Text book Problems

20 Bank Performance

CHAPTER OBJECTIVES

The specific objectives of this chapter are to:

· ▪ identify the factors that affect the valuation of a commercial bank,

· ▪ compare the performance of banks in different size classifications over recent years, and

· ▪ explain how to evaluate the performance of a particular bank based on financial statement data.

A commercial bank's performance is examined for various reasons. Bank regulators identify banks that are experiencing severe problems so that they can be remedied. Shareholders need to determine whether they should buy or sell the stock of various banks. Investment analysts must be able to advise prospective investors on which banks to select for investment. Commercial banks also evaluate their own performance over time to determine the outcomes of previous management decisions so that changes can be made where appropriate. Without persistent monitoring of performance, existing problems can remain unnoticed and lead to financial failure in the future.

20-1 VALUATION OF A COMMERCIAL BANK

Commercial banks (or commercial bank units that are part of a financial conglomerate) are commonly valued by their managers as part of their efforts to monitor performance over time and to determine the proper mix of services that will maximize the bank's value. Banks may also be valued by other financial institutions that are considering an acquisition. An understanding of commercial bank valuation is useful because it identifies the factors that determine a commercial bank's value, which can be modeled as the present value of its future cash flows:

where E(CFt) represents the expected cash flow to be generated in period t and k represents the required rate of return by investors who invest in the commercial bank. Thus, the value of a commercial bank should change in response to changes in its expected cash flows in the future and to changes in the required rate of return by investors:

20-1a Factors That Affect Cash Flows

The change in a commercial bank's expected cash flows may be modeled as

where ECON denotes economic growth, Rf the risk-free interest rate, INDUS the prevailing bank industry conditions (including regulations and competition), and MANAB the abilities of the commercial bank's management.

Change in Economic Growth  Economic growth can enhance a commercial bank's cash flows by increasing the household or business demand for loans. During periods of strong economic growth, loan demand tends to be higher, which allows commercial banks to provide more loans. Because loans tend to generate better returns to commercial banks than investment in Treasury securities or other securities, expected cash flows should be higher. Another reason cash flows may be higher is that, normally, fewer loan defaults occur during periods of strong economic growth.

   Furthermore, the demand for other financial services provided by commercial banks tends to be higher during periods of strong economic growth. For example, brokerage, insurance, and financial planning services typically receive more business when economic growth is strong because households then have relatively high levels of disposable income.

Change in the Risk-Free Interest Rate  Interest rate movements may be inversely related to a commercial bank's cash flows. If the risk-free interest rate decreases other market rates may also decline, which may result in a stronger demand for the commercial bank's loans. Second, commercial banks rely heavily on short-term deposits as a source of funds, and the rates paid on these deposits are typically revised in accordance with other interest rate movements. Banks' uses of funds (such as loans) also are normally sensitive to interest rate movements, but to a smaller degree. Therefore, when interest rates fall, the depository institution's cost of obtaining funds declines more than the decline in the interest earned on its loans and investments. Conversely, an increase in interest rates could reduce a commercial bank's expected cash flows because the interest paid on deposits may increase to a greater degree than the interest earned on loans and investments.

Change in Industry Conditions  One of the most important industry characteristics that can affect a commercial bank's cash flows is regulation. If regulators reduce the constraints imposed on commercial banks, banks' expected cash flows should increase. For example, when regulators eliminated certain geographic constraints, commercial banks were able to expand across new regions in the United States. As regulators reduced constraints on the types of businesses that commercial banks could pursue, the banks were able to expand by offering other financial services (such as brokerage and insurance services).

   Another important industry characteristic that can affect a bank's cash flows is technological innovation, which can improve efficiencies and thereby enhance cash flows. The level of competition is an additional industry characteristic that can affect cash flows, because a high level of competition may reduce the bank's volume of business or reduce the prices it can charge for its services. As regulation has been reduced, competition has intensified. Some commercial banks benefit from this competition, but others may lose some of their market share.

Management Abilities  Of the four characteristics that commonly affect cash flows, the only one over which the bank has control is management abilities. It cannot dictate economic growth, interest rate movements, or regulations, but it can determine its organizational structure, and its sources and uses of funds. The managers can attempt to make internal decisions that will capitalize on the external forces (economic growth, interest rates, regulatory constraints) that the bank cannot control.

