:

U.S. Treasury & Agency securities 90.6% 5,574,108 9.0% 15.9% 6,460,936 8.8%Municipal securities -46.9% 7,719 0.0% 1606.0% 131,685 0.2%Foreign debt securities -100.0% 0 0.0% 0.0% 0 0.0%All other securities 1.1% 8,804,028 14.2% 3.0% 9,064,146 12.3%Interest bearing bank balances 16.4% 259,318 0.4% 51.8% 393,713 0.5%Fed funds sold & resales -54.6% 1,106,733 1.8% 56.2% 1,728,372 2.3%Trading account assets -9.1% 945,042 1.5% 78.3% 1,667,330 2.3%

Total Investments 8.7% 16,686,948 26.9% 16.5% 19,446,182 26.3%

Total Earning Assets -0.5% 50,269,220 81.1% 23.9% 62,267,103 84.4%

Nonint Cash & Due from banks -6.9% 2,926,330 5.6% 8.5% 3,174,493 4.3%Premises fixed assets & capital leases 21.8% 1,039,603 1.3% 2.5% 1,066,028 1.4%Other real estate owned 21.8% 14,208 0.0% 0.7% 14,301 0.0%Investment in unconsolidated subs. 252.4% 17,386 0.0% -12.4% 15,223 0.0%Other assets 51.8% 7,754,149 6.3% -6.2% 7,272,017 9.9%

Total Assets 6.8% 62,020,896 100.0% 19.0% 73,809,165 100.0%

Average Assets During Quarter 6.8% 62,719,462 101.1% 17.0% 73,391,052 99.4%

Community National Bank COMMUNITY NATIONAL BANK

—— HISTORICAL—— —— HISTORICAL——12/31/03 % of 12/31/04 % of

BALANCE SHEET % Cha $ 1,000 Total % Cha $ 1,000 Total

ASSETSLoans:

Real estate loans 4.0% 75,324 39.1% 12.9% 85,050 40.5%Commercial loans -5.8% 34,288 17.8% 12.9% 38,716 18.4%Individual loans 26.7% 8,454 4.4% -5.2% 8,011 3.8%Agricultural loans 0.0% 0 0.0% 0.0% 0 0.0%Other LN&LS in domestic off. 13.0% 26 0.0% 284.6% 100 0.0%LN&LS in foreign off. 0.0% 0 0.0% 0.0% 0 0.0%

Gross Loans & Leases 2.2% 118,092 61.3% 11.7% 131,877 62.8%Less: Unearned Income 0.0% 0 0.0% 0.0% 0 0.0%Loan & Lease loss Allowance 6.7% 1,258 0.7% 28.5% 1,617 0.8%

Net Loans & Leases 2.2% 116,834 60.6% 11.5% 130,260 62.0%Investments:

U.S. Treasury & Agency securities 73.0% 34,937 18.1% 24.8% 43,591 20.7%Municipal securities 50.0% 613 0.3% -0.5% 610 0.3%Foreign debt securities 0.0% 0 0.0% 0.0% 0 0.0%All other securities 0.0% 2,104 1.1% -2.2% 2,057 1.0%Interest bearing bank balances 0.0% 4,428 2.3% -57.5% 1,881 0.9%Fed funds sold & resales 175.0% 7,000 3.6% -21.4% 5,500 2.6%Trading account assets 0.0% 0 0.0% 0.0% 0 0.0%

Total Investments 111.0% 49,082 25.5% 9.3% 53,639 25.5%

Total Earning Assets 20.6% 165,916 86.1% 10.8% 183,899 87.5%

Nonint Cash & Due from banks -16.6% 13,083 6.8% -10.7% 11,682 5.6%Premises fixed assets & capital leases 12.2% 5,642 2.9% 2.2% 5,768 2.7%Other real estate owned -84.3% 325 0.2% -100.0% 0 0.0%Investment in unconsolidated subs. 0.0% 0 0.0% 0.0% 0 0.0%Other assets 259.8% 7,761 4.0% 13.2% 8,783 4.2%

Total Assets 18.6% 192,727 100.0% 9.0% 210,132 100.0%

Average Assets During Quarter 17.5% 191,480 99.4% 9.4% 209,525 99.7%

Adjustments to total loans…three adjustments are made to obtain a net loan figure.

First, the dollar amount of outstanding leases is included in gross loans.

Second, unearned income is deducted from gross interest received.

Finally, gross loans are reduced by the dollar magnitude of a bank's loan-loss reserve, which exists in recognition that some loans will not be repaid.

Bank investments and FASB 115

Following FASB 115 a bank, at purchase, must designate the objective behind buying investment securities as either:

held-to-maturity securities are recorded on the balance sheet at amortized cost.

trading account securities are actively bought and sold, so the bank marks the securities to market (reports them at current market value) on the balance sheet and reports unrealized gains and losses on the income statement.

available-for-sale, all other investment securities, are recorded at market value on the balance sheet with a corresponding change to stockholders’ equity as unrealized gains and losses on securities holdings.

Bank liabilities

Demand deposits transactions accounts that pay no interest

Negotiable orders of withdrawal (NOWs) and automatic transfers from savings (ATS) accounts pay interest set by each bank without federal restrictions

Money market deposit accounts (MMDAs) pay market rates, but a customer is limited to no more than six checks

or automatic transfers each month

Savings and time deposits represent the bulk of interest-bearing liabilities at banks.

