Chapter 1
Banking and the
Financial Services
Industry
1
Credit Crisis of 2007 - 2009
 Lenders Made “Sub-Prime” Mortgages
 Borrowers had insufficient income to
make monthly payments
 Many mortgages had “teaser” rates
 Low payments resulting in negative
amortization
 Multiple Mortgage Banks Fail
 As the mortgages write-downs were
recognized, the mortgage banks’
capital was depleted
2
Credit Crisis of 2007 - 2009
 Collapse and/or Failure of:
 Bear
Stearns
 Lehman Brothers
 Countrywide
 Washington Mutual
 Wachovia
3
Credit Crisis of 2007 - 2009
 Government Response
 Fannie
Mae and Freddie Mac placed
into conservatorship
 Loaned AIG over $150 billion
 Insured money market mutual funds
 Created Commercial Paper Funding
Facility
 Increased FDIC coverage to $250,000

Temporarily through 2009
4
Credit Crisis of 2007 - 2009
 Government Response
 Established
Troubled Asset Relief
Program – TARP
 Established Term Asset-Backed
Securities Loan Facility – TALF
 Invested $125 billion in nine large U.S.
banks
 Promoted mortgage loan modifications
5
Credit Crisis of 2007 - 2009
 Impact on Banks and the Banking
Environment
 Biggest
impact of declining real estate
values concentrated in the areas that
experienced the largest run-up in real
estate values

Many large banks experienced large
losses while many small banks did not
6
Credit Crisis of 2007 - 2009
7
Credit Crisis of 2007 - 2009
 Impact on Banks and the Banking
Environment
 Largest

Investment Banks
Goldman Sachs and Morgan Stanley
 Converted to Financial Holding Companies

Bear Stearns and Merrill Lynch
 Absorbed by other financial institutions

Lehman Brothers
 Failed
8
How Do Banks Differ?
 Global Banks
 Offer
a wide array of products and
services globally
 Super-Regional Banks
 Similar
to global banks but smaller in
size and market penetration
 Community Banks
 Smaller
trade area with total assets
under $1 billion
9
How Do Banks Differ?
10
How Do Banks Differ?
11
How Do Banks Differ?
 Bank Holding Companies
 Owns
controlling interest in one or
more commercial banks
 Parent Organization versus
Subsidiaries
One-Bank Holding Companies
 Multibank Holding Companies

12
How Do Banks Differ?
13
How Do Banks Differ?
 Financial Holding Companies
 The primary advantage to forming an FHC
is that the entity can engage in a wide
range of financial activities not permitted
in the bank or in a BHC
 Authorized to engage in:
 Underwriting and selling insurance and
securities
 Commercial banking
 Merchant banking
 Insurance company portfolio investment
activities
14
How Do Banks Differ?
 Financial Holding Companies
 Fed
may not permit forming an FHC (or
converting a BHC to an FHC) if any of
its insured depository institution
subsidiaries are:
not well capitalized,
 not well managed,
 did not receive at least a “Satisfactory”
rating in its most recent CRA exam

15
How Do Banks Differ?
 Financial Holding Companies
 An
FHC can own a bank or BHC or a
thrift or thrift holding company

Each of these companies owns
subsidiaries, while the parent financial
holding company also owns other
subsidiaries directly
16
How Do Banks Differ?
17
How Do Banks Differ?
 Holding Company Financial
Statements
 The
consolidated financial statements
of a holding company and its
subsidiaries reflect aggregate or
consolidate performance
18
How Do Banks Differ?
19
How Do Banks Differ?
20
How Do Banks Differ?
21
22
How Do Banks Differ?
23
How Do Banks Differ?
 Holding Company Financial
Statements
 While
the consolidated financial
statements of a holding company and
its subsidiaries reflect aggregate
performance, it is useful to examine
the parent company’s statements
alone
24
25
How Do Banks Differ?
 Holding Company Financial Statements
 The parent typically pays very little in
income tax because 80 percent of the
dividends from subsidiaries is exempt
 Taxable income from the remaining 20
percent and interest income is small
relative to deductible expenses
 Under IRS provisions, each subsidiary actually
pays taxes quarterly on its taxable income
 With a consolidated tax return, however, the
parent company can use taxable income from
its subsidiaries to offset its loss
26
Organizational Structure and
Financial Services Business Model
 S-Corporation Banks

Have favorable tax treatment because a
qualifying firm does not pay corporate
income tax

The firm allocates income to shareholders on
a pro rata basis and each individual pays tax
at personal tax rates on the income allocated
to them
 Given the opportunity to avoid double taxation at
the firm and individual level, many closely held
banks have chosen S-corporation status

