CHAPTER 3 1 What are the major categories of depository institution assets and their approximate percentage contribution to total resources? What are the major categories of depository institution lia[.]
CHAPTER What are the major categories of depository institution assets and their approximate percentage contribution to total resources? What are the major categories of depository institution liabilities? What are the fundamental differences between them? For a large bank, assets consist approximately of marketable securities (20%), loans (70%), and other assets (10%) Liabilities consist of core deposits (40%-60%), noncore, purchased liabilities (20%-40%), and other liabilities (5 %-10%) as a fraction of assets Small banks typically obtain more funds in the form of core deposits and less in the form of noncore, purchased liabilities Small banks often invest more in securities as well Of course, the actual percentages for any bank depend on that bank’s business strategy, market competition, and ownership Depository institutions typically differentiate between interest and noninterest income and expense What are the primary components of each? Define net interest income (NIM) and burden What does a bank’s efficiency ratio measure? A bank's interest income consists of interest earned on loans and securities while noninterest income includes revenues from deposit service charges, trust department fees, fees from nonbank subsidiaries, etc - Interest expense consists of interest paid on interest-bearing core deposits and noncore liabilities while noninterest expense is comprised of overhead costs, personnel costs, and other costs A bank’s net interest income equals its interest income minus interest expense Note that interest income may be calculated on a tax-equivalent basis in which tax-exempt interest is converted to its pre-tax equivalent - A bank’s burden is defined as its noninterest expense minus noninterest income This is often quoted as a fraction of total assets - A bank’s efficiency ratio is calculated as noninterest expense divided by the sum of net interest income and noninterest income The denominator effectively measures net operating revenue after subtracting interest expense The efficiency ratio measure the noninterest cost per $1of operating revenue generated Analysts often interpret the efficiency ratio as a measure of a bank’s ability to control overhead relative to its ability to generate noninterest income (and overall revenue) Using PNC (in Exhibit 3.2) as a typical large depository institution, which balance sheet accounts would be affected by the following transactions? Indicate at least two accounts with each transaction a Arturo Rojas opens a money market deposit account with $5,000 The funds are lent in the overnight market for one week b Just as a real estate developer pays off a strip shopping mall loan, a new resident optometrist takes out a mortgage on a home c The bank hires an investment banker to sell shares of stock to the public It plans to use the proceeds to finance additional commercial loans a) Aturo Rojas opens a money market deposit account with $5000 The funds are lent in the overnight market for one week Liabilities: money market deposit accounts +5,000 Assets: LN & LS in domestic off +5,000 b) Just as a real estate developer pays off a strip shopping mall loan, a new resident optometrist takes out a mortgage on a home No transaction because both of these are related to real estate loans c) The bank hires an investment banker to sell shares of stock to the public It plans to use the proceeds to finance additional commercial loans No transaction is made Arrange the following items into an income statement Label each item, place it in the appropriate category, and determine the bank’s bottom-line net income a Interest paid on time deposits under $100,000: $78,002 b Interest paid on jumbo CDs: $101,000 c Interest received on U.S Treasury and agency securities: $44,500 d Fees received on mortgage originations: $23,000 e Dividends paid to stockholders of $0.50 per share for 5,000 shares f Provisions for loan losses: $18,000 g Interest and fees on loans: $189,700 h Interest paid on interest checking accounts: $33,500 i Interest received on municipal bonds: $60,000 j Employee salaries and benefits: $145,000 k Purchase of a new computer system: $50,000 l Service charge receipts from customer accounts: $41,000 m Occupancy expense for bank building: $22,000 n Taxes of 34 percent of taxable income are paid o Trust department income equals: $15,000 Income statement Interest on U.S Treasury & agency securities $44,500 Interest on municipal bonds Interest and fees on loans Interest income = Interest paid on interest-checking accounts Interest paid on time deposits Interest paid on jumbo CDs Interest expense = Net interest income = 60,000 189,700 $294,200 $33,500 78,002 101,000 $212,502 $81,698 Provisions for loan losses = $ 18,000 Net interest income after provisions = $63,698 Fees received on mortgage originations $23,000 Service charge receipts 41,000 Trust department income 15,000 Non-interest income = Employee salaries and benefits Occupancy expense Non-interest expense = Income before income taxes $79,000 $145,000 22,000 $167,000 -$24,302 Income taxes 8,263 Net income = -$16,039 Cash dividends declared Retained earnings = 2,500 -$18,809 What are the primary sources of risk that depository institution managers face? Describe how each risk type potentially affects performance Provide one financial ratio to measure each type of risk and explain how to interpret high versus low values The primary risks faced by banks are credit risk, liquidity risk, market risk (as interest rate risk and foreign exchange