Bank liabilities (continued)

Two general time deposits categories exist: Time deposits in excess of $100,000, labeled jumbo

certificates of deposit (CDs).

Small CDs, considered core deposits which tend to be stable deposits that are typically not withdrawn over short periods of time.

Deposits held in foreign offices balances issued by a bank subsidiary located outside

the U.S.

Rate-sensitive borrowings: Federal Funds purchased and Repos

Core versus volatile funds Core deposits are stable deposits that are not highly interest rate-sensitive.

Core deposits are more sensitive to the fees charged, services rendered, and location of the bank.

Core deposits include: demand deposits, NOW accounts, MMDAs, and small time deposits.

Large, or volatile, borrowings are liabilities that are highly rate-sensitive. Normally issued in uninsured denominations. Ability to borrow is sensitive to the markets perception of their asset

quality.

Volatile liabilities (net non-core) include: large CDs, deposits in foreign offices, federal funds purchased, RPs, and other borrowings with maturities less than one year.*

*The UBPR also includes brokered deposits less than $100,000 and maturing within one year in the definition of net noncore liabilities.

Stockholders equity

Subordinated notes and debentures: notes and bonds with maturities in excess of one year.

Stockholders' equity Ownership interest in the bank.

Common and preferred stock are listed at par

Surplus account represents the amount of proceeds received by the bank in excess of par when it issued the stock.

The income statement Interest income (II)

Interest expense (IE) Interest income-interest expense=net interest income (NII)

Loan-loss provisions (PL) represent management's estimate of potential lost revenue from bad loans.

Noninterest income (OI)

Noninterest expense (OE) noninterest expense usually exceeds noninterest income such that the difference

is labeled the bank's burden Taxes

Income statement (interest income and expenses):PNC and Community National Bank

PNC BANK, NATIONAL ASSOCIATION—— HISTORICAL—— —— HISTORICAL——

12/31/03 % of 12/31/04 % of

Income Statement % Cha $ 1,000 Total % Cha $ 1,000 Total

Interest Income:Interest and fees on loans -17.5% 1,730,575 37.5% 8.3% 1,875,058 38.4%Income from lease financing -20.6% 189,910 4.1% -30.1% 132,839 2.7%

Memo: Fully taxable -17.7% 1,905,782 41.3% 4.6% 1,993,668 40.8%Tax-exempt -25.7% 14,703 0.3% -3.2% 14,229 0.3%Estimated tax benefit -27.7% 7,347 0.2% -22.3% 5,711 0.1%

Income on Loans & Leases (TE) -17.8% 1,927,832 41.7% 4.4% 2,013,608 41.2%

U.S. Treasury & Agency securities 48.2% 34,418 0.7% 221,4% 110,614 2.3%Mortgage Backed Securities -0.7% 366,877 7.9% -8.1% 337,110 6.9%Estimated tax benefit 1.0% 504 0.0% 565.1% 3,352 0.1%

All other securities income -15.4% 117,866 2.6% -31.2% 81,129 1.7%Memo: Tax-Exempt Securities Income 3.7% 1,008 0.0% 728.4% 8,350 0.2%

Investment Interest Income (TE) -2.4% 519,665 11.2% 2.4% 532,205 10.9%

Interest on due from banks 43.8% 4,835 0.1% -24.8% 3,638 0.1%Interest onFed funds sold & resales -32.4% 18,682 0.4% 57.9% 29,503 0.6%Trading account income 216.9% 805 0.0% 2455% 20,575 0.4%Other interest income 127.2% 39,477 0.9% -47.2% 20,847 0.4%

Total interest income (TE) -14.2% 2,511,266 54.4% 4.3% 2,620,376 53.6%Interest Expense:

Int on Deposits held in foreign offices -14.7% 17,335 0.4% 144.0% 42,290 0.9%Interest on CD's over $100M -29.5% 67,714 1.5% 6.4% 72,032 1.5%Interest on All Other Deposits: -30.5% 369,702 8.0% 1.8% 376,244 7.7%

Total interest expense on deposits -29.8% 454,751 9.8% 7.9% 490,566 10.0%

Interest on Fed funds purchased & resale 2.2% 13,260 0.3% 204.9% 40,232 0.8%Interest on Trad Liab & Oth Borrowings -59.0% 26,001 0.6% 429.4% 137,637 2.8%Interest on mortgages & leases 0.0% 0 0.0% 0.0% 0 0.0%Interest on Sub. Notes & Debentures -17.9% 55,449 1.2% 52.1% 84,240 1.7%

Total interest expense -30.6% 549,461 11.9% 37.0% 752,975 15.4%

Net interest income (TE) -8.1% 1,961,805 42.5% -4.8% 1,867,401 38.2%

COMMUNITY NATIONAL BANK—— HISTORICAL—— —— HISTORICAL——

12/31/03 % of 12/31/04 % of

Income Statement % Cha $ 1,000 Total % Cha $ 1,000 Total

Interest Income:Interest and fees on loans 0.0% 7,923 73.6% 7.5% 8,521 72.1%Income from lease financing 0.0% 0 0.0% 0.0% 0 0.0%

