1. ANALYZING BANK PERFORMANCE: USING THE UBPR
Bank Management, 5th edition. Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning
ANALYZING BANK PERFORMANCE: USING THE UBPR
Chapter 3

2. Balance Sheet Assets = Liabilities + Equity.
Balance sheet figures are calculated at a particular point in time and thus represent stock values.
Like other financial intermediaries, commercial banks facilitate the flow of funds from surplus spending units (savers) to deficit spending units (borrowers). Their financial characteristics largely reflect government-imposed operating restrictions and peculiar features of the specific markets served. Three characteristics stand out. First, because their function is primarily financial, most banks own few fixed assets. They have few fixed costs, and thus low operating leverage. Second, many bank liabilities are payable on demand or carry short-term maturities so depositors can renegotiate deposit rates as market interest rates change. As a result, interest expense changes coincidentally with short-run changes in market interest rates. This creates significant asset allocation and pricing problems. Third, banks operate with less equity capital than nonfinancial companies, which increases financial leverage and the volatility of earnings. Each characteristic presents special problems and risks to the bank manager.
The Balance Sheet
A bank’s balance sheet presents financial information comparing what a bank owns with what it owes and the ownership interest of stockholders. Assets indicate what the bank owns; liabilities represent what the bank owes; and equity refers to the owners’ interest such that:
Assets = Liabilities + Equity
Balance sheet figures are calculated at a particular point in time and thus represent stock values. Regulators require that banks report balance sheet and income statement data quarterly, so figures are available publicly at the end of March, June, September, and December each year.

3. Bank Assets Cash and due from banks Investment Securities Loans
Cash and due from banks
vault cash, deposits held at the Fed and other financial institutions, and cash items in the process of collection.
Investment Securities
assets held to earn interest and help meet liquidity needs.
Loans
the major asset, generate the greatest amount of income, exhibit the highest default risk and are relatively illiquid.
Other assets
bank premises and equipment, interest receivable, prepaid expenses, other real estate owned, and customers' liability to the bank
Bank assets fall into one of four general categories: loans, investment securities, noninterest cash and due from banks, and other assets. Loans are the major asset in most banks’ portfolios and generate the greatest amount of income before expenses and taxes. They also exhibit the highest default risk and are relatively illiquid. Investment securities are held to earn interest, help meet liquidity needs, speculate on interest rate movements, and serve as part of a bank’s dealer functions. Noninterest cash and due from banks consists of vault cash, deposits held at Federal Reserve Banks, deposits held at other financial institutions, and cash items in the process of collection. These assets are held to customer withdrawal needs, meet legal reserve requirements, assist in check clearing and wire transfers, or effect the purchase and sale of Treasury securities. Other assets are residual assets of relatively small magnitudes such as bankers acceptances, premises and equipment, other real estate owned and other smaller amounts.

4. Balance Sheet (assets): PNC and Community National Bank
Loans. A bank negotiates loan terms with each borrower that vary with the use of proceeds, source of repayment, and type of collateral. Maturities range from call loans payable on demand to residential mortgages amortized over 30 years. The interest rate may be fixed over the life of the loan or vary with changes in market interest rates. Similarly, the loan principal may be repaid periodically or as a lump sum. Exhibit 3.2 groups loans into six categories according to the use of proceeds: real estate, commercial, individuals, agricultural, other loans in domestic offices, and loans in foreign offices. Real estate loans are loans secured by real estate and generally consist either of property loans secured by first mortgages or interim construction loans. Commercial loans consist of commercial and industrial loans, loans to financial institutions, and obligations (other than securities) to states and political subdivisions. Commercial loans appear in many forms but typically finance a firm’s working capital needs, equipment purchases, and plant expansions. This category also includes credit extended to other financial institutions, security brokers, and dealers. Loans to individuals include those negotiated directly with individuals for household, family, and other personal expenditures, and those obtained indirectly through the purchase of retail paper. Loans made for the purchase of credit card items and durable goods comprise the greatest volume of this consumer credit. Agricultural loans appear in many forms but typically finance agricultural production and include other loans to farmers. Other loans in domestic offices include all other loans and all lease-financing receivables in domestic offices. International loans, labeled loans and leases in foreign offices, are essentially business loans and lease receivables made to foreign enterprises or loans guaranteed by foreign governments. Finally, the dollar amount of outstanding leases is included in gross loans because lease financing is an alternative to direct loans.
The primary attraction to investment securities is that they earn interest and the administration and transaction costs are extremely low. Banks also concentrate their purchases on higher quality instruments so that defaults are rare. When interest rates fall, as they did during much of 1990s, most investment securities increase in value because they carry above average interest rates. Banks can either earn very attractive yields relative to their borrowing costs or sell the securities at a gain. In terms of liquidity, banks own a large amount of short-term securities that can be easily sold to obtain cash. Because of their lower risk, they generally earn less interest than what can be earned on longer-term securities. These short-term investments include interest-bearing bank balances (deposits due from other banks), federal funds sold, securities purchased under agreement to resell (repurchase agreements or RPs), Treasury bills, and municipal tax warrants. They have maturities ranging from overnight to one year and carry returns that vary quickly with changes in money market conditions. They are extremely liquid as they can be easily sold at a price close to that initially paid by the bank.
Long-term investment securities consist of notes and bonds that generate taxable or tax-exempt interest. Treasury securities and obligations of federal agencies, such as the Farm Credit Association, comprise the bulk of taxable investments.[1] Banks also purchase mortgage-backed securities and small amounts of foreign and corporate bonds. Most of these carry fixed-rate interest rates with maturities up to 20 years. Until 1983 banks owned more state and municipal securities than any other investor group. These government securities are classified as general obligation or revenue bonds and pay interest that is exempt from federal income taxes. Recent changes in bank tax rules, however, have made most municipal securities unattractive to banks.[2] Banks cannot generally purchase corporate stock as an investment, but can own it under two conditions: if it is acquired as collateral on a loan, and as members of the Federal Reserve System or Federal Home Loan Bank system wherein they own stock in the Federal Reserve Bank and Federal Home Loan Bank.
[1] The asset category “U.S. Treasury & Agency Securities” listed in the Uniform Bank Performance Report is somewhat misleading. This category is actually defined as the total of U.S. Treasury and Agency securities and corporate obligations. This, in practice, would include almost all of the securities in a bank’s portfolio except for municipal, foreign, and equity securities. For more information consult the UBPR User’s guide available from the FFIEC on the Internet at
[2] As noted in Chapter 2, the Tax Reform Act of 1986 eliminated bank deductions for borrowing costs associated with financing the purchase of most municipal bonds. The impact of this tax change is described in Chapter 20.
Noninterest cash and due from banks. This asset category consists of: vault cash, deposits held at Federal Reserve Banks, deposits held at other financial institutions, and cash items in the process of collection. Vault cash is coin and currency that the bank holds to meet customer withdrawals. Deposits held at Federal Reserve (or other) banks are demand balances used to meet legal reserve requirements, assist in check clearing and wire transfers, or effect the purchase and sale of Treasury securities. The amount of required reserve deposits is set by regulation as a fraction of qualifying bank deposit liabilities and currently stands at 10 percent of transactions deposits. Banks hold balances at other financial institutions, called correspondent banks, primarily to purchase services. The amount is determined by the volume and cost of services provided such that income from investing the deposits at least covers the cost of the services provided by the correspondent bank. The largest component of cash assets, cash items in the process of collection (CIPC), represents checks written against other institutions and presented to the bank for payment for which credit has not been given. To verify that actual balances support each check, the bank delays credit until the check clears or a reasonable time elapses. The volume of net deferred credit is commonly called float.
Other assets. Residual assets of relatively small magnitudes, including customers’ liability to the bank under acceptances (acceptances), the depreciated value of bank premises and equipment, other real estate owned (OREO), investment in unconsolidated subsidiaries, interest receivable, and prepaid expenses. For many problem banks, other real estate owned is substantial because it normally represents property taken as collateral against a loan that was unpaid. As indicated earlier, commercial banks own relatively few fixed assets. They operate with low fixed costs relative to nonfinancial firms and exhibit low operating leverage.