   As the management skills of a commercial bank improve, so should its expected cash flows. For example, skillful managers will recognize how to revise the composition of the bank's assets and liabilities to capitalize on existing economic or regulatory conditions. They can capitalize on economies of scale by expanding specific types of businesses and by offering a diversified set of services that accommodate specific customers. They may restructure operations and use technology in a manner that reduces expenses.

20-1b Factors That Affect the Required Rate of Return by Investors

The required rate of return by investors who invest in a commercial bank can be modeled as

where ΔRf represents a change in the risk-free interest rate and ΔRP a change in the bank's risk premium.

Change in the Risk-Free Rate  When the risk-free rate increases, so does the return required by investors. Recall that the risk-free rate of interest is driven by inflationary expectations (INF), economic growth (ECON), the money supply (MS), and the budget deficit (DEF):

High inflation, economic growth, and a high budget deficit place upward pressure on interest rates, whereas money supply growth places downward pressure on interest rates (assuming it does not cause inflation).

Change in the Risk Premium  If the risk premium on a commercial bank rises, so will the required rate of return by investors who invest in the bank. The risk premium can change in response to changes in economic growth, industry conditions, or management abilities:

High economic growth results in less risk for a commercial bank because its loans and investments in debt securities are less likely to default.

   Bank industry characteristics such as regulatory constraints, technological innovations, and the level of competition can affect the risk premium on banks. Regulatory constraints may include a minimum level of capital required of banks. Capital requirements have increased recently; this change alone reduces the risk premium of banks.

   Regulators have allowed commercial banks to diversify their offerings, which could reduce risk. At the same time, it may allow commercial banks to engage in some services that are riskier than their traditional services and to pursue some services that they cannot provide efficiently. Thus, the reduction in regulatory constraints could actually increase the risk premium required by investors.

   An improvement in management skills may reduce the perceived risk of a commercial bank. To the extent that more skillful managers allocate funds to assets that exhibit less risk, they may reduce the risk premium required by investors who invest in the bank.

    Exhibit 20.1  provides a framework for valuing commercial banks that is based on the preceding discussion. In general, the valuation is favorably affected by economic growth, lower interest rates, a reduction in regulatory constraints (assuming the bank focuses on services that it can provide efficiently), and an improvement in the bank's management abilities.

Exhibit 20.1 Framework for Valuing a Commercial Bank

20-1c Impact of the Credit Crisis on Bank Valuations

Exhibit 20.2  shows the movement in a bank equity index over time, which suggests how bank valuations overall were affected during the credit crisis. Notice the steep decline in bank valuations that occurred during the 2008–2009 recession, which is when the credit crisis was most severe. Many publicly traded banks experienced a decline in their valuation of more than 70 percent during the crisis before rebounding. The main reason for this decline was the weak economic conditions that affected bank cash flows. In addition, investors recognized that they were more susceptible to failure during that period and required higher risk premiums. The banks with weaker management abilities that were overly exposed to mortgage problems suffered more severe losses. In the 2003–2007 period just before the crisis, only 11 banks failed. However, 140 banks failed in 2009 and another 157 banks failed in 2010.

20-2 ASSESSING BANK PERFORMANCE

WEB

www.fdic.gov

Information about the performance of commercial banks.

Exhibit 20.3  illustrates how the general performance of a bank is commonly summarized based mostly on income statement items. This summary is very basic but still offers much insight about a bank's income, expenses, and its efficiency. Each item in  Exhibit 20.3  is measured as a percentage of assets, which allows for easy comparison to other banks or to a set of banks within the same region. Analysts commonly compare a bank's performance with that of other banks of the same size. The Federal Reserve provides bank performance summaries for banks in four size classifications: money center banks (the 10 largest banks that serve money centers such as New York), large banks (ranked 11 to 100 in size), medium banks (ranked 101 to 1,000 in size), and small banks (ranked lower than 1,000 in size).

Exhibit 20.2 Movements in Bank Equity Values Before and After the Financial Crisis

   Measuring each item in  Exhibit 20.3  as a percentage of assets also allows for an assessment of the bank's performance over time. The measurement of the dollar amount of income and expenses over time could be misleading without controlling for the change in the size (as measured by total assets) of the bank over time. A complete analysis of a bank would require the use of a bank's income statement and balance sheet. Yet  Exhibit 20.3  is sufficient for identifying the key indicators of a bank's performance that deserve much attention.

   The following discussion examines the items in  Exhibit 20.3  in the order listed.