Memo: Fully taxable 0.0% 7,923 73.6% 7.5% 8,521 72.1%Tax-exempt 0.0% 0 0.0% 0.0% 0 0.0%Estimated tax benefit 0.0% 0 0.0% 0.0% 0 0.0%

Income on Loans & Leases (TE) 0.0% 7,923 73.6% 7.5% 8,521 72.1%

U.S. Treasury & Agency securities -6.2% 427 4.0% 28.3% 548 4.6%Mortgage Backed Securities -12.6% 368 3.4% 62.8% 599 5.1%Estimated tax benefit 23.5% 21 0.2% 81.0% 38 0.3%

All other securities income 28.1% 41 0.4% 80.5% 74 0.6%Memo: Tax-Exempt Securities Income 28.1% 41 0.4% 80.5% 74 0.6%

Investment Interest Income (TE) -7.4% 857 8.0% 46.9% 1,259 10.7%

Interest on due from banks 164.3% 37 0.3% 21.6% 45 0.4%Interest onFed funds sold & resales -7.0% 133 1.2% -23.3% 102 0.9%Trading account income 0.0% 0 0.0% 0.0% 0 0.0%Other interest income 0.0% 15 0.1% 13.3% 17 0.1%

Total interest income (TE) -0.6% 8,965 83.3% 10.9% 9,944 84.1%Interest Expense:

Int on Deposits held in foreign offices 0.0% 0 0.0% 0.0% 0 0.0%Interest on CD's over $100M -19.2% 375 3.5% 6.4% 399 3.4%Interest on All Other Deposits: -20.5% 1,060 9.8% 3.6% 1,098 9.3%

Total interest expense on deposits -20.2% 1,435 13.3% 4.3% 1,497 12.7%

Interest on Fed funds purchased & resale -52.2% 11 0.1% 90.9% 21 0.2%Interest on Trad Liab & Oth Borrowings 0.0% 0 0.0% 0.0% 0 0.0%Interest on mortgages & leases 0.0% 0 0.0% 0.0% 0 0.0%Interest on Sub. Notes & Debentures 0.0% 0 0.0% 0.0% 0 0.0%

Total interest expense -20.6% 1,446 13.4% 5.0% 1,518 12.8%

Net interest income (TE) 4.5% 7,519 69.8% 12.1% 8,426 71.3%

Interest income …the sum of interest and fees earned on all of a bank's assets.

Interest income includes interest from: Loans

Deposits held at other institutions,

Municipal and taxable securities, and

Investment and trading account securities.

Noninterest expense…composed primarily of: Personnel expense:

salaries and fringe benefits paid to bank employees,

Occupancy expense : rent and depreciation on equipment and premises, and

Other operating expenses: utilities and deposit insurance premiums.

Non-interest expense

Expenses and loan losses directly effect the balance sheet.

The greater the size of loan portfolio, the greater is operating overhead and PLL.

Consumer loans are usually smaller and hence more expensive (non-interest) per dollar of loans.

Relationship between the balance sheet and income statement Ai = dollar amount of asset ILj = dollar amount of liability jNW = dollar amount of stockholder’s equityYi = average yield on asset ICj = cost of liability j

 Interest Expense =  Net Interest Income =

Net Income =

n

i

m

jji NWLA

1 1

m

jjj Lc

1

n

i

m

ijjii LcAy

1 1

TSGPLLBurdenLcAyn

i

m

ijjii

1 1

Return on equity (ROE = NI / TE)… the basic measure of stockholders’ returns

ROE is composed of two parts:

Return on Assets (ROA = NI / TA), represents the returns to the assets the bank

has invested in.

Equity Multiplier (EM = TA / TE), the degree of financial leverage employed by

the bank. Also equals 1/capital or leverage ratio.

Return on assets (ROA = NI / TA)…can be decomposed into two parts: Asset utilization (AU) → income generation Expense ratio (ER) → expense control

ROA = AU - ER= (TR / TA) - (TE / TA)

Where:

TR = total revenue or total operating income = Int. inc. + non-int. inc. + SG(L) and

TE = total expenses= Int. exp. + non-int. exp. + PLL + Taxes

ROA is driven by the bank’s ability to:…generate income (AU) and control expenses (ER)

Income generation (AU) can be found on the UBPR (page 1) as:

TA

losses)( gainsSec

TA

Inc.int. Non.

TA

Inc.Int.AU

Expense Control (ER) can be found on the UBPR (page 1) as:

TA

PLL

TA

.Exp.intNon

TA

.Exp.IntER*

Note, ER* does not include taxes.

INCOME

Return to the BankROA = NI / TA

EXPENSES

Rate

Composition (mix)

Volume

Interest

Overhead

Prov. for LL

Taxes

Fees and Serv Charge

Trust

Other

Rate

Composition (mix)

Volume

Interest

Non Interest

Salaries and Benefits

Occupancy

Other

Bank Performance ModelBank Performance Model

Returns to ShareholdersROE = NI / TE

Returns to ShareholdersROE = NI / TE

Degree of LeverageEM = 1 / (TA / TE)

Expense ratio (ER = Exp / TA)… the ability to control expenses.

