Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2005 by South-Western, a division of Thomson Learning
THE CHANGING BANK
ENVIRONMENT
Chapter 1
The banking industry is consolidating and
diversifying simultaneously.
 The traditional definition of a bank has been blurred
by new products and a wave of mergers, which
have dramatically expanded the scope of activities
and where products and services are offered.

Formerly, a commercial bank was defined as both
accepting demand deposits and making commercial
loans.

Today, these two products are offered by many
financial services companies: including commercial
banks, savings banks, credit unions, insurance
companies, investment banks, finance companies,
retailers, and pension funds.
 What constitutes a bank, today is not as important
as the products and services are offered and the
geographic markets in which it competes.
While competition has increased the number of
firms offering financial products and services,
… the removal of interstate branching restrictions in the
U.S. has dramatically reduced the number of banks but
increased the number of banking offices (primarily
branches).
 Consolidation, in turn, has increased the proportion
of banking assets controlled by the largest banks.
 Not surprisingly, the same trends appear globally.
 The U. S. currently has several banks that operate
in all 50 states and many places outside the U.S.
 The largest foreign banks have significant
operations in the U.S. and throughout the world.
Increased competition
… quickly changing the nature
of commercial banking.
 Competition also means geography no longer limits
the trade area or the markets in which it competes.

Individuals can open a checking account at:
 a traditional depository institution,
 a brokerage firm, or
 a nonbank firm, such as GE Capital, State Farm Insurance,
and AT&T.

You can deposit money electronically, transfer funds
from one account to another, purchase stocks, bonds
and mutual funds, or even request and receive a loan
from any of these firms.

Most allow you to conduct this business by phone, mail, or
over the Internet.
Regulatory restrictions on products and
services offerings worked effectively in
promoting a safe banking system until the
later half of the twentieth century.
 Product innovations and technological advances of
the late 1900s allowed investment banks to
circumvent the regulations restricting their banking
activities.

In the late 1970s Merrill Lynch effectively created an
“interest bearing checking account,” something
banks had not been legally allowed to offer.
 Junk bonds became an alternative financing source
for small business and other companies began to
encroach upon the banks primary market.
Goals and Functions of Bank Regulation
 To ensure Safety and Soundness
 To provide an efficient and competitive system
 Provide Monetary Stability
 Maintain Integrity of payment systems
 Protect consumers from potential abuses
Three separate federal agencies along
with each state's banking department
issue and enforce regulations
 The Federal Reserve
 The Federal Deposit Insurance Corporation
(FDIC)
 Office of the Comptroller of the Currency (OCC)
Most regulations can be classified in
one of three basic categories:
1.
supervision, examination, deposit insurance,
chartering activity, and product restrictions
are associated with safety and soundness
2.
branching, mergers and acquisitions, and
pricing are related to an efficient and
competitive financial system
3.
consumer protection.
Depository institutions and their
regulators
Type of Commercial Bank
Type of Regulation
Safety and Soundness
Supervision and
Examination
National
Comptroller
State member
Insured state
nonmember
Federal Reserve FDIC and state
and state authority
authority
Noninsured state
nonmember
Bank holding
companies
State authority
Federal reserve
Deposit Insurance
FDIC
FDIC
FDIC
State insurance
or none
Not applicable
Chartering and Licensing
OCC
State authority
State authority
State authority
Federal Reserve
and state authority
Efficiency and Competitiveness
Federal Reserve FDIC and state
and state authority
authority
Federal Reserve FDIC and state
Mergers and Acquisitions Comptroller
and state authority
authority
Federal Reserve
Federal Reserve
Federal Reserve
Pricing New Products
and state
and state
and state authority
authority
authority
Federal Reserve,
Federal Reserve
Consumer Protection
Federal Reserve
FDIC, and state
and state authority
authority
Branching
Comptroller
Federal Reserve
and state authority
Federal Reserve
State authority
and state authority
Federal Reserve
and state
Not applicable
authority
Federal Reserve
and state
Not applicable
authority
State authority
Supervision and Examination
 Regulators examine banks for safety and
soundness.






Capital adequacy
Asset quality
Management quality
Earnings quality
Liquidity
Sensitivity to Risk
 1 to 5 rating in each category
 If deficient, regulators issue a MOU or a Cease
and Desist order
Regulation- New Charters
The U.S. System is a dual system with
federal and state charters.
• OCC regulates federal (national) banks
• States individually regulate state
chartered banks, with the FDIC acting
as primary regulator
• The FDIC regulates insured banks too,
even if not the primary regulator
• The Federal Reserve regulates state
member banks and National banks that
are required to be Fed members.
Numbers and types of institutions in
June 2003
Commercial Banks
National Charter
State Charter
Federal Res. Member
Federal Res.nonmemb.
Savings institutions
Credit Unions
# instit.
# Offices
7831
2047
5784
952
4832
1410
9369
73895
35238
38657
14890
23767
13883
NA
Deposits
4.25 trillion
2.30 trillion
1.96 trillion
962 billion
993 billion
875 billion
477 billion
Primary
Regulator
OCC
Fed
FDIC
OTS/Fed
NCUA
Federal Reserve bank regulations
REGULATION
A
B
C
D
E
F
G
H
I
J
K
L
M
N
O
P
Q
R
Subject
Loans to Depository Institutions
Equal Credit Opportunity
Home Mortgage Disclosure
Reserve Requirements
REGULATION
S
T
U
V
Subject
Reimbursement for Providing Financial
Records
Margin Credit Extended by Brokers and
Dealers
Margin Credit Extended by Banks
Guarantee of Loans for National Defense
Work
Extensions of Consumer Credit (revoked)
Borrowers Who Obtain Margin Credit
Bank Holding Companies
Electronic Fund Transfers
W
Limitations on Interbank Liabilities
X
Margin Credit Extended by Parties
Other Than Banks, Brokers, and
Y
Dealers
Membership Requirements for State
Truth in Lending
Z
Chartered Banks
Stock in Federal Reserve Banks
AA
Consumer Complaint Procedures
Check Collection and Funds Transfer
BB
Community Reinvestment
International Banking Operations
CC
Availability of Funds and Collection of Checks
Interlocking Bank Relationships
DD
Truth in Savings
Consumer Leasing
EE
Netting Eligibility for Financial Institutions
Relationships with Foreign Banks
Loans to Executive Officers of Member Banks
Member Bank Protection Standards
Interest on Demand Deposits, Advertising
Interlocking Relationships Between Securities Dealers and Member Banks
The Riegle-Neal Interstate Banking
and Branching Efficiency Act, 1994,
mandates interstate branch banking,
superseding state banking pacts
Nonbank banks
 Edge Act corporations
 Edge Act corporations provide a full range of
banking services but, by law, deal only in
international transactions

There are two types of Edge corporations: banks and
investment companies
 Loan production offices (LPOs)
 make commercial loans but do not accept deposits
 Consumer banks outside their home state
 Consumer banks accept deposits but make only
consumer loans
Consumer Protection.
 State legislatures and the Fed have numerous laws
and regulations to protect the rights of individuals
who try to borrow.

Regs. AA, B, BB, C, E, M, S, Z, and DD apply specifically to
consumer regulation.

Equal credit opportunity (Reg. B)makes it illegal for any
lender to discriminate against a borrower on the basis
of race, gender, marital status, religion, age, or national
origin.

Community reinvestment prohibits redlining in which
lenders do not lend in certain geographic markets.

Reg. Z requires disclosure of effective rates of interest,
total interest paid, the total of all payments, as well as
full disclosure as to why a customer was denied credit.
Trends in federal legislation and
regulation
 The fundamental focus since 1970 has been to
define and expand the product and geographic
markets served by depository institutions, and to
increase competition.
 Subsequent problems with failed savings and loans
and commercial banks raised concerns that only a
few large organizations would survive and large
firms would drive small firms out of business.
Deposit insurance
…The FDIC insures the deposits of banks up to
$100,000 per account holder while almost all CUs are
insured by the National Credit Union Share
Insurance Fund (NCUSIF), which is controlled by
the NCUA.
 The FDIC was created by the Banking Act of 1933, in response
to the large number of bank failures after 1929.
 Originally the FDIC insured deposits up to $5,000.
 All newly chartered banks must obtain FDIC insurance.
 The FDIC also acts as the primary federal regulator of state-
chartered banks that do not belong to the Fed System.
 State banks who are members of the Federal Reserve
System are regulated by the Fed.
 The FDIC also has backup examination and regulatory
authority over national and Fed-member banks.
 The FDIC is also the receiver of failed institutions.

The FDIC handles failed institutions by either liquidating
them or selling the institutions to redeem insured deposits.
Two insurance funds under the FDIC:
 The Bank Insurance Fund (BIF) and the Savings
Association Fund (SAIF).
 The OCC and state banking authorities officially
designate banks as insolvent, but the Federal
Reserve and FDIC assist in closings.
 The Federal Reserve also serves as the federal
government's lender of last resort.

When a bank loses funding sources, the Federal
Reserve may make a discount window loan to
support operations until there is a solution.
The Central Bank
…Congress created the Federal Reserve
System in 1913 as the central bank of the U. S.
and to provide the nation with a flexible and
stable monetary and financial system

The Fed's role in banking and the economy has
expanded over the years, but its primary focus
has remained the same.

The Fed’s three fundamental functions are:
1.
2.
3.

conduct the nation’s monetary policy,
an effective and efficient payments system,
supervise and regulate banking operations.
All three roles have a similar purpose, that of
maintaining monetary and economic stability and
prosperity.
The Federal Reserve System (The
Fed)
 A decentralized central bank, with
 12 districts reserve banks and branches across the
country,

Coordinated by a Board of Governors in Washington,
D.C.

The Board of Governors are appointed by the president
of the United States and confirmed by the Senate for
staggered 14-year terms.

The seven-members of the Board Governors are the
main governing body of the Federal Reserve System.

The Board is charged with overseeing the 12 District
Reserve Banks and with helping implement national
monetary policy.
Monetary Policy

The Federal Reserve conducts monetary policy through
actions designed to influence the supply of money and
credit in order to promote price stability and long-term
sustainable economic growth.

There are basically three distinct monetary policy tools:
1.
open market operations,
2.
changes in the discount rate, and
3.
changes in the required reserve ratio.
Open market operations
… are conducted by the Federal Reserve
Bank of New York under the direction of the
Federal Open Market Committee (FOMC).
 The sale or purchase of U.S. government
securities in the “open market” is the Fed’s most
flexible means of carrying out policy objectives.
 Through the purchase or sale of securities, the
Fed can adjust the level of reserves in the
banking system.


Fed open market purchases increase liquidity, hence
reserves in the banking system, by increasing a
bank’s deposit balances at the Fed.
Fed open market sales of securities decrease bank
reserves and liquidity by lowering deposit balances
at the Fed.
Changes in the discount rate
…directly affect the cost of borrowing
 Banks can borrow deposit balances, or required
reserves, directly from Federal Reserve Banks (in
its role as lender of last resort).

The discount rate is the interest rate that banks pay.
 When the Fed raises (decreases) the discount rate
it discourages (encourages) borrowing by making it
more (less) expensive.
 Many economists argue that the Fed changes the
discount rate primarily to signal future policy
toward monetary ease or tightness rather than to
change bank borrowing activity.