5. Adjustments to total loans …three adjustments are made to obtain a net loan figure.
First, The dollar amount of outstanding leases is included in gross loans.
Second, unearned income is deducted from gross interest received.
Finally, gross loans are reduced by the dollar magnitude of a bank's loan-loss reserve, which exists in recognition that some loans will not be repaid.
Two adjustments are made to gross loans and leases to obtain a net loan figure. First, unearned income is deducted from gross interest received. Unearned income is income that has accrued but not yet been paid. Second, gross loans are reduced by the dollar magnitude of a bank’s loan and lease loss allowance (loan loss reserve), which exists in recognition that some loans will not be repaid. The reserve’s maximum size is determined by tax law but increases with the growth in gross loans and decreases with net loan charge-offs. A bank is permitted a tax deduction for net additions to the loss reserve, denoted as the provision for loan losses on the income statement.

6. Provisions for loan losses
Recoveries
Provisions for loan losses
Reserve for Loan Losses
Charge offs

7. Bank investments and FASB 115
Following FASB 115 a bank, at purchase, must designate the objective behind buying investment securities as either:
held-to-maturity securities are recorded on the balance sheet at amortized cost.
trading account securities are actively bought and sold, so the bank marks the securities to market (reports them at current market value) on the balance sheet and reports unrealized gains and losses on the income statement.
available-for-sale, all other investment securities, are recorded at market value on the balance sheet with a corresponding change to stockholders’ equity as unrealized gains and losses on securities holdings.
At purchase, a bank must designate the objective behind buying investment securities as either held-to-maturity, trading, or available for sale. Following FASB 115, held-to-maturity securities are recorded on the balance sheet at amortized cost. This treatment reflects the objective to hold the securities until they mature so that the expected income is interest income with a return of principal at maturity. A bank actively buys and sells trading account securities principally to speculate on interest rate movements and profit on price changes. These securities are typically held for brief periods, such as a few days, so the bank marks the securities to market (reports them at current market value) on the balance sheet and reports unrealized gains and losses on the income statement. All other investment securities are classified as available-for-sale because management may choose to sell them prior to final maturity. As such, they are recorded at market value on the balance sheet with a corresponding change to stockholders’ equity as unrealized gains and losses on securities holdings. There is no reporting of gains or losses on the income statement with these securities.

8. Average assets, capital and loan loss data: PNC and Community National Bank

9. Bank liabilities Demand deposits
transactions accounts that pay no interest
Negotiable orders of withdrawal (NOWs) and automatic transfers from savings (ATS) accounts
pay interest set by each bank without federal restrictions
Money market deposit accounts (MMDAs)
pay market rates, but a customer is limited to no more than six checks or automatic transfers each month
Savings and time deposits represent the bulk of interest-bearing liabilities at banks.
Bank funding sources are classified according to the type of debt instrument and equity component. The characteristics of various debt instruments differ in terms of check-writing capabilities, interest paid, maturity, whether they carry FDIC insurance, and whether they can be traded in the secondary market.
Demand deposits are transactions accounts held by individuals, partnerships, corporations, and governments that pay no interest. Prior to the Depository Institutions Act of 1980, they served as the only legal transactions account nationally that could be offered by depository institutions. Businesses now own the bulk of existing demand deposits because they are not allowed to own interest-bearing transactions accounts at banks.
NOW and ATS accounts and Money Market Deposit Accounts (MMDAs) represent interest-bearing transactions accounts.[1] Negotiable orders of withdrawal (NOW) and automatic transfers from savings (ATS) accounts pay interest set by each bank without federal restrictions. Banks often require minimum balances before a depositor earns interest, impose service charges, and may limit the number of free checks a customer can write each month, but these terms vary among institutions. NOWs are available only to noncommercial customers. Money market deposit accounts (MMDAs) similarly pay market rates, but a customer is limited to no more than six checks or automatic transfers each month. This restriction exempts banks from holding required reserves against MMDAs as they are technically savings accounts. Thus, banks can pay higher rates of interest on MMDAs versus NOWs for the same effective cost.
Savings and time deposits have, in the past, represented the bulk of interest-bearing liabilities at banks. Today, however, MMDAs and time deposits under $100,000 have become the larger source of interest bearing liabilities. Passbook savings deposits are small-denomination accounts that have no set maturity and no check-writing capabilities.

