Bank Management,
Management 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright 2003 by South-Western, a division of Thomson Learning
Chapter 1
Balance Sheet
Assets = Liabilities + Equity.
Balance sheet figures are calculated at
a particular point in time and thus
represent stock 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
Provisions for loan losses
Recoveries
Provisions for loan losses
Reserve for Loan Losses
Charge offs
Bank investments categaories
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not withdrawn over short periods of time.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.
Their ability to borrow is sensitive to the markets perception of
their asset quality.
Volatile liabilities or net non-core liabilities include: large CDs (over
100,000), deposits in foreign offices, federal funds purchased,
repurchase agreements, and other borrowings with maturities less
than one year.
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 less interest expense is
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
Interest income
Interest income includes interest from:
Loans
Deposits
held at other institutions,
Municipal and taxable securities, and
Investment and trading account
securities.
Noninterest expense
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 (noninterest) per dollar of loans.
Return on equity (ROE = NI / TE)
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.
ROE
Return on assets (ROA = NI / TA)
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 banks ability to:
generate income (AU) and control expenses (ER)
Income generation (AU) can be found on
the UBPR (page 1) as:
Int. Inc. Non. int. Inc. Sec gains (losses)
AU
TA
TA
TA
Expense Control (ER) can be found on the
UBPR (page 1) as:
Int. Exp. Non int . Exp. PLL
ER
TA
TA
TA
*
Note, ER* does not include taxes.
Bank
BankPerformance
PerformanceModel
Model
Returns
Returnsto
to
Shareholders
Shareholders
ROE
ROE==NI
NI//TE
TE
Interest
Rate
Composition (mix)
Volume
INCOME
Fees and Serv Charge
Non Interest
Trust
Other
Return to the Bank
ROA = NI / TA
Rate
Interest
Composition (mix)
Volume
EXPENSES
Overhead
Degree of Leverage
EM = 1 / (TA / TE)
Prov. for LL
Taxes
Salaries and Benefits
Occupancy
Other
Expense ratio (ER = Exp / TA)
Interest expense / TA
Cost per liability (rate)
Int. exp. liab. (j) / $ amt. liab. (j)
Composition of liabilities
$ amt. of liab. (j) / 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):
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)
Spread
Spread = (int inc / EA) (int exp / int bear. Liab.)
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 for bank
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?
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.
2.
Composition of investments
Maturity of investments
By borrowing.
Core deposits
Volatile deposits
Market risk
the risk to a financial institutions
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.
Foreign exchange risk
the risk to a financial institutions
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 currencies different
from the banks domestic (home) currency.
This risk is often found in off-balance sheet
loan commitments and guarantees
denominated in foreign currencies; foreign
currency translation risk.
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 offbalance 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 banks operating risk is closely related to its
operating policies and processes and whether is has
adequate controls
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.
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
institutions business practices,
whether true or not, will cause a
decline in the customer base, costly
litigation, or revenue reductions.
2008
2.211
0.96
0.42
0.8
0.53
1.49
1.43
35.77
2.91
55.24
72.85
4.92
45.5
75
15.91
5.3
56.44
64.49
1.46
27.41
3.24
43.14
74.17
0.7
0.41
20.79
4.5
45.32
71.77
0.25
13.59
2.45
48.8
63.71
0.33
1.13
18.23
2.8
33.3
56.4
2.28
1.22
26.06
4.82
41.04
70.82
0.34
1.21
13.83
3.11
51.37
73.29
0.58
1.19
19.57
2.96
39.62
64.45
0.79
1.06
13.57
0.87
1.2
17.91
5.1
63
57.98
0.4
1.31
20.68
3.1
52.74
59.5
15.230
5.72
47.07
61.55
2008
29.31
1.21
0.17
203.32
15.45
5.06
23
1.21
0.19
131.59
16
17.52
0.92
0.16
152.5
26.5
14.6
24.11
1.11
0.46
225.73
27
6.56
1.82
0.36
151.22
10.95
7.46
32.83
26.89
3.13
0.48
121.72
29.12
10.81
18.9
2.29
0.24
130.15
18.2
10.75
21.31
0.83
0.07
226.58
25.82
8.94
28.8
1.36
0.2
150.03
12.74
12.32
29.32
1.92
0.17
116.83
15.41
9.54
39.24
1.54
0.04
170.76
12.89
20.68
34.92
1.55
0.83
180.23
9.08
16.42
20.96
2.21
0.23
131.58
21.65
10.17
2008
8.88
4.42
27.01
599
16298
2.34
9.98
3.41
26.45
6500
11885
2.0100
16.15
3.23
24.54
35.5
689.6
1.4
11.34
5.31
32.14
667
21608
2.47
11.4
3.72
36.56
2054
9810
2.76
13.43
3.4
17.6
5575
106494
2.76
13.06
2.9
20.4
365.12
135983
2.97
11.24
2.82
19.77
860
3238
0.65
14.32
4.21
23.95
931
13572
2.04
13.47
0.51
21.1
1927
29814
1.23
24.12
3.53
26.91
99.34
1122
0.2
19.66
7.83
40.89
309
5383
2.79
12.16
3.68
20.72
6,571
54,026
2.91
2008
396548
408247
142,498
947,293
653,310
151,485
329,196
454,944
1,646
785,786
647,903
136,237
46486
29736
76,222
57,779
18,443
620,707
1,178,240
99,504
1,898,451
1,322,004
476,943
199335
188402
97,613
485,350
327,350
60,387
1550720
1853674
253,367
3,657,761
1,585,764
1,818,630
3990043
3959172
116,009
8,065,224
7,548,195
401,020
279521
278258
74647
632,426
468,886
88,893
414,053
521,362
10,427
945,842
763,279
172,136
879,300
785,580
201686
1,866,566
1,020,120
644,760
28,703
25,878
8,151
62,732
44,045
10,536
191730
117509
6,601
315,840
255,118
54,121
3,103,002
2,607,353
67,961
5,778,316
3,434,021
2,276,334
2008
55,721
24,187
37845
1,309,425
41,702
0.9682
56,115
25,902
51307
1,054,350
54,672
0.9481
4,959
2,068
8403
103,263
8,805
0.9147
71,963
25,393
71472
1,571,797
79,515
0.9494
37,370
20910
26416
731,599
276054
0.6227
257,953
113,807
443980
6,955,694
468,272
0.9327
433,235
173,693
510549
9,757,654
603,183
0.9382
52525
26332
46315
1,020,899
49,022
0.9520
58,868
22,776
92042
1,187,837
95,346
0.9197
116,787
51,149
132151
2,678,255
145,209
0.9458
4,539
1943
10219
93,706
11,346
0.8789
18,578
7,490
31716
417,022
33,794
0.9190
355,438
131,597
431353
7,555,452
467,562
0.9381