Changes in the discount rate are formally announced
and market participants recognize that the Fed will
likely be adding liquidity or taking liquidity out of the
banking system.
Changes in reserve requirements
…directly affect the amount of legal required
reserves and thus change the amount of money a
bank can lend out.
 For example, a required reserve ratio of 10 percent means
that a bank with $100 in demand deposit liabilities
 must hold $10 in legal required reserves in support of
the DDAs.
 The bank can thus lend only 90 percent of its DDAs.
 When the Fed increases reserve requirements, it formally
increases the required reserve ratio that directly reduces
the amount of money a bank can lend. The reverse for
reducing reserve requirements.
 Lower reserve requirements increase bank liquidity and
lending capacity while higher reserve requirements
decrease bank liquidity and lending capacity.
Percent of Total, Depository Institutions
Percent of Total, All Others
There has been a fundamental shift in the
structure of financial institutions over the
past two decades.
20.0%
65.0%
18.0%
60.0%
16.0%
55.0%
14.0%
50.0%
12.0%
10.0%
45.0%
8.0%
40.0%
6.0%
35.0%
4.0%
30.0%
2.0%
25.0%
0.0%
1970
Dec-70
1975
Dec-75
1980
Dec-80
1985
Dec-85
1990
Dec-90
Dec-95
1995
Dec-00
2000
Dec-01
Monetary authority
5.1%
4.6%
3.5%
2.9%
2.4%
2.8%
2.4%
2.4%
Insurance Companies
16.8%
14.1%
13.9%
12.8%
14.6%
14.9%
11.6%
11.4%
Pension and Retirement Funds 7.0%
7.3%
8.2%
9.1%
8.6%
8.4%
7.2%
6.7%
Mutual Funds
0.6%
0.6%
1.7%
4.9%
7.6%
10.2%
11.8%
12.5%
Finance companies
4.5%
4.2%
4.9%
4.9%
4.7%
3.8%
4.0%
3.8%
Mortgage related
Other
1.3%
4.2%
2.2%
4.9%
3.6%
5.3%
6.3%
7.4%
10.8%
8.6%
11.8%
12.4%
12.2%
18.8%
12.8%
19.6%
Depository Institutions
60.5%
62.1%
58.9%
51.8%
42.8%
35.7%
31.9%
30.7%
Year
Consolidations, new charters and
bank failures
 The number of failed banks increased sharply from
1980 through 1988

This period coincides with economic problems
throughout various sectors of the U.S. economy
ranging from agriculture to energy to real estate.

As regional economies faltered, problem loans grew
at banks and thrifts that were overextended and
subsequent losses forced closings.
 New charters representing the start-up of a new
bank’s operations declined from 1984 to 1994,
increased through 1998, and then decreased
through 2001.
The major force behind consolidation has
been mergers and acquisitions in which
existing banks combine operations in order
to cut costs, improve profitability, and
increase their competitive position.
 Bankers who either lose their jobs in a merger or
choose not to work for a large banking organization
often find investors to put up the capital needed to
start a new bank.
 Both mergers and new charters slowed
dramatically in late 1998 as a result of a 25 percent
fall in stock values at the largest bank holding
companies and in 2001 with the continuing market
decline.
Structural changes among FDIC-insured
commercial banks, 1980–2001
700
600
Number of Banks
Mergers
500
400
300
New Charters
200
100
Failures
0
1980
1983
1986
1989
1992
1995
1998
2001
Organizational form of the banking
industry
 The organizational structure of banking has
changed significantly over the past two decades
but changed most dramatically in the later half of
the 1990’s due primarily to:



the impact of interstate branching,
the Federal Reserve System’s relaxation of
securities powers restrictions using a clause in the
Glass-Steagall Act and most recently
with the Gramm-Leach-Bliley Act of 1999.
 Banks can now branch across state lines and
acquire insurance and securities firms by
forming a Financial Holding Company under the
provisions of Gramm-Leach-Bliley.
Commercial banks are classified either as unit
banks, with all operations housed in a single
office, or as branch banks with multiple
offices.
 Prior to the Riegle-Neal Interstate Banking and
Branching Efficiency Act of 1994, which allows
nationwide interstate branching, state law
determined branching for commercial banks.
 Any organization that owns controlling interest in
one or more commercial banks is a bank holding
company (BHC).

Control is ownership or indirect control via the power
to vote more than 25% of the voting shares in a bank.

Prior to interstate branching, the motivation to form a
bank holding company was to circumvent branching
and product restrictions.
Unit versus Branch banking
…The current structure of the commercial banking
system as well as the dramatic changes in the
number of banks has been heavily influenced by
historical regulations which prevent branching to
one degree of another.
 One of the primary reasons the number of
banks has declined almost 50 percent since
the mid 1980’s is the relaxation of branching
restrictions provided by Riegle-Neal.
 Since the mid 1980’s, the number of banks
has fallen about 50 percent while the
number of branches has increased by 50
percent.
Changes in the number of banks and bank
branches, 1960 – 2001
80,000
70,000
Number of U.S. Banking Offices
60,000
All U.S. Banking Offices
(Main Offices plus Branches)
50,000
40,000
Branches
30,000
20,000
10,000
Main Offices
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2001*
Branches
10,556
15,872
21,839
30,205
38,738
43,293
50,406
56,512
64,079
63,989
Banks
13,126
13,544
13,511
14,384
14,434
14,417
12,347
9,942
8,315
8,178
The number of interstate branches
increased dramatically after
interstate branching became fully
effective in 1997.
Unit banks each have their own board, officers,
charters and technology.
 Expenses are usually higher for the parent that owns
multiple independent banks as compared to branches of
the “lead” bank.

Relaxation in branching restrictions and more efficiency
are motivating factors for a bank to form a BHC.
 Risk is considered higher with restrictive branching
because individual banks were less diversified.
 States with the highest bank failure rates historically
restricted branching.
 Branching generally reduces competitors, lowers
expenses, allows greater asset diversification, and
expands each bank’s consumer deposit base

Each of these factors decreases the chances of failure,
everything else being equal.
Like commercial banks, bank holding
companies are heavily regulated by states
and the federal government.
 The Bank Holding Company Act stipulates that the
Board of Governors of the Federal Reserve System
must approve all holding company formations and
acquisitions.

One-bank holding companies (OBHCs) control only
one bank and typically arise when the owners of an
existing bank exchange their shares for stock in the
holding company.

Multibank holding companies (MBHCs) control at
least two commercial banks.
The Gramm-Leach-Bliley Act of 1999 also gave
regulatory responsibility over Financial Holding
Companies to the Federal Reserve.
 The Glass-Steagall Act effectively separated commercial
banking from investment banking
 Commercial banks were able to underwrite and deal in
securities through Section 20 subsidiaries.

The Fed resolved the issue of “principally engaged” by
allowing banks in 1987 to earn only 5 percent of the
revenue in their securities affiliates. This was raised to 10
percent in 1989 and to 25 percent in March of 1997.
 The Gramm-Leach-Bliley Act of 1999 repeals the restrictions
on banks affiliating with securities firms
 The law creates a new financial holding company,
authorized to engage in: underwriting and selling
insurance and securities, conducting both commercial and
merchant banking, investing in and developing real estate
Financial holding companies (FHC) are
distinct entities from bank holding
companies (BHC).
 A company can form a BHC or a FHC or both.
 Advantages in forming a FHC is that they can
engage in a wide range of financial activities not
permitted in the bank or in a BHC including:




insurance and securities underwriting
merchant banking
insurance company portfolio investment activities.
activities that are "complementary" to financial
activities also are authorized.
 The Fed may not permit FHC formation if any of its
insured subsidiaries are not well capitalized and
well managed, or did not receive at least a
satisfactory rating in their most recent CRA exam.
Nonbank activities permitted bank
holding companies
 The Federal Reserve Board regulates allowable
nonbank activities that are “closely related to
banking” in which bank holding companies may
acquire subsidiaries.
 Restrictions came about for three reasons.
1. It was feared that large financial conglomerates
would control the financial system because they
would have a competitive advantage.
2. There was concern that banks would require
customers to buy nonbank services in order to
obtain loans.
3. Some critics simply did not believe that bank
holding companies should engage in businesses
that were less regulated and thus relatively risky.
Organizational structure of financial
services company
Financial Services
Holding Company
Bank
Holding
Company
Thrift
Holding
Company
Nonbank
Subsidiaries
Subsidiaries
and Service
Companies
Securities
Subsidiaries
Insurance
Subsidiaries
Real
Estate
Subsidiary
Organizational structure of the OBHC
One-Bank Holding Company
Board of Directors
Parent Company
Bank Subsidiary
The bottom four levels have
the same organizational form
as the independent bank.
Nonbank Subsidiaries
Each subsidiary has a
president and line officers.
Organizational structure of the MBHC.
MultiBank Holding Company
Board of Directors
Parent Company
Bank Subsidiaries
Nonbank Subsidiaries
Bank Subsidiaries
Key Legislation: 1970 - 1993
 Depository Inst. Deregulation and Monetary Control Act of 1980
 Garn-St. Germain Depository Institutions Act of 1982
 The Tax Reform Act of 1986
 Competitive Equality Banking Act of 1987
 The Financial Inst. Reform, Recovery and Enforcement Act of
1989
 The Federal Deposit Insurance Corp. Improvement Act of 1991
 Market value accounting and FASB 115
Key Legislation: 1994 - 2004
 Riegle-Neal Interstate Banking and Branching Efficiency
Act of 1994
 The 1998 Credit Union Membership Access Act
 Financial Services Modernization Act (Gramm-Leach-
Bliley) of 1999)
 USA Patriot Act of 2001
 Sarbanes-Oxley Act 2002
Financial Services Modernization Act
(Gramm-Leach-Bliley Act of 1999)
 The repeal of restrictions on banks affiliating with
securities firms clearly tops the list of provisions of
Gramm-Leach-Bliley.
 The Act, also addressed new powers and products
of the financial services industry, functional
regulation of the industry, insurance powers, the
elimination of new charters for unitary savings and
loan holding companies, and consumer privacy
protection.
 The privacy section of the bill that has some of the
most far reaching beyond banking.
Banking business models
…The
business models followed by the
majority of banks (small banks) is
generally different that that of largest
banks.
 Historically, small banks have been called
independent or community banks while large
banks have been labeled large holding
company banks, multibank holding
companies, or even money center banks.
 Nevertheless, banks of the same size often
pursue substantially different strategies
Business model structure of
commercial banking
 The organizational structure of commercial banks
can be characterized as banks falling into one of
the following categories based on the range of
products and services offered and the different
geographic markets served:





Global banks
Nationwide banks
Super Regional banks
Regional banks
Specialty banks


limited region
limited product line
Specialty Community Banks
…When many of us think of banks, we think of
the largest banks in the country such as Bank of
America, Citibank, etc.
 Of the approximate 8,100 commercial banks
operating in the United States, however, only
about 80 are greater than $10 billion in assets.

The vast majority of banks are small banks (about
5,000), under $100 million in assets with a legal
lending limit of less than $1 million.

In fact, almost 96% of all banks have total assets
less than $1 billion.

Still, the largest banks (over $10 billion) hold almost
70 percent of all bank assets
The largest commercial banks:
(thousands of dollars, 2003)
A. Largest Commercial Banks
Rank
1
2
3
4
5
6
7
8
9
10
Name
JP Morgan Chase Bank
Bank of America NA
Citibank NA
Wachovia Bank NA
Bank One NA
Wells Fargo Bk NA
Fleet National Bank
US Bank, NA
SunTrust Bank
HSBC Bank USA
State
NY
NC
NY
NC
IL
CA
RI
MN
GA
NY
Total Assets
628,662,000
617,962,335
582,123,000
353,541,000
256,787,000
250,474,572
192,265,000
189,159,050
124,453,567
92,958,123
Historically, banks, savings
associations, and credit unions each
served a different purpose and a
different market.
 Commercial banks mostly specialize in short-term
business credit, but also make consumer loans and
mortgages, and have a broad range of financial
powers.
 Banks accept deposits in a variety of different
accounts and invest these funds into loans and
other financial instruments.
 Their corporate charters and the powers granted to
them under state and federal law determines the
range of their activities.
Savings and loan associations and savings
banks, have historically specialized in real
estate lending; e.g., loans for single-family
homes and other residential properties.
 Savings associations are generally referred to as “thrifts”
because they originally offered only savings or time
deposits
 They have acquired a wide range of financial powers over
the past two decades, and now offer checking accounts,
make business and consumer loans, mortgages, and offer
virtually any other product a bank offers.
 Savings institutions must maintain 65% of their assets in
housing-related or other qualified assets to maintain their
savings institution status.
 This is called the “qualified thrift lender” (QTL) test.
The number of thrifts has declined
dramatically during the last two
decades.
 The savings and loan crisis of the 1980s forced many
institutions to close or merge with others, at an
extraordinary cost to the federal government.
 Due to liberalization of the QTL, there was a resurgence
in the thrift charter, and many insurance and securities
firms, as well as non-financial, acquiring a unitary thrift
holding company in order to bypass prohibitions in the
Glass Steagall Act and the Bank Holding Company Act.

This resurgence stopped with the passage of
Gramm-Leach- Bliley, which eliminated the issuance
of new unitary thrift charters.
Credit unions are nonprofit institutions
with an original purpose to encourage
savings and provide loans within a
community at low cost to their members.
 A “common bond” defines their members, although
this common bond can be loosely defined.
 Members pool funds to form the deposit base and the
members own and control the institution.
 Credit unions accept deposits in a variety of forms.