10. Bank liabilities (continued)
Two general time deposits categories exist:
Time deposits in excess of $100,000, labeled jumbo certificates of deposit (CDs).
Small CDs, considered core deposits which tend to be stable deposits that are typically not withdrawn over short periods of time.
Deposits held in foreign offices
balances issued by a bank subsidiary located outside the U.S.
Rate-sensitive borrowings:
Federal Funds purchased and
Repos
Two general time deposit categories exist with a $100,000 denomination separating the groups. Time deposits of $100,000 or more are labeled jumbo certificates of deposit (CDs) and are negotiable with a well established secondary market. Anyone who buys a jumbo CD can easily sell it in the secondary market as long as the issuing bank is not suffering known problems. The most common maturities are one month, three months, and six months, with $1 million the typical size. Most CDs are sold to nonfinancial corporations, local governmental units, and other financial institutions. The features of smaller time deposits under $100,000 are not as standardized. Banks and customers negotiate the maturity, interest rate, and dollar magnitude of each deposit. The only stipulation is that small time deposits carry early withdrawal penalties whereby banks reduce the effective interest paid if a depositor withdraws funds prior to the stated maturity date. Most banks market standardized instruments so that customers are not confused. Brokered deposits refer to jumbo CDs that a bank obtains through a brokerage house that markets the CDs to its customers. These are separated because the bank has virtually no customer contact with the holders of these CDs and the funds will leave the bank quickly when a competitor offers a higher rate. [1] Prior to 1983, banks and savings and loans could not pay market interest rates on most deposits under $100,000. Limits were gradually removed so that by 1986 only demand deposit rates were restricted.
Deposits held in foreign offices refers to the same types of dollar-denominated demand and time deposits discussed above except that the balances are issued by a bank subsidiary (owned by the bank holding company) located outside the United States. The average foreign deposit balance is generally quite large. Nonfinancial corporations engaged in international trade and governmental units own most of these deposits.
Large banks also rely on other rate-sensitive borrowings that can be used to acquire funds quickly; federal funds purchased and resales are the most popular source. Resales represent securities sold under agreement to repurchase (RPs) and are essentially collateralized federal funds borrowings. These immediately available funds are traded in multiples of $1 million overnight or with extended maturities. Reputable banks need only offer a small premium over the current market rate to acquire funds. Large banks also issue commercial paper through their holding companies. Commercial paper represents short-term, unsecured corporate promissory notes.

11. Core versus volatile funds
Core deposits are stable deposits that are not highly interest rate-sensitive.
Core deposits are more sensitive to the fees charged, services rendered, and location of the bank.
Core deposits include: demand deposits, NOW accounts, MMDAs, and small time deposits.
Large, or volatile, borrowings are liabilities that are highly rate-sensitive.
Normally issued in uninsured denominations.
Their ability to borrow is sensitive to the markets perception of their asset quality.
Volatile liabilities or net non-core liabilities include: large CDs (over 100,000), deposits in foreign offices, federal funds purchased, repurchase agreements, and other borrowings with maturities less than one year.*
*The UBPR also includes brokered deposits less than $100,000 and maturing within one year in the definition of net noncore liabilities.
Liabilities that are highly rate-sensitive do not represent a stable source of funding, particularly when a bank gets into trouble. They are normally issued in denominations above the amount that is federally insured so the depositor bears some risk of default. Thus, if a bank reports problems or a competitor offers a higher rate, customers are quite willing to move their deposits. Jumbo CDs, deposits in foreign offices, federal funds purchased, RPs, and other borrowings with maturities of less than one year, are subsequently referred to as volatile liabilities, purchased liabilities, or hot money. The UPBR defines the sum of these accounts as short-term noncore funding.[1]7
[1] Short-term noncore funding is normally defined in the UBPR as certificates of deposit and open account time deposits of $100,000 or more, brokered deposits less than $100,000, other borrowings, and deposits in foreign offices, securities sold under agreements to repurchase, federal funds purchased all with maturities less than one year as well as cumulative foreign currency translation adjustments and demand notes issued to the United States Treasury.

12. Balance Sheet (liabilities): PNC and Community National Bank

13. Stockholders equity Subordinated notes and debentures:
notes and bonds with maturities in excess of one year.
Stockholders' equity
Ownership interest in the bank.
Common and preferred stock are listed at par
Surplus account represents the amount of proceeds received by the bank in excess of par when it issued the stock.
Larger banks also issue subordinated notes and debentures, which are basically long-term uninsured debt. The components of equity (common and preferred capital) also have different characteristics and arise under varied circumstances such as the issuance of stock, net income not paid out as dividends, and Treasury stock or related transactions.
Subordinated notes and debentures consist of notes and bonds with maturities in excess of one year. Most meet requirements as bank capital for regulatory purposes. Unlike deposits, the debt is not federally insured and claims of bondholders are subordinated to claims of depositors. Thus, when a bank fails, depositors are paid before subordinated debt holders. Other liabilities include acceptances outstanding, taxes and dividends payable, trade credit, and other miscellaneous claims.
All common and preferred capital, or stockholders’ equity, is the ownership interest in the bank. Common and preferred stock are listed at their par values while the surplus account represents the amount of proceeds received by the bank in excess of par when it issued the stock. Retained earnings represents the bank’s cumulative net income since the firm started operation, minus all cash dividends paid to stockholders. Other equity is small and usually reflects capital reserves. The book value of equity equals the difference between the book value of assets and aggregate liabilities. A detailed discussion of each component of stockholders’ equity and associated regulatory requirements appears in Chapter 13.

