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Chapter 20 Bank Performance Outline Valuation of a Commercial Bank Factors That Affect Cash Flows Factors That Affect the Required Rate of Return by Investors Impact of the Credit Crisis on Bank Valuation Assessing Bank Performance Interest Income and Expenses Noninterest Income and Expenses Evaluation of a Bank’s ROA Converting ROA to ROE Application Key Concepts 1. Explain with the use of an income statement that the return on a bank’s assets is primarily a function of net interest margin, noninterest income and expenses, and loan losses. 2. Explain how performance is influenced by management decisions, which is influenced by their abilities to recognize risk and their incentives to take risk. 3. Explain how to evaluate a bank's performance. POINT/COUNTER-POINT: Does a Bank’s Income Statement Clearly Indicate the Bank’s Performance? POINT: Yes. The bank’s income statement can be partitioned to determine its performance and the underlying reasons for its performance. COUNTER-POINT: No. The bank’s income statement can be manipulated because the bank may not fully recognize loan losses (will not write off loans that are likely to default) until a future period. WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: There is some degree of manipulation that is possible for banks, but regulatory oversight may limit the inaccurate financial reporting. The accounting irregularities in recent years have been in other industries. Questions 1. Interest Income. How can gross interest income rise, while the net interest margin remains somewhat stable for a particular bank? ANSWER: Gross expenses may rise during periods in which gross interest income rises, as both variables respond to increasing market interest rates. Under these conditions, the net interest margin may remain somewhat stable. 2. Impact on Income. If a bank shifts its loan policy to pursue more credit card loans, how will its net interest margin be affected? ANSWER: If the customers repay their loans, the net interest margin will increase. However, if many of them default on their loans, the net interest margin could decline and the bank may experience greater loan losses. 3. Noninterest Income. What has been the trend in noninterest income in recent years? Explain. ANSWER: Noninterest income increased during the 1990s, as banks were providing more financial services (for which fees are charged). However, as competition among financial institutions has increased, noninterest income has leveled off or declined slightly. 4. Net Interest Margin. How could a bank generate higher income before tax (as a percentage of assets) when its net interest margin has decreased? ANSWER: Even if the net interest margin decreased, a bank could generate higher before-tax income (as a percentage of assets) by reducing noninterest expenses, increasing noninterest income, or reducing loan losses. 5. Net Interest Income. Suppose the net income generated by a bank is equal to 1.5 percent of assets. Based on past experience, would the bank experience a loss or a gain? Explain. ANSWER: This bank would experience a loss, because even though the bank will also have some noninterest income, the noninterest expenses and loan losses will more than offset the revenues. 6. Noninterest Income. Why have large money center banks’ noninterest income levels typically been higher than those of smaller banks? ANSWER: Money center banks have higher noninterest income levels (as a percentage of assets) because they offer more services such as insurance or brokerage that generate fee income. 7. Bank Leverage. What does the assets/equity ratio of a bank indicate? ANSWER: A bank’s assets/equity ratio is a measure of financial leverage, because it indicates how much assets it has per dollar of equity invested. The more debt that it uses, the more assets it can support with its equity. 8. Analysis of a Bank’s ROA. What are some of the more common reasons for a bank to experience a low ROA? ANSWER: A low ROA could occur because of: excessive interest expenses, excessive noninterest expenses, low interest income, low noninterest income, and high loan losses. 9. Loan Loss Provisions. Explain why loan loss provisions of most banks could increase in a particular period. ANSWER: Under poor economic conditions, loan prepayment problems would increase, and banks would boost their loan loss provisions in anticipation that they would have to write off more loans. 10. Bank Performance During the Credit Crisis. Why do you think some banks suffered larger losses during the credit crisis than other banks? ANSWER: Some banks suffered larger losses because they were more exposed to mortgage loans and more heavily invested in mortgage-backed securities. . 11. Weak Performance. What are likely reasons for weak bank performance? ANSWER: Weak performance may be due to: 1. Inefficiency (high noninterest expenses); 2. A high loan default percentage; 3. Limited provision of services (low noninterest income). 