Interest expense / TA Cost per liability (rate)

Int. exp. liab. / $ amt. liab. Composition of liabilities

$ amt. of liab. / TA Volume of debt and equity

Non-interest expenses / TA Salaries and employee benefits / TA Occupancy expenses / TA Other operating expense / TA

Provisions for loan losses / TA Taxes / TA

Asset utilization (AU = TR / TA):… the ability to generate income.

Interest Income / TA Asset yields (rate)

Interest income asset (i) / $ amount of asset (i)

Composition of assets (mix) $ amount asset (i) / TA

Volume of Earning Assets Earning assets / TA

Non interest income / TA Fees and Service Charges Securities Gains (Losses) Other income

Aggregate profitability measures Net interest margin

NIM = NII / earning assets (EA). In practice I often use NII divided by total assets.

Spread Spread = (int inc / EA) (int exp / int bear. Liab.) (Also

note that spread can equal average asset rates less average deposit rates).

Earnings base Eb = ea / ta

Burden / TA (Noninterest exp. - Noninterest income) / TA

Efficiency ratio Non int. Exp. / (Net int. Inc. + Non int. Inc.)

Fundamental risks : Credit risk

Liquidity risk

Market risk

Operational risk

Capital or solvency risk

Legal risk

Reputational risk

Credit risk…the potential variation in net income and market value of equity resulting from nonpayment or delayed payment.

Three Question need to be addressed:

1. What has been the loss experience?

2. What amount of losses do we expect?

3. How prepared is the bank?

Credit ratios to consider What has been the loss experience?

Net loss to average total LN&LS Gross losses to average total LN&LS Recoveries to avg tot LN&LS Recoveries to prior period losses. Net losses by type of LN&LS

What amount of losses do we expect? Non-current LN&LS to tot loans Total P/D LN&LS - incl nonaccural Non-curr restruc LN&LS / GR LN&LS Curr-Non-curr restruct / GR LN&LS Past due by loan type

Credit ratios to consider (continued)

How prepared are we? Loss Provision to: average assets and avg

tot LN&LS

LN&LS Allowance to: net losses and total LN&LS

Earnings coverage of net loss

PNC BANK, NATIONAL ASSOCIATION

UBPR Dec-04

RISK RATIOS Pg # CALC UBPR PEER1 CALC UBPR PEER1

Credit RiskGross loss / Avg. Tot LN&LS 7 0.73% 0.73% 0.53% 0.40% 0.40% 0.36%Net loss / Avg. Tot LN&LS 7 0.59% 0.59% 0.41% 0.28% 0.28% 0.25%Recoveries / Avg. Tot LN&LS 7 0.13% 0.13% 0.12% 0.12% 0.12% 0.11%Recoveries to prior credit loss 7 19.00% 19.03% 22.26% 19.5% 19.52% 23.76%0.00% 0.00%90 days past due / EOP LN&LS 8A 0.21% 0.21% 0.13% 0.13% 0.13% 0.10%Total Nonaccrual LN&LS / EOP LN&LS 8A 0.79% 0.79% 0.66% 0.33% 0.33% 0.46%Total Noncurrent / EOP LN&LS 8A 1.00% 1.00% 0.83% 0.46% 0.46% 0.59%

LN&LS Allowance to total LN&LS 7 1.77% 1.78% 1.44% 1.34% 1.35% 1.27%LN&LS Allowance / Net losses 7 2.90x 2.92x 4.18x 5.20x 5.23x 7.51xLN&LS Allowance/Total Non Accrual 7 1.77x 2.24x 2.73x 2.92x 4.12x 3.73xEarn Coverage of net losses 7 7.44x 7.44x 10.92x 11.61x 11.61x 19.94xNet Loan and lease growth rate 1 -4.55% -4.55% 10.14% 27.51% 27.51% 17.96%

Dec-03

Credit risk ratios :PNC and Community National

COMMUNITY NATIONAL BANK

UBPR Dec-04

RISK RATIOS Pg # CALC UBPR PEER4 CALC UBPR PEER4

Credit RiskGross loss / Avg. Tot LN&LS 7 0.54% 0.54% 0.26% 0.21% 0.21% 0.20%Net loss / Avg. Tot LN&LS 7 0.53% 0.53% 0.21% 0.20% 0.20% 0.16%Recoveries / Avg. Tot LN&LS 7 0.01% 0.01% 0.06% 0.02% 0.02% 0.05%Recoveries to prior credit loss 7 6.70% 6.70% 29.21% 3.1% 3.08% 24.53%0.00% 0.00%90 days past due / EOP LN&LS 8A 0.16% 0.16% 0.13% 0.00% 0.00% 0.10%Total Nonaccrual LN&LS / EOP LN&LS 8A 0.19% 0.19% 0.47% 0.16% 0.16% 0.41%Total Noncurrent / EOP LN&LS 8A 0.35% 0.35% 0.66% 0.16% 0.16% 0.56%

LN&LS Allowance to total LN&LS 7 1.07% 1.07% 1.25% 1.23% 1.23% 1.20%LN&LS Allowance / Net losses 7 2.10x 2.08x 11.89x 6.70x 6.71x 14.52xLN&LS Allowance/Total Non Accrual 7 3.05x 5.49x 4.35x 7.77x 7.77x 5.63xEarn Coverage of net losses 7 2.57x 2.57x 23.89x 10.38x 10.38x 30.80xNet Loan and lease growth rate 1 2.16% 2.16% 11.61% 11.49% 11.49% 14.24%

Dec-03

Liquidity risk…the variation in net income and market value of equity caused by a bank's difficulty in obtaining cash at a reasonable cost from either the sale of assets or new borrowings.

