Expert answer:US FINANCIAL SYSTEM-MARKETS
Expert answer:TERM PROJECT #1: BANK MANAGEMENT ISSUES (20 points)Due date: No later than 11:59PM on Wednesday, January 10, 2018.Deliverable: A maximum of two (2) typed page-writeup (12-point font size, single-spaced) including any references. Use bullet points, as necessary. Refer to the article “Analyzing a Bank’s Financial Statements” by Hans Wagner, After reading the article, answer the questions below. In answering the questions, you are encouraged to use input from the article and from your own research or experience.A maximum of two (2) typed page-writeup (12-point font
size, single-spaced) including any references. Use bullet points, as necessary. TERM PROJECT #2: BANK RISK AND REGULATION (20 points)Due date: No later than 11:59PM on Wednesday, January 10, 2018.Deliverable: A maximum of two (2) typed page-writeup (12-point font size, single-spaced) including any references. Use bullet points, as necessary.
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Analyzing A Bank’s Financial Statements
By Hans Wagner | Updated January 20, 2017 — 6:00 AM EST
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Financial statements for banks present a different analytical problem than
statements for manufacturing and service companies. As a result, analysis of a
bank’s financial statements requires a distinct approach that recognizes a bank’s
unique risks.
Banks take deposits from savers and pay interest on some of these accounts.
They pass these funds on to borrowers and receive interest on the loans. Their
profits are derived from the spread between the rate they pay for funds and the
rate they receive from borrowers. This ability to pool deposits from many sources
that can be lent to many different borrowers creates the flow of funds inherent in
the banking system. By managing this flow of funds, banks generate profits,
acting as the intermediary of interest paid and interest received, and taking on
the risks of offering credit.
Leverage and Risk
Banking is a highly-leveraged business requiring regulators to dictate minimal
capital levels to help ensure the solvency of each bank and the banking system.
In the U.S., a bank’s primary regulator could be the Federal Reserve Board, the
Office of the Comptroller of the Currency, the Office of Thrift Supervision or any
one of 50 state regulatory bodies, depending on the charter of the bank. Within
the Federal Reserve Board, there are 12 districts with 12 different regulatory
staffing groups. These regulators focus on compliance with certain requirements,
restrictions and guidelines, aiming to uphold the soundness and integrity of the
banking system.
As one of the most highly regulated banking industries in the world, investors
have some level of assurance in the soundness of the banking system. As a
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result, investors can focus most of their efforts on how a bank will perform in
different economic environments.
Below is a sample income statement and balance sheet for a large bank. The
first thing to notice is that the line items in the statements are not the same as
your typical manufacturing or service firm. Instead, there are entries that
represent interest earned or expensed, as well as deposits and loans.
Figure 1: The Income Statement
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Figure 2: The Balance Sheet
As financial intermediaries, banks assume two primary types of risk as they
manage the flow of money through their business. Interest rate risk is the
management of the spread between interest paid on deposits and received on
loans over time. Credit risk is the likelihood that a borrower will default on a loan
or lease, causing the bank to lose any potential interest earned as well as the
principal that was loaned to the borrower. As investors, these are the primary
elements that need to be understood when analyzing a bank’s financial
statement.
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Interest Rate Risk
The primary business of a bank is managing the spread between deposits
(liabilities, loans and assets). Basically, when the interest that a bank earns from
loans is greater than the interest it must pay on deposits, it generates a positive
interest spread or net interest income. The size of this spread is a major
determinant of the profit generated by a bank. This interest rate risk is primarily
determined by the shape of the yield curve.
As a result, net interest income will vary, due to differences in the timing of
accrual changes and changing rate and yield curve relationships. Changes in the
general level of market interest rates also may cause changes in the volume and
mix of a bank’s balance sheet products. For example, when economic activity
continues to expand while interest rates are rising, commercial loan demand may
increase while residential mortgage loan growth and prepayments slow.
Banks, in the normal course of business, assume financial risk by making loans
at interest rates that differ from rates paid on deposits. Deposits often have
shorter maturities than loans and adjust to current market rates faster than loans.
The result is a balance sheet mismatch between assets (loans) and liabilities
(deposits). An upward sloping yield curve is favorable to a bank as the bulk of its
deposits are short term and their loans are longer term. This mismatch of
maturities generates the net interest revenue banks enjoy. When the yield curve
flattens, this mismatch causes net interest revenue to diminish.
