BANK MANAGEMENT
AND PROFITABILITY
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2000 by Harcourt, Inc.
14-1

Total interest and fee income
Loans
Investment securities
Other
Total interest expense
Deposits
Federal funds purchased and securities sold under agreements to repurchase
Other Borrowed Money
Subordinated notes and debentures
Net interest income
Provisions for loan and lease losses
Total noninterest income
Fiduciary activities
Service charges on deposit accounts
Trading account gains and fees
All other noninterest income
Total noninterest expense
Salaries and employee benefits
Premises and equipment
All other noninterest expense
Pre-tax net operating income
Applicable income taxes
Net income
All Insured Commercial
Banks a
Billions e
Percent of
Assets f
361,682
264,046
56,370
41,266
6.9%
5.0%
1.1%
0.8%
180,036
125,600
22,519
3.4%
2.4%
0.4%
27,156
4,762
181,645
22,293
119,264
18,137
19,572
7,641
73,914
186,154
77,242
23,413
85,499
92,462
33,093
62,789
0.5%
0.1%
3.4%
0.4%
2.3%
0.3%
0.4%
0.1%
1.4%
3.5%
1.5%
0.4%
1.6%
1.8%
0.6%
1.2%
Small
Banks b
Percent of
Assets f
7.5%
5.5%
1.6%
0.4%
3.4%
3.2%
0.0%
Medium-
Sized Banks c
Percent of
Assets f
7.4%
5.6%
1.5%
0.3%
3.3%
3.0%
0.2%
0.1%
0.0%
4.1%
0.2%
1.4%
0.1%
0.4%
0.0%
0.9%
3.6%
1.7%
0.5%
1.5%
1.7%
0.5%
1.2%
0.2%
0.0%
4.1%
0.3%
1.5%
0.3%
0.4%
0.0%
0.9%
3.5%
1.6%
0.5%
1.4%
1.9%
0.6%
1.3%
Large
Banks d
Percent of
Assets f
6.7%
4.9%
1.0%
0.8%
3.4%
2.2%
0.5%
0.6%
0.1%
3.3%
0.5%
2.4%
0.4%
0.4%
0.2%
1.5%
3.5%
1.4%
0.4%
1.7%
1.7%
0.6%
1.2%
Dollar amounts and percentages are annualized figures based on the first three quarters of 1998..Source: FDIC, Statistics on Banking , September 30, 1998.
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2000 by Harcourt, Inc.
14-2

 Interest and fees on loans is the major source of income for commercial banks.
 Interest paid on deposits is the largest expense item.
 Both of the above follow market rates of interest.
 Net interest income represents the difference between gross interest income and gross interest expense.
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2000 by Harcourt, Inc.
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14%
12%
10%
8%
6%
4%
2%
0%
1935 1945 1955 1965 1975 1985 1995
Year
Source: FDIC Statistics on Banking .
Gross Interest Income
Gross Interest Expense
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2000 by Harcourt, Inc.
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 The provision for loan losses is an expense item that adds to a bank’s loan loss reserve (a contraasset account).
 Banks increase their provision for loan losses in anticipation of credit quality problems in their loan portfolio.
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2000 by Harcourt, Inc.
14-5

2.0%
1.5%
1.0%
0.5%
0.0%
1935 1945 1955 1965 1975 1985 1995
Source: FDIC Statistics on Banking .
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2000 by Harcourt, Inc.
Provision for Loan
Losses
14-6

 Noninterest income includes fees and service charges. This source of revenue has grown significantly in importance.
 Noninterest expense includes salary expenditures. These expenses have also grown in recent years.
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2000 by Harcourt, Inc.
14-7

4.5%
4.0%
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
1935 1945 1955 1965 1975 1985 1995
Source: FDIC Statistics on Banking .
Noninterest Expense
Noninterest Income
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 Trends in profitability can be assessed by examining return on average assets
(net income / average total assets) over time.
 Another measure of profitability is return on average equity .
 In the mid- and late-1990s, bank profitability improved significantly.
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1.4% 18.0%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
6.0%
4.0%
2.0%
0.0%
16.0%
14.0%
12.0%
10.0%
8.0%
0.0%
1935 1945 1955 1965
ROAA
1975
ROAE
1985 1995
Source: FDIC Statistics on Banking
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2000 by Harcourt, Inc.
14-10