Banks can acquire liquidity in two distinct ways:1. By liquidation of assets.

Composition of investments

Maturity of investments

2. By borrowing.

Core deposits

Volatile deposits

PNC BANK, NATIONAL ASSOCIATION

UBPR Dec-04

RISK RATIOS Pg # CALC UBPR PEER1 CALC UBPR PEER1

Liquidity Risk%Total (EOP) Assets (except where noted)

Total equity 11 9.07% 9.07% 8.95% 8.26% 8.26% 9.74%Core deposits 10 67.41% 66.75% 53.75% 64.84% 63.23% 54.19%S.T Non-core funding 10 NA 11.47% 23.24% NA 12.11% 23.42%

Net loans & leases / Total Deposits 10 73.73% 73.73% 87.72% 81.00% 81.00% 88.28%Net loans & leases / Core Deposits 10 81.11% 81.11% 115.16% 91.76% 91.76% 116.1%Avg. Available for sale securities / Avg. TA6 21.41% 21.90% 21.11% 22.12% 22.03% 21.00%Short-term investments 10 NA 2.73% 6.25% NA 3.02% 5.23%Pledged securities 10 NA 46.50% 49.08% NA 51.76% 54.78%

Dec-03

Liquidity risk ratios :PNC and Community National

COMMUNITY NATIONAL BANK

UBPR Dec-04

RISK RATIOS Pg # CALC CALC UBPR PEER7 CALC UBPR PEER7

Liquidity Risk%Total (EOP) Assets (except where noted)

Total equity 11 9.07% 7.29% 7.29% 9.28% 7.23% 7.23% 9.42%Core deposits 10 67.41% 84.26% 84.95% 71.85% 85.00% 85.04% 71.10%S.T Non-core funding 10 NA NA 4.10% 11.90% NA 4.84% 12.21%

Net loans & leases / Total Deposits 10 73.73% 65.90% 65.90% 78.94% 67.35% 67.35% 81.42%Net loans & leases / Core Deposits 10 81.11% 71.36% 71.36% 93.85% 72.89% 72.89% 97.58%Avg. Available for sale securities / Avg. TA6 21.41% 14.44% 13.39% 15.88% 19.38% 19.04% 15.80%Short-term investments 10 NA NA 5.99% 5.41% NA 5.72% 5.26%Pledged securities 10 NA NA 29.25% 40.34% NA 28.49% 41.20%

Dec-03

Market risk…the risk to a financial institution’s condition resulting from adverse movements in market rates or prices .

Market risk arises from changes in:

Interest rates

Foreign exchange rates

Equity and security prices.

Interest rate risk …the potential variability in a bank's net interest income and market value of equity due to changes in the level of market interest rates.Example: $10,000 Car loan

4 year Car loan at 8.5%1 year CD at 4.5%

Spread 4.0%But for How long? Funding GAP = $RSA - $RSL,

where $RSA = $ amount of assets which will mature or reprice in a give period of time.

In this example: GAP3m = $0.00 - $10,000 = - $10,000

This is a negative GAP.

Foreign exchange risk… the risk to a financial institution’s condition resulting from adverse movements in foreign exchange rates. Foreign exchange risk arises from changes

in foreign exchange rates that affect the values of assets, liabilities, and off-balance sheet activities denominated in foreign currencies.

This risk is often found in off-balance sheet loan commitments and guarantees denominated in foreign currencies

Equity and security price risk…change in market prices, interest rates and foreign exchange rates affect the market values of equities, fixed income securities, foreign currency holdings, and associated derivative and other off-balance sheet contracts.

Large banks must conduct value-at-risk analysis to assess the risk of loss with their trading account portfolios.

Operational risk …measures the cost efficiency of the bank's activities; i.e., expense control or productivity. Typical ratios focus on:

total assets per employee total personnel expense per employee noninterest expense ratio

There is no meaningful way to estimate the likelihood of fraud or other contingencies from published data

A bank’s operating risk is closely related to its operating policies and processes and whether is has adequate controls

PNC BANK, NATIONAL ASSOCIATION

UBPR Dec-04

RISK RATIOS Pg # CALC UBPR PEER1 CALC UBPR PEER10.00% 0.00%0.00% 0.00%

Operational RiskTotal Assets / Number of employees 3 $4.09 $4.02 $5.17 $4.71 $4.44 $6.09Personnel expense / number of employees3 73.43x 72.06x 60.48x 90.68x 85.48x 65.26xEfficiency ratio 3 60.93% 60.96% 57.73% 68.01% 67.97% 57.92%

Dec-03

Operational risk ratios:PNC and Community National

COMMUNITY NATIONAL BANK

UBPR Dec-04

RISK RATIOS Pg # CALC UBPR PEER7 CALC UBPR PEER70.00% 0.00%0.00% 0.00%

Operational RiskTotal Assets / Number of employees 3 $3.00 $2.75 $2.95 $2.98 $2.84 $3.08Personnel expense / number of employees3 65.46x 60.03x 48.27x 61.47x 58.58x 50.10xEfficiency ratio 3 82.72% 82.75% 66.06% 75.35% 75.34% 65.99%

Dec-03

Capital risk… closely tied to asset quality and a bank's overall risk profile

The more risk taken, the greater is the amount of capital required.

