UBPR report

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C H A P T E R 3 Analyzing Bank Performance 121

To account for the potential risk of off-balance sheet activities, risk-based capital requirements oblige a bank to convert off-balance sheet activities to “on- balance” sheet equivalents and hold capital against these activities. Appropriate capital risk measures include all the risk measures discussed earlier, as well as ratios measuring the following: Tier 1 capital and total risk-based capital to risk- weighted assets, equity capital to total assets, dividend payout, and the growth rate in Tier 1 capital. Tier 1 (or core) capital or Tier 1 leverage 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. See Chapter 12 for more details on the calculation of required regulatory capital at banks. Importantly, a bank’s dividend policy also affects its capital risk by influencing retained earnings.

Evaluating Bank Performance: An Application

A complete analysis of a financial firm is similar to that of any other industry with a few exceptions. The analyst begins by gathering background information on the firm’s operations, including specific characteristics of the business and intensity of competition, organizational and business structure, management character and quality, as well as the quality of reported data. Is the bank a holding company or financial holding company with subsidiaries and branches, or a single entity? Does it operate as a C-corporation or an S-corporation?42 Is the firm privately held or publicly traded? When did the firm begin operations, and in what geographic markets does it now compete? The evaluation should also identify the products or services provided and the bank’s competitive position in the marketplace as measured by market share, degree of product differentiation, presence of economies of scale or scope in the cost structure, and the bargaining power of customers with whom the bank deals. Much of this discussion for PNC Bank was presented earlier in the chapter and hence the following discussion focuses on the financial data of PNC introduced in Exhibits 3.2, 3.4, and 3.7. It examines data for 2007 relative to peer banks and summarizes trends from 2003 to 2007. Profitability is evaluated following the ROE model presented in the chapter using data from PNC Bank’s UBPR data. This evaluation is contrasted with the firm’s risk position using the risk categories discussed in the “Managing Risk and Returns” section presented previously.

PROFITABILITY ANALYSIS FOR PNC IN 2007

Profitability ratios are provided in Exhibit 3.8. The first three columns of data are for 2006 and the next three columns are for 2007. The first column in 2006 and 2007 is labeled “CALC” and contains the ratios calculated using data listed in Exhibits 3.2, 3.4, and 3.7. The second column, “BANK,” provides profitability

42 It is important to know if a bank operates as an S-corporation. S-corporations do not pay taxes at the bank level; rather these tax obligations are passed on to shareholders. This means that net income is “overstated” relative to a C-corporation because it does not consider the taxes that must be paid by shareholders on behalf of the bank. Analysts should adjust all after-tax figures for S-corporation banks to compare to C-corporation banks.

122 C H A P T E R 3 Analyzing Bank Performance

ratios taken directly from the UBPR. The third column, titled “PG 1,” represents peer group comparative figures obtained from the UBPR for other U.S. banks with more than $3 billion in assets.43 The equations provided in the chapter apply to data in the column labeled “CALC.” Because the UBPR uses several different methods of averaging balance sheet data, the calculated ratios will not always equal the UBPR ratios. Quarterly average balance sheet data are not published in the UBPR except for average total assets and average total loans. When other average balance sheet data are needed to calculate a ratio, the average value is obtained by using an average of year-end data. The calculated values are provided as a reference for applying the formulas and equations presented earlier in the chapter. Because the use of quarterly average balance sheet data will generally provide more accurate ratios, the following analysis will use ratios obtained directly from the UBPR and compare these with the listed peer group figures.44

PNC’s profitability fell dramatically in 2007, such that the return on equity (ROE) was only 8.80 percent, 96 basis points below that of peers for the year, as well as 463 basis points below returns for 2006.45 ROE was generated by an ROA of 0.93 percent and an equity multiplier of 9.69x. Profitability at the bank was 5 basis points below that of peers according to ROA, while its financial leverage was slightly higher than that of peers (EM of 9.61x). The bank’s lower ROE was a result of lower return on assets, rather than less leverage. In fact, PNC’s higher equity multiplier signals slightly lower equity to assets. The bank’s lower returns, combined with higher risk (greater leverage), is a potential sign that the bank is currently a lower-performance institution.

