Banking, Investing and Insurance BUSINESS AND BANKING AND PROFITABILITY

2 Bank Earnings: Net Interest Income Loan interest and fees represent the main source of bank revenue, followed by interest on investment securities. Interest paid on deposits is the largest expense, followed by interest on other borrowings. Net interest income is the difference between gross interest income and gross interest expense.

3 Bank Earnings: Provision for Loan Losses Provision for loan losses is an expense item that adds to a bank’s loan loss reserve (a contra-asset account). Banks provide for loan losses in anticipation of credit quality problems in the loan portfolio. Loans are written off against the loan loss reserve

4 Bank Earnings: Non-interest income and expense Noninterest income includes fees and service charges. This source of revenue has grown significantly in importance. Noninterest expense includes personnel, occupancy, technology, and administration. These expenses have also grown in recent years.

5 Bank Performance 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.

6 Dilemma: Profitability vs. Safety 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 regulators Each with their own interest in profitability and safety.

7 Solvency and Liquidity Solvency: Maintaining the momentum of a going concern, attracting customers and financing. A firm is insolvent when the value of its liabilities exceeds the value of its assets. Banks have relatively low capital/asset ratios but generally high-quality assets. Liquidity: the ability to fund deposit withdrawals, loan requests, and other promised disbursements when due. A bank can be profitable and still fail because of illiquidity.

8 Conflicting Demands A bank must balance profitability, liquidity, and solvency. Bank failure can result from excessive 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 liquidity demands. If assets are profitable but illiquid, the bank also has a problem. Bank insolvency often leads to bank illiquidity.

9 Liquidity Management 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.

10 Asset Management 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

11 Asset Management (cont.) The bank must manage its assets to provide a compromise of liquidity and profitability. Primary and secondary reserve levels relate to: deposit variability other sources of liquidity (e.g. Fed funds) bank regulations - permissible areas of investment risk posture that bank management will assume

12 Liability Management Assumes bank can borrow its liquidity needs at will in money markets by paying market rate or better Liability levels (borrowing) may be quickly adjusted to loan (asset) needs or deposit variability Bank liability liquidity sources include “non- deposit borrowing" (e.g. Fed funds, etc.) LM supplements asset management, but does not supersede it

13 Definition of Bank Capital Tier 1 capital or “core” capital includes common stock, common surplus, retained earnings, non- cumulative perpetual preferred stock, minority interest in consolidated subsidiaries, minus goodwill and other intangible assets. Tier 2 capital or “supplemental” capital includes cumulative perpetual preferred stock, loan loss reserves, mandatory convertible debt, and subordinated notes and debentures.

14 Functions of Bank Capital Absorb losses on assets (loans) and limit the risk of insolvency. Maintain confidence in the banking system. Provide protection to uninsured depositors and creditors. Ultimate source of funds and leverage base to raise depositor funds.

15 Regulatory Capital Standards As capital requirements have increased, regulators have also implemented risk-based capital standards. Capital is measured against risk-weighted assets. Risk-weighting is a measure of total assets that weighs high-risk assets more heavily. The purpose is to require high-risk banks to hold more capital than low-risk banks.

16 Minimum Capital Requirements Ratio of Tier 1 capital to risk-weighted assets must be at least 4% Ratio of Total Capital (Tier 1 plus Tier 2) to risk-weighted assets must be at least 8%. Undercapitalized banks receive extra regulatory scrutiny; regulators may limit activities, intervene in management, or even revoke charter.

17 Managing Credit Risk 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.

18 Managing Credit Risk of Individual Loans Requires close monitoring to identify problem loans quickly The goal is to recover as much as possible once a problem loan is identified.

19 Managing Credit Risk of Loan Portfolio Internal Credit Risk Ratings are used to identify problem loans determine adequacy of loan loss reserves price loans 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.

Questions, Comments, Concerns 20