Appropriate risk measures include all the risk measures discussed earlier as well as ratios measuring the ratio of:

tier 1 capital and total risk based capital to risk weighted assets,

equity capital to total assets,

dividend payout, and growth rate in tier 1 capital.

Definitions of capital

Tier 1 capital is:

total common equity capital plus noncumulative preferred stock, plus minority interest in unconsolidated subsidiaries, less ineligible intangibles.

Risk weighted assets are:

the total of risk adjusted assets where the risk weights are based on four risk classes of assets.

Importantly, a bank's dividend policy affects its capital risk by influencing retained earnings.

PNC BANK, NATIONAL ASSOCIATION

UBPR Dec-04

RISK RATIOS Pg # CALC UBPR PEER1 CALC UBPR PEER10.00% 0.00%

Capital RiskTier 1 Leverage Capital / Total Assets 11A 8.28% 8.37% 7.67% 6.89% 7.14% 7.71%Tier 1 Capital / Risk-weighted assets 11A 9.91% 9.89% 11.13% 8.65% 8.36% 11.17%Total RBC / Risk weighted Assets 11A 12.91% 12.89% 13.08% 11.55% 11.55% 12.98%Equity Capital / Total Assets 11 9.07% 9.07% 8.95% 8.26% 8.26% 9.74%Dividend Payout 11 77.30% 77.30% 57.26% 87.58% 87.58% 46.73%Growth rate in total equity capital 11 -4.09% -4.09% 10.34% 8.42% 8.42% 20.28%Equity growth less asset growth 11 -8.09% -8.09% 0.59% -10.59% -10.59% 4.55%0.00% 0.00%

Dec-03

Capital risk ratios :PNC and Community National

COMMUNITY NATIONAL BANK

UBPR Dec-04

RISK RATIOS Pg # CALC UBPR PEER7 CALC UBPR PEER70.00% 0.00%

Capital RiskTier 1 Leverage Capital / Total Assets 11A 7.27% 7.31% 8.97% 7.27% 7.29% 9.11%Tier 1 Capital / Risk-weighted assets 11A 10.73% 10.73% 12.64% 10.27% 10.27% 12.64%Total RBC / Risk weighted Assets 11A 11.70% 11.70% 13.80% 11.35% 11.35% 13.76%Equity Capital / Total Assets 11 7.29% 7.29% 9.28% 7.23% 7.23% 9.42%Dividend Payout 11 0.00% 0.00% 30.77% 0.00% 0.00% 29.34%Growth rate in total equity capital 11 11.99% 11.99% 10.99% 8.20% 8.20% 11.32%Equity growth less asset growth 11 -6.56% -6.56% 0.41% -0.83% -0.83% 0.28%0.00% 0.00%

Dec-03

Legal risk…the potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of banking organization

Legal risk include:

Compliance risks

Strategic risks

General liability issues

Reputational risk

Reputational risk is the potential that negative publicity regarding an institution’s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions.

Risk, return, and maximizing shareholder wealth

Notice PNC’s ROA vs. Loan Loss Reserve for the past 4 years:

2002 2001 2000 1999PNC PG1 PNC PG1 PNC PG1 PNC PG1

LLR 0.49 0.38 1.42 0.40 0.20 0.33 0.23 0.25ROA 1.78 1.29 0.77 1.19 1.50 1.11 1.53 1.32

It appears that PNC may have understated LLR in 2000 to report higher ROA, but then “paid the price” in 2001 as evidenced by lower ROA.

Managers can maximize shareholder value by focusing on some of the key areas:

1. Asset management (composition and volume)2. Liability management (composition and volume)3. Management of off-balance sheet activities4. Interest rate margin/spread management5. Credit risk management6. Liquidity management7. Tax Management

Can Managers Manipulate Financial Statements?

In a word, yes.

•Off-balance Sheet activities, both to increase income, and in bad cases, to hide losses•Window dressing at period end•Using preferred stock•Manipulating non-performing loans•Allowance for loan losses•Securities gains and losses•Non-recurring sales of assets

MANAGING NONINTEREST INCOME AND NONINTEREST EXPENSE

Chapter 3

Bank ManagementBank Management, 6th edition.6th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2005 by South-Western, a division of Thomson Learning

A common view among bank managers and analysts is that banks must rely less on net interest income and more on noninterest income to be more successful. The highest earning banks will be those that

generate an increasing share of operating revenue from noninterest sources.

A related assumption is that not all fees are created equal.

Some fees are stable and predictable over time, while others are highly volatile because they derive from cyclical activities.

The fundamental issue among managers is to determine the appropriate customer mix and business mix to grow profits at high rates, with a strong focus on fee-based revenues.