The primary limitation to qualifying for Scorporation status is a requirement that the
bank must have no more than 100
shareholders
27
Organizational Structure and
Financial Services Business Model
 S-Corporation Banks
28
Organizational Structure and
Financial Services Business Model
 Financial Services Business Models

The principal advantage of being a
depository institution is access to FDIC
deposit insurance


The FDIC charges banks a premium for the
insurance, which ensures qualifying deposit
holders that the FDIC will guarantee the
principal amount of each deposit up to the
maximum allowed
The existence of deposit insurance allows
depository institutions to pay low rates on
insured deposits and ensures that such
deposits are relatively stable in times of crisis
29
Organizational Structure and
Financial Services Business Model
 Financial Services Business Models


The primary disadvantage of operating as a
bank (or BHC) is that the firm is subject to
regulation as a bank
Prior to 2008, investment banks avoided
regulation as banks, which allowed them to
operate with substantially lower equity
capital per dollar of risk assets and enter
lines of business not generally available to
commercial banks

The combined effect was greater financial
leverage and business operations in many
high-risk areas such as proprietary trading
30
Organizational Structure and
Financial Services Business Model
 Transactions Banking Versus
Relationship Banking
 Transactions
Banking
Involves the provision of transactions
services such as checking accounts,
credit card loans, and mortgage loans
that occur with high frequency and
exhibit standardized features
 Because the products are highly
standardized, they require little human
input to manage

31
Organizational Structure and
Financial Services Business Model
 Transactions Banking Versus
Relationship Banking
 Relationship

Banking
Emphasizes the personal relationship
between the banker and customer
 For example, the key feature of a loan that
is relationship driven is that the lender
adds real value to the borrower during the
credit granting process
 In addition to the provision of funds, the
lender may provide expertise in
accounting, business, and tax planning
32
Organizational Structure and
Financial Services Business Model
 Transactions Banking Versus
Relationship Banking
 Relationship
Banking
Lending institutions generally charge
higher rates and often hold the loans in
portfolio
 Aggressively market noncredit
products and services to such
customers in order to lock in the
relationship

33
Organizational Structure and
Financial Services Business Model
 Transactions Banking Versus Relationship
Banking
 Securitization

The process of pooling a group of assets with
similar features—for example, credit card
loans or mortgages—and issuing securities
that are collateralized by the assets
 The securities are sold to investors who receive the
cash flows from the loans net of servicing,
guarantee, and trust fees
 The entire process adds liquidity to the market
because the loan originators regularly repeat the
process knowing that investors will demand the
securities
34
Organizational Structure and
Financial Services Business Model
 Transactions Banking Versus
Relationship Banking
 Originate-to-Distribute

(OTD)
When loan origination is separated
from ownership
 The flaw is that lenders who originated the
loans knew they would not own the loans
long term
 They were, therefore, less concerned about
the quality of the assets originated
35
Organizational Structure and
Financial Services Business Model
 Transactions Banking Versus
Relationship Banking

Originate-to-Distribute (OTD)
 In order to grow their business and continue
originating loans, they increasingly made
loans to less qualified borrowers
 When the underlying assets defaulted at
higher-than-expected rates, investors in the
securities did not receive the promised
payments
 The net result is that liquidity largely dried up
for most securitizations
36
Organizational Structure and
Financial Services Business Model
 Universal Banking

Refers to a structure for a financial services
company in which the company offers a
broad range of financial products and
services


Combined traditional commercial banking
that focused on loans and deposit gathering
with investment banking
Underwrote securities, advised on mergers
and acquisitions, managed investment assets
for customers, took equity positions in
companies, bought and sold assets for a
speculative profit, offered brokerage services,
and made loans and accepted deposits
37
Organizational Structure and
Financial Services Business Model
 Universal Banking
 The
presumed advantage of universal
banking is the ability to cross-sell
services among customers
 Participation in diverse products and
services would presumably increase
the information advantage and allow
the bank to serve customers more
efficiently and at better prices
38
Organizational Structure and
Financial Services Business Model
 Universal Banking
 There
is no consensus on whether
universal banking is successful
 U.S. firms that tried to achieve this
goal of a “one-stop financial
supermarket” have not outperformed
more traditional competitors
39
40
Different Channels for Delivering
Banking Services
 Branch Banking
 Automated Teller Machines
 Internet (Online) Banking
 Call Centers
 Mobile Banking
41
Chapter 2
Banking and the
Financial Services
Industry
42
Government Policies
and Regulation
43
Historical Bank Regulation
 Glass-Steagall Act (1933-1999)
 Created
three distinct industries
Commercial Banking
 Investment Banking
 Insurance

44
Historical Bank Regulation
 Definition of a Commercial Bank
 Limitations on:
 Geographic
Scope
 Products and Services
 Results:
 Large
number of small banks
 Limited products and services banks
could offer
 Limited geographic area to operate
45
Historical Bank Regulation
 Changes in:
 Products
and Services
MMMFs
 LPOs
 Commercial Paper
 Junk Bonds
 Payment Methods