20-2a Interest Income and Expenses

Gross interest income  (Row 1 of  Exhibit 20.3 ) is interest income generated from all assets. It is affected by market rates and the composition of assets held by the bank. Gross interest income tends to increase when interest rates rise and to decrease when interest rates decline.

   The gross interest income varies among banks of different sizes because of the rates they may charge on particular types of loans. Small banks tend to make more loans to small local businesses, which may allow them to charge higher interest rates than the money center and large banks charge on loans they provide to larger businesses. The rates charged to larger businesses tend to be lower because those businesses generally have more options for obtaining funds than do small local businesses.

Exhibit 20.3 Example of Performance Summary of Canyon Bank 2012

ITEM	2013
1. Gross interest income	6.2%
2. Gross interest expenses	3.2
3. Net interest income	3.0
4. Noninterest income	2.0
5. Loan loss provision	.6
6. Noninterest expenses	3.
7. Securities gains (losses)	0.0
8. Income before tax	1.4
9. Taxes	.4
10. Net income	1.0
11. Cash dividends provided	.3
12. Retained earnings	.7

Note: All items in the exhibit are estimated as a proportion of total assets.

    Gross interest expenses  (Row 2) represent interest paid on deposits and on other borrowed funds (from the federal funds market). These expenses are affected by market rates and the composition of the bank's liabilities. Gross interest expenses will normally be higher when market interest rates are higher. The gross interest expenses will vary among banks depending on how they obtain their deposits. Banks that rely more heavily on NOW accounts, money market deposit accounts, and CDs instead of checking accounts for deposits will incur higher gross interest expenses.

   Net interest income (Row 3 of  Exhibit 20.3 ) is the difference between gross interest income and interest expenses and is measured as a percentage of assets. This measure is commonly referred to as net interest margin. It has a major effect on the bank's performance. Banks need to earn more interest income than their interest expenses in order to cover their other expenses. Yet competition prevents them from charging excessive rates (and earning excessive income). In general, the net interest margin of all banks is fairly stable over time.

20-2b Noninterest Income and Expenses

Noninterest income (Row 4 of  Exhibit 20.3 ) results from fees charged on services provided, such as lockbox services, banker's acceptances, cashier's checks, and foreign exchange transactions. During the 1990s, banks increased their noninterest income as they offered more fee-based services. Since 2000, however, noninterest income has stabilized because of more intense competition among financial institutions offering fee-based services. Noninterest income is usually higher for money center, large, and medium banks than for small banks. This difference occurs because the larger banks tend to provide more services for which they can charge fees.

   The  loan loss provision  (Row 5 of  Exhibit 20.3 ) is a reserve account established by the bank in anticipation of loan losses in the future. It should increase during periods when loan losses are more likely, such as during a recessionary period. The amount of loan losses as a percentage of assets is higher for banks that provide riskier loans, especially when economic conditions weaken. For example, as a result of the financial crisis, the average loan loss provision was 1.95 percent of total assets in 2009 among banks, whereas it was only 0.27 percent just two years earlier. The increase was primarily due to mortgage and real estate loan defaults. The large loan loss provision in 2009 offset bank profits from all other operations of banks in that year.

   The reporting of a bank's earnings requires managerial judgment on the amount of existing loans that will default. This can cause two banks with similar loan portfolios to have different earnings. A bank with conservative management may account for larger loan losses, which reduces the reported earnings now. In contrast, a bank with more aggressive management may understate the likely level of loan losses, which essentially defers the bad news until some future time. This lack of transparency can be beneficial in the short run to the bank with more aggressive management. Because the stock price is partially driven by earnings, the bank may be able to keep its stock price artificially high by understating its loan losses (and therefore overstating its earnings). If managerial compensation is tied to the bank's short-term stock price movements or earnings, managers may be tempted to understate loan losses.

    Noninterest expenses  (Row 6 of  Exhibit 20.3 ) include salaries, office equipment, and other expenses not related to the payment of interest on deposits. Noninterest expenses depend partially on personnel costs associated with the credit assessment of loan applications, which in turn are affected by the bank's asset composition (proportion of funds allocated to loans). Noninterest expenses also depend on the liability composition because small deposits are more time-consuming to handle than large deposits. Banks offering more nontraditional services will incur higher noninterest expenses, although they expect to offset the higher costs with higher noninterest income.

