Bank Mgt. 5th Ed, Chapter 3 Revised

Bank Mgt. 5th Ed, Chapter 3 Revised - Chapter 3 Evaluating...

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Unformatted text preview: Chapter 3 Evaluating a Bank’s Evaluating Returns, Risks, and Overall Performance Overall 1 Using Basic Ideas From Business Using Finance Finance ® Attaining the Primary Objective ® Activities of business described in either operating or Activities financial terms. financial ® Basic tenet of financial theory holds that Basic management’s first objective is to maximize value of owner’s investment. owner’s ® Maximize value by seeking highest returns for risk Maximize level deemed appropriate by the owners. + level Continued 2 Using Basic Ideas From Business Using Finance Finance ® Beginning Return Measures for a Company ® Table 3.1 in text presents simplified balance sheet, Table income statement, and profitability analysis of ABC Manufacturing Company. Manufacturing ® In Table 3.2, the return on equity (or DuPont model) In isolates the sources of the firm’s profitability. + isolates Continued 3 Using Basic Ideas From Business Using Finance Finance ® Additional Information Needed ® In-depth profitability analysis needed to In-depth examine quality of ABC’s returns. examine ® Then, compare return & risks measures with Then, firms of similar size in the same industry. firms ® Observe higher returns if firm takes higher Observe degree of risk. degree ® In the end, optimal balance of risks & returns In should maximize values of firm. + should Continued 4 Using Basic Ideas From Business Using Finance Finance ® Parallels with Banking ® Like non-financial firm, financial firm obtains funds Like from creditors & owners to obtain raw materials, labor & capital. labor ® Financial firms purchase funds instead of raw Financial materials such as iron ore. materials ® The product sold is loans instead of steel, etc. ® Financial firm seeks to maximize value much like a Financial manufacturing or other type firm. + manufacturing Continued 5 Table 3.1 ABC Manufacturing Co. Average Balance Sheet for 1998 Assets Cash Accounts receivable Inventory Plant & equipment $500,000 3,000,000 2,000,000 4,500,000 $10,000,000 Income Statement for Year 1998 Revenue (or sales) Cost of goods sold Gross operating income Selling & adminstrative expenses Net operating income Interest Taxable income Taxes (34%) Net income $20,000,000 15,000,000 5,000,000 3,000,000 2,000,000 400,000 1,600,000 544,000 $1,056,000 Liabilities & Net Worth Current liabilities Long-term debt Common stock Retained earnings $3,000,000 2,000,000 1,000,000 4,000,000 $10,000,000 Continued 6 Table 3.1 ABC Manufacturing Co. Profitability Analysis Gross margin Gross operating income R evenue Net operating income = R evenue Net income = Revenue Revenues = A ssets Net income = A ssets Assets = Equity Net income = Equity = 5,000,000 20,000,000 2,000,000 20,000,000 1,056,000 20,000,000 20,000,000 10,000,000 1,056,000 10,000,000 10,000,000 5,000,000 1,056,000 5,000,000 =25% Net margin (before i nterest & taxes Net margin (after i nterest & taxes Asset utilization (assets turnover) Return on assets =10% =5.28% =2X =10.56% Leverage multiplier =2X Return on equity =21.12% 7 Table 3.3 XYZ Commercial Bank Average Balance Sheet for 1998 Assets Cash & due from banks Short-term loans & securities Long-term loans & securities Premises & equipment $ 8,000,000 60,000,000 30,000,000 2,000,000 $100,000,000 $100,000,000 Liabilities and Net Worth Current liabilities Long-term liabilities Common stock Undivided profits $ 70,000,000 23,000,000 1,000,000 6,000,000 $100,000,000 Income Statement for Year of 1998 Income Revenues--interest Interest expenses Net interest income Overhead(people & premises) Net operating income Taxes (34%) Net income $9,000,000 4,000,000 5,000,000 3,000,000 2,000,000 680,000 $1,320,000 Continued 8 Table 3.3 XYZ Commercial Bank Profitability Analysis Interest margin Net interest income = Earning assets Earning Net income Revenues Revenues Assets Assets Net income Assets Assets Assets Equity Net income Equity Equity 5,000,000 = 90,000,000 = 5.6% Net margin (after tax) (after Asset utilization = 1,320,000 9,000,000 = 14.7% 9,000,000 = 100,000,000 1,320,000 = 100,000,000 9.0% Return on assets = 1.32% Leverage multiplier = 100,000,000 = 7,000,000 = 