46
Goals and Functions of Bank
Regulation
 Ensure the Safety and Soundness of
Banks
 Provide an Efficient and Competitive
Financial System
 Provide Monetary Stability
 Maintain the Integrity of the Payments
System
 Protect Consumers from Abuses
47
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Supervision and Examination
 FDIC
 OCC
48
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Supervision and Examination
 CAMELS
Capital
 Asset Quality
 Management Quality
 Earnings Quality
 Liquidity
 Sensitivity to Market Risk

49
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Supervision and Examination
 Memorandum

of Understanding
Formal regulatory document
 Cease
and Desist Order
Legal document
 Has legal standing

50
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 New Charters
 Dual
Banking System
 Office of the Comptroller of the
Currency

Charters national banks
 Office

of Thrift Supervision
Charters federal savings banks and
savings associations
 National

Credit Union Administration
Charters federal credit unions
51
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 New Charters
 State

Charter state banks
 State

Savings Authorities
Charter state savings banks
 State

Banking Authorities
Credit Union Authorities
Charter state credit unions
52
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 National versus State Charter
 All
banks obtain FDIC deposit
insurance as part of the chartering
process
 National banks must join the Fed

Primary regulator is the OCC
53
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 National versus State Charter
 State
banks may join the Fed
State banks are regulated by their state
banking authority
 State banks also have a primary federal
regulator

 Federal Reserve for member banks
 FDIC for non-member banks
54
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
55
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
56
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Commercial Banks, Savings
Institutions, and Credit Unions
 Commercial

Banks
Specialize in short-term business credit
 Savings
Institutions
Specialize in real estate loans
 Stockholder versus Mutual Ownership
 “Qualified Thrift Lender”
 Unitary Thrift Holding Company

57
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Commercial Banks, Savings
Institutions, and Credit Unions
 Credit
Unions
“Common Bond” requirement
 Exempt from Federal Taxation

58
59
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Farm Credit System
 Farm
Credit Administration
 4 Farm Credit Banks
 81 Agricultural Credit Associations
 9 Federal land Credit Associations
 1 Agricultural Credit Bank
60
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Farm Credit System
 Provides credit and other services to:
 Agricultural producers and farmer-owned
agricultural and aquatic cooperatives
 Agricultural processing and marketing
activities
 Rural housing
 Farm-related businesses
 Rural utilities
 Foreign and domestic companies involved
in international agricultural trade
61
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Farm Credit System
 Not
considered depository institutions
because they do not accept
transactions deposits
 Federal Farm Credit Banks Funding
Corporation

Issues debt on behalf of the Farm
Credit Banks
62
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Federal Deposit Insurance
 Currently full coverage for demand
deposit accounts until 12/31/2013
 Currently coverage of at least $250,000
per depositor on interest-bearing
accounts
 Coverage will revert to $100,000
($250,000 for retirement accounts) per
depositor on 1/1/2014
 Original limit in 1933 was $5,000
63
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Federal Deposit Insurance
 Goal
is for fund to be 1.25% of
deposits

Banks pay risk-based deposit
insurance premium to the Deposit
Insurance Fund
64
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Federal Deposit Insurance
 Federal

Deposit Insurance Corporation
Receiver of failed institutions
 Liquidate
 Sell

Too Big to Fail Policy
65
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Product Restrictions: Depository
Institutions versus Non-Depository
Institutions
 Banks
are restricted on what products
and services they can offer
 http://www.occ.treas.gov/corpapps/Ba
nkAct.pdf
66
67
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Activities Permissible for a National Bank
 General Banking Activities
 Branching
 Consulting and financial advice
 Corporate governance
 Correspondent service
 Finder activities
 Leasing
 Lending
 Payment services
68
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Activities Permissible for a National
Bank
 Fiduciary,
Insurance and Annuities
Activities
General trust activities, employee
benefit accounts, and real estate
brokerage
 Insurance and annuities activities
 Securities activities

69
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Activities Permissible for a National
Bank
 Technology
and Electronic Activities
Digital certification
 Electronic bill payments
 Electronic correspondent services
 Electronic storage and safekeeping
 Internet access service
 Internet and PC banking
 Software development and production

70
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Activities Permissible for a National Bank
 Investments
 Asset-backed securities
 Bank stock
 Bankers acceptances
 Corporate bonds
 Collateralized mortgage-related
investments
 Commercial paper
 Money market preferred stock,
 Trust preferred securities
 State and local bonds
71
Ensure Safety & Soundness and Provide
an Efficient & Competitive System
 Shortcomings of Restrictive Bank
Regulation
 Does
not prevent bank failure
 Cannot eliminate economic risk
Assumed markets for bank products
could be protected
 Discriminated against U.S. based firms