Trends in net interest margin and noninterest income: 1990 - 1997

NIM rose from 1990 to 1994, on average, and has fallen sharply thereafter for both banks under $100 million in assets and larger banks.

13.5

4.0

4.5

5.0

1990 1991 1992 1993 1994 1995 1996 1997

Assets,$100 Million

Assets.$100 Million

4.90%

Net

Inte

rest

marg

in (

%)

A. Banks with,$100 Million or.$100 Million in Assets: 1990-1997*

2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 1

It is widely recognized that the days of record-breaking net interest margins for banks are long gone.

This recent decline in NIMs reflects competitive pressures on both the cost of bank funds and yields on earning assets.

13.5

4.0

4.5

5.0

1997 1998 1999 2000 2001

Assets,$1 Billion

Assets.$1 Billion

4.40%

4.10%

Ne

t In

tere

st m

arg

in (

%)

B. Banks with,$100 Billion or.$100 Billion in Assets: 1997-2001

2 3 4 1 2 3 4 1 2 3 4 1 2 3 4 41 2 3

NIMs have fallen sharply since 1994 for

both banks under $100 million in

assets and larger banks.

Pressure on margins Inexpensive core deposit growth has slowed because

customers have many alternatives, such as mutual funds and cash management accounts, that offer similar transactions and savings services and pay higher rates.

Loan yields have fallen on a relative basis because of competition from nonbank lenders, such as commercial and consumer finance companies, leasing companies, and other banks that compete for the most profitable small business loans, credit card receivables, and so on.

Over-reliance on net interest margin?

Potential earnings difficulties are compounded by the fact that asset quality was quite strong during the late 1990s, such that loan loss provisions were low and not likely to show much improvement.

Problem loans are often made at the peak or end of the business cycle. The U.S. economy fell into a modest recession in March

2001, around which loan quality worsened.

The impact is that banks must grow their noninterest income relative to noninterest expense if they want to see net income grow.

Sustained increase in all banks’ noninterest income as a fraction of net operating revenue

Net operating revenue equals the sum of net interest income and noninterest income.

The largest banks rely much more on this source of revenue

Smaller banks still rely more heavily on net interest income.

Composition of noninterest income …biggest contributors are deposit service charges and ‘other.’ (other includes items such as safe deposit boxes, bank drafts, etc.)

Minimum balance requirements to avoid fees and average fees charged on transactions accounts at all U.S. banks from 1994 to 1999.

Change in fees that banks charge for special actions related to customer transaction accounts from 1994 to 1999. Special actions consist of stop-payment orders, NSF checks, overdrafts, and returned deposit items.

Noninterest Income Source

Percent of Total

Noninterest Income

Number of Banks

Reporting Non-Zero Balances

Percent of All Banks

Fiduciary Income 13.00% 1,505 18.60%

Service Charges on Deposit Accounts 17.00% 7,829 96.70%

Trading Gains & Fees 7.60% 149 1.80%

Investment Banking/Brokerage Fees 5.10% 1,948 24.00%

Venture Capital Revenue 0.10% 42 0.50%

Net Servicing Fees 8.50% 1,582 19.50%

Net Securitization Income 11.00% 80 1.00%

Insurance Commissions & Fees 2.00% 3,449 42.60%

Net Gains/Losses On Loan Sales 4.40% 1,568 19.40%

Net Gains/Losses On OREO Sales 0.00% 1,155 14.30%Net Gains/Losses On Sales Of Other Assets -0.10% 1,174 14.50%

Other Noninterest Income 31.40% 7,841 96.80%

Total Noninterest Income 100% 7,972 98.40%

Net Gains On Asset Sales 4.20% 2,774 34.20%

Increasing amount of fees from investment banking and brokerage activities at the larger banks.

Investment and brokerage activities contribute a far greater portion of noninterest income at the largest banks. This explains why noninterest income is a much higher

fraction of their operating revenue.

These fees are highly cyclical in nature and depend on the capital markets.

In late 1998, many large banks reported large trading losses on activities in Russia and Asia.

< $100 mill > $1 bill12/31/2001 12/31/2001

Number of institutions reporting 4486 400Total noninterest income 1.02% 2.63%

Fiduciary activities 0.05% 0.34%Service charges on deposit accounts 0.43% 0.41%Trading account gains & fees 0.00% 0.23%Investment banking, advisory, brokerage, and underwriting fees and commissions

0.01% 0.16%

Venture capital revenue 0.00% -0.01%Net servicing fees (servicing real estate mort., credit cards, and 0.14% 0.19%Net securitization income 0.00% 0.29%Insurance commission fees and income 0.03% 0.05%Net gains(losses) on sales of loans 0.03% 0.07%net gains (losses) on sales of other real estate owned 0.00% 0.00%Net gains (losses) on sales of other assets (excluding securities) 0.01% 0.04%

Other noninterest income 0.29% 0.83%Securities gains (losses) 0.03% 0.08%

Percent of Average Assets

Community banks generated most of their noninterest income from: deposit account fees, trust fees, mortgage fees, insurance product fees and commissions and investment product fees.