1,320,000 7,000,000 = 14.3X Return on equity 18.86% 9 Balancing Risks & Returns ® Today, Many Banks Will Have To Take Today, Higher Risks To Get Acceptable Returns. Higher ® A Bank’s Performance Will Affect It Value Bank’s In The Marketplace. In ® Modeling Provides An Excellent Planning Modeling Tool. Tool. (Look at Table 3-6 on page 67 in text.) + 10 10 Simplified Bank Example ® Both bank & ABC have short-and-long term Both assets & funds obtained from current liabilities, & either issued or retained common equity. either ® Bank has small amount of fixed assets & ABC Bank has substantial fixed assets. has ® Bank has small amount of equity. ® Bank’s revenues & expenses are similar. + Bank’s 11 11 Key Return & Risk Measures for Key a Sample Bank Sample ® Example of Smithville Bank in hypothetical Example environment to examine risks & returns. environment ® Assume bank can obtain funds in only five ways: ® Transaction deposits (demand & now accounts). ® Short-term time & savings deposits. ® Long-term time deposits (maturities over 180 days). ® Money borrowed from other sources. ® Equity capital & retained earnings. + Continued 12 12 Key Return & Risk Measures for Key a Sample Bank Sample ® Likewise, we assume that, after meeting cash & Likewise, premises requirements, bank employs funds in one of only five ways: of ® Short-term, high quality debt securities(under 180 days). ® Long-term, high quality debt securities(over 180 days). ® Good-quality loans with rates varying with market rates. ® Medium-quality loans with rates varying with market. ® Good-quality fixed-rate loans. + 13 13 Table 3.4 Hypothesized Table Environment for Smithville Bank Environment Rates Reserve & cash requirements Transaction deposits Transaction Time deposits Time Potential earnings available Short-term securities Short-term Long-term securities (currently) Long-term Long-term securities (held) Long-term High-quality variable rate loans High-quality Medium-quality variable rate loans Medium-quality Fixed-rate loans (currently) Fixed-rate Fixed-rate loans (held) Fixed-rate Expenses in environment Transaction deposits Transaction Short-term time deposits Short-term Borrowings Borrowings Other expenses (net of other income) Other Income tax rate 15% 4% 5% 7% 8% 7% 9% 8% 9% 3% 4% 4% $2 million 34% 34% 14 14 Table 3.5 Smithville Bank Balance Sheet (dollars in thousands) Assets Cash & due from banks Short-term securities Long-term securities High variable loans Medium variable loans Fixed-rate loans Premises & other assets $ 6,900 15,000 15,000 20,000 20,000 20,000 3,100 $100,000 Liabilities & Net Worth Transaction deposits Short-term time deposits Long-term time deposits Borrowings Equity capital $ 30,000 30,000 30,000 3,000 7,000 $100,000 Income Statement (dollars in thousands) Revenues Interest expenses Other expenses (net) Operating income Taxes Net Income $6,950 -3,720 -2,000 $1,230 - 418 $ 812 15 15 Income & Expense Statement Income Calculations for Smithville Bank Calculations Category Cash & due from banks Short-term securities Long-term securities High variable loans Medium variable loans Fixed-rate loans Premises Total revenues Balance $ 6,900 15,000 15,000 20,000 20,000 20,000 3,100 x Yield = 0% 5% 8% 7% 9% 9% 0% Revenue $ 0 750 1,200 1,400 1,800 1,800 0 $6,950 Category Balance Transaction deposits $30,000 Short-term deposits 30,000 Long-term deposits 30,000 Borrowing 3,000 Total interest expenses x Cost = 3% 4% 5% 4% Expenses $ 900 1,200 1,500 120 $3,720 16 16 Table 3.6 Return & Risk Measures (Smithville Bank) Category Interest Margin = Equation Int. Inc.-Int. Exp. = Earning Assets Net Income Revenues Revenues Revenues Assets Net Income Assets Assets Equity Net Income Equity Equity = = Calculations 6,950 -3,720 = 90,000 812 6,950 6,950 100,000 = 812 100,000 100,000 7,000 812 7,000 = Results 3.59% Net Margin = Net 11.68% X 6.95% X 0.81% X 14.29X = 11.60% Asset Utilization= = = Return On Assets= = Leverage Multiplier = Return on Capital = = Continued 17 17 Table 3.6 Return & Risk Table Measures (Smithville Bank) Measures Risk Measures Category Liquidity Risk Equation Calculations Short-term Securities = 15,000 = Deposits 90,000 Deposits Int. Sensitive Asset = Int. Asset Int. Sensitive Liabilities 55,000 63,000 Results 16.67% Interest Rate Risk = 0.87% (Int. Sen. Assets= Sh. Term