CUs have savings, checking, time deposits, with
some offering and money market accounts.
 Products and activities include almost anything a
bank or thrift offers, including home loans, issuing
credit cards, and even commercial loans.
 CUs are exempt from federal taxation and sometimes
receive subsidies, in the form of free space or
supplies, from their sponsors.
Largest savings institutions and credit
unions (thousands of dollars, 2003)
C. Largest Savings Institutions
Rank
1
2
3
4
5
6
7
8
9
10
Name
Washington Mutual
Golden West Financial Corp.
Sovereign Bancorp
Astoria Financial Corp
Telebanc Financial Corp
ING USA Holding Co.
Temple-Inland
Webster Financial Corp.
USAA Bancorp
Indymac Bancorp
State
WA
CA
PA
NY
VA
DE
TX
CT
CA
CA
Total Assets
235,442,148
82,049,858
43,610,071
22,419,375
20,288,424
19,145,012
17,275,395
14,441,069
13,721,232
13,189,979
D. Largest Credit Unions
Rank
1
2
3
4
5
6
7
8
9
10
Name
Navy Federal CU
State Employees' CU
Pentagon Federal CU
Golden 1 CU
Boeing Employees
Orange County Teachers Fed. CU
United Airlines Employees' CU
Suncoast Schools Federal CU
American Airlines
Security Service Federal CU
STATE
VA
NC
VA
CA
WA
CA
IL
FL
TX
TX
Total Assets
20,039,756
11,339,309
6,057,833
4,860,270
4,672,619
4,562,145
4,352,392
3,935,904
3,924,129
3,185,393
Five fundamental forces have
transformed the financial services
market
1.
2.
3.
4.
5.
Deregulation/re-regulation
Financial innovation
Securitization
Globalization
Advances in technology.
The latter factors actually represent
responses to deregulation and
re-regulation.
Historically, commercial banks have
been the most heavily regulated
companies in the United States
 Regulations took many forms including :
 maximum interest rates that could be paid on
deposits or charged on loans,
 minimum capital-to-asset ratios,
 minimum legal reserve requirements,
 limited geographic markets for full-service
banking,
 constraints on the type of investments
permitted, and
 restrictions on the range of products and
services offered.
Banks and other market participants have
consistently restructured their operations
to circumvent regulation and meet
perceived customer need
 In response, regulators or lawmakers would
impose new restrictions, which market
participants circumvented again.
 This process of regulation and market
response (financial innovation) and
imposition of new regulations (reregulation) is the regulatory dialectic.
Increased competition
 The McFadden Act of 1927 and the Glass-Steagall
Act of 1933 determined the framework within which
financial institutions operated for the next 50 years.

The McFadden Act sheltered banks from
competition with other banks by extending state
restrictions on geographic expansion to national
banks.

The Glass-Steagall Act forbade banks from
underwriting equities and other corporate
securities, thereby separating banking from
commerce.
The fundamental forces of change
… increased competition
 Competition for deposits
 Competition for loans
 Competition for payment services
 Competition for other financial services
 Discussion: What do you think is the result
of this increased competition?
Competition for deposits
 High inflation reduced the stable spread
between asset yields and liability costs in
the late 1970s.
 In 1973, several investment banks created
money market mutual funds (MMMFs).

Without competing instruments, MMMFs
increased from $10.4 billion in 1978 to almost
$189 billion in 1981.
 Congress passed legislation enabling banks
and thrifts to offer similar accounts
including money market deposit accounts
(MMDAs) and Super NOWs.
Competition for loans
 Loan yields fell relative to borrowing costs,
as lending institutions competed for a
decreasing pool of quality borrowers.
 High loan growth also raised bank capital
requirements.
 Junk bonds, commercial paper, auto finance
companies, credit unions, and insurance
companies compete directly for the same
good quality customers.
Competition for loans (continued)
 As bank funding costs rose, competition for
loans put downward pressure on loan yields
and interest spreads.
 Prime corporate borrowers had the option
to issue commercial paper (CP) or long-term
bonds rather than borrow from banks.
 Glass-Steagall prevented commercial banks
from underwriting CP, banks lost corporate
borrowers, who now bypassed them by
issuing commercial paper at lower cost.
Competition for loans (continued)
 The competition for loans comes in many
forms:



Commercial paper
Captive automobile finance companies
Other finance companies
 The development of the junk bond market
extended loan competition to medium-sized
companies representing lower-quality
borrowers.
 The growth in junk bonds reduced the pool of
good-quality loans and lowered risk-adjusted
yield spreads over bank borrowing costs.
Today, different size banks generally
pursue different strategies.
 Small- to medium-size banks continue to
concentrate on loans but seek to strengthen the
customer relationship by offering personal service.
 These same banks have generally rediscovered the
consumer loan.
 The largest banks, in contrast, are looking to move
assets off the balance sheet.

Regulatory capital requirements and the new
corporate debt substitutes often make the remaining
loans too expensive and too risky.
Loan concentrations:
Consumer and commercial credits
Credit Risk Diversification
Commercial borrowers
Consumer loans
80.0%
70.0%
Percent of loans
60.0%
69%
67% 65%
64% 62%
60% 58%
59% 60% 60% 59%
57% 55% 55% 57% 57%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
36% 38%
35%
31% 33%
43% 45% 45% 43% 43%
42%
41% 40% 40% 41%
40%
Captive automobile finance companies
 The three largest U.S. automobile
manufacturers as well as most foreign
automobile manufactures are aggressively
expanding in the financial services industry
as part of their long-term strategic plans.
Competition for payment services
 In an American Banker article, Diogo
Teixeira comment that:
GE Capital has almost $300 billion of financial
assets. GMAC has $12 billion of financial
services revenue, more than Microsoft's total
corporate revenue. Microsoft has no leasing
subsidiary, takes no deposits, makes no loans,
and offers not a single financial product -- in an
age when everybody has financial products.
Yet Microsoft is viewed as the threat, not GE
Capital or GMAC.
Competition for payment services
…the impact of technology
 Once the domain of banks and other
depository institutions only, the payment
system has become highly competitive.
 The real challenge for the Federal Reserve
System and the banking industry is in the
delivery of payment processing services.
 This competition is coming from emerging
electronic payment systems, such as:



smart and stored-value cards
automatic bill payment
bill presentment processing
It's not just electronic payment systems that are
eroding the banks traditional markets
 Cash can be acquired at any ATM machine all over
the country.
 You can open a checking account, apply for a loan
and receive the answer and funds electronically.
 Direct deposit of paychecks, credit cards,
electronic bill payment, and smart cards means that
competition for financial services goes well beyond
the traditional banking services lines we think of
from the recent past!
Although cash remains the dominate form
of payment, the average payment size of
cash is the smallest
Volume of Transactions
% of
Cashless Growth:
Cash
Cheques issued
Electronic Transactions:
ACH
ATM
Credit Card
Debit Card
Total retail electronic
Chips
% Total Payments 19952000
2000
200
2000
0
550,000 82.3% #N/A
69,000 10.3%
58.2%
1.8%
6,900
13,200
20,000
9,275
49,375
58
1.0%
2.0%
3.0%
1.4%
7.4%
0.0%
5.8%
11.1%
16.9%
7.8%
41.7%
0.0%
14.6%
6.4%
6.0%
42.1%
10.7%
2.6%
Fed Wire
108
Total wholesale electronic 166
0.0%
0.0%
0.1%
0.1%
7.4%
41.8%
Total Electronic
49,541
Value of Transactions
%
Growth: Average
Total 1995- Transaction
1995
2000
2000 2000 Size 2000
#N/A
2,200,000 0.3%
$
4.00
73,515,000 85,000,000 10.9%
2.9% $ 1,231.88
12,231,500 20,300,000
656,600
800,000
879,000 1,400,000
59,100
400,000
13,826,200 22,900,000
310,021,200 292,147,000
2.6%
0.1%
0.2%
0.1%
2.9%
37.4%
10.7% $ 2,942.03
4.0% $
60.61
9.8% $
70.00
46.6% $
43.13
10.6% $ 463.80
-1.2% $ 5,037,017
7.3%
5.5%
222,954,100 379,756,000 48.6%
532,975,300 671,903,000 85.9%
11.2% $ 3,516,259
4.7% $ 4,047,608
10.7%
546,801,500 694,803,000 88.8%
4.9% $
14,025
Competition for other bank services
 Banks and their affiliates offer many
products and services in addition to
deposits and loans.







Trust services
Brokerage
Data processing
Securities underwriting
Real estate appraisal
Credit life insurance
Personal financial consulting
“Non-bank” activities of banks
…the Gramm-Leach-Bliley Act.
 Since the Glass-Steagall and Bank Holding
Company acts, banks could not directly
underwrite securities domestically.
 Today, a bank can enter this line of business
by forming a financial holding company
through provisions of the Gramm-LeachBliley Act.

A financial holding company owns a bank or
bank holding company as well as an
investment subsidiary.

The investment subsidiary of a financial
holding company is not restricted in the
amount or type of investment underwriting.
Investment banking
 Commercial banks consider investment
banking attractive because most investment
banks:




already offer many banking services to prime
commercial customers and high net worth
individuals and
sell a wide range of products not available
through banks.
can compete in any geographic market
without the heavy regulation of the FRS,
FDIC, and OCC.
earn extraordinarily high fees for certain
types of transactions and can put their own
capital at risk in selected investments.
Investment banking
 Investment banking encompasses
three broad functions:
1.
2.
3.
underwriting public offerings of new
securities
trading existing securities
advising and
financing mergers
and acquisitions
Deregulation and re-regulation
 Deregulation is the process of eliminating
regulations, such as the elimination of
Regulation Q (interest rate ceilings imposed
on time and demand deposits offered by
depository institutions.)
 Deregulation is often confused with
reregulation, which is the process of
implementing new restrictions or modifying
existing controls on individuals and
activities associated with banking.
Efforts at deregulation and reregulation generally address:
 Pricing issues
 removing price controls on the maximum interest
rates paid to depositors and the rate charged to
borrowers (usury ceilings).
 Allowable geographic expansion
 The Riegle-Neal Interstate Banking and Branching
Efficiency Act of 1994 has eliminate branching
restrictions.
 New products and services
 Gramm-Leach-Bliley Act of 1999 has dramatically
expanded the banks’ product choices; e.g.,
insurance, brokerage services, and securities
underwriting.
Financial innovation
 Financial innovation is the catalyst behind the
evolving financial services industry.
 Innovations take the form of new securities and
financial markets, new products and services, new
organizational forms, and new delivery systems.
 Regulation Q brought about financial innovation as
depository institutions tried to slow
disintermediation.
Financial innovation (continued)
 Banks developed new products to compete with
Treasury bills, MMMFs, and cash management
accounts.
 Regulators typically imposed marginal reserve
requirements against the new instruments, raising
the interest rate ceiling, and then authorized a new
deposit instrument.
 Recent innovations take the form of new futures,
options, options-on-futures, and the development
of markets for a wide range of securitized assets.
Response of banks
 One competitive response to asset quality
problems and earnings pressure has been
to substitute fee income for interest income.
 Banks also lower their required capital and
reduce credit risk by selling assets and
servicing the payments between borrower
and lender rather than holding the same
assets to earn interest.
 This process of converting assets into
marketable securities is called
securitization.
Securitization
 Securitization is the process of converting assets
into marketable securities.
 It enables banks to move assets off-balance sheet
and increase fee income.
 It increases competition for standardized products
such as:

mortgages and other credit-scored loans
 Eventually lowers the prices paid by consumers by
increasing the supply and liquidity of these
products.
The objectives behind securitization
include the following:
 Free capital for other uses
 Improve ROE via servicing income
 Diversify credit risk
 Obtain new sources of liquidity
 Reduce interest rate risk
Generally, any loan that can be standardized can
potentially be securitized.
Securitization allows nonbank firms to originate
loans, package them into pools, and sell securities
collateralized by securities in the pools.
This increases the competition for the securitized
asset and will eventually lead to lower rates.
Off-balance sheet activities,
asset sales and Enron
 Enron engaged in questionable activities including
not reporting losses from business activities that
the firm inappropriately moved off-balance sheet.


Enron hid losses on the business activities and/or
used its off-balance sheet activities to artificially
inflate reported earnings.
 Many banks also enter into agreements that do not
have a balance sheet impact until a transaction is
effected.


