1.8.12 Evaluation of Banks

7/28/2019 1.8.12 Evaluation of Banks

1/61

Analyzing Bank Performance


2/61

Balance Sheet

Assets = Liabilities + EquityBalance sheet figures are calculated ata particular point in time


3/61

Bank Assets

Cash and due from banksVault cash, deposits held at Central Bank andother financial institutions, and cash items inthe process of collection.

Investment SecuritiesSecurities held to earn interest and help meetliquidity needs, speculate on interest ratemovements etc

LoansThe major asset, generate the greatest amountof income, exhibit the highest default risk andare relatively illiquid.

Other assets

Bank premises and equipment, interestreceivable, prepaid expenses, other real estate


4/61

Provisions for loan losses

Provisions for loan losses

Reserve for Loan Losses

Recoveries

Charge off


5/61

Loans

Maturities differ, Interest rates differ,Use of Proceeds differ, Type of Collaterals differ.Real EstateCommercial LoansIndividual loansAgricultural loansOther loansInternational loans


6/61

Bank investments

A bank, at purchase, must designate the objectivebehind buying investment securities as either:Held to maturityHeld for Trading

Available for SaleShort Term and Long Term Securities


7/61

Bank liabilities

Demand depositsTransactions accounts that pay no interest

Time DepositsPay interest set by each bank without RBI

restrictionsSavings and time deposits represent thebulk of interest-bearing liabilities at banks.


8/61

Bank liabilities (continued)

Certificate of DepositsDeposits held in foreign officesBalances issued by a bank subsidiarylocated outside India.

Purchased liabilities, (rate-sensitiveborrowings):Purchased fundsReposOther borrowings less than one year


9/61

Core versus volatile fundsCore depo si ts are stable deposits that are not highlyinterest rate-sensitive.

More sensitive to the fees charged, services rendered,and location of the bank.Includes: demand deposits and small time deposits.

Large, or vo lat i le, bo rrow ing s are liabilities that are

highly rate-sensitive.Normally issued in uninsured denominationsAbility to borrow is asset quality sensitiveIncludes: large CDs (over 100,000), deposits in foreign

offices, funds purchased, repurchase agreements, andother borrowings with maturities less than one year.**


10/61

Stockholders equity

Subordinated notes and debentures:Notes and bonds with maturities in excessof one year.

Stockholders' equityOwnership 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.Retained earnings equals accumulated netincome not paid out as cash dividends


11/61


12/61

Interest incomethe sum of interest and loan fees earned

on all of a bank' s assets.

Interest income includes interest from:

1. Loans2. Deposits held at other institutions,3. Investment securities

Taxable and municipal securities4. Trading account securities


13/61

Noninterest incomehas increased signif icantly and consists

of fees & other revenues for services

Fiduciary activitiesDeposit service chargesTrading revenue, venture cap., securitize inc.Investment banking, advisory inc.Insurance commissions & feesNet servicing feesLoan & lease net gains (losses)Other net gains (losses)

Other noninterest income


14/61

Noninterest expensecomposed primarily of:

Personnel expense:Salaries and fringe benefits paid tobank employees

Occupancy expense :Rent and depreciation on equipmentand premises, and

Other operating expenses:UtilitiesDeposit insurance premiums


15/61

Noninterest expense

Expenses and loan losses directlyaffect the balance sheet.The greater the size of loan portfolio,

the greater is operating overhead andPLL.Consumer loans are usually smaller

and hence more costly (non-interest)per rupee of loans.


16/61

Return on equity (ROE = NI / TE) the basic measure of stockholders returns

ROE is composed of two parts:Return on Assets (ROA = NI / TA),

represents the returns to the assets thebank has invested in

Equity Multiplier (EM = TA / TE),the degree of financial leverageemployed by the bank


17/61

Return on assets (ROA = NI / TA)can be decomposed into two parts:

Asset Uti l ization (AU) income generation Expense Ratio (ER) expense contr ol

ROA = AU - ER= (TR / TA) - (TE / TA)

Where:

TR = total revenue or total operating income= Int. inc. + Non-int. inc. + SG andTE = total expenses

= Int. exp. + Non-int. exp. + PLL + Taxes


18/61

ROA is driven by the banks ability to: generate income (AU) and control expenses (ER)

Income generation (AU)

TAlosses)(gainsSec

TAInc.int. Non.

TAInc.Int.AU

Expense Control (ER)

TAPLL

TA.Exp.int Non

TA.Exp.Int

ER *

Note, ER* does not include taxes.


19/61

INCOME

Return to the BankROA = NI / TA

EXPENSES

Rate

Composition (mix)

Volume

Interest

Overhead

Prov. for LL

Taxes

Fees and Serv Charge

Trust

Other

Rate

Composition (mix)

VolumeInterest

Non Interest

Salaries and Benefits

Occupancy

Other

Bank Performance Model

Returns toShareholders

ROE = NI / TE

Degree of LeverageEM =1 / (TE / TA)


20/61

Expense ratio (ER = Exp / TA) the ability to control expenses.

