Bank Performance I Brent Vanderheide

Discussion Starter Q: Which bank would you rather own and why? Bank ABank B Difference A-B Interest Income3.55%3.90%(0.35%) Interest Expense1.15%0.60%0.55% Net Interest Income2.40%3.30%(0.90%) Provision0.80%1.25%(0.45%) Non Interest Income1.70%2.25%(0.55%) Non Interest Expense2.00%3.00%(1.00%) Net Overhead0.30%0.75%(0.45%) Pretax Income1.30% - Income Taxes0.30% - Net Income1.00% - 2

Our Journey: Year 1 Retail Strategy Retail Strategy Customer acquisition Branding & marketing Product & pricing Delivery optimization Bank Management Strategy Economic value & risk Capital considerations Analyst influences 360° executive management Financial Strategy Financial analysis Key performance drivers Earnings power Risk considerations 3

Objectives for Today’s Discussion  Understand the drivers behind Retail Bank Performance; connect drivers and outcomes  Explore Quality vs. Quantity of earnings— does it matter?  Provide some insight you can use in running your MarketSim bank and your Retail franchise back home 4

By way of review… Financial statements are a tool to summarize the results of the bank’s business activities. They represent the cumulative impact of transactions done by the bank and by the bank’s customers Balance SheetIncome Statement  Represents the financial position of the bank as of a specific point in time (the balance sheet date)  Reflects all the assets, liabilities (obligations), and shareholders equity (investment) as of that point in time  Summarizes the income and expense impact of transactions over a specific period of time  Reflects all the income or revenue generated, and all expenses or costs incurred  The bottom line result – net income (or loss!) – is added to the Retained Earnings account (part of shareholders equity) on the balance sheet 5

For Example: Balance Sheet December 31, 2013 Cash$100 Loans$1,000 Total Assets$1,100 Deposits$950 Shareholders Equity$150 Total Liabilities and Shareholders Equity$1,100 6

Income Statement reflects Revenue & Costs: Income Statement for year ended December 31, 2014 Transactions from January 1, 2014 through December 31, 2014 Interest income$50(a) Rec’d interest at 5% rate on loans Interest expense$(19)(b) Accrued interest at 2% rate on deposits Net Interest income$31 Non Interest income$5(c) Service charge fee Non-interest expense$20(d) Paid rent and salaries for the year Pretax income$16 Income taxes$4 Net income$12 7

Balance Sheet reflects increase in Cash, Deposits, and Profits: Balance Sheet December 31, 2013 Results of 2014 Transactions Balance Sheet December 31, 2014 Cash$ $131 Loans$1,000 Total Assets$1,100$1,131 Deposits$950+19$969 Shareholders Equity $150+12$162 Total Liabilities and Shareholders Equity $1,100$1,131 8

What this looks like in MarketSim 9

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How to evaluate Performance 11 Q: Bank A earned a 1% ROA for the period ending 12/31/14. How do you feel about that? ComparisonTime PeriodQuestions to Ask 1.Against ItselfAnalysis of bank performance against itself over time (trend)  Are the results of management’s chosen strategy becoming more evident over time?  Do I like the direction? 11 ComparisonTime PeriodQuestions to Ask 1.Against ItselfAnalysis of bank performance against itself over time (trend)  Are the results of management’s chosen strategy becoming more evident over time?  Do I like the direction? 2.Relative to peer performance Analysis of bank performance against peers either as of a point in time, or trended over time  Are management’s chosen strategies being executed successfully?  Are these strategies driving better outcomes than peers?  Consider changes in underlying drivers like market share, asset mix, and risk tolerance.