An example might be a long-term loan commitment
to a potential borrower.
Off-balance sheet positions generate noninterest
income but also entail some risk as the bank must
perform under the contracts.
Globalization
 Gradual evolution of markets and
institutions so that geographic boundaries
do not restrict financial transactions.
 Financial markets and institutions are
becoming increasingly global in scope.
 Firms must recognize that businesses in
other countries as well as their own are
competitors, and that international events
affect domestic operations.
Increased consolidation
 The dominant trend of the structure of financial
institutions is that of consolidation.
 With the asset quality problems of Texas banks in
the 1980, regulators authorized acquisitions by outof-state banks.
 By 1998, effectively all interstate branching
restrictions had been eliminated

this has lead to
consolidation frenzy
in which we have
almost half as many
banks as compared
to the 1980’s
The later half of the 1990s saw not only a
large number of bank mergers but also
several of the largest bank consolidations:
 Citicorp merges with Travelers
 Chase Manhattan acquires Chemical Banking
 Chase Manhattan acquires J.P. Morgan
 Mellon Bank acquires Dreyfus
 NationsBank acquires BankAmerica
 Bank of New York acquires Irving Bank Corp
 Fleet Financial Group acquires BankBoston
 Bank One acquires First USA
 Southern National acquires BB&T Financial
The removal of restrictive branching laws
as well as “merger mania” of the late 1990s
has dramatically reduced the number of
banks.
 The primary factor leading the reduction in
the number of banks from a high of 14,364
in 1979 to about 8,000 at the beginning of
2002 can be attributed to the removal of
branching restrictions provided by RiegleNeal Interstate Banking and Branching
Efficiency Act of 1994
GE Capital Services is the financial
subsidiary of General Electric
 GECS divides its operations into two segments, Financing and
Specialty Insurance. The operations of GECS Financing are
divided into four areas:
 Consumer services provides products such as private-label and



bank credit card loans, personal loans, time sales and revolving
credit and inventory financing for retail merchants, auto leasing
and inventory financing, mortgage servicing, consumer savings
and insurance services .
Equipment management provides leases, loans, sales, and asset
management services for equipment.
Mid-market financing provides loans and financing and operating
leases for middle-market customers for a variety of equipment.
Specialized financing provides loans and leases for major capital
assets, commercial and residential real estate loans, and
investments; and loans to and investments in management
buyouts and corporate recapitalizations.
 Specialty insurance provides U.S. and international property and
casualty reinsurance; specialty insurance and life reinsurance;
financial guaranty insurance (principally on municipal bonds and
structured finance issues); private mortgage insurance; and
creditor insurance covering international customer loan
repayments.
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2005
by South-Western, a division of Thomson Learning
EVALUATING BANK
PERFORMANCE
Chapter 2
Balance Sheet
 Assets = Liabilities + Equity.
 Balance sheet figures are calculated at a
particular point in time and thus represent a
“snapshot” of bank values.
Bank Assets
http://www2.fdic.gov/ubpr/UbprReport/SearchEngine/Default.asp
 Cash and due from banks
 vault cash, deposits held at the Fed and other financial
institutions, and cash items in the process of collection.
 Investment Securities
 assets held to earn interest and help meet liquidity
needs.
 Loans
 the major asset, generate the greatest amount of
income, exhibit the highest default risk and are
relatively illiquid.
 Other assets
 bank premises and equipment, interest receivable,
prepaid expenses, other real estate owned, and
customers' liability to the bank
Balance Sheet PNC National Bank
PNC BANK NATIONAL ASSOCIATION
BALANCE SHEET
—— HISTORICAL——
12/31/03
% of
% Cha
$ 1,000
Total
% Cha
—— HISTORICAL——
12/31/04
% of
$ 1,000
Total
ASSETS
Loans:
Real estate loans
Commercial loans
Individual loans
Agricultural loans
Other LN&LS in domestic off.
LN&LS in foreign off.
Gross Loans & Leases
Less: Unearned Income
Loan & Lease loss Allowance
Net Loans & Leases
Investments:
U.S. Treasury & Agency securities
Municipal securities
Foreign debt securities
All other securities
Interest bearing bank balances
Fed funds sold & resales
Trading account assets
Total Investments
Total Earning Assets
Nonint Cash & Due from banks
Premises fixed assets & capital leases
Other real estate owned
Investment in unconsolidated subs.
Other assets
Total Assets
Average Assets During Quarter
1.2%
-8.4%
-4.4%
9.2%
-20.5%
15.6%
-4.6%
8.0%
-5.8%
-4.5%
15,639,089
11,879,285
2,501,847
984
3,022,795
1,190,025
34,234,025
44,867
606,886
33,582,272
25.2%
19.2%
4.0%
0.0%
4.9%
1.9%
55.2%
0.1%
1.0%
54.1%
32.4%
23.8%
52.6%
57.0%
-0.8%
2.8%
26.9%
0.2%
-3.8%
27.5%
20,701,894
14,707,458
3,816,861
1,545
2,999,113
1,222,904
43,449,785
44,949
583,915
42,820,921
28.0%
19.9%
5.2%
0.0%
4.1%
1.7%
58.9%
0.1%
0.8%
58.0%
90.6%
-46.9%
-100.0%
1.1%
16.4%
-54.6%
-9.1%
8.7%
5,574,108
7,719
0
8,804,028
259,318
1,106,733
945,042
16,686,948
9.0%
0.0%
0.0%
14.2%
0.4%
1.8%
1.5%
26.9%
15.9%
1606.0%
0.0%
3.0%
51.8%
56.2%
78.3%
16.5%
6,460,936
131,685
0
9,064,146
393,713
1,728,372
1,667,330
19,446,182
8.8%
0.2%
0.0%
12.3%
0.5%
2.3%
2.3%
26.3%
-0.5%
50,269,220
81.1%
23.9%
62,267,103
84.4%
-6.9%
21.8%
21.8%
252.4%
51.8%
6.8%
2,926,330
1,039,603
14,208
17,386
7,754,149
62,020,896
5.6%
1.3%
0.0%
0.0%
6.3%
100.0%
8.5%
2.5%
0.7%
-12.4%
-6.2%
19.0%
3,174,493
1,066,028
14,301
15,223
7,272,017
73,809,165
4.3%
1.4%
0.0%
0.0%
9.9%
100.0%
6.8%
62,719,462
101.1%
17.0%
73,391,052
99.4%
Community National Bank
COMMUNITY NATIONAL BANK
BALANCE SHEET
—— HISTORICAL——
12/31/03
% of
% Cha
$ 1,000
Total
—— HISTORICAL——
12/31/04
% of
% Cha
$ 1,000
Total
ASSETS
Loans:
Real estate loans
Commercial loans
Individual loans
Agricultural loans
Other LN&LS in domestic off.
LN&LS in foreign off.
Gross Loans & Leases
Less: Unearned Income
Loan & Lease loss Allowance
Net Loans & Leases
Investments:
U.S. Treasury & Agency securities
Municipal securities
Foreign debt securities
All other securities
Interest bearing bank balances
Fed funds sold & resales
Trading account assets
Total Investments
Total Earning Assets
Nonint Cash & Due from banks
Premises fixed assets & capital leases
Other real estate owned
Investment in unconsolidated subs.
Other assets
Total Assets
Average Assets During Quarter
4.0%
-5.8%
26.7%
0.0%
13.0%
0.0%
2.2%
0.0%
6.7%
2.2%
75,324
34,288
8,454
0
26
0
118,092
0
1,258
116,834
39.1%
17.8%
4.4%
0.0%
0.0%
0.0%
61.3%
0.0%
0.7%
60.6%
12.9%
12.9%
-5.2%
0.0%
284.6%
0.0%
11.7%
0.0%
28.5%
11.5%
85,050
38,716
8,011
0
100
0
131,877
0
1,617
130,260
40.5%
18.4%
3.8%
0.0%
0.0%
0.0%
62.8%
0.0%
0.8%
62.0%
73.0%
50.0%
0.0%
0.0%
0.0%
175.0%
0.0%
111.0%
34,937
613
0
2,104
4,428
7,000
0
49,082
18.1%
0.3%
0.0%
1.1%
2.3%
3.6%
0.0%
25.5%
24.8%
-0.5%
0.0%
-2.2%
-57.5%
-21.4%
0.0%
9.3%
43,591
610
0
2,057
1,881
5,500
0
53,639
20.7%
0.3%
0.0%
1.0%
0.9%
2.6%
0.0%
25.5%
20.6%
165,916
86.1%
10.8%
183,899
87.5%
-16.6%
12.2%
-84.3%
0.0%
259.8%
18.6%
13,083
5,642
325
0
7,761
192,727
6.8%
2.9%
0.2%
0.0%
4.0%
100.0%
-10.7%
2.2%
-100.0%
0.0%
13.2%
9.0%
11,682
5,768
0
0
8,783
210,132
5.6%
2.7%
0.0%
0.0%
4.2%
100.0%
17.5%
191,480
99.4%
9.4%
209,525
99.7%
Adjustments to total loans
…three adjustments are made to obtain a
net loan figure.
 First, the dollar amount of outstanding
leases is included in gross loans.
 Second, unearned income is deducted from
gross interest received.
 Finally, gross loans are reduced by the
dollar magnitude of a bank's loan-loss
reserve, which exists in recognition that
some loans will not be repaid.
Bank investments and FASB 115
 Following FASB 115 a bank, at purchase, must designate the
objective behind buying investment securities as either:

held-to-maturity securities are recorded on the balance
sheet at amortized cost.

trading account securities are actively bought and sold, so
the bank marks the securities to market (reports them at
current market value) on the balance sheet and reports
unrealized gains and losses on the income statement.

available-for-sale, all other investment securities, are
recorded at market value on the balance sheet with a
corresponding change to stockholders’ equity as
unrealized gains and losses on securities holdings.
Bank liabilities
 Demand deposits
 transactions accounts that pay no interest
 Negotiable orders of withdrawal (NOWs) and
automatic transfers from savings (ATS) accounts

pay interest set by each bank without federal
restrictions
 Money market deposit accounts (MMDAs)
 pay market rates, but a customer is limited to no more
than six checks or automatic transfers each month
 Savings and time deposits represent the bulk of
interest-bearing liabilities at banks.
Bank liabilities (continued)
 Two general time deposits categories exist:
 Time deposits in excess of $100,000, labeled jumbo
certificates of deposit (CDs).

Small CDs, considered core deposits which tend to
be stable deposits that are typically not withdrawn
over short periods of time.
 Deposits held in foreign offices
 balances issued by a bank subsidiary located outside
the U.S.
 Rate-sensitive borrowings:
 Federal Funds purchased and
 Repos
Core versus volatile funds
 Core deposits are stable deposits that are not highly interest rate-
sensitive.
 Core deposits are more sensitive to the fees charged, services
rendered, and location of the bank.

Core deposits include: demand deposits, NOW accounts,
MMDAs, and small time deposits.
 Large, or volatile, borrowings are liabilities that are highly rate-
sensitive.
 Normally issued in uninsured denominations.
 Ability to borrow is sensitive to the markets perception of their
asset quality.