Interest expense / TACost per liability (avg. rate paid)Int. exp. liab. (j) / Rs. amt. liab. (j)

Composition of liabilities

Rs. amt. of liab. (j) / TAVolume of int. bearing debt and equity

Non-interest expense / TASalaries and employee benefits / TAOccupancy expense / TAOther operating expense / TA

Provisions for loan losses / TATaxes / TA


21/61

Asset utilization (AU = TR / TA): the ability to generate income.

Interest Income / TAAsset yields (avg. rate earned)Interest income asset (i) / Rs. amount of asset(i)

Composition of assets (mix)Rs. amount asset (i) / TA

Volume of Earning AssetsEarning assets / TA

Noninterest income / TAFees and Service ChargesSecurities Gains (Losses)Other income


22/61

Asset quality Ratio Gross NPA/total Assets

Movement in NPAMovement in provisions

Extent of coverage of provisions vis--vis the NPAs

Outstanding provisions/gross NPAs.Gross NPA generation rate Additions to grossNPAs / TA


23/61


24/61

Management

Level and quality of Board of Directors

Management Oversight

Internal policies, MIS, Audits andcompliance

Past performance


25/61

Earnings

Stability, quality, potential

Liquidity

Level of liquidity compared to fundingneedsReliance on volatile funds to fund longterm assets.Sensitivity to Market Risk


26/61

Aggregate profitability measures

Net interest marginNIM = NII / Earning Assets (EA)Spread

Spread = (Int Inc / EA) (Int Exp / Int bear. Liab.)

Earnings baseEB = EA / TA

Burden / TA

(Noninterest Exp. - Noninterest Income) / TAEfficiency ratioNon int. Exp. / (Net int. Inc. + Non-int. Inc.)


27/61

Fundamental risks :

Credit riskLiquidity risk

Market riskOperational risk

Capital or solvency riskLegal risk

Reputational risk


28/61

Credit risk the potential variation in net income and

market value of equity resulting from nonpayment or delayed payment on loans and secur i ties

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?


29/61

Credit ratios to consider

What has been the loss experience?Net loss to average total LoansGross losses to average total LoansRecoveries to avg. total Loans

Recoveries to prior period lossesNet losses by type of Loans

What amount of losses do we expect?Non-current Loans to total loansTotal Past/Due Loans - including nonaccrualNon-current & restruc Loans / Gross LoansCurrent - Non-current & restruc/ Gr Loans

Past due loans by loan type


30/61

Credit ratios to consider (continued)

How prepared are we?Provision for loan loss to: averageassets and average total Loans

Loans Allowance to: net losses andtotal LoansEarnings coverage of net loss

Li idit i k


31/61

Liquidity risk the variation in net income and market value of equi ty caused by a bank' s diff icul ty in obtaining cash

at a r easonable cost f rom either the sale of assets or new bor rowings

Banks can acquire liquidity in two distinctways:

1. By liquidation of assetsComposition of loans & investmentsMaturity of loans & investmentsPercent of loans and investments pledged

as collateral 2. By borrowing

Core depositsVolatile deposits

Asset quality & stockholders equity


32/61

Market risk the risk to a financial institutionscondition resulting from adverse movements in market r ates or pr ices

Market risk arises from changes in:Interest ratesForeign exchange rates

Equity, commodity and security prices

Interest rate risk


33/61

Interest rate risk the potential variability in a bank's net interest i ncome and market value of equi ty due to changes in the level of market interest rates

Example: Rs.10,000 Car loan4 year fixed-rate car loan at 8.5%1 year CD at 4.5%

Spread 4.0%But for How long?

Funding GAPGAP = Rs.RSA Rs.RSL,where Rs. RSA = Rs. amount of assets expected toreprice in a give period of time.In this example:GAP

1yr = Rs.0 Rs.10,000 = - Rs.10,000

This is a negative GAP.


34/61

Foreign exchange risk the risk to a financial institutions

condition resulting from adverse movements in foreign exchange rates

Foreign exchange risk arises from changesin foreign exchange rates that affect thevalues of assets, liabilities, and off-balancesheet activities denominated in currenciesdifferent from the banks domestic (home)

currency.This risk is also often found in off-balancesheet loan commitments and guaranteesdenominated in foreign currencies; foreigncurrency translation risk

E it d it i i k


35/61

Equity and security price risk change in market prices, interest rates and foreign exchange rates affect the market values of

equi ties, fixed income secur i ties, foreign cur rency holdings, and associated der ivative and other off- balance sheet contr acts.

Large banks must conduct value-at- r i sk analys is to assess the risk of losswith their trading account portfolios.

perat onal r sk


36/61

perat onal r sk measures the cost efficiency of the bank'sactivities; i .e., expense control or productivity; also measures whether the bank has the proper procedures and systems in place .

Typical ratios focus on:total assets per employee

total personnel expense per employeeNon-interest expense ratio

There is no meaningful way to estimate the

likelihood of fraud or other contingenciesfrom published data.A banks operating risk is closely related toits operating policies and processes andwhether is has adequate controls.


