Banker has to Manage Credit - - PDF document

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 2018, Jay Cochran, III PhD

• Banker has to Manage Credit Risk, Interest Rate Risk, and

Liquidity, and still earn a profit

• A Business in a set of Financial Statements

– Balance Sheet

• “Snapshot” of a moment in time
• What the firm owns (assets), and to whom it owes money
• Assets = Liabilities + Owners’ Equity (Capital)

– IMPORTANT: Capital = Assets – Liabilities

– Income Statement

• “Movie” of money flowing through a firm over time
• Revenue – Expenses = Op’g Income – Taxes = Net Income
• The 2 are connected by Capital (OE) & Net Income

– Net Income (Loss) not paid out in dividends is Retained

• Firms can pay dividends even if not profitable.

 2018, Jay Cochran, III PhD

• Determine your Bank’s FDIC Certificate No.
• Using the FDIC’s “Statistics on Depository Institutions

(SDI)” Database and your Bank’s FDIC Certificate No., pull the following reports:

– Balance Sheet – Income Statement

• Including detail of loan and deposit interest
• Example reports tie to SDI Report Line no.s

– If missing Line no. = calculation – Analytical “Cookbook”

 2018, Jay Cochran, III PhD

• Assets

Liabilities & Capital

OWNS (Revenue Generators) OWES (Financial Structure) Cash (“Reserves”) Securities Loans Property & Equipment Deposits Notes & Bonds Capital

Assets = Liabilities + Capital

• Recent US Banking System Balance Sheet

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 2018 Jay Cochran, III PhD

• Revenues – Expenses = Net Income
• Revenues

– Interest Income (Securities, Loans) – Fee Income (NSF, ATM, Trust, Payments …)

• Expenses

– Interest Expense (Deposits, Borrowing) – Provision for Loan Losses – Non-interest Expenses (Wages, deprec., …) – Others (Taxes, extraordinary items, …)

• Recent US Banking System Income Statement

 2018, Jay Cochran, III PhD

• US Banking System Analytical Results
• 1. Basic Spread

Average Loan Yield – Average Deposit Yield

• 2. Return on Assets (ROA)

Net Income/Assets

• 3. Return on Capital (ROK)

Net Income/Capital

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• Historical Profitability Performance
• Returns (profits) are generated by taking risks

 2018, Jay Cochran, III PhD

• US Banking System Analytical Results
• 4. Capitalization Capital/Total Assets
• 5. Gap Analysis one measure of Interest Rate Risk

– Balance sheet has built-in maturity mis-match

• Costs ↑ faster than revenues with ↑ interest rates
• Gap = Rate-sensitive Assets – Rate-sensitive Liab. (more below)
• 6. Liquidity Management Reserves/Deposits

– Securities Account – Temporary Liquidity Sources: Fed Funds, FRB Discount Loans

• Insolvent vs. Illiquid “…lend at penalty rates against the latter; lend not at any price against the

former…”

• 7. Credit Losses Charge-Offs/Capital

– Some losses to be expected, no matter what – Addressing Info Asymmetries helps to control risk

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 2018, Jay Cochran, III PhD

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• Criticality of Capital

– The Inevitability of Losses

• Capital Adequacy determines firm survival (solvency)
• Accumulates Profits; Absorbs Losses

– Also can help Align Owners’ Incentives w/Depositors’

• Capital/Assets = Capitalization ratio
• Historical Capitalization Rates
• Leverage = Assets/Capital

– Inverse of Capitalization; a force multiplier – Leverage as a 2-Edged Sword

 2018, Jay Cochran, III PhD

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• Assumptions:

– Each Bank has $10M in Capital – Loans = 60% of B/S; earning Basic Spread = 2%

• Now Assume Loan Losses = 10%

– Bank “C” Loan Losses = $6M hit to capital ( impaired but still solvent) – Bank “R” Loan Losses = $12M hit to capital (insolvent)

Bank “C” Bank “R” 10% Cap.; Assets = $100M Loans = $60M Gross Margin = $1.2M ROK = 12% 5% Cap.; Assets = $200M Loans = $120M Gross Margin = $2.4M ROK = 24%

 2018, Jay Cochran, III PhD

• Rate Sensitivity Gap

– Gap is typically negative (nature of banking)

1. Gap = Rate-sensitive Assets – Rate-sensitive Liabilities 2. ∆ Profits = Assumed ∆ in ST interest rates x Gap 3. ∆ Profits/Assets = Implied Change in ROA

• Duration also measures Interest Rate Risk

– Weights Assets & Liabilities by their maturities

• Historical Gap Performance

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 2018, Jay Cochran, III PhD

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Balancing Act: keep enough cash on hand to keep depositors happy, but not so much that you forego profitable lending opportunities

• Primary Liquidity Ratio = Reserves/Deposits
• Historical Liquidity Ratios

 2018, Jay Cochran, III PhD

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• Charge-Offs/Capital
• Some losses are expected (big losses are not)
• Depends on Loss Recognition Speed

– Past Due Accounts are “aged”

• Typically become “Non-Performing” > 90 days past due

– Mark-to-Market Rules Suspension (FASB 157)

• Historical Credit Loss Experience

 2018, Jay Cochran, III PhD

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• How does your bank compare to the US banking

system as a whole?

– Currently and historically – Is it earning profits and are they within “reason?” – Are higher credit losses necessarily bad? – How much liquidity is too much or too little? – Is the bank sufficiently capitalized?

• Draw a conclusion re: your bank’s Safety &

Soundness

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• Akerloff’s “Lemons” problem
• Buyers have difficulty discerning good quality cars from

lemons

– Suppose a good car sells for $2,000 and a lemon sells for $1,000 – If there’s a 50:50 chance of any given car being a lemon, then used cars will sell for an average $1,500. [E(V)]

• $1,500 is not enough for sellers of good cars
• That leaves only lemons in the market
• Supposed to illustrate how markets can fail if there is a

persistent information asymmetry …but…?

We use information (professional opinions, histories, information services, prices themselves, etc.) to overcome information asymmetry problems.

 2018, Jay Cochran, III PhD

• Information Asymmetry each side of a trade has a different

information set. Information is unbalanced.

• Adverse Selection: those most in need of a financial service are

those most likely to seek it out, and those parties have information that the other does not.

– Unobservable characteristic – Risks people bring to a prospective financial transaction that exist logically prior to the transaction

• Smokers vs. non-smokers and insurance (price discrimination)
• Moral Hazard: People respond to incentives. If a financial

transaction changes incentives, it can also lead to changed behaviors.

– Unobservable action – Behaviors that change after the financial event.

• Reckless driving and car insurance
• Deposit Insurance and Bailouts of “too big to fail” banks

 2018, Jay Cochran, III PhD

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• Information is costly to obtain but once obtained is

(potentially) easy to transmit/replicate

– Valuable information often kept private – If info becomes public, gives rise to a potential “free rider” problem.

• The inability to internalize all the benefits of information that

becomes public ⇒ undersupply of information

• Does not necessarily imply a role for public provision to make

up for the undersupply

– Low Value when publicly held – Repetitious information becomes stale, often ignored.

• Optimum levels of information rather than maximum.

– Balancing MC of an add’l bit of information vs. the MB of it

 2018, Jay Cochran, III PhD

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• Collateral

– Ensures at least partial recovery in event of default – Helps align borrower’s incentives w/lender’s

• Strategic defaults
• Net Worth

– Indicates past success at managing assets and liabilities. – Unencumbered assets

 2018, Jay Cochran, III PhD