Volatile liabilities (net non-core) include: large CDs, deposits
in foreign offices, federal funds purchased, RPs, and other
borrowings with maturities less than one year.*
*The UBPR also includes brokered deposits less than $100,000 and maturing
within one year in the definition of net noncore liabilities.
BALANCE SHEET
% Cha
PNC BANK NATIONAL ASSOCIATION
—— HISTORICAL——
—— HISTORICAL——
12/31/03
% of
12/31/04
$ 1,000
Total
% Cha
$ 1,000
% of
Total
LIABILITIES
Demand deposits
All NOW & ATS Accounts
Money market deposit accounts
Other savings deposits
Time deposits under $100M
Core Deposits
2.6%
9.9%
6.8%
5.0%
-15.9%
2.0%
7,070,434
1,529,861
24,502,371
2,055,659
6,242,628
41,400,953
11.4%
2.5%
39.5%
3.3%
10.1%
66.8%
20.1%
8.9%
8.8%
35.4%
13.1%
12.7%
8,488,607
1,666,003
26,665,024
2,782,931
7,063,499
46,666,064
11.5%
2.3%
36.1%
3.8%
9.6%
63.2%
Time deposits of $100M or more
Deposits held in foreign offices
Total deposits
-17.6%
71.5%
3.2%
1,775,943
2,371,548
45,548,444
2.9%
3.8%
73.4%
80.5%
26.3%
16.1%
3,205,331
2,994,623
52,866,018
4.3%
4.1%
71.6%
Fed funds purchased & resale
FHLB Borr. < 1 year
Other borrowings inc mat < 1 yr
Memo: S.T. non core funding
Memo: Volatile liabilities
FHLB Borr. > 1 year
Other borrowings inc mat > 1 yr
Acceptances & other liabilities
Total Liabilities before Sub. Notes
Sub. Notes & Debentures
Total Liabilities
25.2%
898.2%
99.4%
73.5%
36.2%
-90.0%
-2.9%
-0.1%
4.6%
16.2%
4.9%
499,232
1,000,000
2,264,921
7,111,124
6,911,644
115,406
1,765,851
3,864,388
55,058,242
1,340,133
56,398,375
0.8%
1.6%
3.7%
11.5%
11.1%
0.2%
2.8%
6.2%
88.8%
2.2%
90.0%
221.8%
-100.0%
34.5%
25.7%
57.0%
-23.3%
105.2%
18.7%
19.5%
41.4%
20.1%
1,606,647
0
3,046,632
8,936,809
10,853,233
88,508
3,624,223
4,585,994
65,818,022
1,895,482
67,713,504
2.2%
0.0%
4.1%
12.1%
14.7%
0.1%
4.9%
6.2%
89.2%
2.6%
91.7%
-4.1%
4.0%
5,622,521
62,020,896
9.1%
100.0%
8.4%
19.0%
6,095,661
73,809,165
8.3%
100.0%
0.0%
-19.4%
21.8%
-10.2%
23.4%
23.4%
2
14,211
14,208
1,378,603
2,114
14,383,741
14,385,855
0.0%
0.0%
0.0%
2.2%
0.0%
23.2%
23.2%
50.0%
58.0%
0.7%
20.9%
-100.0%
8.9%
8.8%
3
22,449
14,301
1,667,154
0
15,656,767
15,656,767
0.0%
0.0%
0.0%
2.3%
0.0%
21.2%
21.2%
14.2%
1,533,123
2.5%
49.3%
2,289,151
3.1%
All common and preferred capital
Total Liabilities & Capital
Memoranda:
Officer Shareholder Loans (#)
Officer Shareholder Loans ($)
Non-investment ORE
Loans Held for Sale
Held-to Maturity Securities
Available-for-Sale-Securities
Total Securities
All Brokered Deposits
NA
BALANCE SHEET
COM M UNITY NATIONAL BANK
—— HISTORICAL——
—— HISTORICAL——
12/31/03
% of
12/31/04
% of
% Cha
$ 1,000
Total
% Cha
$ 1,000
Total
LIABILITIES
Demand deposits
12.6%
72,500
37.6%
12.4%
81,514
All NOW & ATS Accounts
15.5%
12,478
6.5%
39.7%
17,437
8.3%
Money market deposit accounts
56.7%
46,458
24.1%
5.3%
48,908
23.3%
7.3%
7,812
4.1%
26.7%
9,896
4.7%
Other savings deposits
Time deposits under $100M
Core Deposits
Time deposits of $100M or more
Deposits held in foreign offices
38.8%
4.0%
24,469
12.7%
-14.4%
20,949
10.0%
20.7%
163,717
84.9%
9.2%
178,704
85.0%
4.9%
13,572
7.0%
8.4%
14,714
7.0%
0.0%
0
0.0%
0.0%
0
0.0%
19.3%
177,289
92.0%
9.1%
193,418
92.0%
Fed funds purchased & resale
0.0%
1,000
0.5%
0.0%
1,000
0.5%
FHLB Borr. < 1 year
Total deposits
0.0%
0
0.0%
0.0%
0
0.0%
Other borrowings inc mat < 1 yr
0.0%
0
0.0%
0.0%
0
0.0%
Memo: S.T. non core funding
0.1%
7,901
4.1%
28.7%
10,169
4.8%
Memo: Volatile liabilities
4.5%
14,572
7.6%
7.8%
15,714
7.5%
FHLB Borr. > 1 year
0.0%
0
0.0%
0.0%
0
0.0%
Other borrowings inc mat > 1 yr
0.0%
0
0.0%
0.0%
0
0.0%
Acceptances & other liabilities
-11.0%
395
0.2%
31.6%
520
0.2%
Total Liabilities before Sub. Notes
19.1%
178,684
92.7%
9.1%
194,938
92.8%
0.0%
0
0.0%
0.0%
0
0.0%
19.1%
178,684
92.7%
9.1%
194,938
92.8%
15,194
7.2%
Sub. Notes & Debentures
Total Liabilities
All common and preferred capital
Total Liabilities & Capital
12.0%
14,043
7.3%
8.2%
18.6%
192,727
100.0%
9.0%
2,101
100.0%
0.0%
1
0.0%
Memoranda:
Officer Shareholder Loans (#)
Officer Shareholder Loans ($)
-50.0%
1
0.0%
31.7%
1,852
1.0%
22.2%
2,263
1.1%
-84.3%
325
0.2%
-100.0%
0
0.0%
0.0%
0
0.0%
0.0%
0
0.0%
Held-to Maturity Securities
36.7%
4,073
2.1%
-56.2%
1,785
0.8%
Available-for-Sale-Securities
89.4%
33,581
17.4%
32.4%
44,473
21.2%
19.5%
22.9%
46,258
22.0%
0.0%
0.0%
0
0.0%
Non-investment ORE
Loans Held for Sale
Total Securities
All Brokered Deposits
81.8%
14.2%
37,654
0
Stockholders equity
 Subordinated notes and debentures:
 notes and bonds with maturities in excess of
one year.
 Stockholders' equity
 Ownership 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.
The income statement
 Interest income (II)
 Interest expense (IE)
 Interest income-interest expense=net interest income (NII)
 Loan-loss provisions (PL)
 represent management's estimate of potential lost revenue
from bad loans.
 Noninterest income (OI)
 Noninterest expense (OE)
 noninterest expense usually exceeds noninterest income
such that the difference is labeled the bank's burden
 Taxes
Income statement (interest income and expenses):
PNC and Community National Bank
PNC BANK, NATIONAL ASSOCIATION
Income Statement
Interest Income:
Interest and fees on loans
Income from lease financing
M emo: Fully taxable
Tax-exempt
Estimated tax benefit
Income on Loans & Leases (TE)
—— HISTORICAL——
12/31/03
% of
% Cha
$ 1,000
Total
-17.5%
-20.6%
-17.7%
-25.7%
-27.7%
-17.8%
1,730,575
189,910
1,905,782
14,703
7,347
1,927,832
48.2%
-0.7%
1.0%
-15.4%
3.7%
-2.4%
34,418
366,877
504
117,866
1,008
519,665
43.8%
-32.4%
216.9%
127.2%
-14.2%
4,835
18,682
805
39,477
2,511,266
0.1%
0.4%
0.0%
0.9%
54.4%
-14.7%
-29.5%
-30.5%
-29.8%
17,335
67,714
369,702
454,751
Interest on Fed funds purchased & resale
2.2%
Interest on Trad Liab & Oth Borrowings
-59.0%
Interest on mortgages & leases
0.0%
Interest on Sub. Notes & Debentures
-17.9%
Total interest expense
-30.6%
U.S. Treasury & Agency securities
Mortgage Backed Securities
Estimated tax benefit
All other securities income
Memo: Tax-Exempt Securities Income
Investment Interest Income (TE)
Interest on due from banks
Interest onFed funds sold & resales
Trading account income
Other interest income
Total interest income (TE)
Interest Expense:
Int on Deposits held in foreign offices
Interest on CD's over $100M
Interest on All Other Deposits:
Total interest expense on deposits
Net interest income (TE)
-8.1%
37.5%
4.1%
41.3%
0.3%
0.2%
41.7%
—— HISTORICAL——
12/31/04
% of
% Cha
$ 1,000
Total
8.3%
-30.1%
4.6%
-3.2%
-22.3%
4.4%
1,875,058
132,839
1,993,668
14,229
5,711
2,013,608
38.4%
2.7%
40.8%
0.3%
0.1%
41.2%
0.7% 221,4%
7.9%
-8.1%
0.0%
565.1%
2.6%
-31.2%
0.0%
728.4%
11.2%
2.4%
110,614
337,110
3,352
81,129
8,350
532,205
2.3%
6.9%
0.1%
1.7%
0.2%
10.9%
-24.8%
57.9%
2455%
-47.2%
4.3%
3,638
29,503
20,575
20,847
2,620,376
0.1%
0.6%
0.4%
0.4%
53.6%
0.4%
1.5%
8.0%
9.8%
144.0%
6.4%
1.8%
7.9%
42,290
72,032
376,244
490,566
0.9%
1.5%
7.7%
10.0%
13,260
26,001
0
55,449
549,461
0.3%
0.6%
0.0%
1.2%
11.9%
204.9%
429.4%
0.0%
52.1%
37.0%
40,232
137,637
0
84,240
752,975
0.8%
2.8%
0.0%
1.7%
15.4%
1,961,805
42.5%
-4.8%
1,867,401
38.2%
COMMUNITY NATIONAL BANK
Income Statement
Interest Income:
Interest and fees on loans
Income from lease financing
M emo: Fully taxable
Tax-exempt
Estimated tax benefit
Income on Loans & Leases (TE)
—— HISTORICAL——
12/31/03
% of
% Cha
$ 1,000
Total
—— HISTORICAL——
12/31/04
% of
% Cha
$ 1,000
Total
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
7,923
0
7,923
0
0
7,923
73.6%
0.0%
73.6%
0.0%
0.0%
73.6%
7.5%
0.0%
7.5%
0.0%
0.0%
7.5%
8,521
0
8,521
0
0
8,521
72.1%
0.0%
72.1%
0.0%
0.0%
72.1%
-6.2%
-12.6%
23.5%
28.1%
28.1%
-7.4%
427
368
21
41
41
857
4.0%
3.4%
0.2%
0.4%
0.4%
8.0%
28.3%
62.8%
81.0%
80.5%
80.5%
46.9%
548
599
38
74
74
1,259
4.6%
5.1%
0.3%
0.6%
0.6%
10.7%
164.3%
-7.0%
0.0%
0.0%
-0.6%
37
133
0
15
8,965
0.3%
1.2%
0.0%
0.1%
83.3%
21.6%
-23.3%
0.0%
13.3%
10.9%
45
102
0
17
9,944
0.4%
0.9%
0.0%
0.1%
84.1%
0.0%
-19.2%
-20.5%
-20.2%
0
375
1,060
1,435
0.0%
3.5%
9.8%
13.3%
0.0%
6.4%
3.6%
4.3%
0
399
1,098
1,497
0.0%
3.4%
9.3%
12.7%
Interest on Fed funds purchased & resale -52.2%
Interest on Trad Liab & Oth Borrowings
0.0%
Interest on mortgages & leases
0.0%
Interest on Sub. Notes & Debentures
0.0%
Total interest expense
-20.6%
11
0
0
0
1,446
0.1%
0.0%
0.0%
0.0%
13.4%
90.9%
0.0%
0.0%
0.0%
5.0%
21
0
0
0
1,518
0.2%
0.0%
0.0%
0.0%
12.8%
7,519
69.8%
12.1%
8,426
71.3%
U.S. Treasury & Agency securities
Mortgage Backed Securities
Estimated tax benefit
All other securities income
Memo: Tax-Exempt Securities Income
Investment Interest Income (TE)
Interest on due from banks
Interest onFed funds sold & resales
Trading account income
Other interest income
Total interest income (TE)
Interest Expense:
Int on Deposits held in foreign offices
Interest on CD's over $100M
Interest on All Other Deposits:
Total interest expense on deposits
Net interest income (TE)
4.5%
PNC BANK, NATIONAL ASSOCIATION
Income Statement
Noninterest Income:
Fiduciary Activities
Deposit service charges
Trading revenue
Investment Banking Advisory
Insurance Commissions & Fees
Net Servicing Fees
Loan and Lease gain (losses)
Other Net Gains (Losses)
Other Non-interest income
Total noninterest income
—— HISTORICAL——
12/31/03
% of
% Cha
$ 1,000
Total
-5.4%
4.8%
61.8%
3.5%
-74.8%
-7.9%
-13.4%
-39.1%
10.5%
3.7%
—— HISTORICAL——
12/31/04
% of
% Cha
$ 1,000
Total
291,582
422,100
88,985
562,482
(660)
32,245
134,969
10,036
474,040
2,018,779
6.3%
9.1%
1.9%
12.2%
0.0%
0.8%
2.9%
0.2%
10.3%
43.7%
1.6%
2.1%
-24.4%
32.7%
-1896%
45.3%
-3.0%
-88.8%
1.3%
9.8%
296,226
431,169
67,267
746,475
11,856
51,212
130,953
1,124
479,982
2,216,264
6.1%
8.8%
1.4%
15.3%
0.2%
1.0%
2.7%
0.0%
9.8%
45.4%
Adjusted Operating Income (TE)
-2.5%
Non-Interest Expenses:
Personnel expenses
5.7%
Occupancy expense
11.8%
Goodwill impairment
0.0%
Other intangible amortization
-4.6%
Other operating expense (incl. intangibles) 10.9%
Total Noninterest Expenses
8.6%
3,980,584
86.2%
2.6%
4,083,665
83.6%
1,112,208
352,506
0
4,006
956,533
2,425,253
24.1%
7.6%
0.0%
0.1%
20.7%
52.5%
27.8%
-0.6%
0.0%
186.5%
3.9%
14.5%
1,421,341
350,550
0
11,476
994,122
2,777,489
29.1%
7.2%
0.0%
0.2%
20.3%
56.8%
Provision: Loan & Lease Losses
Pretax Operating Income (TE)
Realized G/L Hld-to-Maturity Sec.
Realized G/L Avail-for-Sale Sec.
Pretax Net Operating Income (TE)
Applicable Income Taxes
Current tax equivalent adj.
Other tax equivalent adj.
Applicable Income Taxes
Net Operating Income
Net Extraordinary Items
Net Income
-39.1%
-11.5%
0.0%
12.6%
-10.4%
-13.4%
-26.4%
0.0%
-13.6%
-8.6%
0.0%
-8.6%
176,612
1,378,719
0
89,786
1,468,505
490,376
7,851
0
498,227
970,278
0
970,278
3.8%
29.8%
0.0%
1.9%
31.8%
10.6%
0.2%
0.0%
10.8%
21.0%
0.0%
21.0%
-70.8%
-9.0%
0.0%
-44.5%
-11.2%
-22.1%
15.4%
0.0%
-21.5%
-5.9%
0.0%
-5.9%
51,553
1,254,623
0
49,792
1,304,415
381,926
9,063
0
390,989
913,426
0
913,426
1.1%
25.7%
0.0%
1.0%
26.7%
7.8%
0.2%
0.0%
8.0%
18.7%
0.0%
18.7%
Cash Dividends Declared
Retained Earnings
Memo: Net International Income
Memo: Total operating income
Memo: Net operating income
87.5%
-66.7%
0.0%
-6.7%
-2.5%
750,000
220,278
0
4,619,831
3,980,584
16.2%
4.8%
0.0%
100.0%
86.2%
6.7%
-48.5%
0.0%
5.8%
2.6%
800,000
113,426
0
4,886,432
4,083,665
16.4%
2.3%
0.0%
100.0%
83.6%
COMMUNITY NATIONAL BANK
Income Statement
Noninterest Income:
Fiduciary Activities
Deposit service charges
Trading revenue
Investment Banking Advisory
Insurance Commissions & Fees
Net Servicing Fees
Loan and Lease gain (losses)
Other Net Gains (Losses)
Other Non-interest income
Total noninterest income
—— HISTORICAL——
12/31/03
% of
% Cha
$ 1,000
Total
—— HISTORICAL——
12/31/04
% of
% Cha
$ 1,000
Total
0.0%
16.7%
0.0%
0.0%
-66.7%
0.0%
-100.0%
-1012%
-31.9%
-16.6%
0
1,070
0
0
1
0
0
73
590
1,588
0.0%
9.9%
0.0%
0.0%
0.0%
0.0%
0.0%
-0.7%
5.5%
14.7%
0.0%
30.5%
0.0%
0.0%
100.0%
0.0%
0.0%
-75.3%
-15.8%
18.2%
Adjusted Operating Income (TE)
0.1%
Non-Interest Expenses:
Personnel expenses
-2.4%
Occupancy expense
4.5%
Goodwill impairment
0.0%
Other intangible amortization
0.0%
Other operating expense (incl. intangibles) -2.8%
Total Noninterest Expenses
-1.4%
9,107
84.6%
13.1%
10,303
87.2%
4,202
1,256
0
11
2,064
7,533
39.0%
11.7%
0.0%
0.1%
19.2%
70.0%
3.2%
2.2%
0.0%
0.0%
3.3%
3.1%
4,335
1,284
0
11
2,133
7,763
36.7%
10.9%
0.0%
0.1%
18.0%
65.7%
Provision: Loan & Lease Losses
Pretax Operating Income (TE)
Realized G/L Hld-to-Maturity Sec.
Realized G/L Avail-for-Sale Sec.
Pretax Net Operating Income (TE)
Applicable Income Taxes
Current tax equivalent adj.
Other tax equivalent adj.
Applicable Income Taxes
Net Operating Income
Net Extraordinary Items
Net Income
42.5%
-8.9%
0.0%
110.8%
2.4%
-2.2%
23.5%
0.0%
-1.1%
4.3%
0.0%
4.3%
684
890
0
215
1,105
355
21
0
376
729
0
729
6.4%
8.3%
0.0%
2.0%
10.3%
3.3%
0.2%
0.0%
3.5%
6.8%
0.0%
6.8%
-12.3%
118.0%
0.0%
-100.0%
75.6%
80.6%
81.0%
0.0%
80.6%
73.0%
0.0%
73.0%
600
1,940
0
0
1,940
641
38
0
679
1,261
0
1,261
5.1%
16.4%
0.0%
0.0%
16.4%
5.4%
0.3%
0.0%
5.7%
10.7%
0.0%
10.7%
-100.0%
58.8%
0.0%
-2.3%
0.1%
0
729
0
10,768
9,107
0.0%
6.8%
0.0%
100.0%
84.6%
0.0%
73.0%
0.0%
9.8%
13.1%
0
1,261
0
11,821
10,303
0.0%
10.7%
0.0%
100.0%
87.2%
Cash Dividends Declared
Retained Earnings
Memo: Net International Income
Memo: Total operating income
Memo: Net operating income
0
1,396
0
0
2
0
0
(18)
497
1,877
0.0%
11.8%
0.0%
0.0%
0.0%
0.0%
0.0%
-0.2%
4.2%
15.9%
Interest income
…the sum of interest and fees earned on all
of a bank's assets.
 Interest income includes interest from:
 Loans