 Does
not guarantee that bank
management will make good decisions
72
Maintaining Monetary Stability and
the Integrity of the Payments System
 The Role of the Central Bank in the
Economy: The Federal Reserve
System
 Fundamental
Functions
Conduct monetary policy
 Provide and maintain the payments
system
 Supervise and regulate banking
operations

73
Maintaining Monetary Stability and
the Integrity of the Payments System
 The Role of the Central Bank in the
Economy: The Federal Reserve
System
 Organization
Board of Governors
 12 Federal Reserve District Banks

74
Maintaining Monetary Stability and
the Integrity of the Payments System
 The Role of the Central Bank in the
Economy: The Federal Reserve
System
 Monetary

Policy
Open Market Operations
 Open market purchases (sales) increase
(decrease) reserves & the money supply
75
Maintaining Monetary Stability and
the Integrity of the Payments System
 The Role of the Central Bank in the
Economy: The Federal Reserve
System
 Monetary

Policy
Discount Rate
 Decreasing (Increasing) the discount rate
makes bank borrowing less (more)
expensive, which leads to an increase
(decrease) in the money supply
76
Maintaining Monetary Stability and
the Integrity of the Payments System
 The Role of the Central Bank in the
Economy: The Federal Reserve
System
 Monetary

Policy
Reserve Requirements
 Decreasing (Increasing) reserve
requirements increases (decreases) the
money supply
 Last changed April 1992
77
Maintaining Monetary Stability and
the Integrity of the Payments System
 The Federal Reserve’s Crisis
Management Tools
 Term
Auction Facility
 Term Securities Lending Facility
 Primary Dealer Credit Facility
78
Maintaining Monetary Stability and
the Integrity of the Payments System
 The Role of Depository Institutions
and the Economy
 Banks
are the primary conduit for
monetary policy
 Banks are the primary source of credit
for most small businesses and many
individuals
79
Maintaining Monetary Stability and
the Integrity of the Payments System
80
81
Efficient and Competitive
Financial System
 Product restrictions, barriers to entry,
and restrictions on mergers and the
degree of branching can clearly
enhance safety and soundness, but
they also hinder competition
 Effective financial regulation requires
a delicate balance between the
system’s competitiveness and general
safety and soundness concerns
82
Efficient and Competitive
Financial System
 Organizational Form of the Banking
Industry
 Bank
Holding Companies
Parent
 Subsidiaries

 One-Bank
Holding Companies
 Mutli-Bank Holding Companies
83
Efficient and Competitive
Financial System
 Consumer Protection

Reg. B

Equal Credit Opportunity
 Cannot discriminate on the basis of sex, race,
marital status, religion, age, or national origin

Reg. Z

Truth-in-Lending
 Requires disclosure of:
 Effective interest rates, total interest paid,
total of all payments
 Why credit was denied
84
Efficient and Competitive
Financial System
 Key Federal Legislation
 Depository
Institutions Deregulation
and Monetary Control Act of 1980

DIDMCA
 Depository

Institutions Act of 1982
Garn-St. Germain
 Competitive
Equality Banking Act of
1987
85
Efficient and Competitive
Financial System
 Key Federal Legislation
 Financial Institutions Reform, Recovery,
and Enforcement Act of 1989
 FIRREA
 Federal Deposit Insurance Corporation
Improvement Act of 1991
 FASB 115
 Held-to-maturity
 Trading account securities
 Available-for-sale
86
Efficient and Competitive
Financial System
 Key Federal Legislation
 Riegle-Neal
Interstate Banking and
Branching Efficiency Act of 1994
 Gramm-Leach-Bliley Act of 1999
 USA Patriot Act (2001)
 Sarbanes-Oxley Act (2002)
 Check Clearing for the 21st Century
Act aka Check 21 (2004)
87
Efficient and Competitive
Financial System
 Key Federal Legislation
 Fair
and Accurate Credit Transactions
Act (FACT) of 2003
 Servicemembers Civil Relief Act
(SCRA) of 2003
 Deposit Insurance Reform Act of 2005
 Troubled Asset Relief Act (2008)
 TARP Capital Purchase Program (2008)
 Amended Reg. Z (Truth in Lending Act
of 1968)
88
Efficient and Competitive
Financial System
 Key Federal Legislation
 Housing and Economic Recovery Act
(HERA) of 2008
 Federal Housing Finance Regulatory
Reform Act of 2008
 Federal Housing Finance Agency (FHFA)
 HOPE for Homeowners Act of 2008
 Treasury Emergency Authority Provisions
 Secure and Fair Enforcement of Mortgage
Licensing Act (SAFE) of 2008
 Foreclosure Prevention Act of 2008
 FHA Modernization Act of 2008
89
Efficient and Competitive
Financial System
 Current Unresolved Regulatory Issues
 Capital
Adequacy
From a regulator’s perspective,
increased capital requirements make
banks safer
 Increasing capital requirements also
has disadvantages