Quantity vs. Quality Q: Would you rather have high earnings, or high- quality earnings? A: Both, of course! The value of the bank is related to the sustainability and volatility of profits, perhaps more than the recent quantity of earnings. 12

Quantity of Earnings  2 classic measures to gauge the quantity of earnings: Return on Assets (ROA) Return on Equity (ROE) 13

Return on Assets (ROA)  Measures the ability of the bank's investments to generate net income  Calculated as:  Commonly expressed as a percent, with 2 decimal places  In our example, ROA is: $12 [($1100+$1131)/2] Net Income Average Total Assets = 1.08% or 108 basis points 14

Net Income Average Total Assets Return on Assets (ROA) Balance Sheet December 31, 2013 Results of 2014 Transactions Balance Sheet December 31, 2014 Cash$ $131 Loans$1,000 Total Assets$1,100$1,131 Deposits$950+19$969 Shareholders Equity $150+12$162 Total Liabilities and Shareholders Equity $1,100$1,131 ROA = $12 [($1100+$1131)/2] 1.08% or 108 basis points = = 15

Return on Equity (ROE)  Measures the net income generated based on the shareholders interest  Calculated as:  Commonly expressed as a percent, with 1 decimal place  In our example, ROE is: Net Income Average Common Stockholders Equity $12 [($150 + $162)/2] = 7.7% 16

Net Income Return on Equity (ROE) Balance Sheet December 31, 2013 Results of 2014 Transactions Balance Sheet December 31, 2014 Cash$ $131 Loans$1,000 Total Assets$1,100$1,131 Deposits$950+19$969 Shareholders Equity $150+12$162 Total Liabilities and Shareholders Equity $1,100$1,131 ROE= $12 [($150+$162)/2] 7.7% = = Avg. Common Equity 17

Where is Equity in MarketSim? 18

What is Equity? 19 Equity is a Source of Funds and serves as a ‘cushion’ on the balance sheet to reduce the risk that the bank’s creditors won’t be paid. Investments Loans Non-earning Assets Bank A Equity Other Borrowings Non-Int Bearing Interest Bearing Deposits Bank A Liabilities & Shareholders Equity Uses of Funds Sources of Funds 19

Quantity of Earnings Source: FDIC, Q: What kind of ROA should a bank earn? Commercial Bank Industry Averages (2013 most recent year) Last 5 years0.69% Last 10 years0.82% Last 20 years1.00% 1934 – 2013 series0.74% (2003, 1.35%) (1934, -0.77%) 20

The Balanced Scorecard   Q: Quantity of earnings is represented by only 2 metrics on the balanced scorecard, why? 21

By way of review… The Balanced Scorecard is intended to overcome issues with GAAP and focus on what management can control to drive sustainable earnings. Pros (+)Cons (-) Focuses on Retail Strategy Looks at all Drivers of Success Contains both Leading and Lagging Indicators Factors in Employees May not directly sync with Exec’s incentive plans Hard sell to CFO Will the “Street” give you time for the Scorecard to drive Earnings? 22

Quality of Earnings Q: Why is quality of earnings important? A: The value of the bank is related to the sustainability and volatility of profits. The notion of quality of earnings underlies 2 critical demands on management: Grow the value of the Franchise Generate Current Period Profit &

Quality of Earnings Net Interest Margin Asset QualityNon Interest IncomeEfficiency RatioLiquidity – Loan to Deposit Ratio  BSI Metrics used to gauge the quality of earnings: 24

Quality of Earnings - Example  Management desires to earn an ROA of 100bp, and have constructed this income statement profile to determine what rate to charge on loans:  Let’s compare that profile to recent results for the industry… ROA100 bp Income Taxes+ 30 bp Non Interest Expenses+ 200 bp Non Interest Income-170 bp Provision Expense+ 80 bp Interest Expense+ 115 bp Interest Income= 355 bp needed rate on loans 25

Quality of Earnings - Example Example BankIndustry Average Last 5 Years Difference (Example – Industry) Interest Income3.55%3.90%(0.35%) Interest Expense1.15%0.90%0.25% Net Interest Income2.40%3.00% 0.60% Provision Expense0.80%1.10%(0.30%) Non Interest Income1.70%1.75%(0.05%) Non Interest Expense2.00%2.95%(0.95%) Net Overhead0.30%1.20%(0.90%) Pretax Profit1.30%0.70%0.60% Income Taxes0.30%0.20%0.10% Net Income1.00%0.50% What questions would you have for management? Industry Average Source: FDIC, (Rounded for Discussion) 26

Net Interest Income  Interest income = f(rates earned on loans and investments) + f(proportion of the balance sheet made up of loans vs. securities vs. non-earning assets)  Interest expense = f(rates paid on deposits and borrowings) + f(proportion of the balance sheet funded by interest bearing liabilities vs. non-interest bearing deposits vs. equity) Net Interest Income Interest Income Interest Expense 27

Net Interest Income Which bank would have higher interest income? Non-earning Investments Loans Investments Loans Non-earning Assets Bank ABank B Equity Other Borrowings Non-Interest Bearing Dep Interest Bearing Deposits Equity Other Borrowings Non-Int Bear Interest Bearing Deposits Bank ABank B Liabilities & Shareholders Equity 28 Interest expense?