Deposits held at other institutions,

Municipal and taxable securities, and

Investment and trading account securities.
Noninterest expense
…composed primarily of:
 Personnel expense:
 salaries and fringe benefits paid to bank
employees,
 Occupancy expense :
 rent and depreciation on equipment and
premises, and
 Other operating expenses:
 utilities and
 deposit insurance premiums.
Non-interest expense
 Expenses and loan losses directly effect the
balance sheet.
 The greater the size of loan portfolio, the
greater is operating overhead and PLL.
 Consumer loans are usually smaller and
hence more expensive (non-interest) per
dollar of loans.
Relationship between the balance
sheet and income statement
Ai = dollar amount of asset I
Lj = dollar amount of liability j
NW = dollar amount of stockholder’s equity
Yi = average yield on asset I
Cj = cost of liability j
n
m
 A  L
i 1
i
j 1
j
 NW
m
c
Interest Expense =
j 1
j
Lj
n
Net Interest Income =
 y A  c
i
i 1
m
n
Net Income =
m
 y A  c L
i 1
i
i
i 1
j
i
j
i 1
j
Lj
 Burden  PLL  SG  T
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 the bank
has invested in.
Equity Multiplier (EM = TA / TE),

the degree of financial leverage employed by
the bank. Also equals 1/capital or leverage
ratio.
Return on assets (ROA = NI / TA)
…can be decomposed into two parts:
 Asset utilization (AU) → income generation
 Expense ratio (ER) → expense control
 ROA
=
=
AU (TR / TA)
ER
- (TE / TA)
Where:
TR = total revenue or total operating income
= Int. inc. + non-int. inc. + SG(L) and
TE = total expenses
= Int. exp. + non-int. exp. + PLL + Taxes
ROA is driven by the bank’s ability to:
…generate income (AU) and control expenses (ER)
 Income generation (AU) can be found on the
UBPR (page 1) as:
Int. Inc. Non. int. Inc. Sec gains (losses)
AU 


TA
TA
TA
 Expense Control (ER) can be found on the UBPR
(page 1) as:
Int . Exp . Non  int . Exp . PLL
ER 


TA
TA
TA
*
 Note, ER* does not include taxes.
Bank Performance Model
Returns to
Shareholders
ROE = NI / TE
Interest
Rate
Composition (mix)
Volume
INCOME
Fees and Serv Charge
Non Interest
Trust
Other
Return to the Bank
ROA = NI / TA
Rate
Interest
Composition (mix)
Volume
EXPENSES
Overhead
Salaries and Benefits
Occupancy
Degree of Leverage
EM = 1 / (TA / TE)
Prov. for LL
Taxes
Other
Expense ratio (ER = Exp / TA)
… the ability to control expenses.
 Interest expense / TA
 Cost per liability (rate)
Int. exp. liab. / $ amt. liab.
Composition of liabilities
 $ amt. of liab. / TA
Volume of debt and equity



 Non-interest expenses / TA
 Salaries and employee benefits / TA
 Occupancy expenses / TA
 Other operating expense / TA
 Provisions for loan losses / TA
 Taxes / TA
Asset utilization (AU = TR / TA):
… the ability to generate income.
 Interest Income / TA
 Asset yields (rate)


Composition of assets (mix)


Interest income asset (i) / $ amount of asset (i)
$ amount asset (i) / TA
Volume of Earning Assets

Earning assets / TA
 Non interest income / TA
 Fees and Service Charges
 Securities Gains (Losses)
 Other income
Aggregate profitability measures
 Net interest margin
 NIM = NII / earning assets (EA). In practice I often use
NII divided by total assets.
 Spread
 Spread = (int inc / EA) (int exp / int bear. Liab.) (Also
note that spread can equal average asset rates less
average deposit rates).
 Earnings base
 Eb = ea / ta
 Burden / TA
 (Noninterest exp. - Noninterest income) / TA
 Efficiency ratio
 Non int. Exp. / (Net int. Inc. + Non int. Inc.)
Fundamental risks :
 Credit risk
 Liquidity risk
 Market risk
 Operational risk
 Capital or solvency risk
 Legal risk
 Reputational risk
Credit risk
…the potential variation in net income and
market value of equity resulting from
nonpayment or delayed payment.