Noninterest expense

The Uniform Bank Performance Report lists three components of noninterest expense:

1. Personnel expense wages, salaries, and benefits

2. Occupancy expense rent and depreciation on buildings and

equipment

3. Other operating expenses, general overhead, data processing and

other expenses not listed

Bankers and analysts typically measure performance over time and versus peer

Key ratios measuring noninterest expense and income performance are: Burden = nonint. exp. minus nonint. inc.,

Net non-interest margin = burden / total assets,

Efficiency ratio = nonint. Exp. (net int. inc. + nonint. inc.)

Better performance is indicated by a smaller figure or percentage.

55

57

59

61

63

65

67

69E

ffic

ien

cy r

atio

%

Assets<$1 Billion Assets>$1 Billion

Assets<$1 Billion 68 65.3 65.5 64.6 63.1 62 61.7 62.6 62.6 62.7 64.1 62 63 63

Assets>$1 Billion 67.7 64.4 63.3 63.1 61.4 60.5 58.6 60.7 57.9 57.7 56.6 54.9 55 55.5

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Annual efficiency ratios 1991 – 2004

Operating risk ratios…differentiate performance attributable to cost controls versus fee generation.

The lower the operating risk ratio, the better the bank’s operating performance because it generates proportionately more of

its revenues from fees, which are more stable and thus more valuable.

The ratio subtracts fee income from noninterest expense and divides the total by NIM:

margininterest Net

inc. Fee-expNonint ratio risk Operating

Operating risk ratio signals the benefit of fee income Operating Risk Ratio Signals the Benefit of Fee Income Ratio Bay Bank River Bank Return on Assets (ROA) 1.4% 1.4% Net Interest Margin (NIM) 4.0% 4.625% Percent of Average Total Assets: Net interest income 3.20% 3.70% Noninterest income (fee) 1.40% 0.90% Operating Revenue 4.60% 4.60% Noninterest Expense 3.00% 3.00% Earning Assets 80.00% 80.00% Taxes 0.20% 0.20% Efficiency Ratio: 65.22%

= 0.03/(0.032+0.014) 65.22% = 0.03/(0.037+0.009)

Operating Risk Ratio: 40.00% = (0.03-0.014)/0.04

45.41% = (0.03-0.009)/0.04625

RAROC = risk – adjusted income capital

RORAC = income allocated risk capital

Productivity ratios…indicate how efficiently banks are using their employees relative to capital assets.

Two commonly cited ratios are:1. Assets per full time employee and 2. Average personnel expense.

The more productive bank typically has fewer employees per dollar of assets held and often controls personnel expense per employee better.

The second ratio is often high for high performance banks because they operate with fewer people but pay them more.

Community banks also typically examine two additional ratios…Because loans typically represent the largest asset holding, it is meaningful to calculate a loans-per-employee ratio as an indicator of loan productivity.

Since loans are often an the largest asset held, community banks examine: Loans per full time employee

A ratio of net income per employee generally indicates the productivity and profitability of a bank’s workforce: = Net income / Number of full time employees

Customer profitability and business mix

Typical analyses of customer profitability profiles suggest that banks make most of their profit from a relatively small fraction of customers.

The traditional view is that up to 80 percent of a bank's customers are unprofitable when all services are fully costed.

Such figures support the increase in fees assessed by most banks over the past few years.

Which customers are profitable?

The first step in identifying profitable growth is to determine which of the bank’s customers and lines of business are profitable.

RAROC / RORAC framework can be used to assess the risk-adjusted return on allocated capital for a specific product or line of business.

Data on customer profitability are beneficial in helping management target niches, develop new products, and change pricing.

Product offerings at community banks

Aggregate results from total customer account profitability indicates…

A small fraction of customers contribute the bulk of bank profits.

Many customer profitability models show that a significant difference between profitable and unprofitable accounts is that profitable customers maintain substantial loan and investment business with the bank.

Strategies to manage noninterest expense

Four different strategies are: 1. expense reduction,

2. increase operating efficiency,

3. Revenue enhancement, and

4. pursuing contribution growth whereby noninterest revenues rise by more than noninterest expense.

Cost management strategies …expense reduction

Many banks begin cost management efforts by identifying and eliminating excessive expenses.

Given that noninterest expenses consist primarily of personnel, occupancy, and data processing costs, these are the areas where cuts are initially made.

Cost management strategies …increase operating efficiencies

Another strategy is to increase operating efficiency in providing products and services.

This can be achieved in one of three ways: 1. reducing costs but maintaining the existing level of

products and services,

2. increasing the level of output but maintaining the level of current expenses, or

3. improving work flow.

All these approaches fall under the label of increasing productivity because they involve delivering products at lower unit costs.

Cost management strategies …revenue enhancement

This strategy involves changing the pricing of specific products but maintaining a sufficiently high volume of business so that total revenues increase.

It is closely linked to the concept of price elasticity.

Here, management wants to identify products or services that exhibit price inelastic demand.

Cost management strategies …contribution growth With this strategy, management allocates resources

to best improve overall long-term profitability.

Increases in expenses are acceptable, but they must coincide with greater anticipated increases in associated revenues.

An example might be investing in new computer systems and technology to provide better customer service at reduced unit costs once volume is sufficiently large. In essence, expenses are cut in the long run but not

in the near future.