 One way for a bank to increase expected profits is to take on more risk. However, this can jeopardize bank safety.
 For a bank to survive, it must balance the demands of three constituencies: shareholders, depositors, and regulators, each with their own interest in profitability and safety.
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(continued)
 Bank Solvency -- Maintaining the momentum of a going concern, attracting customers and financing in the market.
– A firm is insolvent when the value of its liabilities exceeds the value of its assets.
– Banks have relatively low capital/asset positions and high quality assets.
 Bank Liquidity -- the ability to accommodate deposit withdrawals, loan requests, and pay off other liabilities as they come due.
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2000 by Harcourt, Inc.
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(concluded)
 Banks supply liquidity to customers.
– Depositors store their liquidity in banks; loan customers come to the bank to borrow liquidity.
– The bank supplies liquidity from two sources: sale of assets and borrowing.
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2000 by Harcourt, Inc.
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A bank must successfully balance profitability on one hand and liquidity and solvency on the other.
 Bank failure can result from the depletion of capital caused by losses on loans or securities -- from over-aggressive profit seeking. But a bank that only invests in high-quality assets may not be profitable.
 Failure can also occur if a bank cannot meet the liquidity demands of its depositors -- a run on the bank occurs. If assets are profitable, but illiquid, the bank also has a problem.
 Bank insolvency very often leads to bank illiquidity.
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2000 by Harcourt, Inc.
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2000 by Harcourt, Inc.
14-15

 Banks rely on both asset sources of liquidity and liability sources of liquidity to meet the demands for liquidity.
 The demands for liquidity include accommodating deposit withdrawals, paying other liabilities as they come due, and accommodating loan requests.
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2000 by Harcourt, Inc.
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
(classifies bank assets from very liquid/low profitability to very illiquid/profitable).
Primary Reserves are noninterest bearing, extremely liquid bank assets.
 Secondary Reserves are high-quality, short-term, marketable earning assets.
 Bank Loans are made after absolute liquidity needs are met.
 After loan demand is satisfied, funds are allocated to Income Investments that provide income, reasonable safety, and some liquidity, if needed.
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2000 by Harcourt, Inc.
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(concluded)
 The bank must manage its assets to provide a compromise of liquidity and profitability.
 The primary and secondary reserve level is related to:
– deposit variability.
– other sources of liquidity.
– bank regulations - permissible areas of investment.
– risk posture that bank management will assume.
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2000 by Harcourt, Inc.
14-18

C ATEGORY AND T YPE
OF A SSET
Primary Reserves
Vault cash
Deposits at the Fed
Deposits at other banks
Secondary Reserves
Treasury bills
Federal Funds sold
Short-term agency securities
Bank Loans
Business loans
Consumer loans
Real estate loans
Agriculture loans
Investments
Treasury securities
Agency securities
Municipal bonds
P URPOSE
Immediately available funds
Easily marketable funds
Income
Income when safe loans are unavailable and tax advantages
L IQUIDITY
Highest
High
Lowest
Medium
Y IELD
None
Low
Highest
Medium
To maintain adequate liquidity, banks hold both primary and secondary reserves. Secondary reserves allow banks to earn some interest income while still meeting their liquidity needs.
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2000 by Harcourt, Inc.
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-assumes that the bank can borrow its liquidity needs.
 Liability levels (borrowing) may be adjusted to loan (asset) needs or deposit variability.
 LM assumes that the bank may raise sufficient amounts of funds by paying the market rate.
 Bank liability liquidity sources include the bank's
"borrowing" liability category.
 LM supplements asset management, but does not replace it.
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2000 by Harcourt, Inc.
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 Absorb losses on assets (loans) and limit the risk of insolvency.
 Maintain confidence in the banking system.
 Provide protection to uninsured depositors and creditors.
 Act as a source of funds and serve as a leverage base to raise depositor funds.
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2000 by Harcourt, Inc.
14-21

 Capital levels declined in the late 1960s and early 1970s as banks’ assets grew faster than their capital levels.
 The number of bank failures increased significantly in the 1980s.
 Capital standards were increased in the mid and late 1980s in response to these failures.
 By the late 1990s, bank capital ratios have increased substantially.
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2000 by Harcourt, Inc.
14-22

14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
1935 1945
Source: FDIC Statistics on Banking .
1955 1965 1975 1985 1995
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2000 by Harcourt, Inc.
14-23

 As bank capital requirements were increased, regulators also implemented risk-based capital standards.
 Capital levels are measured against riskweighted assets . Risk-weighted assets is a measure of total assets that weighs high-risk assets more heavily than low-risk assets.
 The purpose is to require high-risk banks to hold more capital than low-risk banks.
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2000 by Harcourt, Inc.
14-24