Securities, Var. Rate Loans.) (Int. Sen. Liabilities=Transaction Deposits, Sh. Term Time/Savings & Borrowings.) Credit Risk= Medium Loans Assets Assets Capital Risk Assets = 20,000 20,000 100,000 100,000 7,000 100,000 = 20.00% 20.00% Capital Risk= = = 7.00% 18 18 Measuring Risks ® Liquidity Risk ® Shows the relationship of a bank’s liquidity needs for meeting Shows deposit outflows & loan increases versus its actual or potential sources of liquidity from either selling an asset it holds or acquiring additional liabilities. acquiring The bank’s interest rate risk is related to the changes in asset The & liability returns & values caused by movements in interest rates. A beginning measurement of this risk is the ratio of interest-sensitive assets to interest-sensitive liabilities. Goal is to have a ratio close to 1.0. + to Continued Continued 19 19 ® Interest Rate Risk ® Measuring Risks ® Credit Risk ® The credit risk of a bank is defined as the risk that the The interest or principal, or both, on securities & loans will not be paid as promised. not The capital risk of a bank indicates how much asset The values may decline before the position of its depositors (or the depositor insurer such as the FDIC) and other creditors is jeopardized. + creditors 20 20 ® Capital Risk ® Setting Objectives for Returns & Setting Risks Risks ® Returns increase by increasing one or more of Returns the primary risks. the ® Management would prefer highest returns for Management given level of risks & lowest risks for a given level of returns. level ® Three steps in setting objectives: ® Assess how other banks have made risk decisions. ® Compare performance with other banks. ® Set reasonable performance goals. + 21 21 Table 3.7 Performance Table Objectives for Smithville Bank Objectives Return Measures Interest margin Net margin Asset utilization Return on assets Leverage multiplier Return on equity Risk Measures Liquidity risk Interest rate risk Credit risk Capital risk Objectives 4.00% 12.50% 8.00% 1.00% 15.00X 15.00% Objectives 23.00% 1.00 20.00% 6.67% Actual 3.59% 11.68% 6.95% 0.81% 14.29X 11.60% Actual 16.67% 0.87% 20.00% 7.00% 22 22 Return-Risk Tradeoffs ® Difficult to achieve conflicting goals & most banks Difficult have to consider tradeoffs. have ® Assume in year following example (Table 3.5) Assume deposits grew $10 million and capital grew $1 million while revenues & expenses remained the same (Table 3.4). same ® Highest priority now is to increase bank’s liquidity Highest position & minimize interest fluctuations. position ® To achieve goal, bank placed new funds in shortterm securities (see Table 3.8). + 23 23 Table 3.8 Emphasis on Liquidity & Balanced Table Interest Sensitivity (for Smithville Bank) Interest Balance Sheet (dollars in thousands) Assets Cash & due from banks Short-term securities Long-term securities High variable loans Medium variable loans Fixed-rate loans Premises & other assets $ 7,300 25,600 15,000 20,000 20,000 20,000 3,100 $111,000 Liabilities & Net Worth Transaction deposits Short-term time deposits Long-term time deposits Borrowings Equity capital $ 30,000 35,000 35,000 3,000 8,000 $111,000 Income Statement (dollars in thousands) Revenues Interest expenses Other expenses (net) Operating income Taxes Net Income $7,480 -4,170 -2,000 $1,310 - 445 $ 865 Continued 24 24 Table 3.8 Emphasis on Liquidity & Balanced Table Interest Sensitivity (for Smithville Bank) Interest Return Measures Interest margin Net margin Asset utilization Return on assets Leverage multiplier Return on equity Objectives 4.00% 12.50% 8.00% 1.00% 15.00X 15.00% Emphasizing Previous Liquidity 3.59% 3.29% 11.68% 11.56% 6.95% 6.74% 0.81% 0.78% 14.29X 13.88X 11.60% 10.81% Emphasizing Liquidity 25.60% 0.96% 7.21% Risk Measures Liquidity risk Interest rate risk Credit risk Capital risk Objectives 23.00% 1.00 20.00% 6.67% Previous 16.67% 0.87% 20.00% 18.02% 7.00% 25 25 Results of Improving Returns ® Using the same figures in the previous Using example (Table 3.8), this next example assumes that management decided to emphasize increasing returns. emphasize ® Bank will invest newly attracted funds in Bank the two asset categories that produce highest returns. + highest 26 26 Table 3.9 Emphasis on Profitability (for Table Smithville Bank) Smithville Balance Sheet (dollars in