 Equity is more expensive than debt
 Most banks do not have ready access to
the equity markets

This can lead to more consolidation
90
Efficient and Competitive
Financial System
 Current Unresolved Regulatory Issues
 Regulatory

Reform
Regulation of depository institutions is
highly fragmented
 Federal Reserve
 OCC
 OTS
 FDIC
 NCUA
91
Efficient and Competitive
Financial System
 Current Unresolved Regulatory Issues
 Regulatory

Reform
Non-depository institutions are not
subject to the same regulatory burdens
as depository institutions
 Large investment banks
 Insurance companies
 Finance companies
 Hedge funds
 Credit card companies
92
Efficient and Competitive
Financial System
 Current Unresolved Regulatory Issues
 Regulatory

Reform
Since the Fed is willing and able to
assist financial players they do not
directly supervise, the system appears
to be at greater risk than it was before
the most recent financial innovations
93
Chapter 3
Analyzing Bank
Performance
94
Analyzing Bank Performance
 In 2008, depository institutions
reported:
 Worsening
asset quality leading to
higher charge-offs
 Shrinking net interest income
 Declining non-interest income

These factors led to lower profits, ROE,
ROA, and bank failures
95
96
Analyzing Bank Performance
 Depository Institution Failures
 Over
1,500 bank failures between 1985
and 1993
 0 in 2005 or 2006
 3 in 2007
 Sharp increase in 2008 and 2009
26 in 2008
 72 through mid-August 2009

97
Commercial Bank Financial
Statements
 Most depository financial institutions
own few fixed assets and thus exhibit
low operating leverage
 Many bank liabilities carry short-term
maturities. As a result, interest
expense changes coincidentally with
short-run changes in market interest
rates
98
Commercial Bank Financial
Statements
 Many commercial bank deposits are
insured by the FDIC. Insured deposits
carry below-market interest rates
 Banks operate with less equity capital
than non-financial companies, which
increases financial leverage and the
volatility of earnings
99
Commercial Bank Financial
Statements
 Bank Assets
 Loans
Real Estate
 Commercial
 Individual
 Agricultural
 Other loans in domestic offices
 Loans and leases in foreign offices

100
Commercial Bank Financial
Statements
 Bank Assets
 Adjustment

to Loans
Gross Loans and Leases
 minus
Unearned Income
 Loan and Lease Loss (Allowance for
Loan Loss or ALL)

 equals

Net Loans and Leases
101
Commercial Bank Financial
Statements
 Bank Assets
 Investment

Securities
Short-Term Investments
 One year or less
 Examples:
 Interest-Bearing Deposits Due from
Other Banks
 Fed Funds Sold
 Reverse Repos
 T-Bills
102
Commercial Bank Financial
Statements
 Bank Assets

Investment Securities

Long-Term Investments
 Over one year
 Examples:
 T-Notes and T-Bonds
 Government Agency Issues
 Foreign and Corporate Bonds
 Mortgage-Backed Securities
 Municipal Securities: General Obligation
 Municipal Securities: Revenue
103
Commercial Bank Financial
Statements
 Bank Assets
 Investment
Securities
Held-to-Maturity
 Trading Account
 Available-for-Sale

104
Commercial Bank Financial
Statements
 Bank Assets
 Investment

Securities
Held-to-Maturity
 Intent and ability to hold until maturity
 Recorded at cost (Book Value)
 Changes in value (unrealized gains or
losses) are NOT reflected on the balance
sheet or income statement
 May be a current or long-term asset,
depending on maturity
105
Commercial Bank Financial
Statements
 Bank Assets
 Investment

Securities
Trading Account
 Objective is to generate trading profits
 Marked-to-Market
 Changes in value (unrealized gains and
losses) ARE reflected on the Income
Statement
 Always a current asset, regardless of
maturity of the underlying security
106
Commercial Bank Financial
Statements
 Bank Assets
 Investment Securities
 Available-for-Sale
 For those securities that do not fall into the
HTM or
Trading categories
 Market-to-Market
 Change in value (unrealized gains or
losses) ARE reflected on the Balance
Sheet (Change to Shareholder’s Equity)
 May be a current or long-term asset,
depending on maturity
107
Commercial Bank Financial
Statements
 Bank Assets
 Non-Interest
Cash and Due From
Banks
Vault Cash
 Deposits held at the Federal Reserve
 Cash Items in Process of Collection
(CIPC)

 Largest component of this category
108
Commercial Bank Financial
Statements
 Bank Assets
 Other
Assets
Bank Premises
 OREO