14. Risk Based Capital: PNC and Community National Bank

15. The income statement Interest income (II) Interest expense (IE)
Interest income less interest expense is net interest income (NII)
Loan-loss provisions (PL)
represent management's estimate of potential lost revenue from bad loans.
Noninterest income (OI)
Noninterest expense (OE)
noninterest expense usually exceeds noninterest income such that the difference is labeled the bank's burden
Taxes
A bank’s income statement reflects the financial nature of banking, as interest on loans and investments comprises the bulk of revenue. Interest income made up approximately 93 percent of total income at a bank in 1981, but only about 74 percent of total income at the end of The trend away from interest income toward noninterest income, as shown in Exhibit 3.3, has played a major role in changing bank management. Interest payments on borrowings similarly represent the primary expense.
The income statement format starts with interest income then subtracts interest expense to produce net interest income. As described below, net interest income must be large enough to cover a bank’s expenses and taxes such that changes in net interest income dramatically affect aggregate profitability. The other major source of bank revenue is noninterest income, which is comprised primarily of deposit service charges and fee income. After adding noninterest income, banks subtract noninterest expense, which represents overhead costs. Although banks constantly try to increase their noninterest income and reduce noninterest expense, the latter usually exceeds the former such that the difference is labeled the bank’s burden. Formally, a bank’s burden equals noninterest expense minus noninterest income. The next step is to subtract provisions for loan and lease losses, which represent management’s estimate of potential lost revenue from bad loans. The resulting figure essentially represents operating income before securities transactions and taxes. Next, realized gains or losses from the sale of securities are added to produce pretax net operating income. Subtracting applicable income taxes, tax equivalent adjustments, and any extraordinary items yields net income.

16. Income statement (interest income and expenses): PNC and Community National Bank
Interest income is the sum of interest and fees earned on all of a bank’s assets, including loans, deposits held at other institutions, municipal and taxable securities, and trading account securities. It also includes rental receipts from lease financing. All income is taxable, except for the interest on state and municipal securities and some loan and lease income, which is exempt from federal income taxes. The estimated tax benefit for loan and lease financing and tax-exempt securities income is the estimated dollar tax benefit from not paying taxes on certain loan and lease receivables and tax-exempt municipal securities. For comparative purposes, tax-exempt interest income can be converted to a taxable equivalent (te) amount by dividing tax-exempt interest by one minus the bank’s marginal income tax rate. The estimated tax benefit on municipal securities can be approximated by:[1]
[1] Actually, the estimated tax benefit is calculated on the UBPR using a tax-equivalent adjustment worksheet. You can find this worksheet on the FFIEC’s Web page at

17. Income statement (noninterest income and expenses): PNC and Community National Bank

18. Interest income …the sum of interest and fees earned on all of a bank's assets.
Interest income includes interest from:
Loans
Deposits held at other institutions,
Municipal and taxable securities, and
Investment and trading account securities.
Interest income is the sum of interest and fees earned on all of a bank’s assets, including loans, deposits held at other institutions, municipal and taxable securities, and trading account securities. It also includes rental receipts from lease financing. All income is taxable, except for the interest on state and municipal securities and some loan and lease income, which is exempt from federal income taxes. The estimated tax benefit for loan and lease financing and tax-exempt securities income is the estimated dollar tax benefit from not paying taxes on certain loan and lease receivables and tax-exempt municipal securities. For comparative purposes, tax-exempt interest income can be converted to a taxable equivalent (te) amount by dividing tax-exempt interest by one minus the bank’s marginal income tax rate. The estimated tax benefit on municipal securities can be approximated by:[1]
Estimated tax benefit=Muni income / (1 – marginal tax rate) =municipal interest income
[1] Actually, the estimated tax benefit is calculated on the UBPR using a tax-equivalent adjustment worksheet. You can find this worksheet on the FFIEC’s Web page at

19. Noninterest expense …composed primarily of:
Personnel expense:
salaries and fringe benefits paid to bank employees,
Occupancy expense :
rent and depreciation on equipment and premises, and
Other operating expenses:
utilities and
deposit insurance premiums.
Noninterest expense is composed primarily of personnel expense, which includes salaries and fringe benefits paid to bank employees, occupancy expense from rent and depreciation on equipment and premises, and other operating expenses, including technology expenditures, utilities, and deposit insurance premiums. Noninterest expense far exceeds noninterest income at most banks, hence the label burden. Reducing this burden will improve profitability. Because most banks today face great pressure to keep net interest income from shrinking, they have aggressively tried to raise fee income and cut expenses to support profit growth.
Provision for loan and lease losses is a deduction from income representing a bank’s periodic allocation to its loan and lease loss allowance (loan loss reserve) on the balance sheet. Conceptually, management is allocating a portion of income to a reserve to protect against potential loan losses. It is a noncash expense but indicates management’s perception of the quality of the bank’s loans. It is subtracted from net interest income in recognition that some of the reported interest income overstates what will actually be received when some of the loans go into default. Although management determines the size of the provision and thus what is reported to stockholders, Internal Revenue Service (IRS) rules specify the maximum allowable tax deduction, which normally exceeds what is reported to shareholders.

20. Non-interest expense
Expenses and loan losses directly effect the balance sheet.
The greater the size of loan portfolio, the greater is operating overhead and PLL.
Consumer loans are usually smaller and hence more expensive (non-interest) per dollar of loans.
A bank’s balance sheet and income statement are interrelated. The composition of assets and liabilities and the relationships between different interest rates determine net interest income. The mix of deposits between consumer and commercial customers affects the services provided and thus the magnitude of noninterest income and noninterest expense. The ownership of nonbank subsidiaries increases fee income but often raises noninterest expense. The following analysis emphasizes these interrelationships.

21. Return on equity (ROE = NI / TE) … the basic measure of stockholders’ returns
ROE is composed of two parts:
Return on Assets (ROA = NI / TA),
represents the returns to the assets the bank has invested in.
Equity Multiplier (EM = TA / TE),
the degree of financial leverage employed by the bank.