A Banking Balance Sheet
The table below ties together the bank’s balance sheet with the income
statement and displays the yield generated from earning assets and interestbearing deposits. Most banks provide this type of table in their annual reports.
The following table represents the same bank as in the previous examples:
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Figure 3: Average Balance and Interest Rates
First of all, the balance sheet is an average balance for the line item, rather than
the balance at the end of the period. Average balances provide a better analytical
framework to help understand the bank’s financial performance. Notice that for
each average balance item there is a corresponding interest-related income, or
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expense item, and the average yield for the time period. It also demonstrates the
impact that a flattening yield curve can have on a bank’s net interest income.
The best place to start is with the net interest income line item. The bank
experienced lower net interest income even though it had grown average
balances. To help understand how this occurred, look at the yield achieved on
total earning assets. For the current period, it is actually higher than the prior
period. Then examine the yield on the interest-bearing assets. It is substantially
higher in the current period, causing higher interest-generating expenses. This
discrepancy in the performance of the bank is due to the flattening of the yield
curve.
As the yield curve flattens, the interest rate that the bank pays on shorter-term
deposits tends to increase faster than the rates it can earn from its loans. This
causes the net interest income line to narrow, as shown above. One way banks
try to overcome the impact of the flattening of the yield curve is to increase the
fees they charge for services. As these fees become a larger portion of the
bank’s income, it becomes less dependent on net interest income to drive
earnings.
Changes in the general level of interest rates may affect the volume of certain
types of banking activities that generate fee-related income. For example, the
volume of residential mortgage loan originations typically declines as interest
rates rise, resulting in lower originating fees. In contrast, mortgage-servicing
pools often face slower prepayments when rates are rising, since borrowers are
less likely to refinance. As a result, fee income and associated economic value
arising from mortgage servicing-related businesses may increase or remain
stable in periods of moderately rising interest rates.
When analyzing a bank, you should also consider how interest rate risk might act
jointly with other risks facing the bank. For example, in a rising rate environment,
loan customers may not be able to meet interest payments because of the
increase in the size of the payment or a reduction in earnings. The result will be a
higher level of problem loans. An increase in interest rates exposes a bank with a
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significant concentration in adjustable rate loans to credit risk. For a bank that is
predominately funded with short-term liabilities, a rise in rates may decrease net
interest income at the same time that credit quality problems are on the rise.
Credit Risk
Credit risk is most simply defined as the potential of a bank borrower or
counterparty to fail in meeting its obligations in accordance with agreed terms.
When this happens, the bank will experience a loss of some or all of the credit it
provided to its customer. To absorb these losses, banks maintain an allowance
for loan and lease losses.
In essence, this allowance can be viewed as a pool of capital specifically set
aside to absorb estimated loan losses. This allowance should be maintained at a
level that is adequate to absorb the estimated amount of probable losses in the
institution’s loan portfolio.
Actual losses are written off from the balance sheet account “allowance” for loan
and lease losses. The allowance for loan and lease losses is replenished through
the income statement line item “provision” for loan losses. Figure 4 shows how
this calculation is performed for the bank being analyzed.
Figure 4: Loan Losses
Investors should consider a couple points from Figure 4. First, the actual writeoffs were more than the amount management included in the provision for loan
losses. While this in itself isn’t necessarily a problem, it is suspect because the
flattening of the yield curve has likely caused a slowdown in the economy and put
pressure on marginal borrowers.
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Arriving at the provision for loan losses involves a high degree of judgment,
representing management’s best evaluation of the appropriate loss to reserve.
Because it is a management judgment, the provision for loan losses can be used
to manage a bank’s earnings. Looking at the income statement for this bank
shows that it had lower net income due primarily to the higher interest paid on
interest-bearing liabilities. The increase in the provision for loan losses was 1.8%,
while actual loan losses were significantly higher. Had the bank’s management
just matched its actual losses, it would have had a net income that was $983 less
(or $1,772).
An investor should be concerned that this bank is not reserving sufficient capital
to cover its future loan and lease losses. It also seems that this bank is trying to
manage its net income. Substantially higher loan and lease losses would
decrease its loan and lease reserve account to the point where this bank would
have to increase the future provision for loan losses on the income statement.
This could cause the bank to report a loss in income. In addition, regulators could
place the bank on a watch list and possibly require that it take further corrective
action, such as issuing additional capital. Neither of these situations benefits
investors.
Overall, a careful review of a bank’s financial statements can highlight the key
factors that should be considered before making a trading or investing decision.