 Measures the difference between income generated from interest earning assets and interest paid to secure funding  Calculated as:  Commonly expressed as a percent, with 2 decimal places  In our example, the NIM is: Interest Income – Interest Expense Average Earning Assets Net Interest Margin (NIM) $50-$19 [($ $1000)/2] = 3.10% 29

Net Interest Income Income Statement for year ended December 31, 2013 Transactions from January 1, 2013 through December 31, 2013 Interest income$50(a) Rec’d interest at 5% rate on loans Interest expense$(19)(b) Accrued interest at 2% rate on deposits Net Interest income$31 Non Interest income$5(c) Service charge fee Non-interest expense$20(d) Paid rent and salaries for the year Pretax income$16 Income taxes$4 Net income$12 30

Net Interest Income Net Interest Margin (NIM) Balance Sheet December 31, 2013 Results of 2014 Transactions Balance Sheet December 31, 2014 Cash$ $131 Loans$1,000 Total Assets$1,100$1,131 Deposits$950+19$969 Shareholders Equity $150+12$162 Total Liabilities and Shareholders Equity $1,100$1,131 NIM= $50 - $19 [($1000+$1000)/2] 3.10% = = Avg. Earning Assets 31

Strategy in the Sim… Q: Which portfolio would you rather have based on Margin? 32

Provision  Provision = the credit loss expense for the (year; quarter; month)  Provision expense is based on a forecast of future credit losses. This forecast reflects:  Recent past results, for example loan charge-offs in the last year  Forward looking indicators, for example the percentage of loans that are delinquent as of the balance sheet date  Environmental factors, for example the health of the housing market may influence losses in a mortgage portfolio 33

What is Risk? Q: Is RISK the occurrence of a LOSS? A: NO!  Losses are an expected part of doing business  Expected losses are included in the calculation when you set the price. For example: 34

Setting a Loan Rate Income ContributionRate Desired Profit1.50% Income Tax.50% Operating Expenses1.50% Expected Credit Loss1.00% Cost of Funds0.75% Needed Customer Rate5.25% 35

What is Risk? Risk is volatility in the range of possible outcomes; it is the possibility of not achieving your objective. 36

What is Risk? Q: Is RISK the occurrence of a LOSS? A: No! Risk taking results in volatility of [credit losses, net interest income, liquidity, etc.] – reflecting business choices 37

Provision Income Statement for year ended December 31, 2014 Transactions from January 1, 2014 through December 31, 2014 Interest income$50(a) Rec’d interest at 5% rate on loans Interest expense$(19)(b) Accrued interest at 2% rate on deposits Net Interest income$31 Provision for Credit Loss$10(e) 1% expected loss on $1,000 of loans Non Interest income$5(c) Service charge fee Non-interest expense$20(d) Paid rent and salaries for the year Pretax income$6 Income taxes$1 Net income$5 38

Allowance for Losses Balance Sheet December 31, 2013 Results of 2014 Transactions Balance Sheet December 31, 2014 Cash$ $134 Loans$1,000 ALLL$0+10($10) Total Assets$1,100$1,124 Deposits$950+19$969 Shareholders Equity $150+5$155 Total Liabilities and Shareholders Equity $1,100$1,124 39

Asset Quality on BSI  Provision = f(expected loss by asset class as an outcome of risk appetite, credit standards, and go-to-market strategy) + f(environmental factors)  Average Earning Assets = f(target customer segments, product design, credit policy, other competitive factors) Provision to Assets Provision Average Earning Assets 40

 Measures the level of current period provision (expected loss) as a percent of average earning assets  Calculated as:  Expressed as a percent, with 2 decimal places  In our example, Provision to Assets is: Provision Average Earning Assets Asset Quality on the BSI $10 [($ $990)/2] = 1.01% 41