    Securities gains and losses  (Row 7 of  Exhibit 20.3 ) result from the bank's sale of securities. They are usually negligible for banks in aggregate, although an individual bank's gains or losses can be significant. During the financial crisis, securities losses were pronounced as banks in general suffered losses on their investments in mortgagebacked securities during the credit crisis.

    Income before tax  (Row 8 of  Exhibit 20.3 ) is obtained by summing net interest income, noninterest income, and securities gains and then subtracting from this sum the provision for loan losses and noninterest expenses.

   The key income statement item, according to many analysts, is net income (Row 10 of  Exhibit 20.3 ), which accounts for any taxes paid. Therefore, the net income is the focus in the following section.

20-3 EVALUATION OF A BANK'S ROA

WEB

www.fdic.gov

Financial data provided for individual commercial banks allows their performance to be evaluated. The site also provides a quarterly outlook for the banking industry.

The net income figure shown in  Exhibit 20.3  is measured as a percentage of assets and therefore represents the  return on assets (ROA) . The ROA is influenced by all previously mentioned income statement items and therefore by all policies and other factors that affect those items.

    Exhibit 20.4  identifies some of the key policy decisions that influence a bank's income statement. This exhibit also identifies factors not controlled by the bank that affect the bank's income statement.

Exhibit 20.4 Influence of Bank Policies and Other Factors on a Bank's Income Statement

INCOME STATEMENT ITEM AS A PERCENTAGE OF ASSETS	BANK POLICY DECISIONS AFFECTING THE INCOME STATEMENT ITEM	UNCONTROLLABLE FACTORS AFFECTING THE INCOME STATEMENT ITEM
(1) Gross interest income	· • Composition of assets · • Quality of assets · • Maturity and rate sensitivity of assets · • Loan pricing policy	· • Economic conditions · • Market interest rate movements
(2) Gross interest expenses	· • Composition of liabilities · • Maturities and rate sensitivity of liabilities	· • Market interest rate movements
(3) Net interest income = (1) − (2)
(4) Noninterest income	· • Service charges · • Nontraditional activities	· • Regulatory provisions
(5) Noninterest expenses	· • Composition of assets · • Composition of liabilities · • Nontraditional activities · • Efficiency of personnel · • Costs of office space and equipment · • Marketing costs · • Other costs	· • Inflation
(6) Loan losses	· • Composition of assets · • Quality of assets · • Collection department capabilities	· • Economic conditions · • Market interest rate movements
(7) Pretax return on assets = (3) + (4) − (5) − (6)
(8) Taxes	· • Tax planning	· • Tax laws
9) After-tax return on assets = (7) − (8)
(10) Financial leverage, measured here as (assets/equity)	· • Capital structure policies	· • Capital structure regulations
(11) Return on equity = (9) × (10)

20-3a Reasons for a Low ROA

The ROA will usually reveal when a bank's performance is not up to par, but it does not indicate the reason for the poor performance. Therefore, its components must be evaluated separately.  Exhibit 20.5  identifies the factors that affect bank performance as measured by ROA and ROE. If a bank's ROA is less than desired, the bank is possibly incurring excessive interest expenses. Banks typically know what deposit rate is necessary to attract deposits and therefore are not likely to pay excessive interest. Yet if all a bank's sources of funds require a market-determined rate, the bank will face relatively high interest expenses. A relatively low ROA could also be due to low interest received on loans and securities because the bank has been overly conservative with its funds or was locked into fixed rates prior to an increase in market interest rates. High interest expenses and/or low interest revenues (on a relative basis) will reduce the net interest margin and thereby reduce ROA.

Exhibit 20.5 Breakdown of Performance Measures

MEASURES OF BANK PERFORMANCE	FINANCIAL CHARACTERISTICS INFLUENCING PERFORMANCE	BANK DECISIONS AFFECTING FINANCIAL CHARACTERISTICS
1) Return on assets (ROA)	Net interest margin     Noninterest revenues Noninterest expenses     Loan losses	Deposit rate decisions Loan rate decisions Loan losses Bank services offered Overhead requirements Efficiency Advertising Risk level of loans provided
(2) Return on equity (ROE)	ROA Leverage measure	Same as for ROA Capital structure decision

   A relatively low ROA may also result from insufficient noninterest income. Some banks have made a much greater effort than others to offer services that generate fee (noninterest) income. Because a bank's net interest margin is dictated in part by interest rate trends and balance sheet composition, many banks attempt to focus on noninterest income to boost their ROA.