22. Return on assets (ROA = NI / TA) …can be decomposed into two parts:  Asset utilization (AU) → income generation  Expense ratio (ER) → expense control
ROA = AU - ER = (TR / TA) - (TE / TA) Where:
TR = total revenue or total operating income = Int. inc. + non-int. inc. + SG(L) and
TE = total expenses = Int. exp. + non-int. exp. + PLL + Taxes

23. Interest expense ratio = Interest expense (IE) / Avg. total assets
ROA is driven by the bank’s ability to: …generate income (AU) and control expenses (ER)
Income generation (AU) can be found on the UBPR (page 1) as:
Expense Control (ER) can be found on the UBPR (page 1) as:
Consider first the expense ratio (ER), which has a very intuitive interpretation. For example, an ER of 5.5 percent indicates that a bank’s gross operating expenses equal 5.5 percent of total investment; that is, total assets. Thus, the lower (greater) the ER, the more (less) efficient a bank will be in controlling expenses. For example, suppose that two banks have the same total assets, but one reports total expenses that are twice as large as the other’s --ER is twice as large. To produce this difference, the bank with the greater ER reported higher expenses.
The decomposition of ER appears at the top of Exhibit 3.5. Three additional ratios isolate the impact of specific types of operating expenses:
Interest expense ratio = Interest expense (IE) / Avg. total assets
Noninterest expense ratio = Noninterest expense (OE) / Avg. total assets
Provision for loan loss ratio = Provisions for loan losses (PLL) / Avg. total assets
The sum of these ratios equals the total expense ratio
The decomposition of AU appears at the bottom of Exhibit 3.5. The greater is AU, the greater the bank’s ability to generate income from the assets that the bank owns. The asset utilization ratio has a very intuitive interpretation. For example, if a bank’s AU equals 10 percent, its gross return (before expenses and taxes) on average total assets equals 10 percent. A higher figure indicates greater profits, everything else held constant. If the same bank’s ER is 7 percent, then the bank’s net return on investment (assets) before taxes is 3 percent.
Total revenue (TR), or total operating income, can be divided into three components:
TR=Interest Income (II)+Noninterest Income (OI)+Realized Security Gains or Losses (SG),
Note, ER* does not include taxes.

24. Bank Performance Model
Rate
Composition (mix)
Interest
Non Interest
Returns to Shareholders
ROE = NI / TE
Volume
INCOME
Fees and Serv Charge
Trust
Other
Return to the Bank
ROA = NI / TA
Rate
Interest
Composition (mix)
Volume
EXPENSES
Salaries and Benefits
Overhead
Occupancy
Degree of Leverage
EM = 1 / (TA / TE)
Other
Prov. for LL
Taxes

25. Expense ratio (ER = Exp / TA) … the ability to control expenses.
Interest expense / TA
Cost per liability (rate)
Int. exp. liab. (j) / $ amt. liab. (j)
Composition of liabilities
$ amt. of liab. (j) / TA
Volume of debt and equity
Non-interest expenses / TA
Salaries and employee benefits / TA
Occupancy expenses / TA
Other operating expense / TA
Provisions for loan losses / TA
Taxes / TA
Interest expense and noninterest expense should be further examined by source. Interest expense may vary between banks for three reasons; rate, composition, or volume effects. Rate effects suggest that the interest cost per liability, cj from Equation 3.4, which indicates the average cost of financing assets, may differ between banks. The gross interest cost of each liability can be calculated by dividing interest expense on the particular liability by the average total dollar amount of the liability from the balance sheet:[1]
Cost of liabilityj = Interest expense on liabilityj/Average balance of liabilityj
Differences in interest expense arise in part because banks pay different risk premiums indicating how the market perceives their asset quality and overall risk. The greater the risk, the higher the cost of liabilities. Banks also time their borrowings differently relative to the interest rate cycle. If they borrow when rates are low, their interest costs will fall below banks that issue new debt when rates are higher. Finally, banks use different maturities of deposits and debt that pay different rates depending on the yield curve at the time of issue. Typically, longer-term deposits pay higher rates than short-term deposits. The cj will differ among banks for any of these reasons.
Composition effects suggest that the mix of liabilities may differ. Banks with substantial amounts of demand deposits pay less in interest because these deposits are noninterest-bearing. A bank that relies on CDs and federal funds purchased will pay higher average rates than a bank with a larger base of lower cost demand and small time deposits because these liabilities are riskier to those advancing the funds. This represents a key advantage of core deposits over volatile or noncore liabilities. These composition effects are revealed by common size ratios that measure each liability as a percentage of average total assets.
Volume effects recognize that a bank may pay more or less in interest expense simply because it operates with different amounts of debt and equity and thus pays interest on a different amount of liabilities. A bank’s relative amount of debt to equity is revealed by its equity multiplier. When EM is high, interest expense may be high reflecting proportionately high amounts of debt financing. When EM is low, interest expense is normally low. This is true even if the bank pays the same effective interest rates and has the same percentage composition of liabilities.
Noninterest expense — or overhead expense — can be similarly decomposed. Measures of personnel expense, which includes salaries and benefit payments, occupancy expense, and other operating expenses as a percentage of total overhead expense indicate where cost efficiencies are being realized, or where a bank has a comparative disadvantage. Similar ratios are often constructed comparing these expenses to average assets to allow comparisons across different-sized banks. Noninterest expense may vary between banks depending on the composition of liabilities. Banks with large amounts of transactions deposits, for example, exhibit greater relative overhead costs.
[1] Costs and yields calculated using balance sheet data and costs and yields provided in the UBPR will be an area of discrepancy. For example, the average cost of CD’s over $100M is calculate to be 6.41% = 211,127 / ((3,179, ,412,724) / 2). The value reported for PNC in the UBPR is 6.30%. The costs and yields provided on page 03 of the UBPR (p. ????) use averages of quarterly figures for the individual asset values. Hence, calculating costs or yields using averages of end-of-year data may not be as accurate.

26. Asset utilization (AU = TR / TA): … the ability to generate income.
Interest Income / TA
Asset yields (rate)
Interest income asset (i) / $ amount of asset (i)
Composition of assets (mix)
$ amount asset (i) / TA
Volume of Earning Assets
Earning assets / TA
Non interest income / TA
Fees and Service Charges
Securities Gains (Losses)
Other income
The decomposition of AU appears at the bottom of Exhibit 3.5. The greater is AU, the greater the bank’s ability to generate income from the assets that the bank owns. The asset utilization ratio has a very intuitive interpretation. For example, if a bank’s AU equals 9 percent, its gross return (before expenses and taxes) on average total assets equals 9 percent. A higher figure indicates greater profits, everything else held constant. If the same bank’s ER is 6 percent, then the bank’s net return on investment (assets) before taxes is 3 percent.
Total revenue (TR), or total operating income, can be divided into three components:
TR=Interest Income (II)+Noninterest Income (OI)+Realized Security Gains or Losses (SG)
Noninterest income can also be decomposed into its contributing sources. Examining the proportion of noninterest income contributed by fees, fiduciary activities, deposit service charges, trading revenue, and other noninterest income relative to average total assets or total noninterest income indicates which component contributes the most to AU and why differences might exist with peers. It also identifies whether other income that can be biased by nonrecurring items is substantial. When a bank reports extraordinary income an analyst should subtract the amount from net income before calculating the performance ratios. This purges extraordinary income so that a truer picture of operating performance appears.
The last factor affecting ROAis a bank’s tax payments. Generally, applicable income taxes are divided by average assets per Equation 3.9. In summary form:
ROE = [AU – ER – TAX] x EM