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?
Credit ratios to consider
 What has been the loss experience?
 Net loss to average total LN&LS
 Gross losses to average total LN&LS
 Recoveries to avg tot LN&LS
 Recoveries to prior period losses.
 Net losses by type of LN&LS
 What amount of losses do we expect?
 Non-current LN&LS to tot loans
 Total P/D LN&LS - incl nonaccural
 Non-curr restruc LN&LS / GR LN&LS
 Curr-Non-curr restruct / GR LN&LS
 Past due by loan type
Credit ratios to consider (continued)
 How prepared are we?
 Loss Provision to: average assets and avg
tot LN&LS

LN&LS Allowance to: net losses and total
LN&LS

Earnings coverage of net loss
Credit risk ratios :
PNC and Community National
CALC
PNC BANK, NATIONAL ASSOCIATION
Dec-03
Dec-04
UBPR
PEER1 CALC
UBPR
PEER1
7
7
7
7
0.73%
0.59%
0.13%
19.00%
0.73%
0.59%
0.13%
19.03%
0.53%
0.41%
0.12%
22.26%
0.00%
0.40%
0.28%
0.12%
19.5%
0.00%
0.40%
0.28%
0.12%
19.52%
0.36%
0.25%
0.11%
23.76%
90 days past due / EOP LN&LS
Total Nonaccrual LN&LS / EOP LN&LS
Total Noncurrent / EOP LN&LS
8A
8A
8A
0.21%
0.79%
1.00%
0.21%
0.79%
1.00%
0.13%
0.66%
0.83%
0.13%
0.33%
0.46%
0.13%
0.33%
0.46%
0.10%
0.46%
0.59%
LN&LS Allowance to total LN&LS
LN&LS Allowance / Net losses
LN&LS Allowance/Total Non Accrual
Earn Coverage of net losses
Net Loan and lease growth rate
7
7
7
7
1
1.77%
2.90x
1.77x
7.44x
-4.55%
1.78%
2.92x
2.24x
7.44x
-4.55%
1.44% 1.34%
4.18x
5.20x
2.73x
2.92x
10.92x 11.61x
10.14% 27.51%
1.35%
5.23x
4.12x
11.61x
27.51%
1.27%
7.51x
3.73x
19.94x
17.96%
UBPR
RISK RATIOS
Credit Risk
Gross loss / Avg. Tot LN&LS
Net loss / Avg. Tot LN&LS
Recoveries / Avg. Tot LN&LS
Recoveries to prior credit loss
Pg #
UBPR
RISK RATIOS
Credit Risk
Gross loss / Avg. Tot LN&LS
Net loss / Avg. Tot LN&LS
Recoveries / Avg. Tot LN&LS
Recoveries to prior credit loss
Pg #
CALC
COMMUNITY NATIONAL BANK
Dec-03
Dec-04
UBPR
PEER4 CALC
UBPR PEER4
7
7
7
7
0.54%
0.53%
0.01%
6.70%
0.54% 0.26%
0.53% 0.21%
0.01% 0.06%
6.70% 29.21%
0.21%
0.20%
0.02%
3.1%
0.00%
0.21% 0.20%
0.20% 0.16%
0.02% 0.05%
3.08%
0.00% 24.53%
90 days past due / EOP LN&LS
Total Nonaccrual LN&LS / EOP LN&LS
Total Noncurrent / EOP LN&LS
8A
8A
8A
0.16%
0.19%
0.35%
0.16%
0.19%
0.35%
0.00%
0.16%
0.16%
0.00%
0.16%
0.16%
LN&LS Allowance to total LN&LS
LN&LS Allowance / Net losses
LN&LS Allowance/Total Non Accrual
Earn Coverage of net losses
Net Loan and lease growth rate
7
7
7
7
1
1.07%
2.10x
3.05x
2.57x
2.16%
1.07% 1.25% 1.23%
2.08x 11.89x
6.70x
5.49x
4.35x
7.77x
2.57x 23.89x 10.38x
2.16% 11.61% 11.49%
0.13%
0.47%
0.66%
0.10%
0.41%
0.56%
1.23% 1.20%
6.71x 14.52x
7.77x
5.63x
10.38x 30.80x
11.49% 14.24%
Liquidity risk
…the variation in net income and market value of
equity caused by a bank's difficulty in obtaining
cash at a reasonable cost from either the sale of
assets or new borrowings.

Banks can acquire liquidity in two distinct ways:
By liquidation of assets.
1.

Composition of investments

Maturity of investments
By borrowing.
2.

Core deposits

Volatile deposits
Liquidity risk ratios :
PNC and Community National
UBPR
RISK RATIOS
Pg #
Liquidity Risk
%Total (EOP) Assets (except where noted)
Total equity
11
Core deposits
10
S.T Non-core funding
10
Net loans & leases / Total Deposits
10
Net loans & leases / Core Deposits
10
Avg. Available for sale securities / Avg. TA6
Short-term investments
10
Pledged securities
10
CALC
9.07%
67.41%
NA
73.73%
81.11%
21.41%
NA
NA
PNC BANK, NATIONAL ASSOCIATION
Dec-03
Dec-04
UBPR
PEER1
CALC
UBPR
PEER1
9.07%
66.75%
11.47%
73.73%
81.11%
21.90%
2.73%
46.50%
8.95%
8.26%
53.75%
64.84%
23.24% NA
87.72%
81.00%
115.16%
91.76%
21.11%
22.12%
6.25% NA
49.08% NA
8.26%
63.23%
12.11%
81.00%
91.76%
22.03%
3.02%
51.76%
9.74%
54.19%
23.42%
88.28%
116.1%
21.00%
5.23%
54.78%
UBPR
RISK RATIOS
Pg #
Liquidity Risk
%Total (EOP) Assets (except where noted)
Total equity
11
Core deposits
10
S.T Non-core funding
10
Net loans & leases / Total Deposits
10
Net loans & leases / Core Deposits
10
Avg. Available for sale securities / Avg. TA6
Short-term investments
10
Pledged securities
10
CALC
CALC
9.07%
67.41%
NA
NA
73.73%
81.11%
21.41%
NA
NA
NA
NA
7.29%
84.26%
65.90%
71.36%
14.44%
COMMUNITY NATIONAL BANK
Dec-03
Dec-04
UBPR
PEER7
CALC
UBPR
7.29%
84.95%
4.10%
65.90%
71.36%
13.39%
5.99%
29.25%
9.28%
71.85%
11.90% NA
78.94%
93.85%
15.88%
5.41% NA
40.34% NA
7.23%
85.00%
67.35%
72.89%
19.38%
7.23%
85.04%
4.84%
67.35%
72.89%
19.04%
5.72%
28.49%
PEER7
9.42%
71.10%
12.21%
81.42%
97.58%
15.80%
5.26%
41.20%
Market risk
…the risk to a financial institution’s
condition resulting from adverse movements
in market rates or prices .
 Market risk arises from changes in:

Interest rates

Foreign exchange rates

Equity and security prices.
Interest rate risk
…the potential variability in a bank's net
interest income and market value of equity
due to changes in the level of market
interest rates.
Example: $10,000 Car loan
4 year Car loan at
8.5%
1 year CD at
4.5%
Spread
4.0%
But for How long?
 Funding GAP = $RSA - $RSL,
where $RSA = $ amount of assets which will mature or
reprice in a give period of time.
 In this example:
GAP3m = $0.00 - $10,000 = - $10,000
This is a negative GAP.
Foreign exchange risk
… the risk to a financial institution’s
condition resulting from adverse movements
in foreign exchange rates.
 Foreign exchange risk arises from changes
in foreign exchange rates that affect the
values of assets, liabilities, and off-balance
sheet activities denominated in foreign
currencies.
 This risk is often found in off-balance sheet
loan commitments and guarantees
denominated in foreign currencies
Equity and security price risk
…change in market prices, interest rates and
foreign exchange rates affect the market values of
equities, fixed income securities, foreign currency
holdings, and associated derivative and other offbalance sheet contracts.
 Large banks must conduct value-at-risk
analysis to assess the risk of loss with their
trading account portfolios.
Operational risk
…measures the cost efficiency of the bank's
activities; i.e., expense control or productivity.
 Typical ratios focus on:
 total assets per employee
 total personnel expense per employee
 noninterest expense ratio
 There is no meaningful way to estimate the
likelihood of fraud or other contingencies from
published data
 A bank’s operating risk is closely related to its
operating policies and processes and whether is
has adequate controls
Operational risk ratios:
PNC and Community National
UBPR
RISK RATIOS
Pg #
Operational Risk
Total Assets / Number of employees
3
Personnel expense / number of employees3
Efficiency ratio
3
CALC
0.00%
0.00%
$4.09
73.43x
60.93%
PNC BANK, NATIONAL ASSOCIATION
Dec-03
Dec-04
UBPR
PEER1 CALC UBPR PEER1
0.00%
0.00%
$4.02 $5.17 $4.71
72.06x 60.48x 90.68x
60.96% 57.73% 68.01%
$4.44
$6.09
85.48x 65.26x
67.97% 57.92%
UBPR
RISK RATIOS
Pg #
Operational Risk
Total Assets / Number of employees
3
Personnel expense / number of employees3
Efficiency ratio
3
COMMUNITY NATIONAL BANK
Dec-03
Dec-04
CALC
UBPR PEER7 CALC UBPR PEER7
0.00%
0.00%
0.00%
0.00%
$3.00
65.46x
82.72%
$2.75 $2.95 $2.98
60.03x 48.27x 61.47x
82.75% 66.06% 75.35%
$2.84 $3.08
58.58x 50.10x
75.34% 65.99%
Capital risk
… closely tied to asset quality and a bank's
overall risk profile
 The more risk taken, the greater is the amount of
capital required.
 Appropriate risk measures include all the risk
measures discussed earlier as well as ratios
measuring the ratio of:

tier 1 capital and total risk based capital to risk
weighted assets,

equity capital to total assets,

dividend payout, and growth rate in tier 1 capital.
Definitions of capital
 Tier 1 capital is:

total common equity capital plus noncumulative
preferred stock, plus minority interest in
unconsolidated subsidiaries, less ineligible
intangibles.
 Risk weighted assets are:

the total of risk adjusted assets where the risk
weights are based on four risk classes of assets.
 Importantly, a bank's dividend policy affects its
capital risk by influencing retained earnings.
Capital risk ratios :
PNC and Community National
UBPR
RISK RATIOS
Pg #
Capital Risk
Tier 1 Leverage Capital / Total Assets
Tier 1 Capital / Risk-weighted assets
Total RBC / Risk weighted Assets
Equity Capital / Total Assets
Dividend Payout
Growth rate in total equity capital
Equity growth less asset growth
11A
11A
11A
11
11
11
11
PNC BANK, NATIONAL ASSOCIATION
Dec-03
Dec-04
CALC
UBPR PEER1 CALC UBPR
PEER1
0.00%
0.00%
8.28%
9.91%
12.91%
9.07%
77.30%
-4.09%
-8.09%
0.00%
8.37%
9.89%
12.89%
9.07%
77.30%
-4.09%
-8.09%
7.67% 6.89%
7.14%
11.13% 8.65%
8.36%
13.08% 11.55% 11.55%
8.95% 8.26%
8.26%
57.26% 87.58% 87.58%
10.34% 8.42%
8.42%
0.59% -10.59%
0.00% -10.59%
7.71%
11.17%
12.98%
9.74%
46.73%
20.28%
4.55%
UBPR
RISK RATIOS
Pg #
Capital Risk
Tier 1 Leverage Capital / Total Assets
Tier 1 Capital / Risk-weighted assets
Total RBC / Risk weighted Assets
Equity Capital / Total Assets
Dividend Payout
Growth rate in total equity capital
Equity growth less asset growth
11A
11A
11A
11
11
11
11
COMMUNITY NATIONAL BANK
Dec-03
Dec-04
CALC UBPR PEER7 CALC UBPR PEER7
0.00%
0.00%
7.27% 7.31% 8.97% 7.27% 7.29% 9.11%
10.73% 10.73% 12.64% 10.27% 10.27% 12.64%
11.70% 11.70% 13.80% 11.35% 11.35% 13.76%
7.29% 7.29% 9.28% 7.23% 7.23% 9.42%
0.00% 0.00% 30.77% 0.00% 0.00% 29.34%
11.99% 11.99% 10.99% 8.20% 8.20% 11.32%
-6.56%
0.00% -6.56% 0.41% -0.83%
0.00% -0.83% 0.28%
Legal risk
…the potential that unenforceable contracts,
lawsuits, or adverse judgments can disrupt or
otherwise negatively affect the operations or
condition of banking organization
 Legal risk include:

Compliance risks

Strategic risks

General liability issues
Reputational risk
 Reputational risk is the potential that
negative publicity regarding an institution’s
business practices, whether true or not, will
cause a decline in the customer base, costly
litigation, or revenue reductions.
Risk, return, and maximizing
shareholder wealth
Notice PNC’s ROA vs. Loan Loss Reserve for the past 4
years:
2002
PNC PG1
LLR 0.49 0.38
ROA 1.78 1.29
2001
2000
PNC PG1 PNC PG1
1.42 0.40 0.20 0.33
0.77 1.19 1.50 1.11
1999
PNC PG1
0.23 0.25
1.53 1.32
It appears that PNC may have understated LLR in 2000 to
report higher ROA, but then “paid the price” in 2001 as
evidenced by lower ROA.
Managers can maximize shareholder value
by focusing on some of the key areas:
1.
2.
3.
4.
5.
6.
7.
Asset management (composition and volume)
Liability management (composition and volume)
Management of off-balance sheet activities
Interest rate margin/spread management
Credit risk management
Liquidity management
Tax Management
Can Managers Manipulate Financial
Statements?
In a word, yes.
•Off-balance Sheet activities, both to increase
income, and in bad cases, to hide losses
•Window dressing at period end
•Using preferred stock
•Manipulating non-performing loans
•Allowance for loan losses
•Securities gains and losses
•Non-recurring sales of assets
Bank Management, 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2005 by South-Western, a division of Thomson Learning
MANAGING
NONINTEREST INCOME AND
NONINTEREST EXPENSE
Chapter 3
A common view among bank managers
and analysts is that banks must rely less on
net interest income and more on noninterest
income to be more successful.
 The highest earning banks will be those that
generate an increasing share of operating revenue
from noninterest sources.