12. Bank Income Statement. Assume that SUNY Bank plans to liquidate Treasury security holdings and use the proceeds for small business loans. Explain how this strategy will affect the different income statement items. Also identify any income statement items for which the effects of this strategy are more difficult to estimate. ANSWER: Gross interest income would be expected to increase because small business loans generate higher interest revenues (assuming the loans are repaid). Noninterest expenses may increase because of an increase in loan applicant evaluations and processing. Loan losses would likely increase. The net income may be affected, depending on whether most of the small business loans are repaid. The net income would now be more uncertain because of the risk involved with small business loans. Treasury securities generate more predicted cash inflows for the bank than small business loans. Interpreting Financial News Interpret the following statements made by Wall Street analysts and portfolio managers. a. “The three most important factors that determine a local bank’s bad debt level are the bank’s location, location, and location.” The bad debt level of a local bank is very susceptible to economic conditions within the local area. If economic conditions become poor, many loans that were expected to perform well may default, no matter how competent the debtor firms are or how competent the bank’s credit analysis is. b. “The bank’s profitability was enhanced by its limited use of capital.” The bank has a high degree of financial leverage so that its return on assets (ROA) converts into high return on equity (ROE). c. “Low risk is not always desirable. Our bank’s risk has been too low, given the market conditions. We will restructure operations in a manner to increase risk.” The bank expects that the economy will be strong, so it can make more loans to customers that might be viewed as risky. These customers will be more capable of repaying loans in a strong economy. The bank can increase its income by pursuing this strategy assuming that the economy strengthens and that the customers repay their loans. Managing in Financial Markets As a manager of Hawaii Bank, you anticipate the following information provided to you: • Loan loss reserves at end of year = 1 percent of assets • Gross interest income over the next year = 9 percent of assets • Noninterest expenses over the next year = 3 percent of assets • Noninterest income over the next year = 1 percent of assets • Gross interest expenses over the next year = 5 percent of assets • Tax rate on income = 30 percent • Capital ratio (capital/assets) at end of year = 5 percent a. Forecast Hawaii Bank’s net interest margin. Net interest margin is 4 percent (see income statement in the answer to part e). b. Forecast Hawaii Bank’s earnings before taxes as a percentage of assets. Earnings before taxes as a percent of assets are 1 percent (see income statement in the answer to part e). c. Forecast Hawaii Bank’s earnings after taxes as a percentage of assets. Earnings after taxes as a percent of assets are 0.7 percent (see income statement in the answer to part e). d. Forecast Hawaii Bank’s return on equity. Return on equity = ROA  (Assets/Capital) = .7%  20 = 14% e. Hawaii Bank is considering a shift in its asset structure to reduce its concentration of Treasury bonds and increase its volume of loans to small businesses. Identify each income statement item that would be affected by this strategy, and explain whether the forecast for that item would increase or decrease as a result. Gross interest income is now expected to be higher. Noninterest expenses are now expected to be higher because of increased efforts on loan evaluation. Loan losses are expected to be higher. Amount as a Percent of Assets Gross interest income 9% Gross interest expense – 5% Net interest margin 4% Noninterest income + 1% Noninterest expense – 3% Loan loss reserve – 1% Net income before taxes 1% Tax (30% rate) – 3% Net income after taxes .7% Problems 1. Assessing Bank Performance. Select a bank whose income statement data are available. Using recent income statement data about a commercial bank, assess its performance. How does the performance of this bank compare to the performance of other banks? Compared with other banks, is its return on equity higher or lower than the ROE of other banks as reported in this chapter? What is the main reason why its ROE is different from the norm? (Is it due to its interest expenses? Its noninterest income?) ANSWER: To assess a bank's performance using income statement data, you typically want to look at key financial metrics such as net interest income, noninterest income, operating expenses, provision for loan losses, and taxes. Here's a step-by-step approach: 1. Calculate Net Interest Income (NII): Net interest income is a crucial component of a bank's income statement, representing the difference between interest income earned on assets (such as loans and securities) and interest expenses paid on liabilities (such as deposits and borrowings). 