Investors need to have a good understanding of the business cycle and the yield
curve; both have a major impact on the economic performance of banks.
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YOUR FULL NAME: _________________________________________________________
ECON 350: US FINANCIAL SYSTEM-MARKETS & INSTITUTIONS
Winter 2018
Dr. Charles Sebuharara
TERM PROJECT #1: BANK MANAGEMENT ISSUES (20 points)
Due date: No later than 11:59PM on Wednesday, January 10, 2018.
Deliverable: A maximum of two (2) typed page-writeup (12-point font size, single-spaced)
including any references. Use bullet points, as necessary.
Submission mode: Upload completed work to MyCourses (Blackboard). Modify the file
name to include your OWN name before ECON350 for easy identification. Your full name
should also be typed at the top of the page.
1. [8 points] Refer to the article “Analyzing a Bank’s Financial Statements” by Hans
Wagner, which is posted on the course site in BU MyCourses (Blackboard) under a new
folder titled “Term Projects.” After reading the article, answer the questions below. In
answering the questions, you are encouraged to use input from the article and from your own
research or experience.
A. What is(are) the primary determinant(s) of a bank interest rate risk?
B. If you were a bank owner or executive, what shape of the Yield Curve would consider as
favorable for the bank’s economic performance? Why?
C. When interest rates in the economy are changing, maybe because of the change in the
Federal Reserve monetary policy, interest rates on which category – bank deposits or
bank loans – tend to adjust more slowly?
D. Under what conditions an increase in interest rates may also expose banks to credit risk?
E. What type of risk a bank is exposed to when interest rates are falling? Example.
F. Based on the sample balance sheet in the article, how did FI Bank performed between
“prior period” and “current period,” based on average Net Income/Yield?
G. What are the advantage(s) and disadvantage(s) of high provision (allowance) for loan
losses in a bank?
H. Indicate which of the following is a “flow” quantity and which is a “stock” quantity:
(1) Provision for loan losses
(2) Allowance for loan and lease losses
2. [5 points] List (bullet points) 10 ways in which banks attempt to manage credit risk.
3. [7 points] In the last couple of years Wells Fargo, one of the largest banks in the U.S., has be
accused of bank scandals.
A. What are the three (3) most serious scandalous activities?
B. What were some of the consequences/costs of these activities?
C. How was Wells Fargo to deal with these problems? (to avoid significant impact on its
financial performance, for example?)
D. What is your own opinion about these scandals and the responses to them?
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FULL NAME: ________________________________________________________________
ECON 350: US FINANCIAL SYSTEM-MARKETS & INSTITUTIONS
Winter 2018
Dr. Charles Sebuharara
TERM PROJECT #2: BANK RISK AND REGULATION (20 points)
Due date: No later than 11:59PM on Wednesday, January 10, 2018.
Deliverable: A maximum of two (2) typed page-writeup (12-point font size, single-spaced)
including any references. Use bullet points, as necessary.
Submission mode: Upload completed work to MyCourses (Blackboard). Modify the file
name to include your OWN name before ECON350 for easy identification. Your full name
should also be typed at the top of the page.
1. [10 points in total] Some global efforts have led to the creation of international rules for
bank supervision.
A. [1 point] What is the key organization that has led these efforts, which resulted in the
adoption, by several nations, of the approach to the calculation of risk-weighted assets
and risk-weighted capital ratio for banks?
_________________________________________________________________.
B. [1 point] Where is the organization located? _____________________________.
C. [1 point] What is the name of the official document which contains the rules for
calculating these risk-adjusted assets and capital ratio?
___________________________________________________________________
D. [4 points] What are the current major asset categories and associated weights for risk
calculation purposes?
E. [3 points] Outline the key provisions of the latest framework, which was put forth in
aftermath of the recent global financial crisis that began around 2007.
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2. Suppose that Oldhat Financial starts its first day of operations with $9 million in capital. A
total of $130 million in checkable deposits is received. The bank makes a $25 million
commercial loan and another $50 million in mortgages with the following terms: 200
standard, 30-year, fixed-rate mortgages with a nominal annual rate of 5.25%, each for
$250,000. Assume that required reserves are 8%.
A. [5 points] What does the bank balance sheet look like?
B. [1 point] How well capitalized is the bank?
C. [4 points] Calculate the risk-weighted assets and risk-weighted capital ratio after
Oldhat’s first day.
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