A related assumption is that not all fees are created
equal.
Some fees are stable and predictable over time, while
others are highly volatile because they derive from
cyclical activities.
 The fundamental issue among managers is to
determine the appropriate customer mix and
business mix to grow profits at high rates, with a
strong focus on fee-based revenues.
Trends in net interest margin and
noninterest income: 1990 - 1997
 NIM rose from 1990 to 1994, on average, and has fallen sharply
thereafter for both banks under $100 million in assets and larger
banks.
It is widely recognized that the days of recordbreaking net interest margins for banks are long gone.
NIMs have
fallen sharply
since 1994 for
both banks
under $100
million in
assets and
larger banks.
 This recent decline in NIMs reflects competitive
pressures on both the cost of bank funds and
yields on earning assets.
Pressure on margins
 Inexpensive core deposit growth has slowed
because customers have many alternatives, such
as mutual funds and cash management accounts,
that offer similar transactions and savings services
and pay higher rates.
 Loan yields have fallen on a relative basis because
of competition from nonbank lenders, such as
commercial and consumer finance companies,
leasing companies, and other banks that compete
for the most profitable small business loans, credit
card receivables, and so on.
Over-reliance on net interest margin?
 Potential earnings difficulties are compounded by
the fact that asset quality was quite strong during
the late 1990s, such that loan loss provisions were
low and not likely to show much improvement.
 Problem loans are often made at the peak or end of
the business cycle.

The U.S. economy fell into a modest recession in March
2001, around which loan quality worsened.
 The impact is that banks must grow their
noninterest income relative to noninterest expense
if they want to see net income grow.
50.00%
The largest banks rely much more
on this source of revenue
45.00%
40.00%
Assets > $1 Billion
Assets < $1 Billion
35.00%
Smaller banks still rely more heavily on
net interest income.
30.00%
25.00%
Net operating revenue equals the sum of net interest income
and noninterest income.
Mar-02
Nov-01
Jul-01
Mar-01
Nov-00
Jul-00
Mar-00
Nov-99
Jul-99
Mar-99
Nov-98
Jul-98
Mar-98
Nov-97
Jul-97
Mar-97
Nov-96
Jul-96
Mar-96
Nov-95
Jul-95
Mar-95
Nov-94
Jul-94
20.00%
Mar-94
Quarterly noninterest income, % of net operating income
Sustained increase in all banks’ noninterest
income as a fraction of net operating revenue
Composition of noninterest income
…biggest contributors are deposit service charges
and ‘other.’ (other includes items such as safe deposit boxes, bank drafts, etc.)
Percent of Total Noninterest Incom e
Net Gains On Asset
Sales
Other Noninterest
Incom e
Net Gains/Losses On
Sales Of Other Assets
Service Charges on
Deposit Accounts
Trading Gains & Fees
Investm ent
Banking/Brokerage
Fees
Venture Capital
Revenue
Net Gains/Losses On
OREO Sales
Net Gains/Losses On
Loan Sales
Insurance
Com m issions & Fees
Fiduciary Incom e
Net Securitization
Incom e
Net Servicing Fees
Minimum balance requirements to avoid fees
and average fees charged on transactions
accounts at all U.S. banks from 1994 to 1999.
Change in fees that banks charge for special
actions related to customer transaction accounts
from 1994 to 1999. Special actions consist of stoppayment orders, NSF checks, overdrafts, and returned
deposit items.
Percent of
Total
Noninterest
Income
Number of
Banks
Reporting
Non-Zero
Balances
Percent of
All Banks
Fiduciary Income
13.00%
1,505
18.60%
Service Charges on Deposit Accounts
17.00%
7,829
96.70%
Trading Gains & Fees
7.60%
149
1.80%
Investment Banking/Brokerage Fees
5.10%
1,948
24.00%
Venture Capital Revenue
0.10%
42
0.50%
Net Servicing Fees
8.50%
1,582
19.50%
Net Securitization Income
11.00%
80
1.00%
Insurance Commissions & Fees
2.00%
3,449
42.60%
Net Gains/Losses On Loan Sales
4.40%
1,568
19.40%
Net
Sales
Net Gains/Losses
Gains/Losses On
On OREO
Sales Of
Other
Assets
0.00%
1,155
14.30%
-0.10%
1,174
14.50%
Other Noninterest Income
31.40%
7,841
96.80%
Total Noninterest Income
100%
7,972
98.40%
Net Gains On Asset Sales
4.20%
2,774
34.20%
Noninterest Income Source
Increasing amount of fees from
investment banking and brokerage
activities at the larger banks.
 Investment and brokerage activities contribute a far
greater portion of noninterest income at the largest
banks.

This explains why noninterest income is a much
higher fraction of their operating revenue.
 These fees are highly cyclical in nature and depend
on the capital markets.
 In late 1998, many large banks reported large
trading losses on activities in Russia and Asia.
Community banks generated most of their
noninterest income from: deposit account fees, trust
fees, mortgage fees, insurance product fees and
commissions and investment product fees.
Percent of Average Assets
Number of institutions reporting
Total noninterest income
Fiduciary activities
Service charges on deposit accounts
Trading account gains & fees
Investment banking, advisory, brokerage, and underwriting fees and
commissions
Venture capital revenue
Net servicing fees (servicing real estate mort., credit cards, and
Net securitization income
Insurance commission fees and income
Net gains(losses) on sales of loans
net gains (losses) on sales of other real estate owned
Net gains (losses) on sales of other assets (excluding securities)
Other noninterest income
Securities gains (losses)
< $100 mill
> $1 bill
12/31/2001 12/31/2001
4486
400
1.02%
2.63%
0.05%
0.34%
0.43%
0.41%
0.00%
0.23%
0.01%
0.16%
0.00%
0.14%
0.00%
0.03%
0.03%
0.00%
0.01%
-0.01%
0.19%
0.29%
0.05%
0.07%
0.00%
0.04%
0.29%
0.03%
0.83%
0.08%
Noninterest expense

The Uniform Bank Performance Report
lists three components of noninterest
expense:
1.
Personnel expense

2.
Occupancy expense

3.
wages, salaries, and benefits
rent and depreciation on buildings and
equipment
Other operating expenses,

general overhead, data processing and
other expenses not listed
Bankers and analysts typically measure
performance over time and versus peer
 Key ratios measuring noninterest expense and
income performance are:

Burden = nonint. exp. minus nonint. inc.,

Net non-interest margin = burden / total assets,

Efficiency ratio
= nonint. Exp.  (net int. inc. + nonint. inc.)
 Better performance is indicated by a smaller figure
or percentage.
Annual efficiency ratios 1991 – 2004
69
Efficiency ratio %
67
Assets<$1 Billion
Assets>$1 Billion
65
63
61
59
57
55
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Assets<$1 Billion
68
65.3 65.5 64.6 63.1
62
61.7 62.6 62.6 62.7 64.1
62
Assets>$1 Billion 67.7 64.4 63.3 63.1 61.4 60.5 58.6 60.7 57.9 57.7 56.6 54.9
63
63
55
55.5
Operating risk ratios
…differentiate performance attributable to cost
controls versus fee generation.
 The lower the operating risk ratio, the better
the bank’s operating performance

because it generates proportionately more of
its revenues from fees, which are more
stable and thus more valuable.
 The ratio subtracts fee income from
noninterest expense and divides the total by
NIM:
Nonint exp - Fee inc.
Operating risk ratio 
Net interest margin
Operating risk ratio signals the benefit of fee income
Operating Risk Ratio Signals the Benefit of Fee Income
Ratio
Return on Assets (ROA)
Net Interest Margin (NIM)
Percent of Average Total Assets:
Net interest income
Noninterest income (fee)
Operating Revenue
Noninterest Expense
Earning Assets
Taxes
Efficiency Ratio:
Operating Risk Ratio:
RAROC = risk – adjusted income
capital
RORAC =
income
allocated risk capital
Bay Bank
1.4%
4.0%
River Bank
1.4%
4.625%
3.20%
1.40%
4.60%
3.00%
80.00%
0.20%
65.22%
= 0.03/(0.032+0.014)
40.00%
= (0.03-0.014)/0.04
3.70%
0.90%
4.60%
3.00%
80.00%
0.20%
65.22%
= 0.03/(0.037+0.009)
45.41%
= (0.03-0.009)/0.04625
Productivity ratios
…indicate how efficiently banks are using their
employees relative to capital assets.

Two commonly cited ratios are:
1.
2.
Assets per full time employee and
Average personnel expense.

The more productive bank typically has fewer
employees per dollar of assets held and often
controls personnel expense per employee better.

The second ratio is often high for high
performance banks because they operate with
fewer people but pay them more.
Community banks also typically examine two
additional ratios
…Because loans typically represent the largest asset
holding, it is meaningful to calculate a loans-peremployee ratio as an indicator of loan productivity.
 Since loans are often an the largest asset held,
community banks examine:

Loans per full time employee
 A ratio of net income per employee generally
indicates the productivity and profitability of a
bank’s workforce:

= Net income / Number of full time employees
Customer profitability and business mix
 Typical analyses of customer profitability profiles
suggest that banks make most of their profit from a
relatively small fraction of customers.
 The traditional view is that up to 80 percent of a
bank's customers are unprofitable when all
services are fully costed.
 Such figures support the increase in fees assessed
by most banks over the past few years.
Which customers are profitable?
 The first step in identifying profitable growth is to
determine which of the bank’s customers and lines
of business are profitable.

RAROC / RORAC framework can be used to assess
the risk-adjusted return on allocated capital for a
specific product or line of business.

Data on customer profitability are beneficial in
helping management target niches, develop new
products, and change pricing.
Debit Cards
Residential Mortgages
Credit Life
ACH Origination
Online Banking
Credit Cards
Life Insurance
Cash Management
Annuities
Mutual Funds
Stock Brokerage
Financial Planning Accounts
Receivable Financing
Personal Trust
Business Property and Casualty Insurance*
Personal Property and Casualty Insurance*
Equipment Leasing
Online Brokerage
Title Insurance
Real Estate Brokerage/ Management*
Auto Leasing
Factoring
Municipal Bond Underwriting
Travel Agency
Product
offerings at
community
banks
Currently offer
Plan to offer
0
10
20
30
40
50
60
70
80
Percentage offering various products
90
100
Aggregate results from total customer
account profitability indicates…
 A small fraction of customers contribute the bulk of
bank profits.
 Many customer profitability models show that a
significant difference between profitable and
unprofitable accounts is that profitable customers
maintain substantial loan and investment business
with the bank.
Strategies to manage noninterest
expense

Four different strategies are:
1. expense reduction,
2. increase operating efficiency,
3. Revenue enhancement, and
4. pursuing contribution growth whereby
noninterest revenues rise by more than
noninterest expense.
Cost management strategies
…expense reduction
 Many banks begin cost management efforts
by identifying and eliminating excessive
expenses.
 Given that noninterest expenses consist
primarily of personnel, occupancy, and data
processing costs, these are the areas where
cuts are initially made.
Cost management strategies
…increase operating efficiencies



Another strategy is to increase operating efficiency
in providing products and services.
This can be achieved in one of three ways:
1.
reducing costs but maintaining the existing level of
products and services,
2.
increasing the level of output but maintaining the
level of current expenses, or
3.
improving work flow.
All these approaches fall under the label of
increasing productivity because they involve
delivering products at lower unit costs.
Cost management strategies
…revenue enhancement
 This strategy involves changing the pricing
of specific products but maintaining a
sufficiently high volume of business so that
total revenues increase.
 It is closely linked to the concept of price
elasticity.
 Here, management wants to identify
products or services that exhibit price
inelastic demand.
Cost management strategies
…contribution growth
 With this strategy, management allocates resources
to best improve overall long-term profitability.
 Increases in expenses are acceptable, but they
must coincide with greater anticipated increases in
associated revenues.
 An example might be investing in new computer
systems and technology to provide better customer
service at reduced unit costs once volume is
sufficiently large.

In essence, expenses are cut in the long run but not
in the near future.