thousands) Assets Cash & due from banks Short-term securities Long-term securities High variable loans Medium variable loans Fixed-rate loans Premises & other assets $ 7,300 15,000 15,000 20,000 25,500 25,100 3,100 $111,000 Liabilities & Net Worth Transaction deposits Short-term time deposits Long-term time deposits Borrowings Equity capital $ 30,000 35,000 35,000 3,000 8,000 $111,000 Income Statement (dollars in thousands) Revenues Interest expenses Other expenses (net) Operating income Taxes Net Income $7,583 -4,170 -2,000 $1,683 - 572 $ 1,111 Continued 27 27 Table 3.9 Emphasis on Profitability (for Table Smithville Bank) Smithville Return Measures Interest margin Net margin Asset utilization Return on assets Leverage multiplier Return on equity Objectives 4.00% 12.50% 8.00% 1.00% 15.00X 15.00% Emphasizing Previous Returns 3.59% 3.66% 11.68% 14.14% 6.95% 7.07% 0.81% 1.00% 14.29X 13.88X 11.60% 13.88% Emphasizing Returns 15.00% 0.86% 7.21% 28 28 Risk Measures Liquidity risk Interest rate risk Credit risk Capital risk Objectives 23.00% 1.00 20.00% 6.67% Previous 16.67% 0.87% 20.00% 22.97% 7.00% Table 3.10 Additional Risk-Return Table Situations for Smithville Bank Situations (1) (2) (3) (4) (1) Liquid Profitable Shifting Rapid LowHigh Fund PurchasedLowCapital Capital Sources Growth Bank Bank Bank Bank 3.21% 3.74% 3.42% 3.50% 10,85% 14.82% 12.52% 15.79% 6.74% 7.07% 7.03% 6.98% 0.73% 1.05% 0.88% 1.10% 18.50X 11.10X 13.88X 13.00X 13.53% 11.64% 12.20% 14.32% Return Measures Interest margin Net margin Asset utilization Return on assets Leverage multiplier Return on equity Objectives 4.00% 12.50% 8.00% 1.00% 15.00X 15.00% Risk Measures_________________________________________________________ Liquidity risk 23.00% 25.60% 15.00% 17.00% 18.36% Interest rate risk 1.00 0.94 0.92 0.98 0.90 Credit risk 20.00% 18.02% 22.97% 19.82% 20.00% Capital risk 6.67% 5.41% 9.01% 7.21% 7.69% 29 29 Good Judgment Is The Key To Risk Management ® Don’t Let “Greed” Put Don’t You At Risk. You ® Don’t Do It Because Don’t Other Banks Are. Other ® “Easy Money” May Easy Work In Gambling-Work But Not Banking. 30 30 Basic Elements Of Risk Management ® If It Sounds Too Good To Be True, It Probably Is. ® Rate Is A Function Of Risk. ® If You Don’t Understand It--Don’t Do It! ® Immediate Gain Can Substantially Impact Future Earnings. 31 31 Risk Management Is Not A Science In An Address To Bankers In Florida, Comptroller Of The Currency Eugene A. Ludwig Said, “There Is An Inherent Degree Of Subjectivity In The Quantification Of Risk--It Has Been & Remains Today An Art As Well As A Science. For That Reason, The Essence Of Sound Risk Management Will Always Be Good Judgment & Experience” 32 32 Areas Of The Bank Subject To Risk ® General--Competition/Strategy/Economy ® Loan/Credit ® Investment/Securities ® Operations/Computer ® Legal/Regulatory ® Financial/Accounting ® Internal/External ® Other Systems Crimes 33 33 Risks Keys To Risk Management ® Risk Identification ® Risk Measurement ® Risk Control 34 34 Must Balance Risk & Customer Service ® Lack Of Risk Control--The Bank Has Potential To Suffer Loss. ® Too Much Control--Customer Dissatisfaction. 35 35 Directors Risk Responsibilities ® Need To Have General Knowledge Of Bank Activities. ® Establish, Review & Implement Policies. ® Review Overall Risk Management Program With Management. ® If You Don’t Understand--Ask Questions! 36 36 Management’s Risk Responsibilities ® Establish Procedures That Insure Policy Implementation. ® Evaluate Every New Product Or service For Risk Elements. ® Establish Programs To Measure On-Going Elements Of Risk. ® Establish Risk Accountability. 37 37 Risk Responsibilities Of Officers & Staff ® Evaluate Risks In Their Area. ® Look For/Report Exceptions To Policy. ® Prepare Check-Lists For Monitoring Risk. ® Accept Responsibility For Monitoring Risk In Their Area. ® Provide Good Data. 38 38 Don’t Overreact To Risk ® Risk Like “Dynamite” Is An Occupational Hazard. ® Manage Risk--Don’t Let Risk Manage You. ® Much Of Risk Entails The Obvious. ® Good Data Is Best Protection. 39 39 ...
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This note was uploaded on 09/30/2010 for the course FIN 468 taught by Professor Bexley during the Fall '10 term at Sam Houston State University.

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