Asset Quality on the BSI Balance Sheet December 31, 2013 Results of 2014 Transactions Balance Sheet December 31, 2014 Cash$ $134 Loans$1,000 ALLL$0+10($10) Total Assets$1,100$1,124 Deposits$950+19$969 Shareholders Equity $150+5$155 Total Liabilities and Shareholders Equity $1,100$1,124 Provision = $10 [($1000+$990)/2] 1.01% = = Avg. Earning Assets Provision to Assets 42

Asset Quality 43 Which bank would have better Asset Quality, all else held equal? Non-earning Investments Home Equity Investments Home Equity Non-earning Assets Bank ABank B Credit Card Lines / Loans 43

Strategy in the Sim… Q: Which loan portfolio would you rather have? 44

Net Overhead  Non Interest Income is primarily influenced by the business mix of the bank. Major categories of non interest income include deposit service charges, debit and credit card interchange and fees, trust fees, and mortgage fees  Non Interest Expense compromises both recurring expenses (major categories include personnel expenses, facilities (including branch) costs, operations and technology) and non-recurring expenses (notably goodwill impairment)  Consider the sustainability question – are all fees created equal? Should all expenses be viewed in the same light? Net Overhead Non Interest Income Non Interest Expense 45

 Measures Non Interest Income contribution to ROA (as a percent of average earning assets)  Calculated as:  Expressed as a percent, with 2 decimal places  In our example, Non Interest Income to Assets is: Non Interest Income Average Earning Assets Non Interest Income to Assets $5 [($ $990)/2] = 0.50% 46

Non Interest Income to Assets Balance Sheet December 31, 2013 Results of 2014 Transactions Balance Sheet December 31, 2014 Cash$ $134 Loans$1,000 ALLL$0+10($10) Total Assets$1,100$1,124 Deposits$950+19$969 Shareholders Equity $150+5$155 Total Liabilities and Shareholders Equity $1,100$1,124 Non Interest Income = $5 [($1000+$990)/2] 0.50% = = Avg. Earning Assets Non Int. Inc. to Assets 47

 Measures the level of operational expense it takes to generate a dollar of revenue  Calculated as:  Commonly expressed as a percent, with 1 decimal places  In our example, the Efficiency Ratio is: Non Interest Expense Net Interest Income + Non Interest Income Efficiency Ratio $20 ($5 + $31) = 55.5% 48

Efficiency Ratio Income Statement for year ended December 31, 2014 Transactions from January 1, 2014 through December 31, 2014 Interest income$50(a) Rec’d interest at 5% rate on loans Interest expense$(19)(b) Accrued interest at 2% rate on deposits Net Interest income$31 Provision for Credit Loss$10(e) 1% expected loss on $1,000 of loans Non Interest income$5(c) Service charge fee Non-interest expense$20(d) Paid rent and salaries for the year Pretax income$6 Income taxes$1 Net income$5 Non-interest Expense = $20 ($5+$31) = =55.5% Total Revenue Efficiency Ratio 49

Q:What causes bank failures? A:Insolvency (meaning not enough capital)? Or lack of liquidity? Consider IndyMac Liquidity Risk 50

Liquidity risk is the possibility that over a specific time horizon the bank will become unable to settle obligations with immediacy Liquidity Risk 51

Liquidity Risk  How you can create liquidity risk  As chief retail officer, you create two products – 5 year fixed rate loans, and money market savings accounts  Loan customers have the option to prepay, but the bank has no option to demand early payment  Deposit customers have the option to withdraw any and all funds daily, but the bank has no option to restrict withdrawals  Does the bank have liquidity risk? 52

 Measures the proportion of deposit funds that are invested in less liquid loan assets  Calculated as:  Commonly expressed as a percent, with 1 decimal places  In our example, the Loan to Deposit Ratio as of December 31, 2013 is: Total Loans Total deposits Loan to Deposit Ratio $990 $969 = 102.2% 53

Loan to Deposit Ratio Balance Sheet December 31, 2013 Results of 2014 Transactions Balance Sheet December 31, 2014 Cash$ $134 Loans$1,000 ALLL$0+10($10) Total Assets$1,100$1,124 Deposits$950+19$969 Shareholders Equity $150+5$155 Total Liabilities and Shareholders Equity $1,100$1,124 Total Loans = $990 $ % = = Total Deposits Loan to Deposit Ratio 54