27. Aggregate profitability measures
Net interest margin
NIM = NII / earning assets (EA)
Spread
Spread = (int inc / EA) ¸ (int exp / int bear. Liab.)
Earnings base
Eb = ea / ta
Burden / TA
(Noninterest exp. - Noninterest income) / TA
Efficiency ratio
Non int. Exp. / (Net int. Inc. + Non int. Inc.)
Net interest margin (NIM) is a summary measure of net interest returns on income-producing assets. Spread, which equals the average yield on earning assets minus the average cost of interest-bearing liabilities, is a measure of the rate spread or funding differential. These two measures are extremely important in evaluating a bank’s ability to manage interest rate risk. As interest rates change, so will a bank’s interest income and interest expense. For example, if interest rates increase, both interest income and interest expense will increase because some assets and liabilities will reprice at higher rates. Variation in NIM and spread indicates whether a bank has positioned its assets and liabilities to take advantage of rate changes — that is, whether it has actually profited or lost when interest rates increased or declined. Also, NIM and spread must be large enough to cover burden, provisions for loan losses, securities losses, and taxes for a bank to be profitable and grow its profits.
The burden ratio measures the amount of noninterest expense covered by fees, service charges, securities gains, and other income as a fraction of average total assets. The greater this ratio, the greater noninterest expense exceeds noninterest income for the bank’s balance sheet size. A bank is thus better off with a low burden ratio, ceteris paribus. The efficiency ratio has become quite popular recently and measures a bank’s ability to control noninterest expense relative to net operating income (NII1noninterest income). Conceptually, it indicates how much a bank pays in noninterest expense for one dollar of operating income. Bank analysts expect larger banks to keep this ratio below 55 percent, or 55 cents per dollar of operating income. Banks use this ratio to measure the success of recent efforts to control noninterest expense while supplementing earnings from increasing fees. The smaller the efficiency ratio, the more profitable the bank, all other factors being equal.

28. Financial ratios …PNC and Community National Bank
UBPR for PNC

29. Interest expense …composition, rate and volume effects for PNC and Community National Bank

30. Interest income …composition, rate and volume effects for PNC and Community National Bank

31. Fundamental risks : Credit risk Liquidity risk Market risk
Operational risk
Capital or solvency risk
Legal risk
Reputational risk

32. Credit risk …the potential variation in net income and market value of equity resulting from nonpayment or delayed payment.
Three Question need to be addressed:
What has been the loss experience?
What amount of losses do we expect?
How prepared is the bank?
Credit risk is the potential variation in net income and market value of equity resulting from this nonpayment or delayed payment. Different types of assets and off-balance sheet activities have different default probabilities. Loans typically exhibit the greatest credit risk. Changes in general economic conditions and a firm’s operating environment alter the cash flow available for debt service. These conditions are difficult to predict. Similarly, an individual’s ability to repay debts varies with changes in employment and personal net worth. For this reason, banks perform a credit analysis on each loan request to assess a borrower’s capacity to repay. Unfortunately, loans tend to deteriorate long before accounting information reveal any problems. In addition, many banks enter into off-balance sheet activities, such as loan commitments, guarantee offers, and derivative contracts. The prospective borrowers and counterparties must perform or the bank may take a loss. These risks can be substantial, but are difficult to measure from published data.
Bank investment securities generally exhibit less credit risk because the borrowers are predominantly federal, state, and local governmental units. Banks are also generally restricted to investment grade securities, those rated Baa (BBB) or higher, which exhibit less default risk. Even municipal bonds are subject to defaults, such as the 1983 default of the Washington Public Power Supply System on $2.25 billion in bonds to finance nuclear power plants.

33. Credit ratios to consider
What has been the loss experience?
Net loss to average total LN&LS
Gross losses to average total LN&LS
Recoveries to avg tot LN&LS
Recoveries to prior period losses.
Net losses by type of LN&LS
What amount of losses do we expect?
Non-current LN&LS to tot loans
Total P/D LN&LS - incl nonaccural
Non-curr restruc LN&LS / GR LN&LS
Curr-Non-curr restruct / GR LN&LS
Past due by loan type
Gross loan losses (charge-offs) equal the dollar value of loans actually written off as uncollectable during a period. Recoveries refer to dollar amount of loans that were previously charged-off but now collected. Net charge-offs equals the difference between gross charge-offs and recoveries. Net loan charge-offs directly reduce reserves that a bank sets aside for potential losses. Net charge-offs are not reported on the income statement, as are provisions for loan losses. Provisions for loan losses represent a transfer of funds (deferral of income taxes because it is deducted from income before determining taxes) to build the allowance for loan losses (loan loss reserve) up to its desired level. A review of Exhibit 3.2 reveals that a bank’s balance sheet lists the allowance for loan and lease losses under gross loans as a contra-asset account. Note that this allowance or loan loss reserve is only an accounting entry and does not represent funds in some cookie jar that a bank can go to when it needs cash. The greater a bank’s loss reserves, the more it has provided for loan losses but not charged off.
Ratios that examine expected future loss rates include loans past due, nonaccrual, total noncurrent loans, and classified loans as a fraction of total loans. Past-due loans represent loans for which contracted interest and principal payments have not been made within 90 days after the due date but are still accruing interest. Nonaccrual loans are those with past due payments which are not currently accruing interest. Total noncurrent loans is the sum of these two types of loans. Restructured loans are loans for which the lender has modified the required payments on principal or interest. Classified loans are a general category of loans in which regulators have forced management to set aside reserves for clearly recognized losses. Because some loans, such as speculative construction loans, are riskier than others, an analyst should examine the composition of a bank’s loan portfolio and the magnitude of past due, nonaccrual, noncurrent, restructured, and classified loans relative to total loans.