One of the greatest challenges of evaluating performance is that a company that assumes a higher degree of risk typically also reports higher profits at first, and only later—when those higher-risk activities create problems—does the bank report higher charge-offs or additional provisions for loan losses.

PNC’s lower ROA is a result of lower income rather than an inability to control expenses. The bank’s lower income, as indicated by an asset utilization of 6.77 percent (versus 7.39 percent for peers) indicates that PNC generates less revenue per dollar of assets. By contrast, the bank’s lower expense ratio of 5.38 percent (versus 5.88 percent for peers) indicates that PNC was more efficient than its peers in controlling total expenses. By breaking down asset utilization into interest income and noninterest income and the expense ratio into interest and noninterest expense and provisions for loan losses, we can better determine the operational strengths and weaknesses of PNC’s profitability.

PNC’s lower overall expenses are attributed to significantly lower interest expense and lower provisions for loan losses rather than lower non-interest expense. PNC actually paid 0.53 percent less in interest expense relative to average

43 There are actually 27 bank peer groups. Peer group 1 is for banks over $3 billion. 44 Although the following analysis will directly compare PNC’s ratio to the peer group, it is important to recognize that the peer group may or may not be the appropriate comparison. To say a bank is doing better than the peer means it is doing better than average and does not always indicate that the bank is “doing well.” 45 The following analysis will use ratios reported in the UBPR rather than those calculated. For example, the ROE reported in the UBPR under the column “BANK,” and listed in the second column under Dec-07 of Exhibit 3.8, is 8.8 percent. The ROE calculated from 2007 data presented in Exhibits 3.2 and 3.4 is 11.45 percent. Ratios reported in the UBPR use one of three types of averages of quarterly figures from balance sheet data and the use of quarterly averages generally produces ratios that are more accurate. Hence, some of the ratios calculated using data from Exhibits 3.2 and 3.4 will not equal those reported in the UBPR that appears in the appendix. See the Contemporary Issues box: “Interpreting Financial Ratios and the Use of Average Balance Sheet Data.”

C H A P T E R 3 Analyzing Bank Performance 123

Exhibit 3.8

Profitability Measures for PNC Bank and Community National Bank, 2006–2007

PNC Bank, National Association

Dec-06 Dec-07 Profitability Ratios Pg # CALC BANK PG 1 CALC BANK PG 1

ROE 11 13.46% 13.43% 12.89% 11.45% 8.80% 9.76% ROA 1 1.02% 1.02% 1.23% 0.93% 0.93% 0.98% EM = 1 / (Total equity / TA) 11 (Calc) 13.25 13.18 9.99 11.09 9.69 9.61

AU (income) *sum 7.41% 7.40% 7.21% 6.77% 6.77% 7.40% *Interest income / aTA 1 5.08% 5.08% 5.95% 4.92% 4.92% 6.16%

Average loans / aTA 6 57.57% 58.21% 63.82% 55.14% 55.06% 66.71% Rate: Loans 3 6.42% 6.42% 7.15% 6.30% 6.30% 7.32%

Investment secs. / aTA 6 24.20% 23.55% 18.54% 23.95% 23.36% 16.32% Rate: Investment secs. (TE) 6 4.82% 4.84% 4.82% 5.40% 5.00% 5.11%

*Noninterest income / aTA 1 2.32% 2.32% 1.26% 1.85% 1.85% 1.24%

*Securities gains and losses 1 –0.24% –0.24% –0.01% 0.00% 0.00% –0.01%

Avg. earning assets / aTA 6 85.22% 85.51% 89.87% 84.40% 83.71% 89.62%

Yield on earning assets 1 5.94% 5.85% 6.47% 6.47% 5.67% 6.74%

Net Interest Margin 1 2.97% 2.92% 3.51% 3.24% 2.84% 3.48%

ER (expenses) *sum 5.68% 5.68% 5.39% 5.38% 5.38% 5.88%

*Interest expense / aTA 1 2.54% 2.54% 2.72% 2.45% 2.45% 2.98% Demand deposits / aTA 6 9.66% 9.51% 5.44% 8.80% 8.35% 4.83% Core deposits / aTA 6 61.83% 61.72% 54.06% 56.60% 54.06% 55.54%