 Often foreclosed property

Banker’s Acceptances
109
110
111
Commercial Bank Financial
Statements
 Bank Liabilities and Stockholder’s Equity
 Transaction Accounts
 Demand Deposits
 Pays no interest
 Available to all customers

NOW Accounts
 Pays “market” interest rate
 Not available to for-profit corporations

ATS Accounts
 Pays “market” interest rate
 Not available to for-profit corporations
112
Commercial Bank Financial
Statements
 Bank Liabilities and Stockholder’s
Equity
 Transaction

Accounts
MMDAs
 Pays market interest rate
 Limited to six checks per month
 Available to all customers
113
Commercial Bank Financial
Statements
 Bank Liabilities and Stockholder’s
Equity
 Savings

and Time Deposits
Savings Deposits
 No Maturity

Time Deposits (CDs)
 “Large” or Jumbo CDs
 Negotiable
 “Small” CDs
114
Commercial Bank Financial
Statements
 Bank Liabilities and Stockholder’s Equity

Other Borrowings
Fed Funds Purchased Repurchase
Agreements
 Brokered Deposits
 Deposits Held in Foreign Offices

 Issued by a bank subsidiary outside the U.S.
Federal Home Loan Bank Borrowings
 Subordinated Notes and Debentures

115
Commercial Bank Financial
Statements
 Bank Liabilities and Stockholder’s Equity
 Core Deposits
 Deposits that are NOT very interest rate
sensitive
 Represent permanent funding base
 Made up of:





Demand Deposits
NOW and ATS accounts
MMDAs
Savings Accounts
“Small” Time Deposits
116
Commercial Bank Financial
Statements
 Bank Liabilities and Stockholder’s
Equity
 Non-Core
Deposits
Deposits that are very interest rate
sensitive
 AKA

 Volatile Liabilities
 Hot Money
 Purchased Liabilities
 Short-Term Non-Core Funding
117
Commercial Bank Financial
Statements
 Bank Liabilities and Stockholder’s
Equity
 Non-Core

Deposits
Consist of:
 Federal Funds Purchased
 Repos
 “Large” Time Deposits
 Brokered Time Deposits
118
Commercial Bank Financial
Statements
 Bank Liabilities and Stockholder’s
Equity
 All
Common and Preferred Equity
Preferred Stock
 Common Stock

119
120
121
122
Commercial Bank Financial
Statements
 Income Statement
 Interest Income (II)
 Includes interest and fees from:
 Loans
 Deposits at other institutions
 Trading Account Securities
 Municipal Securities
 Estimated Tax Benefit =
 Municipal Interest Rate/(1 – Marginal
Tax Rate) = Tax-Equivalent Municipal
Interest Income
123
Commercial Bank Financial
Statements
 Income Statement
 Interest

Expense (IE)
Includes interest paid on all interestbearing liabilities:
 NOW Accounts
 ATS Accounts
 MMDAs
 Savings Accounts
 Time Deposits
 Non-Core Liabilities
 Long-Term Debt
124
Commercial Bank Financial
Statements
 Income Statement
 Interest

minus
 Interest

Income (II)
Expense (IE)
equals
 Net
Interest Income (NII)
125
Commercial Bank Financial
Statements
 Income Statement

Non-Interest Income (OI)

Includes:








Fiduciary (Trust) Income
Deposit Service Charges
Trading Revenues
Investment Banking Fees and Commissions
Insurance Commission Fees and Income
Net Servicing Fees
Net Gains (Losses) on Sales of Loans
Other Net Gains (Losses)
126
Commercial Bank Financial
Statements
 Income Statement
 Non-Interest

Expense (OE)
Includes:
 Personnel
 Occupancy
 Technology
 Utilities
 Deposit Insurance Premiums
 Intangible Amortizations
 Goodwill Imparement
127
Commercial Bank Financial
Statements
 Income Statement
 Non-Interest

minus
 Non-Interest

Expense (OE)
Income (OI)
equals
 Burden
Non-interest expense is typically larger
than non-interest income
 Reducing the Burden will increase bank
profitability

128
Commercial Bank Financial
Statements
 Income Statement

Provision for Loan and Lease Losses (PLL)


Estimate of potential losses on loans
Relationship between PLL and ALL
 Beginning ALL (from Balance Sheet)
 plus
 This year’s PLL (from Income Statement)
 minus
 Charge-offs
 plus
 Recoveries
 Equals
 Ending ALL
129
Commercial Bank Financial
Statements
 Income Statement
 Provision
for Loan and Lease Losses
(PLL)

Relationship between PLL and ALL
 Recall, ALL is a contra-asset account
 When a loan is charged off, Gross
Loans and the ALL account are
decreased by the same amount
130
Commercial Bank Financial
Statements
 Income Statement
 Net