34. Credit ratios to consider (continued)
How prepared are we?
Loss Provision to: average assets and avg tot LN&LS
LN&LS Allowance to: net losses and total LN&LS
Earnings coverage of net loss
The UBPR presents a series of ratios that examine a bank’s ability to handle current and expected future losses. These include the bank’s provisions for loan losses and loan and lease loss allowance (loan loss reserve) as a percentage of total loans, earning coverage of net losses, and loan and lease loss allowance to net losses. When management expects to charge-off large amounts of loans, it will build up the allowance for loan losses. It does this by adding to provisions for loan losses. Thus, a large allowance may indicate both good and bad performance. If asset quality is poor, a bank needs a large allowance because it will need to charge-off many loans. The allowance should be large because charge-offs will deplete it. Cash flows from loans will decline along with reported interest income. In this case, a high loss reserve signals bad performance. With high quality assets, banks charge-off fewer loans, so the allowance can be proportionately less. A bank with a large allowance for loan losses and few past due, nonaccrual, or nonperforming loans will not need all of the reserve to cover charge-offs, which will be low. Such a bank has reported provisions for loan losses that are higher than needed such that prior period net income is too low. Provisions are a deduction from income.

35. Credit risk ratios : PNC and Community National

36. Liquidity risk …the variation in net income and market value of equity caused by a bank's difficulty in obtaining cash at a reasonable cost from either the sale of assets or new borrowings.
Banks can acquire liquidity in two distinct ways:
By liquidation of assets.
Composition of investments
Maturity of investments
By borrowing.
Core deposits
Volatile deposits
Liquidity is often discussed in terms of assets with reference to an owner’s ability to convert the asset to cash with minimal loss from price depreciation. Most banks hold some assets that can be readily sold near par to meet liquidity needs. Banks can not only access new funds not only through the sale of liquid assets but also by directly issuing new liabilities at reasonable cost. Thus, when banks need cash they can either sell assets or increase borrowing.
Liquidity risk measures indicate both the bank’s ability to cheaply and easily borrow funds and the quantity of its liquid assets near maturity or available-for-sale. The equity-to-asset ratio and volatile (net noncore) liability-to-asset ratio represent the bank’s equity base and borrowing capacity in the money markets. Volatile liabilities or net noncore liabilities as they are listed in the UBPR, include large CDs (over 100,000), deposits in foreign offices, federal funds purchased, repurchase agreements, and other borrowings with maturities less than one year.[1] If two banks hold similar assets, the one with the greater total equity or lower financial leverage can take on more debt with less chance of becoming insolvent. A bank that relies less on jumbo CDs, federal funds, RPs, Eurodollars, and commercial paper, can issue greater amounts of new debt in this form. In both instances, the cost of borrowing is lower than that for a bank with the opposite profile.
Core deposits are stable deposits that are not highly interest rate-sensitive. These types of deposits are less sensitive to the interest rate paid but more sensitive to the fees charged, services rendered, and location of the bank. Thus, a bank will retain most of these deposits even when interest rates paid by competitors increase relative to the bank’s own rates. As such, the interest elasticity of the demand for core deposits is low. Core deposits include demand deposits, NOW accounts, MMDAs, and small time deposits that the bank expects to remain on deposit over the business cycle. The greater the core deposits, the lower unexpected deposit withdrawals and potential new funding requirements. Volatile or purchased liquidity is also related to asset quality. The lower are high risk assets relative to equity, the greater is the bank’s borrowing capacity and the lower are its borrowing costs.
[1] The UBPR also includes brokered deposits less than $100,000 and maturing within one year in the definition of net noncore liabilities.

37. Liquidity risk ratios : PNC and Community National

38. Market risk …the risk to a financial institution’s condition resulting from adverse movements in market rates or prices .
Market risk arises from changes in:
Interest rates
Foreign exchange rates
Equity and security prices.

39. Interest rate risk …the potential variability in a bank's net interest income and market value of equity due to changes in the level of market interest rates.
Example: $10,000 Car loan 4 year Car loan at 8.5% 1 year CD at 4.5% Spread 4.0%
But for How long?
Funding GAP
GAP = $RSA - $RSL,
where $RSA = $ amount of assets which will mature or reprice in a give period of time.
In this example:
GAP3m = $ $10,000 = - $10,000
This is a negative GAP.

40. Foreign exchange risk … the risk to a financial institution’s condition resulting from adverse movements in foreign exchange rates.
Foreign exchange risk arises from changes in foreign exchange rates that affect the values of assets, liabilities, and off-balance sheet activities denominated in currencies different from the bank’s domestic (home) currency.
This risk is often found in off-balance sheet loan commitments and guarantees denominated in foreign currencies; foreign currency translation risk.

41. Equity and security price risk …change in market prices, interest rates and foreign exchange rates affect the market values of equities, fixed income securities, foreign currency holdings, and associated derivative and other off-balance sheet contracts.
Large banks must conduct value-at-risk analysis to assess the risk of loss with their trading account portfolios.

42. Operational risk …measures the cost efficiency of the bank's activities; i.e., expense control or productivity.
Typical ratios focus on:
total assets per employee
total personnel expense per employee
noninterest expense ratio
There is no meaningful way to estimate the likelihood of fraud or other contingencies from published data
A bank’s operating risk is closely related to its operating policies and processes and whether is has adequate controls

43. Operational risk ratios: PNC and Community National

44. Capital risk … closely tied to asset quality and a bank's overall risk profile
The more risk taken, the greater is the amount of capital required.
Appropriate risk measures include all the risk measures discussed earlier as well as ratios measuring the ratio of:
tier 1 capital and total risk based capital to risk weighted assets,
equity capital to total assets,
dividend payout, and growth rate in tier 1 capital.
A firm is technically insolvent when it has negative net worth or stockholders’ equity. The economic net worth of a firm is the difference between the market value of its assets and liabilities. Thus, capital risk refers to the potential decrease in the market value of assets below the market value of liabilities indicating economic net worth is zero or less. If such a bank were to liquidate its assets, it would not be able to pay all creditors, and would be bankrupt. A bank with equity capital equal to 10 percent of assets can withstand a greater percentage decline in asset value than a bank with capital equal to only 6 percent of assets. One indicator of capital risk is a comparison of stockholders’ equity with the bank’s assets. The greater equity is to assets, the greater the amount of assets that can default without the bank becoming insolvent.