risk), operational risk, reputational risk, and legal risk In general, promised, or expected, returns should be higher for banks that assume increased risk There should also be greater volatility in returns over time a Credit risk: Net loan charge-offs/Loans High risk - high ratio; Low risk - low ratio High risk manifests itself in occasional high charge-offs, which requires above average provisions for loan losses to replenish the loan loss reserve Thus, net income is volatile over time b Liquidity risk: Core deposits/Assets High risk - low ratio; Low risk - high ratio High risk manifests itself in less stable funding as a bank relies more on noncore, purchased liabilities that fluctuate over time These noncore liabilities are also higher cost, which raises interest expense c Market risk in the form of interest rate risk: (|Repriceable assets-repriceable liabilities|)/Assets High risk - high ratio; Low risk - low ratio High risk banks not closely match the amount of repriceable assets and repriceable liabilities Large differences suggest that net interest income may vary sharply over time as the level of interest rates changes d Market risk in the form of foreign exchange risk: Assets denominated in a foreign currency minus liabilities denominated in the same foreign currency High risk – a large difference; Low risk – a small difference High risk manifests itself when exchange rates change adversely and the value of the bank’s net position of assets versus liabilities denominated in a currency changes sharply Bank L operates with an equity-to-asset ratio of percent, while Bank S operates with a similar ratio of 10 percent Calculate the equity multiplier for each bank and the corresponding return on equity if each bank earns 1.5 percent on assets Suppose, instead, that both banks report an ROA of 1.2 percent What does this suggest about financial leverage? a) EM of Bank L = Assets/Equity = 1/6% = 16,67 EM of Bank S = 1/10% = 10 b) ROE Bank L = ROA*EM = 1,5% * 16,67= 25% ROE Bank S = ROA*EM = 1,5%*10 = 15% c) ROE Bank L = 1,2%*16,67 = 20% ROE Bank S = 1,2%*10 = 12% JUNIOR FINANCE TBS 2013-2014 d) We notice that the EM of Bank L > EM of Bank S, Bank L has a lower capital to assets as cushion for any loss risk, hence it represents a higher risk of insolvency than Bank S Bank L offers a better a return on investment to its stockholders 25% than Bank S does (15%) Although the same return on assets, the banks offer different ROE because of EM The bank with higher EM so with higher financial leverage offers a better ROE but presents a higher risk of insolvency We notice that the decline of ROA of 0,3% had a larger impact on the difference between the banks ROE about 8% (20%-12%) because of the EM magnified this ROA decline In sum, with high financial leverage, a bank offers a better return on investment for its stockholders but not preserve them from insolvency risk Moreover, with a high financial leverage, any change in ROA will be amplified in the ROE Define each of the following components of the return on equity model and discuss their interrelationships: a ROE b ROA c EM d ER e AU a) ROE – return on any dollar invested in the company b) ROA – return on any dollar of assets c) EM – the assets financed by one dollar of equity d) ER – the expenses generated per one dollar of assets e) AU – income revenue generated per one dollar of total assets Explain how and why profitability ratios at small banks typically differ from those at the largest money center banks Profitability ratios differ across banks of different size as measured by assets The primary reasons are that different size banks have different asset and liability compositions and engage in different amounts of off-balance sheet activities Typically, small banks report higher net interest margins because their average asset yields are relatively high while their average cost of funds is relatively low This reflects loans to higher risk borrowers, on average, and proportionately more funding from lower cost core deposits ROEs, in turn, are often lower because small banks operate with more capital relative to assets, that is with lower equity multipliers, so that even with comparable ROAs the ROEs are lower Large banks ROAs are increasing faster over time because large banks operate with lower efficiency ratios as they have been more successful in generating fee income Regulators use the CAMELS system to analyze bank risk What does CAMELS stand for and what financial ratios might best capture each factor? CAMELS C = Capital adequacy: equity/assets A = Asset quality: nonperforming loans/loans; loan charge-offs/loans M = Management: no single ratio is good, although all ratios indicate overall strategy E = Earnings: aggregate profit ratios; ROE, ROA, net interest margin, burden, efficiency L = Liquidity: core deposits/assets; noncore, liabilities/assets; marketable securities/assets purchased S = Sensitivity to market risk; |repriceable assets-repriceable liabilities|/assets; difference in assets and liabilities denominated in the same currency; size of trading positions in commodities, equities and other tradeable assets 10 Rank the following assets from lowest to highest liquidity risk: a Three-month Treasury bills with one-year construction loan b Four-year car loan with monthly payments c Five-year Treasury bond with five-year municipal bond d One-year individual loan to speculate in stocks e Three-month Treasury bill pledged as collateral a Three-month Treasury bills e Three-month Treasury bill pledged as collateral b Four-year car loan with monthly payments d One-year individual loan to speculate in stocks f one-year construction loan g five-year municipal bond c Five-year Treasury