 The current standards define two forms of capital:
– Tier 1 capital includes common stock, common surplus, retained earnings, noncumulative perpetual preferred stock, minority interest in consolidated subsidiaries, minus goodwill and other intangible assets.
– Tier 2 capital includes cumulative perpetual preferred stock, loan loss reserves, mandatory convertible debt, and subordinated notes and debentures.
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2000 by Harcourt, Inc.
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 The minimum capital requirements are that
– the ratio of Tier 1 capital to risk-weighted assets must be at least 4 percent, and
– the ratio of Total Capital ( Tier 1 capital plus Tier 2 capital ) to risk-weighted assets must be at least 8 percent.
 Capital levels are also used by regulators to determine the level of regulatory scrutiny a bank should receive and whether a bank should have any limits placed on its activities.
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2000 by Harcourt, Inc.
14-26

Category 1--Zero Percent Weight
Cash
Balances due from Federal Reserve Banks and claims on central banks in other OECD countries a
U.S. Treasury and Government agency securities and claims on or unconditionally guaranteed by OECD central governments
Federal Reserve stock
Claims collateralized by cash on deposit or by securities issued or guaranteed by OECD central governments or U.S. government agencies
Category 2--20 Percent Weight
Cash items in the process of collection
All claims on or guaranteed by U.S. depository institutions and banks in OECD countries
General obligation bonds of state and local governments
Portions of claims secured by U.S. government agency securities or OECD central government obligations that do not qualify for a zero percent weight
Loans or other claims conditionally guaranteed by the U.S. government
Securities and other claims on U.S. government-sponsored agencies
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2000 by Harcourt, Inc.
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(continued)
Category 3--50 Percent Weight
Loans secured by first liens on 1-to-4 family residential property and certain multifamily residential properties
Certain privately issued mortgage-backed securities
Revenue bonds of state and local governments
Category 4--100 Percent Weight
All loans and other claims on private obligors not placed in a lower risk category
Bank premises, fixed assets, and other real estate owned
Industrial development revenue bonds
Intangible assets and investment in unconsolidated subsidiaries, provided they are not deducted from capital a
The group of countries associated with the Organization for Economic Cooperation and Development (OECD) includes the
United States and 24 other major industrial countries.
Category 1 is the least risky asset category; category 4, the riskiest. The weights reflect that regulators require banks to have more capital set aside to cover riskier activities.
Source: Commercial Bank Examination Manual, Board of Governors, Federal Reserve System, November 1998..
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2000 by Harcourt, Inc.
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(concluded)
RISK WEIGHTS AND CONVERSION RATIOS FOR SELECTED OFF-BALANCE-
SHEET ACTIVITIES
Weight
0%
50%
50%
50%
50%
100%
100%
100%
Conversion Factor
0
0 a
0.005
a
0.01
a
0.05
a
0.2
0.5
1
Off-Balance-Sheet Item
Short-term loan commitments
Short-term interest rate derivatives
Long-term interest rate derivatives
Short-term foreign exchange derivatives
Long-term foreign exchange derivaitves
Commercial letters of credit
Long-term loan commitments
Standby letters of credit
Long-term off-balance-sheet activities require more capital than short-term activities. This is reflected in the weights associated with long-term activities. a In addition to holding capital against potential on-balance-sheet exposures as measured by conversion factors, banks must also hold capital against the current value (replacement cost) of derivative securities.
Source: Commercial Bank Examination Manual , Board of Governors, Federal Reserve System, November 1998.
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2000 by Harcourt, Inc.
14-29

C
APITAL
C
ATEGORIES
Well capitalized a
Adequately
capitalized
Undercapitalized
Significantly
undercapitalized
Critically
undercapitalized c
T
OTAL
R
ISK
-B
ASED
C
APITAL
R
ATIO
10 percent or greater
8 percent or greater
Less than
8 percent
Less than
6 percent
--
AND
AND
OR
OR
T
IER
1 R
ISK
-B
ASED
C
APITAL
R
ATIO
10 percent or greater
4 percent or greater
Less than
4 percent
Less than
3 percent
--
AND
AND
OR
OR
L
EVERAGE
R
ATIO
5 percent or greater
4 percent or greater
Less than
4 percent b
Less than
3 percent
--
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2000 by Harcourt, Inc.
14-30



The credit risk of an individual loan concerns the losses the bank will experience if the borrower does not repay the loan.
The credit risk of a bank’s loan portfolio concerns the aggregate credit risk of all the loans in the bank’s portfolio.
 Banks must manage both dimensions effectively to be successful.
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2000 by Harcourt, Inc.
14-31

 Begins with the lending decisions (and the 5 Cs as discussed in Chapter 13).
 Requires close monitoring to identify problem loans quickly.
 The goal is to recover as much as possible once a problem loan is identified.
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2000 by Harcourt, Inc.
14-32