Cost: MMDAs (trans. accounts) 3 #N/A 2.50% 1.71% #N/A 2.65% 1.85% CDs < 100M / aTA 6 10.70% 10.83% 9.81% 10.15% 10.18% 12.65%

Cost: CDs < 100M 3 #N/A 3.85% 3.98% #N/A 4.73% 4.57% Short-term noncore / aTA 6 16.82% 16.09% 24.55% 18.59% 22.50% 25.74% Time deposits over $100M / aTA 6 6.08% 6.15% 12.54% 5.06% 4.26% 11.68%

Cost: Time deposits over $100M 3 4.96% 4.97% 4.38% 4.25% 4.26% 4.78% *Noninterest expense / aTA 1 3.00% 3.00% 2.54% 2.72% 2.72% 2.62% *PLL / aTA 1 0.14% 0.14% 0.13% 0.21% 0.21% 0.28% Avg. interest-bearing debt / aTA 1 77.41% 77.35% 81.67% 68.85% 76.50% 81.77% Cost of interest-bearing funds 3 3.06% 3.29% 3.36% 3.31% 3.20% 3.68%

Efficiency Ratio 3 61.63% 61.63% 55.31% 62.88% 62.88% 57.60%

*When income statement numbers are used in the numerator, aTA is average total assets from Exhibit 3.7. For consistency, however, all “mix” or composition values use averages of current and prior period. For example, numerator and denominator averages for “Total deposits (avg.) / aTA” are both calculated using end-of-period annual average data.

Note: Short-term noncore funding is defined in the UBPR as certificates of deposit of $100,000 or more, brokered deposits of less than $100,000, other borrowings (of less than one year), deposits in foreign offices, securities sold under agreements to repurchase, and federal funds purchased with maturities of less than one year. Due to the lack of detailed data, calculated volatile liabilities does not include brokered deposits.

124 C H A P T E R 3 Analyzing Bank Performance

Exhibit 3.8

(continued)

Community National Bank

Dec-06 Dec-07 Profitability Ratios Pg # CALC BANK PG 4 CALC BANK PG 4

ROE 11 25.39% 25.41% 11.56% 20.75% 20.68% 9.43% ROA 1 2.27% 2.27% 1.10% 1.89% 1.89% 0.93% EM = 1 / (Total equity / TA) 11 (Calc) 11.06x 11.25x 10.32x 10.75x 10.88x 10.07x

AU (income) *sum 8.06% 8.06% 7.40% 8.23% 8.24% 7.59% *Interest income / aTA 1 7.04% 7.04% 6.62% 7.44% 7.44% 6.84%

Average loans / aTA 6 76.05% 73.59% 69.78% 79.25% 77.98% 70.75% Rate: Loans 3 8.35% 8.35% 7.90% 8.64% 8.64% 8.06%

Investment secs. / aTA 6 6.19% 5.54% 16.20% 5.66% 5.64% 15.17% Rate: Investment secs. (TE) 6 3.81% 4.54% 4.57% 4.46% 4.78% 4.96%

*Noninterest income / aTA 1 1.02% 1.02% 0.78% 0.80% 0.80% 0.75%

*Securities gains and losses 1 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

Avg. earning assets / aTA 6 91.56% 92.54% 91.68% 91.89% 91.77% 91.79%

Yield on earning assets 1 7.77% 7.52% 7.09% 8.25% 8.05% 7.32%

Net Interest Margin 1 5.35% 5.18% 4.44% 5.44% 5.31% 4.21%

ER (expenses) *sum 5.77% 5.77% 5.86% 6.32% 6.32% 6.33%

*Interest expense / aTA 1 2.19% 2.19% 2.49% 2.54% 2.54% 2.91% Demand deposits / aTA 6 20.99% 20.99% 13.66% 20.27% 20.27% 12.07% Core deposits / aTA 6 69.97% 69.94% 68.23% 68.35% 69.05% 66.83%