   A bank's ROA can also be damaged by heavy loan losses. However, if the bank is too conservative in attempting to avoid loan losses then its net interest margin will be low (because of the low interest rates received from very safe loans and investments). Because of the obvious trade-off here, banks generally attempt to shift their risk–return preferences according to economic conditions. They may increase their concentration of relatively risky loans during periods of prosperity, when they can improve their net interest margin without incurring excessive loan losses. Conversely, they may increase their concentration of relatively low-risk (and low-return) investments when economic conditions are less favorable.

   A low ROA may also be attributed to excessive noninterest expenses, such as overhead and advertising expenses. Any waste of resources due to inefficiencies can lead to relatively high noninterest expenses.

20-3b Converting ROA to ROE

An alternative measure of overall bank performance is return on equity (ROE). A bank's ROE is affected by the same income statement items that affect ROA but also by the bank's degree of financial leverage:

The leverage measure is simply the inverse of the capital ratio (when only equity counts as capital). The higher the capital ratio, the lower the leverage measure and the lower the degree of financial leverage. For a given positive level of ROA, a bank's ROE will be higher if it uses more financial leverage.

Exhibit 20.6 Average ROE among Banks Over Time

    Exhibit 20.6  shows the average annualized return on equity among banks over time. The ROE was relatively high during the 2005–2007 period when the U.S. economy was expanding. However, it declined substantially during the financial crisis, even reaching negative levels in 2009, and gradually increased over time as the effects of the crisis subsided.

20-3c Application

Consider the performance characteristics for Zager Bank and the industry in  Exhibit 20.7  over the last five years. The years in the exhibit are labeled Year 1 through Year 5, whereby Year 5 just ended. Because of differences in accounting procedures, the information may not be perfectly comparable. Since Zager Bank is a medium-sized bank, it is compared here to other medium-sized banks.

   Zager Bank has used an aggressive management style of providing loans to borrowers that might be viewed as risky given their limited collateral and their cash flow situation. The bank charges high interest rates on these loans because the borrowers do not have alternative lenders. It also charges these borrowers high annual fees after providing its loans. During the strong economic conditions in Years 1 and 2, Zager's strategy was very successful. It achieved a high net interest margin and high noninterest income. The borrowers typically made their loan payments in a timely manner. However, when the economy weakened in Year 3, many of the borrowers who received loans from Zager Bank could not repay them. Furthermore, Zager was not able to extend many new loans because the demand for loans declined.

   Although other banks also experienced weak performance when the economy weakened, Zager Bank experienced a more pronounced decline in performance because it had more loans that were susceptible to default.  Exhibit 20.7  shows that net income declined for medium-sized banks in general during Year 3, but it actually turned negative for Zager Bank because of its large loan losses. This example illustrates the risk–return tradeoff for Zager Bank. It was rewarded for its risky strategy when the economy was strong, but it was severely penalized for that strategy when the economy was weak.

Exhibit 20.7 Average ROE among Banks Over Time

   Any particular bank will perform a more thorough evaluation of itself than that shown here, including a comprehensive explanation for its performance in recent years. Investors can evaluate any particular bank's performance by conducting an analysis similar to the one described here.

SUMMARY

· ▪ A bank's value depends on its expected future cash flows and the required rate of return by investors who invest in the bank. The bank's expected cash flows are influenced by economic growth, interest rate movements, regulatory constraints, and the abilities of the bank's managers. The required rate of return by investors who invest in the bank is influenced by the prevailing interest rate (which is affected by other economic conditions) and the risk premium (which is affected by economic growth, regulatory constraints, and the management abilities of the bank). In general, the value of commercial banks is favorably affected by strong economic growth, declining interest rates, and strong management abilities.

· ▪ A bank's performance can be evaluated by comparing its income statement items (as a percentage of total assets) to a control group of other banks with a similar size classification. The performance of the bank may be compared to the performance of a control group of banks. Any difference in performance between the bank and the control group is typically because of differences in net interest margin, loan loss reserves, noninterest income, or noninterest expenses. If the bank's net interest margin is relatively low, it either is relying too heavily on deposits with higher interest rates or is not earning adequate interest on its loans. If the bank is forced to boost loan loss reserves, this suggests that its loan portfolio may be too risky. If its noninterest income is relatively low, the bank is not providing enough services that generate fee income. If the bank's noninterest expenses are relatively high, its cost of operations is excessive. There may be other specific details that make the assessment more complex, but the key problems of a bank can usually be detected with the approach described here.