Interest Income (NII)
minus
 Burden

minus
 PLL

plus
 Realized

Security Gains (Losses) (SG)
equals
131
Commercial Bank Financial
Statements
 Income Statement
 Pre-Tax

minus
 Taxes

Net Operating Income (te)
(T)
minus
 Extraordinary

Items
equals
 Net
Income (NI)
132
Commercial Bank Financial
Statements
 Income Statement
 Total
Revenue (TR) or Total Operating
Income (TOI)

Includes:
 Interest Income
 Non-Interest Income
 Realized Security Gains (Losses)

Analogous to Net Sales
133
Commercial Bank Financial
Statements
 Income Statement
 Total

Operating Expense (EXP)
Includes
 Interest Expense
 Non-Interest Expense
 PLL

Analogous to COGS + Operating
Expenses
134
Commercial Bank Financial
Statements
 Income Statement

NI = NII – Burden – PLL + SG – T
135
Relationship Between Balance
Sheet & Income Statement
 Ai = Dollar magnitude of the ith asset
 Lj = Dollar magnitude of the jth liability
 NW = Dollar magnitude of equity
 yi = Average pre-tax yield on the ith
asset
 cj = Average pre-tax cost on the jth
liability
136
Relationship Between Balance
Sheet & Income Statement
n
m
 A  L
i 1
i
j 1
j
 NW
n
Interest Income   yi Ai
i  1
m
Interest Expense   c j L j
i  1
137
Relationship Between Balance
Sheet & Income Statement
 Net Interest Income
 Changes
with changes in:
Composition
 Volume

n
m
i  1
i  1
Net Interest Income   yi Ai   c j L j
n
m
i  1
i  1
Net Income   yi Ai   c j L j  Burden - P LL  SG - T
138
Return on Equity Model
 Profitability Analysis
 Return
on Equity (ROE)
 Return on Assets (ROA)
139
Return on Equity Model
 Profitability Analysis
 Return
on Equity
Net Income/Average Total Equity
 ROA x EM

 Net Income/Average Total Assets x
Average Total Assets/Average Total Equity
140
Return on Equity Model
 Expense Ratio and Asset Utilization
 Asset Utilization (AU)
 Total Revenue/Average Total Assets
 TR/aTA
 Expense

Ratio (ER)
Total Operating Expenses/Average
Total Assets
 EXP/aTA
 Tax

Ratio (TAX)
Taxes/Average Total Assets
141
Return on Equity Model
 Expense Ratio and Asset Utilization
 Net Income/Average Total Assets
ROA 

NI
TR EXP Taxes



aTA aTA aTA aTA
ROA = AU – ER – TAX
142
Return on Equity Model
 Expense Ratio and Asset Utilization
 Expense

Ratio (ER)
Total Operating Expense/Average Total
Assets
 EXP/aTA
ER 
EXP
IE
OE PLL



aTA aTA aTA aTA
143
Return on Equity Model
 Expense Ratio and Asset Utilization
 Expense

Ratio (ER)
IE can change due to changes in:
 Volume
 Different levels of liabilities versus
equity
 Composition
 Different mix of liabilities
 Rates
EXP
IE
OE PLL
ER 



aTA aTA aTA aTA
144
Return on Equity Model
 Expense Ratio (ER)
 Non-Interest Expense
 OE can change due to changes in:
 Personnel Expenses
 Occupancy Expenses
 Technology Expenses
 Other Overhead Expenses
EXP
IE
OE PLL
ER 



aTA aTA aTA aTA
145
Return on Equity Model
 Income: Asset Utilization Components
 Total

Revenue
Includes:
 Interest Income (II)
 Non-Interest Income (OI)
 Realized Security Gains or Losses (SG)
AU 
TR
II
OI
SG



aTA aTA aTA aTA
146
Return on Equity Model
 Income: Asset Utilization Components
 II

can change due to changes in:
Volume
 Different levels of earning assets to total
assets
 Earnings Base (EB) = Average Earning
Assets/aTA

Composition
 Different mix of earning assets

Rates
TR
II
OI
SG
AU 



aTA aTA aTA aTA
147
Return on Equity Model
 Income: Asset Utilization Components
 Non-Interest

Income (OI)
OI can change due to changes in:
 Fees
 Trust Activities
 Service Charges
 Other Non-Interest Income
TR
II
OI
SG
AU 



aTA aTA aTA aTA
148
Return on Equity Model
 Aggregate Profitability Measures
 Net

Interest Margin (NIM)
Net Interest Income/Average Earning
Assets
 Spread

Interest Income/Average Earning
Assets - Interest Expense/Average
Interest-Bearing Liabilities
149
Return on Equity Model
 Aggregate Profitability Measures
 Burden