2. Analyze Noninterest Income: Noninterest income includes fees, commissions, and other revenue streams that are not derived from lending or investing activities. Evaluate the bank's noninterest income to assess its diversification and revenue-generating capabilities beyond traditional banking activities. 3. Assess Operating Expenses: Operating expenses include salaries, rent, marketing expenses, and other costs associated with running the bank. Compare the bank's operating expenses to its total revenue to gauge efficiency and cost management. 4. Evaluate Provision for Loan Losses: The provision for loan losses reflects the amount set aside to cover potential losses from loans that may default. Assess the adequacy of the provision relative to the bank's loan portfolio and credit risk profile. 5. Calculate ROE: ROE is a key profitability metric that measures the bank's ability to generate returns for its shareholders. It is calculated by dividing net income by shareholders' equity. ROE reflects how effectively the bank is utilizing its equity capital to generate profits. Once you have analyzed these components, compare the bank's ROE to industry benchmarks or the ROE of peer banks to assess its relative performance. If the bank's ROE is higher than the industry average, it may indicate superior profitability and efficiency. Conversely, if the ROE is lower, it may suggest underperformance compared to peers. The main reason why a bank's ROE may differ from the norm can vary depending on factors such as its business model, risk appetite, market conditions, and strategic decisions. For example: • If a bank has higher interest expenses relative to its peers due to a reliance on costly funding sources, it may have a lower ROE. • Conversely, if a bank generates significant noninterest income from fee-based services or investment banking activities, it may have a higher ROE despite lower net interest margins. In summary, assessing a bank's performance requires a thorough analysis of its income statement data, including net interest income, noninterest income, operating expenses, provision for loan losses, and taxes. Comparing the bank's ROE to industry benchmarks can provide insights into its relative profitability and efficiency, while identifying the main drivers behind any deviations from the norm. Flow of Funds Exercise How the Flow of Funds Affects Bank Performance In recent years, Carson Company has requested the services listed below from Blazo Financial, a financial conglomerate. These transactions have created a flow of funds between Carson Company and Blazo. a. Classify each service according to how Blazo benefits from the service. • advising on possible targets that Carson may acquire, • futures contract transactions, • options contract transactions, • interest rate derivative transactions, • loans, • line of credit, • purchase of short-term CDs, • checking account. All the services except for the purchase of short-term CDs may generate fees for Blazo Financial, and therefore generates non-interest income. Second, Blazo incurs an interest expense on the CD, but it channels the funds into loans or investments that pay interest income. Third, Blazo’s loans to Carson Company generate interest income. Fourth, Blazo incurs noninterest expenses from establishing the infrastructure and hiring the employees that can provide all of these services. b. Explain why Blazo’s performance from providing these services to Carson Company and other firms will decline if economic growth is reduced. If economic growth is reduced, the demand for advisory services, because there are less acquisitions. This reduces Blazo Bank’s non-interest income. There are fewer loans because there is expansion by firms. This reduces Blazo’s interest income. There may be more loan defaults. Given the potential impact of slow economic growth on a bank’s performance, do you think that commercial banks would prefer that the Fed use a restrictive monetary policy or an expansionary monetary policy? Normally, banks would prefer that the Fed use a loose money policy (assuming that inflation is not out of control). Solution to Integrative Problem for Part IV Forecasting Bank Performance 1. The interest income and expenses are determined by applying the specified interest rate on each asset and liability to the dollar amount for each Treasury bill rate scenario. The loan losses must be deducted from the loan amounts before determining the interest income on loans. The noninterest income and expenses were given in the question. The loan losses are determined by applying the assumed loan loss percentage to the dollar amount of each type of loan. The ROA for each of the three Treasury bill rate scenarios is derived in the following table: Income and Expenses (in millions) Based on Treasury Bill Rate Scenarios Possible Treasury Bill Rate
Assets Amount in Millions 8% 9% 10%
Small business loans $4,000 548.80 588.00 627.20
Large business loans $2,000 237.60 257.40 277.20
Consumer loans $3,000 432.00 460.80 489.60
Treasury bills $1,000 80.00 90.00 100.00
Treasury bonds $1,500 150.00 165.00 180.00
Corporate bonds $1,100 132.00 143.00 154.00
Interest income $1,580.40 $1,704.20 $1,828.00

