Bank Management,

Management 5th edition.

Timothy W. Koch and S. Scott MacDonald
Copyright 2003 by South-Western, a division of Thomson Learning

Chapter 1

Balance Sheet
Assets = Liabilities + Equity.
Balance sheet figures are calculated at

a particular point in time and thus

represent stock values.

Bank Assets
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

Provisions for loan losses

Recoveries

Provisions for loan losses

Reserve for Loan Losses

Charge offs

Bank investments categaories

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.

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 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not withdrawn over short periods of time.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

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.

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.

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

Interest income

Interest income includes interest from:

Loans
Deposits

held at other institutions,

Municipal and taxable securities, and
Investment and trading account
securities.

Noninterest expense
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.

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 (noninterest) per dollar of loans.

Return on equity (ROE = NI / TE)

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.
ROE

Return on assets (ROA = NI / TA)

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

ROA is driven by the banks ability to:

generate income (AU) and control expenses (ER)
Income generation (AU) can be found on

the UBPR (page 1) as:

Int. Inc. Non. int. Inc. Sec gains (losses)
AU

TA
TA
TA

Expense Control (ER) can be found on the

UBPR (page 1) as:

Int. Exp. Non int . Exp. PLL

ER

TA
TA
TA
*

Note, ER* does not include taxes.

Bank
BankPerformance
PerformanceModel
Model
Returns
Returnsto
to
Shareholders
Shareholders
ROE
ROE==NI
NI//TE
TE

Interest

Rate
Composition (mix)
Volume

INCOME

Fees and Serv Charge

Non Interest

Trust
Other

Return to the Bank

ROA = NI / TA

Rate
Interest

Composition (mix)
Volume

EXPENSES
Overhead
Degree of Leverage
EM = 1 / (TA / TE)

Prov. for LL
Taxes

Salaries and Benefits

Occupancy
Other

Expense ratio (ER = Exp / TA)

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

Asset utilization (AU = TR / TA):

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

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.)

Fundamental risks for bank

Credit risk
Liquidity risk
Market risk
Operational risk
Capital or solvency risk
Legal risk
Reputational risk

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:
1.

What has been the loss experience?

2.

What amount of losses do we expect?

3.

How prepared is the bank?

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:
1.

By liquidation of assets.

2.

Composition of investments
Maturity of investments

By borrowing.

Core deposits
Volatile deposits

Market risk
the risk to a financial institutions
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.

Foreign exchange risk

the risk to a financial institutions
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 banks domestic (home) currency.
This risk is often found in off-balance sheet
loan commitments and guarantees
denominated in foreign currencies; foreign
currency translation risk.

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 offbalance sheet contracts.
Large banks must conduct value-at-

risk analysis to assess the risk of loss

with their trading account portfolios.

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 banks operating risk is closely related to its
operating policies and processes and whether is has
adequate controls

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.

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

Reputational risk
Reputational risk is the potential that

negative publicity regarding an

institutions business practices,
whether true or not, will cause a
decline in the customer base, costly
litigation, or revenue reductions.

 2008

2.211

0.96

0.42

0.8

0.53

1.49

1.43

35.77

2.91

55.24

72.85

4.92

45.5

75

15.91

5.3

56.44

64.49

1.46

27.41

3.24

43.14

74.17

0.7

0.41

20.79

4.5

45.32

71.77

0.25

13.59

2.45

48.8

63.71

0.33

1.13

18.23

2.8

33.3

56.4

2.28

1.22

26.06

4.82

41.04

70.82

0.34

1.21

13.83

3.11

51.37

73.29

0.58

1.19

19.57

2.96

39.62

64.45

0.79

1.06

13.57

0.87

1.2

17.91

5.1

63

57.98

0.4

1.31

20.68

3.1

52.74

59.5

15.230

5.72

47.07

61.55

 2008

29.31

1.21

0.17

203.32

15.45

5.06

23

1.21

0.19

131.59

16

17.52

0.92

0.16

152.5

26.5

14.6

24.11

1.11

0.46

225.73

27

6.56

1.82

0.36

151.22

10.95

7.46

32.83

26.89

3.13

0.48

121.72

29.12

10.81

18.9

2.29

0.24

130.15

18.2

10.75

21.31

0.83

0.07

226.58

25.82

8.94

28.8

1.36

0.2

150.03

12.74

12.32

29.32

1.92

0.17

116.83

15.41

9.54

39.24

1.54

0.04

170.76

12.89

20.68

34.92

1.55

0.83

180.23

9.08

16.42

20.96

2.21

0.23

131.58

21.65

10.17

 2008

8.88

4.42

27.01

599

16298

2.34

9.98

3.41

26.45

6500

11885

2.0100

16.15

3.23

24.54

35.5

689.6

1.4

11.34

5.31

32.14

667

21608

2.47

11.4

3.72

36.56

2054

9810

2.76

13.43

3.4

17.6

5575

106494

2.76

13.06

2.9

20.4

365.12

135983

2.97

11.24

2.82

19.77

860

3238

0.65

14.32

4.21

23.95

931

13572

2.04

13.47

0.51

21.1

1927

29814

1.23

24.12

3.53

26.91

99.34

1122

0.2

19.66

7.83

40.89

309

5383

2.79

12.16

3.68

20.72

6,571

54,026

2.91

 2008

396548

408247

142,498

947,293

653,310

151,485

329,196

454,944

1,646

785,786

647,903

136,237

46486

29736

76,222

57,779

18,443

620,707

1,178,240

99,504

1,898,451

1,322,004

476,943

199335

188402

97,613

485,350

327,350

60,387

1550720

1853674

253,367

3,657,761

1,585,764

1,818,630

3990043

3959172

116,009

8,065,224

7,548,195

401,020

279521

278258

74647

632,426

468,886

88,893

414,053

521,362

10,427

945,842

763,279

172,136

879,300

785,580

201686

1,866,566

1,020,120

644,760

28,703

25,878

8,151

62,732

44,045

10,536

191730

117509

6,601

315,840

255,118

54,121

3,103,002

2,607,353

67,961

5,778,316

3,434,021

2,276,334

 2008

55,721

24,187

37845

1,309,425

41,702

0.9682

56,115

25,902

51307

1,054,350

54,672

0.9481

4,959

2,068

8403

103,263

8,805

0.9147

71,963

25,393

71472

1,571,797

79,515

0.9494

37,370

20910

26416

731,599

276054

0.6227

257,953

113,807

443980

6,955,694

468,272

0.9327

433,235

173,693

510549

9,757,654

603,183

0.9382

52525

26332

46315

1,020,899

49,022

0.9520

58,868

22,776

92042

1,187,837

95,346

0.9197

116,787

51,149

132151

2,678,255

145,209

0.9458

4,539

1943

10219

93,706

11,346

0.8789

18,578

7,490

31716

417,022

33,794

0.9190

355,438

131,597

431353

7,555,452

467,562

0.9381