(Non-Interest Expense – Non-Interest
Income)/Average Earning Assets
 Lower numbers are better
 Efficiency

Ratio
Non-Interest Expense/(Net Interest
Income + Non-Interest Income)
 Lower numbers are better
150
151
Managing Risks and Returns
 Risk Management
 Credit
Risk
 Liquidity Risk
 Market Risk
 Operational Risk
 Reputation Risk
 Legal Risk
152
Managing Risks and Returns
 Risk Management
 Credit

Risk
Historical Loss Rate
 Gross Loan Losses (Charge-offs)
 Recoveries
 Net Losses
 Charge-offs - Recoveries
153
Managing Risks and Returns
 Risk Management
 Credit Risk
 Expected Future Losses
 Past-Due Loans
 Interest and Principal has not been paid but
it is still accruing interest
 30-89 days
 90 days and over
 Non-Performing Loans
 90 days or more past-due
 Non-Accrual Loans
 Not accruing interest
154
Managing Risks and Returns
 Risk Management
 Credit

Risk
Expected Future Losses
 Total Non-Current Loans
 Non-Performing + Non-Accrual Loans
 Restructured Loans
 Classified Loans
 Regulations force management to set
aside reserves for loans that are clearly
not going to be paid back
155
Managing Risks and Returns
 Risk Management
 Credit

Risk
Preparation for Losses
 Provision for Loan Loss
 IRS versus FASB and Regulators
 Earnings Coverage of Net Losses
 (Net Interest Income – Burden)/Net Loan
and Lease Losses
 Management can manipulate by
delaying the recognition of bad loans
156
Managing Risks and Returns
 Risk Management
 Credit

Risk
Preparation for Losses
 Lack of Diversification
 High Loan Growth
 Country Risk
157
Managing Risks and Returns
 Risk Management
 Liquidity

Risk
Funding Liquidity Risk
 Inability to liquidate assts or raise required
funding

Market Liquidity Risk
158
Managing Risks and Returns
 Risk Management
 Liquidity Risk
 Holding Liquid Assets
 Pledging Requirements
 Cash Assets
 Not a good source of liquidity for a bank

Ability to Borrow for Liquidity
 Volatile Liabilities
 “Hot Money” versus Core Deposits
 Large CDs
 Fed Funds Purchased
 Repos
159
Managing Risks and Returns
 Risk Management
 Market

Risk
Interest Rate Risk
 Asset or Liability is considered “rate
sensitive” if it can be re-priced during a
particular time period
 GAP/Earnings Sensitivity Analysis
 Changes in spread/NIM due to changes
in rates
 Duration GAP
 Market Value of Equity Sensitivity
160
Managing Risks and Returns
 Risk Management
 Market
Risk
Equity and Security Price Risk
 Foreign Exchange Risk

 Foreign Currency Translation Risk
 Commitments and Guarantees
denominated in a foreign currency
161
Managing Risks and Returns
 Risk Management
 Operational
Risk
Business Interruptions
 Transaction Processing
 Inadequate Information Systems
 Breaches in Internal Controls
 Client Liability

 Legal

Risk
Reputation Risk
162
Managing Risks and Returns
 Risk Management
 Capital

or Solvency Risk
Risk of becoming insolvent
 Liabilities > Assets
 Off-Balance

Sheet Risk
Tier 1 Capital
 Common Equity + Non-cumulative
Preferred Stock

Risk-Weighted Assets
163
Evaluating Bank Performance:
An Application
 Profitability Analysis for PNC in 2007
164
165
166
167
168
169
Maximizing the Market Value of
Bank Equity
 Effective Management of:
 Assets
 Liabilities
 Off-Balance
Sheet Activities
 Interest Rate Margin
 Credit risk
 Liquidity
 Non-Interest Expense
 Taxes
170
Maximizing the Market Value of
Bank Equity
 CAMELS Ratings
 Capital
Adequacy
 Asset Quality
 Management Quality
 Earnings
 Liquidity
 Sensitivity to Market Risk
171
Maximizing the Market Value of
Bank Equity
 CAMELS Ratings
 Ratings

from 1 (best) to 5 (worst)
1&2
 Sound banks

3
 Some underlying problems

4&5
 Problem banks
172
173
Maximizing the Market Value of
Bank Equity
 Performance Characteristics of Banks
by Size
 Large
Banks versus Small Banks
Higher ROE
 Lower NIM
 Higher Charge-offs
 Lower Capital

174
175
Financial Statement Manipulation
 Off-Balance Sheet Activities
 Window
Dressing
 Preferred Stock
 Non-Performing Loans
 Allowance for Loan Losses
 Securities Gains and Losses
 Non-Recurring Extraordinary Items
176
Analyzing Bank
Performance
177