Liabilities
Demand deposits $5,000 0 0 0
Time deposits $2,000 120.00 120.00 120.00
One-year NCDs $3,000 270.00 300.00 330.00
Five-year NCDs $2,500 250.00 275.00 300.00
Interest expense $640.00 $695.00 $750.00

Noninterest income 200.00 200.00 200.00
Noninterest expenses 740.00 740.00 740.00
Loan losses 220.00 220.00 220.00
Income before taxes 180.40 249.20 318.00
Tax (34%) 61.30 84.70 108.10

Net income $119.10 $164.50 $209.90
ROA [total assets = $13.5 billion] .88% 1.22% 1.55%
Interest Rate Scenario Forecasted (Possible T-bill Rate) ROA Probability 8% .88% 30% 9% 1.22% 50% 10% 1.55% 20% 2. Next year’s ROA will be higher if interest rates are higher as of the beginning of the year. Much of the bank’s sources of funds (from its demand deposits and time deposits) are insensitive to interest rates. If interest rates in the upcoming year are higher, it will allow for higher interest revenues, but the interest expenses will not be affected as much. If required reserves were included in the forecasted interest revenue, ROA and ROE would have been lower. 3. The two NCD expense items change, allowing for slightly lower total interest expenses and therefore a slightly higher ROA, as shown in the following table: Income and Expenses (in millions) Based on Treasury Bill Rate Scenarios Possible Treasury Bill Rate
Assets Amount in Millions 8% 9% 10%
Small business loans $4,000 548.80 588.00 627.20
Large business loans $2,000 237.60 257.40 277.20
Consumer loans $3,000 432.00 460.80 489.60
Treasury bills $1,000 80.00 90.00 100.00
Treasury bonds $1,500 150.00 165.00 180.00
Corporate bonds $1,100 132.00 143.00 154.00
Interest income $1,580.40 $1,704.20 $1,828.00

Liabilities
Demand deposits $5,000 0 0 0
Time deposits $2,000 120.00 120.00 120.00
One-year NCDs $4,000 360.00 400.00 440.00
Five-year NCDs $1,500 150.00 165.00 180.00
Interest expense $630.00 $685.00 $740.00

Noninterest income 200.00 200.00 200.00
Noninterest expenses 740.00 740.00 740.00
Loan losses 220.00 220.00 220.00
Income before taxes 190.40 259.20 328.00
Tax (34%) 64.70 88.10 111.50

Net income $125.70 $171.10 $216.50
ROA [total assets = $13.5 billion] .93% 1.26% 1.60%
Interest Rate Scenario Forecasted (Possible T-bill Rate) ROA Probability 8% .93% 30% 9% 1.26% 50% 10% 1.60% 20% 4. Higher. 5. If interest rates rise over time, the interest paid on one-year NCDs will rise while the interest paid on five-year NCDs issued in previous years is unaffected. 6. The interest income and loan losses are affected because of the change in the asset composition. The new levels are shown in the following table. The total loan loss amount is increased by $20 million because of the increased allocation of small business loans. Income and Expenses (in millions) Based on Treasury Bill Rate Scenarios Possible Treasury Bill Rate
Assets Amount in Millions 8% 9% 10%
Small business loans $5,000 686.00 735.00 784.00
Large business loans $2,000 237.60 257.40 277.20
Consumer loans $3,000 432.00 460.80 489.60
Treasury bills $0 0 90.00 0
Treasury bonds $1,500 150.00 165.00 180.00
Corporate bonds $1,100 132.00 143.00 154.00
Interest income $1,637.60 $1,761.20 $1,884.80