45. Definitions of capital
Tier 1 capital is:
total common equity capital plus noncumulative preferred stock, plus minority interest in unconsolidated subsidiaries, less ineligible intangibles.
Risk weighted assets are:
the total of risk adjusted assets where the risk weights are based on four risk classes of assets.
Importantly, a bank's dividend policy affects its capital risk by influencing retained earnings.

46. Capital risk ratios : PNC and Community National

47. Legal risk …the potential that unenforceable contracts, lawsuits, or adverse judgments can disrupt or otherwise negatively affect the operations or condition of banking organization
Legal risk include:
Compliance risks
Strategic risks
General liability issues

48. Reputational risk
Reputational risk is the potential that negative publicity regarding an institution’s business practices, whether true or not, will cause a decline in the customer base, costly litigation, or revenue reductions.

49. (UBPR users manual) UBPR format http://www.ffiec.gov/UBPR.htm
Cover page
Contains basic descriptive information on the bank, its location, charter and certification numbers, and a brief description of the peer group included.
Summary Ratios
Basic summary information on the bank include return on assets; interest and non-interest income and expenses as a percentage of assets.
Risk summary measures on the loan portfolio; liquidity; capitalization; and growth rates are also included.
Income Information
Income Statement - Revenues and Expenses 02
Detailed income statement, in $1,000 of dollars.
Noninterest Income and Expenses and Yields 03
On this page the FDIC mixes additional detail on noninterest income and expenses in $1,000 of dollars with ratio (% of assets) of these same numbers.
In addition, the average rates on, or yields of assets and costs of liabilities, are include in the bottom half of the page.

50. UBPR format Balance Sheet Information:
Balance Sheet - Assets, Liabilities & Capital 04
Basic balance sheet detail in $1,000 of dollars.
Off-Balance Sheet Items
Both dollar amounts and ratios, each off-balance sheet item as a percent of total off-balance sheet items.
Derivatives Analysis A
This is one of many pages that provide additional detail for items from the previous page.
Dollar amounts of derivative contracts and percent of total ratios are provided.
Derivatives Analysis B
notional value of derivatives.
Balance Sheet - % Composition of Assets & Liab. 06
Basic common size analysis.
The balance sheet is presented in percentage of total assets.
Very useful for evaluating the mix of assets and liabilities.

51. UBPR format Balance Sheet Information:
Analysis of Loan & Lease Allowance and Loan Mix 07
Reconciliation of the Loan and Lease (LN&LS) allowance is provided in $1,000 of dollars.
Ratios on the provisions for loan losses (loss provision), LN&LS allowance, gross losses, recoveries, and net losses by loan type are provided as well.
Analysis of Loan & Lease Allowance and Loan Mix 07A
Ratios detailing the loan mix (each loan category as a percentage of total loans) as well as information on mortgage serving assets.
Analysis of Past Due, Nonaccrual & Restructured LN&LS 08
The dollar amount of past due, nonaccrual, restructured and other real estate owned (OREO) is provided.
Ratios, detailing the percentage of non-current loans, by type, for past due and nonaccrual loans is provided.
Analysis of Past Due, Nonaccrual & Restructured LN&LS 08A
Memoranda Information
Additional detail in dollars and percentage of non-current real estate loans.

52. UBPR format Balance Sheet Information:
Interest Rate Risk Analysis as a Percent of Assets 09
Basic interest rate risk information.
Total interest bearing assets and liabilities and the net position (GAP) for three month and one year repricing.
Liquidity and Investment Portfolio
Dollar amount of short term investments, debt securities and high risk mortgage securities.
Liquidity ratios and the securities mix (percentage of total securities) is provided as well.
Capital Analysis
Reconciliation of stockholders equity and the dollar amounts of equity components.
Capital ratios, including return on equity (ROE), dividend payout, and growth rates in capital components.
Risk-Based Capital Analysis 11A
The dollar amount of tier one and tire two capital and its components.
Dollar amount of risk-weighted assets and adjustments to risk-weighted assets.
Risk-based capital and leverage capital ratios are provided as well.

53. UBPR format Balance Sheet Information:
Last-Four Quarters Income Analysis 12
Four quarter summary information which combines information from page 01 and 03 on yield or cost of assets and liabilities.
State Average Summary STAVG
Summary ratios, similar to page 01 for state averages.

54. SUMMARY RATIOS Page 01

55. INCOME STATEMENT - REVENUES AND EXPENSES ($000) Page 02

56. NONINTEREST INCOME AND EXPENSE ($000) AND YIELDS Page 03

57. BALANCE SHEET - ASSETS, LIABILITIES AND CAPITAL ($000) Page 04

58. OFF-BALANCE SHEET ITEMS PAGE 05

59. DERIVATIVES ANALYSIS PAGE 05A

60. DERIVATIVES ANALYSIS PAGE 05B

61. BALANCE SHEET - PERCENTAGE COMPOSITION OF ASSETS & LIABILITIES PAGE 06

62. ANALYSIS OF LOAN & LEASE ALLOWANCE AND LOAN MIX PAGE 07

63. ANALYSIS OF LOAN & LEASE ALLOWANCE AND LOAN MIX PAGE 07A

64. ANALYSIS OF PAST DUE, NONACCRUAL & RESTRUCTURED LOANS & LEASE PAGE 08

65. ANALYSIS OF PAST DUE NONACCRUAL & RESTRUCTURED LOANS & LEASES PAGE 08A

66. INTEREST RATE RISK ANALYSIS AS A PERCENT OF ASSETS PAGE 09

67. LIQUIDITY AND INVESTMENT PORTFOLIO PAGE 10

68. CAPITAL ANALYSIS PAGE 11

69. RISK-BASED CAPITAL ANALYSIS PAGE 11A

70. ONE QUARTER ANNUALIZED INCOME ANALYSIS PAGE 12

71. SUMMARY INFORMATION FOR BANKS IN STATE STAVG

72. ANALYZING BANK PERFORMANCE: USING THE UBPR
Bank Management, 5th edition. Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning
ANALYZING BANK PERFORMANCE: USING THE UBPR
Chapter 3