 Internal Credit Risk Ratings assigned to individual loans are used to
– identify problem loans,
– determine the adequacy of loan loss reserves, and
– loan pricing and profitability analysis.
 Loan Portfolio Analysis is used to ensure that banks are well diversified.
– Concentration ratios measure the percentage of loans allocated to a given geographic location, loan type, or business type.
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2000 by Harcourt, Inc.
14-33

 Gross interest income and gross interest expense have become more volatile in the last
30 years. Consequently, interest rate risk has become a concern to both bank managers and bank regulators.
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2000 by Harcourt, Inc.
14-34

Net Cash Flow from Funding a $1,000 Loan with a 3-Month CD and a 6-Month CD
(Assuming No Change in Interest Rates)
3
E LAPSED T IME (M ONTHS )
6 9 A CTION
Cash Inflows
Issue 3-month CD
(Percent)
Issue 6-month CD
(Percent)
1-year Loan
Total cash inflow
0
$500
(5)
500
(6)
$1,000
$506
(5)
$506
$513
(5)
515
(6)
$1,028
$519
(5)
$519
12
$1,090
$1,090
Cash Outflows
1-year Loan
(Percent)
Pay off
3-month CD
Pay off
6-month CD
Total cash outflow
Net cash flow =
Total cash inflow-
Total cash outflow
1,000
(9)
$1,000
$0
506
$506
$0
513
515
$1,028
$0
519
$519
$0
525
530
$1,055
$35
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2000 by Harcourt, Inc.
14-35

Net Cash Flow from Funding a $1,000 Loan with a 3-Month CD and a 6-Month CD
(Assuming a 1 Percent Increase in Interest
Rates)
E LAPSED T IME (M ONTHS )
6 A CTION
Cash Inflows
Issue 3-month CD
(Percent)
Issue 6-month CD
(Percent)
1-year Loan
Total cash inflow
0
$500
(5)
500
(6)
$1,000
3
$506
(6)
$506
$514
(6)
515
(7)
$1,029
9
$521
(6)
$521
12
$1,090
$1,090
Cash Outflows
1-year Loan
(Percent)
Pay off
3-month CD
Pay off
6-month CD
Total cash outflow
Net cash flow =
Total cash inflow-
Total cash outflow
1,000
(9)
$1,000
$0
506
$506
$0
514
515
$1,029
$0
521
$521
$0
529
533
$1,062
$28
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2000 by Harcourt, Inc.
14-36

 Assets and liabilities which can be repriced
(change the earnings/expense rate in a specified period of time) are identified as rate sensitive.
 A bank's GAP for a period of time is computed by subtracting rate sensitive liabilities (RSL) from rate sensitive assets (RSA).
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 Positive GAP = RSA > RSL
– Net interest income will decline if interest rates fall in the GAP period.
– More assets than liabilities will be repriced downward if interest rates decline, thus reducing net interest income.
– What happens if interest rates increase?
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(concluded)
 Negative GAP = RSA < RSL
– Net interest income will decline if interest rates increase in the GAP period.
– More liabilities than assets will be repriced upward if interest rates increase, thus reducing net interest income.
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2000 by Harcourt, Inc.
14-39

Duration GAP Analysis
 Simple maturity matching, discussed above, may not produce the same cash flow or repricing timing in any period.
 Duration GAP analysis matches cash flows and their repricing capabilities over a period of time.
 The percentage change in the value of a portfolio, given a change in interest rates, is proportional to the duration of the portfolio multiplied by the change in interest rates.
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2000 by Harcourt, Inc.
14-40

Duration GAP Analysis (concluded)

D
G

D
A

( MV
L
/ MV
A
)

D
L
– D
G
– D
A
= duration gap
= duration of assets
– D
L
= duration of liabilities
– MV
A
= market value of assets
– MV
L
= market value of liabilities
Duration GAPs are opposite in sign from maturity
GAPs for the same risk exposure.
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2000 by Harcourt, Inc.
14-41

 Adjustments by asset-sensitive institutions with positive maturity GAP, negative duration GAP--hurt by decreasing interest rates
– Buy financial futures--falling rates would increase value of futures contract, offsetting negative impact of GAP situation
– Buy call options on financial futures
– Swap to increase their variable-rate cash outflows and increase their fixed-rate (long-term) cash flows
– Lengthen the repricing of assets; shorten the repricing capability of liabilities
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2000 by Harcourt, Inc.
14-42

(concluded)
 Adjustments by liability-sensitive institutions with negative maturity GAPs or positive duration
GAPs--hurt by increasing interest rates
– Sell financial futures--increasing rates would increase value of futures contracts, offsetting the negative impact of GAP situation
– Buy put options on financial futures
– Swap long-term, fixed-rate payments for variablerate payments
– Shorten the repricing of assets; lengthen the repricing capability of liabilities
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2000 by Harcourt, Inc.
14-43