FINANCIAL Ratio ANALYSIS

3- The spread is another traditional indicator of return on a bank’s assets by measuring the difference between the average yield on earning assets and the average cost of interest-bearing liabilities. It is defined as:

Figure 1 Decomposition process

4- This decomposition process helps narrow down the causes of bank earnings problems and suggests where the management needs to look for possible cures.

As shown in Figure 1, the decomposition process focuses on the ROE and its key components, ROA and the equity multiplier (also known as leverage multiplier for signifying extent of bank reliance on leverage or debt in the financing of its assets). Together the two component ratios indicate that a higher ROE can be attained by increasing either ROA or financial leverage. The ROA, in turn, may be broken down into its key components, profit margin and asset utilisation. The profit margin and asset utilisation may each be decomposed further. The former would reflect the relative importance of four ratios each of which measures the individual weight of specific types of expenses and taxes (interest expense, non-interest expense, provision for loan losses, and income taxes) in relation to total operating income; asset utilisation would itself be broken down into interest income relative to total assets, and non-interest income to total assets.

Additional ratios may be used to measure performance in other aspects of banking activity, such as operating efficiency (total operating expenses in relation to total operating income), employee productivity (net operating income relative to full-time equivalent employees), off-balance sheet items (relative to total assets), and capital adequacy based on the internationally imposed standards of the Basel agreement – e.g., ratio of core capital (Tier 1) to total risk-weighted assets, and ratio of total capital (Tier 1 plus Tier 2) to total risk-weighted assets.

5-With lending the dominant activity of commercial banks and the key source of revenue income, the relevance and quality of the loan portfolio is measured by such indicators as:

The first ratio has been a traditional gauge of a bank’s exposure to credit risk (debtors’ failure to perform as agreed). With loans among the riskiest of all assets, growth of this ratio increases a bank’s loss potential and undermines the safety of its deposits.

The next four ratios evaluate critical aspects of loan portfolio soundness.

Inability to meet normal operating requirements on a day-to-day basis exposes a bank to liquidity risk (lack of sufficient cash and borrowing capacity to meet customer demands). Key measures of this risk, expressed as a percent of total assets, are the following ratios:

Management challenges

Ponce de Leon Bank was not immune to the effects of the financial crisis owing to its loan portfolio concentration in real estate loans and the somewhat aggressive lending practices it used to expand it – granting loans at higher than normal loan-to-value (LTV) ratios, and using lax structuring of loan repayment terms and conditions (many loans were granted with interest only payment provisions and no significant principal amortisations). As the financial crisis began to unfold, the bank started to experience an increase in its non-current loans and repossessed properties to a level beyond what could be supported by its total capital and loan loss reserves. Regulatory concerns prompted the bank to seek out private investors who contributed $2.0 million of additional capital in early 2009. This move, however, turned out to offer only temporary relief; continued deterioration in asset quality caused additional losses, poor earnings, and return to capital deficiency. The extent of the bank’s exposure may be sensed by the fact that at the end of the first quarter of 2010, commercial real estate loans were valued at $34.7 million and represented 604% of its capital base, while its gas station loans amounted to $12.2 million and represented 211% of its capital. In addition, the bank’s OREO (other real estate owned portfolio-foreclosed loans) surged by more than double – from $3.185 million in 2009 to $7.38 million in 2010 – representing a 120% of its capital.

Addressing the additional loan portfolio exposure (e.g., increasing loan loss reserves for $6.1 million in non-current loans) and meeting regulatory capital requirements was a challenging task for the bank. Yet its management felt confident that as the two-year old government financial rescue plan worked its way through the economy, recovery and growth would soon take hold. Continuing highly stimulative US monetary and fiscal policies had already caused the gradual improvement in the 2010 quarterly GDP data and the drop in the unemployment rate (9.4%). Management reasoned that these policies would prompt real estate to rebound and help restore the bank to a safe and financially sound condition.

The immediate attention of management was directed on boosting the bank’s non-interest income. Its rational was that this source of income diversified earnings from traditional lines of business and contributed significantly to the bank’s long-term potential. A prime favourite was entry into the fiduciary business (trust services). Trust services (e.g., managing customer assets such as securities, land, and buildings) offered the advantage of generating income without utilising bank funds. Bank fees, monthly service charges on deposits, and special charges for special services were viewed as additional favourites for boosting non-interest income.

The size and relative importance of bank operations may be sensed from Tables 4 through 6 which depict the financial condition of the institution in 2009 and 2010. Financial statements were audited by a major US accounting firm.

Table 4 Balance sheets, Ponce de Leon Bank, Coral Gables, Florida (thousands of dollars)

Source: Supplied by the management of the bank

Table 4 Balance sheets, Ponce de Leon Bank, Coral Gables, Florida (thousands of dollars) (continued)

Source: Supplied by the management of the bank

Table 5 Income statements, Ponce de Leon Bank, Coral Gables, Florida (thousands of dollars)

Source: Supplied by the management of the bank

Table 6 Performance ratios, Ponce de Leon Bank, Coral Gables, Florida

20092010

Net income/ total operating income60.81%100.00%

Interest expense / total operating income-93.72%-35.24%

Noninterest expenses / TOI-155.68%-123.57%

provision for loan losses / TOI-63.43%-28.44%

Income tax paid / TOI

Total operating income / total asset-1.87%-3.25%

Interest income / total asset3.84%2.95%

Noninterest income / total asset0.14%-0.12%

Profit margin

Asset Utilization

20092010

Dept ratio88.45%94.27%

Leverage Ratio11.20%5.49%

Loss allowance to loans1.77%2.10%

Leverage Ratio

Cashandbalancesduefromotherdepository

institutions/Total assets7.36%9.88%improving

Cashassetsandshorttermgovernment

securities (one year or less) / Total assets5.65%4.14%falling

Purchased funds / Total assets00

Liquidty Ratio

20092010

ROA-1.14%-3.25%

ROE-10%-57%

20092010

Net interest margin 2.91%2.86%

Net non-interest margin -2.77%-4.13%

20092010

spread-27%-24.00%