Strategy in the Sim… Q: Which Market$im bank illustrates the lowest liquidity risk? 55

The Balanced Scorecard   We have reviewed Quantity of Earnings and a handful of normative metrics on Quality of Earnings, but what about the Drivers of Earnings?     cc 56

Retail Bank Profitability Equation  NIM Net Interest Margin  NII Non Interest Income  NIE Non Interest Expense  RLL Retail Loan Losses NIMNIINIERLLNIBT 57

Customer Based Profitability  Moves financials out of accounting to the people who generate the profits  Can be computed on a single customer, a geography, or a market segment  Actionable information 58 Customers Products per Customer Product Profitability Delivery Costs Profits

Drivers and Outcomes In order to drive long-term sustainability and current period balance sheet and income statement outcomes, Retail officers must focus on the underlying drivers. Drivers must…Outcomes must…  Be actionable  Be measurable  Be controllable by Retail bank management  Lead to long-term predictable expected outcomes  Represent the future of your strategy  Be long-run focused  Be not only bottom line focused  Drive current period financial performance and great long-term value 59

Drivers on the BSI DriverDescriptionCustomer Profitability CRA  LMI Performance  Specialized products and marketing  Increased delivery costs Product Breadth  Products offered  Broader customer appeal  Increased product cost Access to Delivery  Branches, ATMs and Channels  Increased delivery costs  Customer appeal & retention Customer Service  Call Center, Mobile & Online  Increased delivery costs  Customer appeal & retention Market Share  Customers, Balances  More customers!  Increased efficiency Turnover  Customers gained / lost  Customer retention / growth Cost per Tran  Expenses, transactions  Optimize delivery cost 60

Bank Performance Summary Quantity Quality Business Strategy Drivers Outcomes BSI Metric ROE, ROA Asset Quality, Liquidity Ratio, Efficiency Ratio, NIM, Non- interest income to Assets CRA, Product Breadth, Access to Delivery, Customer Service, Market Share, Turnover, Cost per Tran 61

Why does this Matter? This matters because we are managing a bank to create value! Stock Price = EPS x P/E [earnings per share; price earnings ratio] P/E = f(future earnings, variability of future earnings) Variability = f(inherent risks, quality of risk management) 62

Compare two banks … different strategies, different results Bank ABank B Difference A-B Interest Income3.55%3.90%(0.35%) Interest Expense1.15%0.60%0.55% Net Interest Income2.40%3.30%(0.90%) Provision0.80%1.25%(0.45%) Non Interest Income1.70%2.25%(0.55%) Non Interest Expense2.00%3.00%(1.00%) Net Overhead0.30%0.75%(0.45%) Pretax Income1.30% - Income Taxes0.30% - Net Income1.00% - 63

Compare two banks … different strategies, different results  Bank A Strategy  Low investment operator (but might look like low cost operator)  National geographic reach  Reliance on wholesale deposits for funding  Reliance on broker network for loan origination  Limited customer cross sell and depth of relationship  Non interest income primarily related to fees from selling loans  Bank B Strategy  Tight geographic focus, dense retail delivery network  Reliance on customer deposit base for funding  Focus on in-market and customer cross-sell for loan origination  High depth of relationship (number of services per household)  Non interest income primarily related to core deposit products Let’s look at the results again! 64

Compare two banks … different strategies, different results Bank ABank B Difference A-B Interest Income3.55%3.90%(0.35%) Interest Expense1.15%0.60%0.55% Net Interest Income2.40%3.30%(0.90%) Provision0.80%1.25%(0.45%) Non Interest Income1.70%2.25%(0.55%) Non Interest Expense2.00%3.00%(1.00%) Net Overhead0.30%0.75%(0.45%) Pretax Income1.30% - Income Taxes0.30% - Net Income1.00% - 65

Back to our Objectives…  Understand the drivers behind Retail Bank Performance; connect drivers and outcomes  Explore Quality vs. Quantity of earnings— does it matter?  Provide some insight you can use in running your MarketSim bank and your Retail franchise back home 66

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