· ▪ A common measure of a bank's overall performance is its return on assets (ROA). The ROA of a bank is partially determined by movements in market interest rates, as many banks benefit from lower interest rates. In addition, the ROA is highly dependent on economic conditions, because banks can extend more loans to creditworthy customers and may also experience a higher demand for their services.

· ▪ Another useful measure of a bank's overall performance is return on equity (ROE).A bank can increase its ROE by increasing its financial leverage, but its leverage is constrained by capital requirements.

POINT COUNTER-POINT

Does a Bank's Income Statement Clearly Indicate the Bank's Performance?

Point  Yes. The bank's income statement can be partitioned to determine its performance and the underlying reasons for its performance.

Counter-Point  No. The bank's income statement can be manipulated because the bank may not fully recognize loan losses (will not write off loans that are likely to default) until a future period.

Who Is Correct?  Use the Internet to learn more about this issue and then formulate your own opinion.

QUESTIONS AND APPLICATIONS

· 1. Interest Income How can gross interest income rise while the net interest margin remains somewhat stable for a particular bank?

· 2. Impact on Income If a bank shifts its loan policy to pursue more credit card loans, how will its net interest margin be affected?

· 3. Noninterest Income What has been the trend in noninterest income in recent years? Explain.

· 4. Net Interest Margin How could a bank generate higher income before tax (as a percentage of assets) when its net interest margin has decreased?

· 5. Net Interest Income Suppose the net interest income generated by a bank is equal to 1.5 percent of its assets. Based on past experience, would the bank experience a loss or a gain? Explain.

· 6. Noninterest Income Why have large money center banks' noninterest income levels typically been higher than those of smaller banks?

· 7. Bank Leverage What does the assets/equity ratio of a bank indicate?

· 8. Analysis of a Bank's ROA What are some of the more common reasons why a bank may experience a low ROA?

· 9. Loan Loss Provisions Explain why loan loss provisions of most banks could increase in a particular period.

· 10. Bank Performance during the Credit Crisis Why do you think some banks suffered larger losses than other banks during the credit crisis?

· 11. Weak Performance What are likely reasons for weak bank performance?

· 12. Bank Income Statement Assume that SUNY Bank plans to liquidate Treasury security holdings and use the proceeds for small business loans. Explain how this strategy will affect the different income statement items. Also identify any income statement items for which the effects of this strategy are more difficult to estimate.

Interpreting Financial News

· a. “The three most important factors that determine a local bank's bad debt level are the bank's location, location, and location.”

· b. “The bank's profitability was enhanced by its limited use of capital.”

· c. “Low risk is not always desirable. Our bank's risk has been too low, given the market conditions. We will restructure operations in a manner to increase risk.”

Managing in Financial Markets

Forecasting Bank Performance As a manager of Hawaii Bank, you anticipate the following:

· ▪ Loan loss provision at end of year = 1 percent of assets

· ▪ Gross interest income over the next year = 9 percent of assets

· ▪ Noninterest expenses over the next year = 3 percent of assets

· ▪ Noninterest income over the next year = 1 percent of assets

· ▪ Gross interest expenses over the next year = 5 percent of assets

· ▪ Tax rate on income = 30 percent

· ▪ Capital ratio (capital/assets) at end of year = 5 percent

· a. Forecast Hawaii Bank's net interest margin.

· b. Forecast Hawaii Bank's earnings before taxes as a percentage of assets.

· c. Forecast Hawaii Bank's earnings after taxes as a percentage of assets.

· d. Forecast Hawaii Bank's return on equity.

· e. Hawaii Bank is considering a shift in its asset structure to reduce its concentration of Treasury bonds and increase its volume of loans to small businesses. Identify each income statement item that would be affected by this strategy, and explain whether the forecast for that item would increase or decrease as a result.

PROBLEM

Assessing Bank Performance Select a bank whose income statement data are available. Using recent income statement information about the commercial bank, assess its performance. How does the performance of this bank compare to the performance of other banks? Compared with the other banks assessed in this chapter, is its return on equity higher or lower? What is the main reason why its ROE is different from the norm? (Is it due to its interest expenses? Its noninterest income?)