Cost: MMDAs (trans. accounts) 3 #N/A 2.13% 1.24% #N/A 2.62% 1.42% CDs < 100M / aTA 6 17.63% 17.34% 21.21% 15.42% 15.53% 22.96%

Cost: CDs < 100M 3 #N/A 3.64% 4.08% #N/A 4.42% 4.73% Short-term noncore / aTA 6 17.66% 14.19% 16.38% 19.95% 16.47% 17.64% Time deposits over $100M / aTA 6 17.66% 17.49% 15.49% 19.95% 19.26% 16.59%

Cost: Time deposits over $100M 3 4.16% 4.07% 4.27% 4.60% 4.67% 4.84% *Noninterest expense / aTA 1 3.39% 3.39% 3.21% 3.59% 3.59% 3.22% *PLL / aTA 1 0.19% 0.19% 0.16% 0.19% 0.19% 0.20% Avg. interest-bearing debt / aTA 1 68.75% 69.39% 74.95% 68.57% 70.20% 75.90% Cost of interest-bearing funds 3 3.17% 3.16% 3.32% 3.67% 3.62% 3.84%

Efficiency Ratio 3 57.70% 57.70% 65.39% 63.04% 63.04% 68.74%

Source: Tim Koch and Scott MacDonald; from FFIEC, Uniform Bank Performance Report, www2.fdic.gov/ubpr/UbprReport/SearchEngine/Default.asp

assets than peers did (2.45 percent versus 2.98 percent). This difference suggests that PNC operates differently than peers do in at least one of the areas of rates paid, liability composition, or volume of interest-bearing liabilities. The significantly lower volume of interest-bearing debt of 76.5 percent versus 81.8 percent of average assets signals an operational advantage. PNC’s large amount of demand deposits (8.35 percent versus 4.83 percent of average total assets), which are business checking accounts that do not pay interest, are a significant contributor to the lower interest costs. Interestingly, the interest cost of some liabilities was actually higher versus peers. For example, at 2.65 percent versus 1.85 percent, the cost of MMDAs was 80 basis points higher than for peers, as was the cost of CDs under $100,000, which was 16 basis points higher. In terms of funding composition, PNC’s core deposits contributed almost 1.5 percent less in total funding while short-term noncore funding comprised 3.24 percent less. This is a clear indicator that PNC relied relatively more on other (generally

C H A P T E R 3 Analyzing Bank Performance 125

more expensive) borrowings such as federal funds purchased, Federal Home Loan Bank borrowings, and subordinated debt.

The dependence on borrowed funds would normally lead to a higher overall interest expense, but the flat yield curve and low interest rates of 2007 kept the relative cost of these funds closer to other deposits. Thus, PNC’s lower overall interest expense was a result of more non-interest-bearing funds (demand deposits), which indicates a favorable mix of lower-cost liabilities and a lower volume of interest-bearing liabilities. The benefits were offset somewhat by the higher rate paid some of these funds.

Profitability for PNC was lowered by the bank’s higher noninterest expense to assets (2.72 percent versus 2.62 percent for peers). Although personnel expenses were lower, occupancy and other expenses were higher versus peers. PNC delivers banking services through an extensive branching network, including some foreign branches, and focuses on funding the bank with core deposits. PNC has successfully lowered its noninterest expense over the past several years, going from a higher level of noninterest expense relative to peers to lower expenses. There is often an expense tradeoff between the lower interest cost of a large volume of core deposits (particularly demand deposits) and a higher noninterest cost due to additional branch facilities and people needed to support these accounts. PNC benefits from both lower noninterest expense and lower interest expense. Its larger retail network of branches and services also produces more noninterest income such that PNC’s noninterest income is substantially higher than that of peers.