37/61


38/61

Definitions of capital

Tier 1 capital is:Total common equity capital plusnoncumulative preferred stock, plus minorityinterest in unconsolidated subsidiaries, lessineligible intangibles.

Risk-weighted assets are:The total of risk-adjusted assets where therisk weights are based on four risk classes of assets.

Importantly, a bank's dividend policy affectsits capital risk by influencing retainedearnings.


39/61

Legal risk the potential that unenforceable contracts,

lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of the banking organi zation

Legal risk includes:Compliance risksStrategic risks

General liability issues


40/61

Reputational risk

Reputational risk is the potential thatnegative publicity regarding aninstitutions business practices,whether true or not, will cause adecline in the customer base, costlylitigation, or revenue reductions.

Strategies for Maximizing


41/61

Strategies for MaximizingShareholder Wealth

Asset ManagementComposition and Volume

Liability ManagementComposition and Volume

Management of off-balance sheet activitiesNet interest margin managementCredit risk managementLiquidity managementManagement of non-interest expenseSecurities gains/losses management

Tax management


42/61

CAMELS

Capital AdequacyMeasures banks ability to maintaincapital commensurate with the banksrisk

Asset QualityReflects the amount of credit risk withthe loan and investment portfolios

Management QualityReflects managements ability toidentify, measure, monitor, and controlrisks


43/61

CAMELS (continued)

EarningsReflects the quantity, trend, and qualityof earnings

LiquidityReflects the sources of liquidity andfunds management practices

S ensitivity to market riskReflects the degree to which changesin market prices and rates adverselyaffect earnings and capital


44/61

Performance Characteristics of Banks


45/61

Performance Characteristics of Banksby Business Concentration and Size

Wholesale BanksFocus on loans for the largestcommercial customers and purchasesubstantial funds from corporate andgovernment depositors

Retail BanksFocus on consumer, small business,

mortgage, and agriculture loans andobtain deposits form individuals andsmall businesses


46/61

Financial Statement Manipulation

Off-balance sheet activitiesEnron and Special -Purpose Vehicles

Window dressing

Eliminate Fed borrowing prior tofinancial statement reporting dateIncrease asset size prior to year-end

Preferred stockMeets capital requirements but causesNIM, NI, ROE, and ROA to be

overstated


47/61

Financial Statement Manipulation


48/61

Securities gains and lossesBanks often classify all investmentsecurities as available for sale,overstating any true gains or losses

Non-recurring sales of assetsThis type of transaction is not part of the banks daily activities and typicallycannot be repeated; thus it overstatesearnings

Financial Statement Manipulation (continued)


49/61

Summary

Identify key factors that influenceBanks performance this can bedone by splitting profit ratios intovarious componentsAssociate financial ratios for creditrisk, liquidity risk, market risk,operational risk and solvency risk.This will demonstrate trade-off between risk and returns.


50/61

Banks income out of intermediationshould be sufficient so as to Pay to depositorsProvide a reasonable return toshareholders.Cover operating expensesProvide for loss

Generate EquityProvide a long-term growth in thevalue of stock.


51/61

Determine the sources, quality andsustainability of banks earnings, adequateliquidity and adequate capital.Uncertainties in the valuation of loans.Countrys legal framework and businessenvironment.Bank earnings internal capital formation.

Public confidence and consistency inearnings.Liquidity / strength of bank.


52/61

Capital AdequacyValuation of assets or adequacy inloan loss reserves.

NIM Reasons for increase / decrease.Fee income.Operating Expense as percentage of

total expenses.


53/61

Key performance indicatorsMeasures of profitabilityRoA

RoENet SpreadNIM

Other Income to total assetsNet Operating Margin


54/61

Components of Non-Interest ExpensesStaff ExpensesOther Operating Expenses

Occupancy ExpensesLoan loss Provisions


55/61

Provision less resourcesMeasures of Staff ProductivityNet Income per staff

Net Income to staff expenseLoan loss provisions a major destortion.Earning assets to Total assetsFunding MixHigh coverage and loan NPL


56/61


57/61

MONETARY POLICY

Banker to BanksBanker to GovernmentDevelopmental

Objectives of Monetary PolicyPrice StabilityGrowth / EmploymentFinancial Stability Financial Markets& Institutions.


58/61

Regulation & SupervisionLender of last resortBailout

Exchange Rate MechanismImpossible TrinityPromotion of growth

Adequate credit availabilityAssessment of economic outlook andrisks


59/61

Monetary policy relates to macro-economic developments in the countryand global economic situation.

Flow of credit to various sectors.


60/61

ActionPolicy RatesPolicy Thrust enabling credit expansionwithout compromising credit quality.

Interest rate response from banks.Government BorrowingsGrowth Outlook

Inflation outlookMoney SupplyMonetary Policy Stance


61/61

Documents

1.8.12 Evaluation of Banks