Banking, Investing and Insurance

BUSINESS AND BANKING

AND PROFITABILITY

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Bank Earnings: Net Interest Income

Loan interest and fees represent the main source of bank revenue, followed by interest on investment securities.

Interest paid on deposits is the largest expense, followed by interest on other borrowings.

Net interest income is the difference between gross interest income and gross interest expense.

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Bank Earnings: Provision for Loan Losses

Provision for loan losses is an expense item that adds to a bank’s loan loss reserve (a contra-asset account).

Banks provide for loan losses in anticipation of credit quality problems in the loan portfolio.

Loans are written off against the loan loss reserve

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Bank Earnings: Non-interest income and expense

Noninterest income includes fees and service charges. This source of revenue has grown significantly in importance.

Noninterest expense includes personnel, occupancy, technology, and administration. These expenses have also grown in recent years.

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Bank Performance

Trends in profitability can be assessed by examining return on average assets(net income / average total assets) over time.

Another measure of profitability is return on average equity.

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Dilemma: Profitability vs. Safety

One way for a bank to increase expected profits is to take on more risk. However, this can jeopardize bank safety.

For a bank to survive, it must balance the demands of three constituencies:

shareholdersdepositorsregulators

Each with their own interest in profitability and safety.

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Solvency and Liquidity

Solvency: Maintaining the momentum of a going concern, attracting customers and financing.

A firm is insolvent when the value of its liabilities exceeds the value of its assets.Banks have relatively low capital/asset ratios but generally high-quality assets.

Liquidity: the ability to fund deposit withdrawals, loan requests, and other promised disbursements when due.

A bank can be profitable and still fail because of illiquidity.

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Conflicting Demands

A bank must balance profitability, liquidity, and solvency.

Bank failure can result from excessive losses on loans or securities -- from over-aggressive profit seeking. But a bank that only invests in high-quality assets may not be profitable.

Failure can also occur if a bank cannot meet liquidity demands. If assets are profitable but illiquid, the bank also has a problem.

Bank insolvency often leads to bank illiquidity.

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Liquidity Management

Banks rely on both asset sources of liquidity and liability sources of liquidity to meet the demands for liquidity.

The demands for liquidity include accommodating deposit withdrawals, paying other liabilities as they come due, and accommodating loan requests.

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Asset Management

Primary Reserves are noninterest bearing, extremely liquid bank assets

Secondary Reserves are high-quality, short-term, marketable earning assets

Bank Loans are made after absolute liquidity needs are met

After loan demand is satisfied, funds are allocated to Income Investments that provide income, reasonable safety, and some liquidity, if needed

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Asset Management (cont.)

The bank must manage its assets to provide a compromise of liquidity and profitability.

Primary and secondary reserve levels relate to:deposit variability

other sources of liquidity (e.g. Fed funds)

bank regulations - permissible areas of investment

risk posture that bank management will assume

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Liability Management

Assumes bank can borrow its liquidity needs at will in money markets by paying market rate or better

Liability levels (borrowing) may be quickly adjusted to loan (asset) needs or deposit variability

Bank liability liquidity sources include “non-deposit borrowing" (e.g. Fed funds, etc.)

LM supplements asset management, but does not supersede it

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Definition of Bank Capital

Tier 1 capital or “core” capital includes common stock, common surplus, retained earnings, non-cumulative perpetual preferred stock, minority interest in consolidated subsidiaries, minus goodwill and other intangible assets.

Tier 2 capital or “supplemental” capital includes cumulative perpetual preferred stock, loan loss reserves, mandatory convertible debt, and subordinated notes and debentures.

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Functions of Bank Capital

Absorb losses on assets (loans) and limit the risk of insolvency.Maintain confidence in the banking system.Provide protection to uninsured depositors and creditors.Ultimate source of funds and leverage base to raise depositor funds.

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Regulatory Capital Standards

As capital requirements have increased, regulators have also implemented risk-based capital standards.

Capital is measured against risk-weighted assets.

Risk-weighting is a measure of total assets that weighs high-risk assets more heavily.

The purpose is to require high-risk banks to hold more capital than low-risk banks.

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Minimum Capital Requirements

Ratio of Tier 1 capital to risk-weighted assets must be at least 4%

Ratio of Total Capital (Tier 1 plus Tier 2) to risk-weighted assets must be at least 8%.

Undercapitalized banks receive extra regulatory scrutiny; regulators may limit activities, intervene in management, or even revoke charter.

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Managing Credit Risk

The credit risk of an individual loan concerns the losses the bank will experience if the borrower does not repay the loan.

The credit risk of a bank’s loan portfolio concerns the aggregate credit risk of all the loans in the bank’s portfolio.

Banks must manage both dimensions effectively to be successful.

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Managing Credit Risk of Individual Loans

Requires close monitoring to identify problem loans quickly

The goal is to recover as much as possible once a problem loan is identified.

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Managing Credit Risk of Loan Portfolio

Internal Credit Risk Ratings are used toidentify problem loans

determine adequacy of loan loss reserves

price loans

Loan Portfolio Analysis is used to ensure that banks are well diversified.

Concentration ratios measure the percentage of loans allocated to a given geographic location, loan type, or business type.

Questions, Comments, Concerns

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