FLOW OF FUNDS EXERCISE

How the Flow of Funds Affects Bank Performance

In recent years, Carson Company has requested the services listed below from Blazo Financial, a financial conglomerate. These transactions have created a flow of funds between Carson Company and Blazo.

· a. Classify each service according to how Blazo benefits from the service.

· ▪ Advising on possible targets that Carson may acquire

· ▪ Futures contract transactions

· ▪ Options contract transactions

· ▪ Interest rate derivative transactions

· ▪ Loans

· ▪ Line of credit

· ▪ Purchase of short-term CDs

· ▪ Checking account

· b. Explain why Blazo's performance from providing these services to Carson Company and other firms will decline if economic growth is reduced.

· c. Given the potential impact of slow economic growth on a bank's performance, do you think that commercial banks would prefer that the Fed use a restrictive monetary policy or an expansionary monetary policy?

INTERNET/EXCEL EXERCISES

· 1. Go to  www.suntrust.com  and retrieve a recent annual report of the SunTrust Bank. Use the income statement to determine SunTrust's performance. Describe SunTrust's performance in recent years.

· 2. Has SunTrust's ROA increased since the year before? Explain what caused its ROA to change over the last year. Has its net interest margin changed since last year? How has its noninterest income (as a percentage of assets) changed over the last year? How have its noninterest expenses changed over the last year? How have its loan loss reserves changed in the last year? Discuss how SunTrust's recent strategy and economic conditions might explain the changes in these components of its income statement.

WSJ EXERCISE

Assessing Bank Performance

Using a recent issue of the Wall Street Journal, summarize an article that discussed the recent performance of a particular commercial bank. Does the article suggest that the bank's performance was better or worse than the norm? What is the reason given for the performance?

ONLINE ARTICLES WITH REAL-WORLD EXAMPLES

Find a recent practical article available online that describes a real-world example regarding a specific financial institution or financial market that reinforces one or more concepts covered in this chapter.

   If your class has an online component, your professor may ask you to post your summary of the article there and provide a link to the article so that other students can access it.

   If your class is live, your professor may ask you to summarize your application of the article in class. Your professor may assign specific students to complete this assignment or may allow any students to do the assignment on a volunteer basis.

   For recent online articles and real-world examples related to this chapter, consider using the following search terms (be sure to include the prevailing year as a search term to ensure that the online articles are recent):

· 1. [name of a specific bank] AND interest income

· 2. [name of a specific bank] AND interest expense

· 3. [name of a specific bank] AND loan loss

· 4. [name of a specific bank] AND net income

· 5. [name of a specific bank] AND net interest margin

· 6. [name of a specific bank] AND earnings

· 7. [name of a specific bank] AND return on equity

· 8. bank AND income

· 9. bank AND return on assets

· 10. bank AND net interest margin

PART 6 INTEGRATIVE PROBLEM: Forecasting Bank Performance

This problem requires an understanding of banks' sources and uses of funds ( Chapter 17 ), bank management ( Chapter 19 ), and bank performance ( Chapter 20 ). It also requires the use of spreadsheet software such as Microsoft Excel. The data provided can be input onto a spreadsheet so that the necessary computations can be completed more easily. A conceptual understanding of commercial banking is needed to interpret the computations.

As an analyst of a medium-sized commercial bank, you have been asked to forecast next year's performance. In June you were provided with information about the sources and uses of funds for the upcoming year. The bank's sources of funds for the upcoming year are as follows (where NCDs are negotiable certificates of deposit):

SOURCES OF FUNDS	DOLLAR AMOUNT (IN MILLIONS)	INTEREST RATE TO BE OFFERED
Demand deposits	$5,000	0%
Time deposits	2,000	6%
1-year NCDs	3,000	T-bill rate + 1%
5-year NCDs	2,500	1-year NCD rate + 1%

The bank also has $1 billion in capital.