bond 11 In each pair below, indicate which asset exhibits the greatest credit risk Describe why a Commercial loan to a Fortune 500 company or a loan to a corner grocery store b Commercial loans to two businesses in the same industry; one is collateralized by accounts receivable from sales, while the other is collateralized by inventory as work-in-process c Five-year Baa-rated municipal bond or a five-year agency bond from the Federal Home Loan Bank system d One-year student loan (college) or a one-year car loan a) Commercial loans to a Fortune 500 company or a loan to a corner grocery store The grocery store poses a greater credit risk because the Fortune 500 company has proved its ability to make capital while the grocery store may have a harder time due to big name retailers b) Commercial loans to two businesses in the same industry; one is collateralized by accounts receivable from sales, while the other is collateralized by inventory as work-in-process The business collateralized by inventory poses a higher risk because there is the chance that the inventory it possesses won’t be turned into capital c) Five-year Ba-rated municipal bond or a five-year agency bond from the Federal Home Loan Mortgage Corporation The five-year agency bond poses a greater credit risk because anything relating to a home loan mortgage corporation can be risky d) One-year student loan or a one-year car loan The student loan is riskier because the loan can be given to an individual with no previous credit while a car loan is generally given prior to a credit check to ensure repayment 12 What ratios on common-sized financial statements would indicate a small bank versus a large, multibank holding company? Cite at least five The largest banks generally employ fewer people per dollar of assets than smaller banks The largest banks are generally offering very standardized loans and deposit products, hence competition is steep and margins small Smaller banks generally operate with proportionately more core deposits and fewer volatile liabilities as compared with the largest banks Largest banks report much higher net charge-offs than smaller banks Larger banks operate with less equity and more debt 13 In some instances, when a depository institution borrower cannot make the promised principal and interest payment on loan, the bank will extend another loan for the customer to make the payment a Is the first loan classified as a nonperforming loan? b What is the rationale for this type of lending? c What are the risks on this type of lending? a The new loan is typically not classified as nonperforming because no payments are past due b Often a bank recognizes that the loan is in the problem stage and the borrower renegotiates the terms in its favor; rationale is that the borrower may default if the loan is not restructured Note that this restructuring gives the appearance that asset quality is higher c The primary risk is that the bank is throwing more money down a sink hole and will never recover any of its loan 14 Suppose that your bank had reported a substantial loss during the past year You are meeting with the bank’s board of directors to discuss whether the bank should make its traditional (25 years straight) dividend payment to common stockholders Provide several arguments for why the bank should authorize and make the dividend payment The, provide several arguments for why it should not make the payment What should decide the issue? Dividend payment: For: the loss is temporary and stockholders expect the dividend payment Failure to make the payment will sharply lower the stock price because stockholders will be alienated Against: the bank has not generated sufficient cash to make the payment from normal operations By paying the cash dividend, the bank is self-liquidating The cash dividend will lower the bank’s capital What normally decides the issue is whether the loss is truly temporary or more permanent Management typically errs by assuming that losses are temporary, and thus continues to make dividend payments when it should be reducing or eliminating them 15 Explain how each of the following potentially affects a bank’s liquidity risk: a Most (95 percent) of the bank’s securities holdings are classified as held-tomaturity b The bank’s core deposit base is a low (35 percent) fraction of total assets c The bank’s securities all mature after eight years d The bank has no pledged securities out of the $10 million in securities it owns a Securities that are classified as held-to-maturity typically cannot be sold for liquidity purposes unless a release is issued Therefore it is more difficult for this bank to meet financing needs should a liquidity crunch occur, and liquidity risk is higher b A low core deposit base means that the bank is relying more on noncore, volatile liabilities that are more likely to leave the bank if rates change The bank’s funding resources are then less reliable, subjecting the bank to higher liquidity risk c Even if the securities are capable of being sold quickly (as they are classified as available-for-sale), these securities are subject to ... EM of Bank L = Assets/Equity = 1/6% = 16,67 EM of Bank S = 1/10% = 10 b) ROE Bank L = ROA*EM = 1,5% * 16,67= 25% ROE Bank S = ROA*EM = 1,5%*10 = 15% c) ROE Bank L = 1,2%*16,67 = 20% ROE Bank S... notice that the EM of Bank L > EM of Bank S, Bank L has a lower capital to assets as cushion for any loss risk, hence it represents a higher risk of insolvency than Bank S Bank L offers a better... indicate a small bank versus a large, multibank holding company? Cite at least five The largest banks generally employ fewer people per dollar of assets than smaller banks The largest banks are generally