Consider the components of asset utilization. PNC’s AU, which was 62 basis points lower than that of peers, was a result of its lower interest income (4.92 percent versus 6.16 percent for peers) rather than its higher noninterest income (1.85 percent versus 1.24 percent for peers). In general, lower interest income might be due to lower yields on assets, fewer loans, a smaller volume of earning assets, or a combination of these factors. Examining the yield on earning assets, we find that PNC earned 107 basis points less (5.67 percent versus 6.74 percent for peers) and invested almost 6 percent less in earning assets.46 PNC also earned much lower yields on both loans and investments and operated with fewer total loans and leases (55.66 percent of average assets versus 66.71 percent for peers), but had 7.04 percent more investments. Generally, loans offer the highest yields, but in 2007, PNC’s average loan yield was actually below its average investment yield. The fact that PNC held fewer assets in loans, that the yield on these loans was low, and that PNC invested less in earning assets, resulted in lower interest income. Rate, mix, and volume effects thus contributed to PNC’s lower interest income.

The lower yield on loans might suggest lower risk, but PNC’s history has shown loan problems in the past. For example, PNC’s loan rates were also lower in 2000 yet its loan problems of 2001 indicated a greater-risk loan portfolio.47 PNC pursued a lower credit-risk strategy after their loan problems of 2001, which is reflected in its lower returns. PNC’s changing business model is one of the many reasons an analyst should carefully examine the bank’s credit risk.

46 The UBPR reports “Average earning assets/Average assets” on page 1 and “Total earning assets” on page 6. The first measure reported on page 1 includes total loans (rather than net loans) and a five period average of interest-only strips and equity securities. Hence, we use the measure on page 6 for the analysis. 47 See the Contemporary Issues box: “The Fall of Enron and Its Impact on PNC Bank.”

126 C H A P T E R 3 Analyzing Bank Performance

The relationship between interest income and interest expense is expressed in terms of net interest margin (NIM). PNC’s lower net interest margin (2.84 percent versus 3.48 percent for peers) indicates that PNC’s lower interest income is not offset by its lower interest expense. PNC’s net interest margin is lower than that of peers, in part, because it has fewer earning assets and fewer loans and because of the fact that the yield on these loans was less than for peers. An aggregate measure of the trade-off between interest and noninterest income and expense is the efficiency ratio, which equals noninterest expense divided by net operating income. PNC’s efficiency ratio is higher than that of peers at 62.88 percent versus 57.60 percent. The ratio indicates that PNC spends almost 63 cents to generate one dollar in net operating income, about 5.3 cents more than peers do.

Although interest income was much lower at PNC, noninterest income was much higher than for peers. Like other large banking organizations, PNC recently restructured its business model to rely proportionately more on noninterest income and less on loan income, particularly asset management and the custody business. In order to reduce overall credit risk, management stated an objective to become more selective in the types of loans made. Many large banks generally encourage loans to larger businesses with more easily verifiable credit qualities, hence lower loan rates. This assists the bank in keeping overhead costs down and in cross-selling other products, thus producing more fee income.

Peer group data presented in Exhibit 3.3, however, masks some important differences between PNC’s performance and that of its peers. The peer data in Exhibit 3.3 are for banks with total assets of more than $3 billion because larger banks typically generate higher levels of noninterest income than smaller banks do. Exhibit 3.10 provides additional detail on noninterest income and compares PNC against banks with assets of more than $10 billion. Consistent with the sale of more products, PNC’s noninterest income is from multiple sources: investment banking, advisory, brokerage, and underwriting fees and commissions; fiduciary activities; service charges; and net gains on loan sales. PNC’s noninterest income position appears to be better than that of the average peer bank presented in the UBPR and Exhibit 3.3, but when compared with banks with more than $10 billion in assets, PNC generates 26 basis points less in noninterest income.

In summary, PNC returns in 2007 are below those of a high-performance bank. Returns to the entire banking industry were down significantly in 2007 but PNC’s were down even more. PNC’s lower returns and slightly higher financial leverage indicates more financial risk but lower returns. Its lower ROA is a direct result of lower interest income and slightly higher noninterest expenses. PNC produces less interest income due to lower rates on loans and investments, a smaller loan portfolio, and fewer earning assets. PNC’s primary profitability strengths are its lower interest expense and higher noninterest income. A lower proportion of interest-bearing liabilities (more demand deposits) is the primary driver of PNC’s lower interest expense. Although its noninterest expense is somewhat higher than that of peers, noninterest expense control has improved over the past five years.