   The bank's uses of funds for the upcoming year are as follows:

USES OF FUNDS	DOLLAR AMOUNT (IN MILLIONS)	INTEREST RATE	LOAN LOSS PERCENTAGE
Loans to small businesses	$4,000	T-bill rate + 6%	2%
Loans to large businesses	2,000	T-bill rate + 4%	1
Consumer loans	3,000	T-bill rate + 7%	4
Treasury bills	1,000	T-bill rate	0
Treasury bonds	1,500	T-bill rate + 2%	0
Corporate bonds	1,100	Treasury bond rate + 2%	0

   The bank also has $900 million in fixed assets. The interest rates on loans to small and large businesses are tied to the T-bill rate and will change at the beginning of each new year. The forecasted Treasury bond rate is tied to the future T-bill rate because an upward-sloping yield curve is expected at the beginning of next year. The corporate bond rate is tied to the Treasury bond rate, allowing for a risk premium of 2 percent. Consumer loans will be provided at the beginning of next year, and interest rates will be fixed over the lifetime of the loan. The remaining time to maturity on all assets except T-bills exceeds three years. As the one-year T-bills mature, the funds are to be reinvested in new one-year T-bills (all T-bills are to be purchased at the beginning of the year). The bank's loan loss percentage reflects the percentage of bad loans. Assume that no interest will be received on these loans. In addition, assume that this percentage of loans will be accounted for as loan loss reserves (i.e., assume that they should be subtracted when determining before-tax income).

   The bank has forecast its noninterest revenues to be $200 million and its noninterest expenses to be $740 million. A tax rate of 34 percent can be applied to the before-tax income in order to estimate after-tax income. The bank has developed the following probability distribution for the one-year T-bill rate at the beginning of next year:

POSSIBLE T-BILL RATE	PROBABILITY
8%	30%
9	50
10	20

Questions

· 1. Using the information provided, determine the probability distribution of return on assets (ROA) for next year by completing the following table:

INTEREST RATE SCENARIO (POSSIBLE T-BILL RATE)	FORECASTED ROA	PROBABILITY
8%
9
10

· 2. Will the bank's ROA next year be higher or lower if market interest rates are higher? (Use the T-bill rate as a proxy for market interest rates.) Why? The information provided did not assume any required reserves. Explain how including required reserves would affect forecasted interest revenue, ROA, and ROE.

· 3. The bank is considering a strategy of attempting to attract an extra $1 billion as one-year negotiable certificates of deposit to replace $1 billion of five-year NCDs. Develop the probability distribution of ROA based on this strategy:

INTEREST RATE SCENARIO	FORECASTED ROA BASED ON THE STRATEGY OF INCREASING ONE-YEAR NCDs	PROBABILITY
8%
9
10

· 4. Is the bank's ROA likely to be higher next year if it uses this strategy of attracting more one-year NCDs?

· 5. What would be an obvious concern about a strategy of using more one-year NCDs and fewer five-year NCDs beyond the next year?

· 6. The bank is considering a strategy of using $1 billion to offer additional loans to small businesses instead of purchasing T-bills. Using all the original assumptions provided, determine the probability distribution of ROA (assume that noninterest expenses would not be affected by this change in strategy).

INTEREST RATE SCENARIO (POSSIBLE T-BILL RATE)	FORECASTED ROA IF AN EXTRA $1 BILLION IS USED FOR LOANS TO SMALL BUSINESSES	PROBABILITY
8%
9
10

· 7. Would the bank's ROA likely be higher or lower over the next year if it allocates the extra funds to small business loans?

· 8. What is the obvious risk of such a strategy beyond the next year?

· 9. The previous strategy of attracting more one-year NCDs could affect noninterest expenses and revenues. How would noninterest expenses be affected by this strategy of offering additional loans to small businesses? How would noninterest revenues be affected by this strategy?

· 10. Now assume that the bank is considering a strategy of increasing its consumer loans by $1 billion instead of using the funds for loans to small businesses. Using this information along with all the original assumptions provided, determine the probability distribution of ROA.

INTEREST RATE SCENARIO (POSSIBLE T-BILL RATE)	POSSIBLE ROA IF AN EXTRA $1 BILLION IS USED FOR CONSUMER LOANS	PROBABILITY
8%
9
10

· 11. Other than possible changes in the economy that may affect credit risk, what key factor will determine whether this strategy is beneficial beyond one year?

· 12. Now assume that the bank wants to determine how its forecasted return on equity (ROE) next year would be affected by boosting its capital from $1 billion to $1.2 billion. (The extra capital would not be used to increase interest or noninterest revenues.) Using all the original assumptions provided, complete the following table:

INTEREST RATE SCENARIO (POSSIBLE T-BILL RATE)	FORECASTED ROE IF CAPITAL = $1 BILLION	FORECASTED ROE IF CAPITAL = $1.2 BILLION	PROBABILITY
8%
9
10

· Briefly state how the ROE will be affected if the capital level is increased.