10/5/2018 ����������������������� Banker has to Manage Credit Risk, Interest Rate Risk, and Liquidity, and still earn a profit • A Business in a set of Financial Statements – Balance Sheet • “Snapshot” of a moment in time • What the firm owns (assets), and to whom it owes money • Assets = Liabilities + Owners’ Equity (Capital) – IMPORTANT: Capital = Assets – Liabilities – Income Statement • “Movie” of money flowing through a firm over time • Revenue – Expenses = Op’g Income – Taxes = Net Income • The 2 are connected by Capital (OE) & Net Income – Net Income (Loss) not paid out in dividends is Retained • Firms can pay dividends even if not profitable. 2018, Jay Cochran, III PhD ��������������� • Determine your Bank’s FDIC Certificate No. • Using the FDIC’s “Statistics on Depository Institutions (SDI)” Database and your Bank’s FDIC Certificate No., pull the following reports: – Balance Sheet – Income Statement • Including detail of loan and deposit interest • Example reports tie to SDI Report Line no.s – If missing Line no. = calculation – Analytical “Cookbook” 2018, Jay Cochran, III PhD ��������������������������������� Assets = Liabilities + Capital Assets Liabilities & Capital OWNS OWES (Revenue Generators) (Financial Structure) Cash (“Reserves”) Deposits Securities Notes & Bonds Loans Capital Property & Equipment • Recent US Banking System Balance Sheet 2018, Jay Cochran, III PhD 1
10/5/2018 �������������������� Revenues – Expenses = Net Income • Revenues – Interest Income (Securities, Loans) – Fee Income (NSF, ATM, Trust, Payments …) • Expenses – Interest Expense (Deposits, Borrowing) – Provision for Loan Losses – Non-interest Expenses (Wages, deprec., …) – Others (Taxes, extraordinary items, …) • Recent US Banking System Income Statement 2018 Jay Cochran, III PhD ������������������������� US Banking System Analytical Results 1. Basic Spread Average Loan Yield – Average Deposit Yield 2. Return on Assets (ROA) Net Income/Assets 3. Return on Capital (ROK) Net Income/Capital ������ ���!������ �������������������������������������������"�#�#$������������� ��������%��������������������&����$�������&�����������' • Historical Profitability Performance • Returns (profits) are generated by taking risks 2018, Jay Cochran, III PhD ��������������� US Banking System Analytical Results 4. Capitalization Capital/Total Assets 5. Gap Analysis one measure of Interest Rate Risk – Balance sheet has built-in maturity mis-match Costs ↑ faster than revenues with ↑ interest rates • • Gap = Rate-sensitive Assets – Rate-sensitive Liab. (more below) 6. Liquidity Management Reserves/Deposits – Securities Account – Temporary Liquidity Sources: Fed Funds, FRB Discount Loans • Insolvent vs. Illiquid “…lend at penalty rates against the latter; lend not at any price against the former…” 7. Credit Losses Charge-Offs/Capital – Some losses to be expected, no matter what – Addressing Info Asymmetries helps to control risk 2018, Jay Cochran, III PhD 2
10/5/2018 (�������%����� • Criticality of Capital – The Inevitability of Losses • Capital Adequacy determines firm survival (solvency) • Accumulates Profits; Absorbs Losses – Also can help Align Owners’ Incentives w/Depositors’ • Capital/Assets = Capitalization ratio • Historical Capitalization Rates • Leverage = Assets/Capital – Inverse of Capitalization; a force multiplier – Leverage as a 2-Edged Sword 2018, Jay Cochran, III PhD )������*�)�������+�&����� • Assumptions: – Each Bank has $10M in Capital – Loans = 60% of B/S; earning Basic Spread = 2% Bank “C” Bank “R” 10% Cap.; Assets = $100M 5% Cap.; Assets = $200M Loans = $60M Loans = $120M Gross Margin = $1.2M Gross Margin = $2.4M ROK = 12% ROK = 24% • Now Assume Loan Losses = 10% – Bank “C” Loan Losses = $6M hit to capital ( impaired but still solvent) – Bank “R” Loan Losses = $12M hit to capital (insolvent) 2018, Jay Cochran, III PhD ������������������ • Rate Sensitivity Gap – Gap is typically negative (nature of banking) 1. Gap = Rate-sensitive Assets – Rate-sensitive Liabilities 2. ∆ Profits = Assumed ∆ in ST interest rates x Gap ∆ Profits/Assets = Implied Change in ROA 3. • Duration also measures Interest Rate Risk – Weights Assets & Liabilities by their maturities • Historical Gap Performance 2018, Jay Cochran, III PhD 3
10/5/2018 +�,�� �������������� Balancing Act : keep enough cash on hand to keep depositors happy, but not so much that you forego profitable lending opportunities • Primary Liquidity Ratio = Reserves/Deposits • Historical Liquidity Ratios 2018, Jay Cochran, III PhD (�� ���+����-.�������� • Charge-Offs/Capital • Some losses are expected (big losses are not) • Depends on Loss Recognition Speed – Past Due Accounts are “aged” • Typically become “Non-Performing” > 90 days past due – Mark-to-Market Rules Suspension (FASB 157) • Historical Credit Loss Experience 2018, Jay Cochran, III PhD ���/���(��������� • How does your bank compare to the US banking system as a whole? – Currently and historically – Is it earning profits and are they within “reason?” – Are higher credit losses necessarily bad? – How much liquidity is too much or too little? – Is the bank sufficiently capitalized? • Draw a conclusion re: your bank’s Safety & Soundness ������*�0������1��������������������������������������2�/������������%� $�������������&�������������� ������������ �����������������������&���&������������ �������������#��3������ ��������4�� ���������&�$���/�&�������&������/���,�� ����������������#���&�����$�������� ����� ��������� ��,�� ������� ��������������������#�� 2018, Jay Cochran, III PhD 4
10/5/2018 �������������� Akerloff’s “Lemons” problem • Buyers have difficulty discerning good quality cars from lemons – Suppose a good car sells for $2,000 and a lemon sells for $1,000 – If there’s a 50:50 chance of any given car being a lemon, then used cars will sell for an average $1,500. [E(V)] • $1,500 is not enough for sellers of good cars • That leaves only lemons in the market • Supposed to illustrate how markets can fail if there is a persistent information asymmetry …but…? We use information (professional opinions, histories, information services, prices themselves, etc.) to overcome information asymmetry problems. 2018, Jay Cochran, III PhD ��������������������� Information Asymmetry each side of a trade has a different information set. Information is unbalanced. • Adverse Selection: those most in need of a financial service are those most likely to seek it out, and those parties have information that the other does not. – Unobservable characteristic – Risks people bring to a prospective financial transaction that exist logically prior to the transaction • Smokers vs. non-smokers and insurance (price discrimination) • Moral Hazard: People respond to incentives. If a financial transaction changes incentives, it can also lead to changed behaviors. – Unobservable action – Behaviors that change after the financial event. • Reckless driving and car insurance • Deposit Insurance and Bailouts of “too big to fail” banks 2018, Jay Cochran, III PhD (���������������������� • Information is costly to obtain but once obtained is (potentially) easy to transmit/replicate – Valuable information often kept private – If info becomes public, gives rise to a potential “free rider” problem. • The inability to internalize all the benefits of information that becomes public ⇒ undersupply of information • Does not necessarily imply a role for public provision to make up for the undersupply – Low Value when publicly held – Repetitious information becomes stale, often ignored. • Optimum levels of information rather than maximum. – Balancing MC of an add’l bit of information vs. the MB of it 2018, Jay Cochran, III PhD 5
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