Banking, Investing and
Insurance
BUSINESS AND BANKING
AND PROFITABILITY
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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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Questions, Comments, Concerns
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