Liabilities
Demand deposits $5,000 0 0 0
Time deposits $2,000 120.00 120.00 120.00
One-year NCDs $3,000 270.00 300.00 330.00
Five-year NCDs $2,500 250.00 275.00 300.00
Interest expense $640.00 $695.00 $750.00

Noninterest income 200.00 200.00 200.00
Noninterest expenses 740.00 740.00 740.00
Loan losses 220.00 240.00 220.00
Income before taxes 217.60 286.20 354.80
Tax (34%) 74.00 97.30 120.60

Net income $143.60 $188.90 $234.20
ROA [total assets = $13.5 billion] 1.06% 1.40% 1.73%
Forecasted ROA if an Extra $1 Billion is Interest Rate Scenario Used for Loans to (Possible T-bill Rate) Small Businesses Probability 8% 1.06% 30% 9% 1.40% 50% 10% 1.73% 20% 7. Higher. 8. The default rate on consumer loans may increase in the following years, causing the bank’s ROA to be lower with the extra consumer loans than it would have been if it purchased Treasury bills. 9. Noninterest expenses would likely be higher because of costs involved in evaluating the creditworthiness and servicing the additional small business loans. Noninterest revenues could be higher as well because of possible fees charged to the additional small businesses. 10. The interest income is higher as a result of the increased allocation of consumer loans, but loan losses are larger. The effects are offsetting to a degree, so that the ROA is adjusted just slightly, as shown in the following table:
Income and Expenses (in millions) Based on Treasury Bill Rate Scenarios Possible Treasury Bill Rate
Assets Amount in Millions 8% 9% 10%
Small business loans $4,000 548.80 588.00 627.20
Large business loans $1,000 118.80 128.70 138.60
Consumer loans $4,000 576.00 614.40 652.80
Treasury bills $1,000 80.00 90.00 100.00
Treasury bonds $1,500 150.00 165.00 180.00
Corporate bonds $1,100 132.00 143.00 154.00
Interest income $1,605.60 $1,729.10 $1,852.60

Liabilities
Demand deposits $5,000 0 0 0
Time deposits $2,000 120.00 120.00 120.00
One-year NCDs $4,000 360.00 400.00 440.00
Five-year NCDs $1,500 150.00 175.00 180.00
Interest expense $640.00 $695.00 $750.00

Noninterest income 200.00 200.00 200.00
Noninterest expenses 740.00 740.00 740.00
Loan losses 250.00 250.00 250.00
Income before taxes 175.60 244.10 312.60
Tax (34%) 59.70 83.00 106.30

Net income $115.90 $161.10 $206.30
ROA [total assets = $13.5 billion] .86% 1.19% 1.53%
Possible ROA if an Interest Rate Scenario Extra $1 Billion is (Possible T-bill Rate) Used for Consumer Loans Probability 8% .86% 30% 9% 1.19% 50% 10% 1.53% 20%
11. If interest rates rise after the loans are provided, the interest received on consumer loans will be unaffected, while the interest received on business loans would rise (because their rates are tied to the T-bill rate). In this case, the consumer loans would not perform as well as the business loans. 12. Interest Rate Scenario Forecasted ROE Forecasted ROE (Possible T- if Capital = if Capital = bill Rate $1 Billion $1.2 Billion Probability 8% 11.88% 9.90% 30% 9% 16.47% 13.73% 50% 10% 20.92% 17.44% 20% The ROE will be lower if the capital level is increased. Solution Manual for Financial Markets and Institutions 9781133947875, 9780134519265, 9780133423624, 9780132136839, 9781260091953, 9781264098729 Jeff Madura, Frederic S. Mishkin, Stanley Eakins, Anthony Saunders , Marcia Cornett,Otgo Erhemjamts

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