Banking and Financial Institution PDF

BANKING AND FINANCIAL INSTITUTION PROF. 2 LESSON II – THE FINANCIAL STATEMENTS OF BANKS AND THE PRINCIPAL COMPETITORS (FINAL PERIOD) Banks and Financial Institutions have a differ...

BANKING AND FINANCIAL INSTITUTION PROF. 2 LESSON II – THE FINANCIAL STATEMENTS OF BANKS AND THE PRINCIPAL COMPETITORS (FINAL PERIOD) Banks and Financial Institutions have a different or unique Financial statements or recordings unlike a typical business as mentioned by Wagner (2020) on his article entitled Analyzing bank’s financial statements. “The reported financial statements for banks are somewhat different from most companies that investors analyze. For example, there are no accounts receivables or inventory to gauge whether sales are rising or falling. On top of that, there are several unique characteristics of bank financial statements that include how the balance sheet and income statement are laid out. However, once investors have a solid understanding of how banks earn revenue and how to analyze what's driving that revenue, bank financial statements are relatively easy to grasp.” Let’s start to analyze a bank’s financial statement so, what is Financial Statements? These are literally a “road map” telling us where a financial firm has been in the past, where it is now, and, perhaps, where it is headed in the future. They are invaluable guideposts that can, if properly constructed and interpreted, signal success or disaster. There are Two main Financial Statements that managers, customers, and the regulatory authorities rely upon: 1. balance sheet (Report of Condition) - It is a list of financial inputs and outputs and shows the amount and composition of fund sources (financial input) drawn upon to finance lending and investing activities and how much has been allocated to loans, securities, and other funds uses (financial outputs) at any given point in time. Assets = Liabilities + Capital Assets – cash in the vault, deposits held at other depository institutions (C), government and private interest-bearing securities purchased in the open market (S), loans and lease financing made available to customers(L) and miscellaneous assets (MA). Liabilities – deposits made by and owed to various customers (D), and non- deposit borrowings of funds in the money and capital markets(NDB). Capital – long-term funds the owners contribute (EC). Therefore, the balance sheet identity for a depository institution can be written: C+S+L+MA = D+NDM + EC Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 24 BANKING AND FINANCIAL INSTITUTION PROF. 2 Watch illustrative videos on these links: https://www.youtube.com/watch?v=C1jBlzGr98w https://www.youtube.com/watch?v=UtiGuNjihBA 2. income statement (Report of Income) - It shows how much it has cost to acquire funds and to generate revenues from the financial firm has made of those funds. These costs include interest paid to depositors and other creditors of the institution, the expenses of hiring management and staff, overhead costs in acquiring and using office facilities, and taxes paid for government services. It also shows the revenues (cash flow) generated by selling services to the public, including making loans and servicing customer deposits. Finally it shows net earnings after all costs are deducted from the sum of all revenues, some of which will be reinvested in the financial firm for future growth and some of which will flow to stockholders as dividends. The principal source of bank revenue generally is the interest income generated by earning assets-mainly loans and investments. Additional revenue is provided by the fees charged for specific services (such as ATM usage). The major expense incurred in generating this revenue include interest paid to depositors, interest owed to non-deposit borrowings, the cost of equity capital, salaries, wages, and benefits paid to employees, overhead expenses associated with the physical plant, funds set aside for possible loan losses, and taxes owed. Net income = Total revenue item – Total expense item Watch illustrative videos on these links: https://www.investopedia.com/terms/i/incomestatement.asp https://www.investopedia.com/terms/c/commonsizeincomestatement.asp Measuring and Evaluating the Performance of Banks and Their Principal Competitors What do we mean by the word perform when it comes to financial firms. In this case, performance refers to how adequately a financial firm meets the needs of its stockholders (owners), employees, depositors and other creditors, and borrowing customers. At the same time, financial firms must find a way to keep government regulators satisfied that their operating policies, loans, and investments are sound, protecting the public interest. The success or lack of success of these institutions in meeting the expectations of others is usually revealed by a careful study of their financial statements. Why are financial statements under such heavy scrutiny today? One key reason is that banks and other financial institutions now depend heavily upon the open market to raise the funds they need, selling stocks, bonds, and short term IOU’s (including deposits). Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 25 BANKING AND FINANCIAL INSTITUTION PROF. 2 Watch illustrative videos on these links: https://www.investopedia.com/ask/answers/121514/what -difference-between- pl-statement-andbalance-sheet.asp https://www.youtube.com/watch? v=KEd_JeEH4_4 https://www.youtube.com/watch?v=h3lMANILkw0 Evaluating Performance How can we use financial statements, particularly the Report of Condition (balance sheet) and Report of Income (income statement), to evaluate how well a financial firm is performing? 1. Determining Long-Range Objectives: Maximizing the Value of the Firm A fair evaluation of any financial firm’s performance should start by evaluating whether it has been able to achieve the objectives its management and stockholders have chosen. The basic principles of financial management, as that science is practiced today, suggest strongly that attempting to maximize a corporation’s stock value is the key objective that should have priority over all others. If the stock fails to rise in value commensurate with stockholder expectations, current investors may seek to unload their shares and the financial institutions will have difficulty raising new capital to support its future growth. The value of the financial firm’s stock will tend to rise in any of the following situations: a. The value of the stream of future stockholder dividends is expected to increase, due perhaps to recent growth in some of the markets served or perhaps because of profitable acquisitions the organization has made. b. The financial organization’s perceived level of risk falls, due perhaps to an increase in equity capital, a decrease in its loan losses, or the perception of investors that the institution is less risky overall (perhaps because it has further diversified its service offerings and expanded the number of markets it serves) and, therefore, has a lower equity risk premium. c. Market interest rates decreases, reducing shareholders acceptable rates of return via the risk-free rate of interest component of all market interest rates. d. Expected dividend increases are combined with declining risk, as perceived by investors. Watch illustrative videos on these links: https://corporatefinanceinstitute.com/resources/knowledge/finance/analysis -of- financial-statements/ https://www.investopedia.com/terms/f/financial -statement- analysis.asp https://slideplayer.com/slide/4546213/ Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 26 BANKING AND FINANCIAL INSTITUTION PROF. 2 2. Determining Profitability Ratios: A Surrogate for Stock Values The behavior of a stock’s price is the best indicator of a financial firm’s performance because it reflects the market’s evaluation of that firm, this indicator is often not available for smaller banks and other relatively small financial-service corporations because the stock issued by smaller institutions is frequently not actively traded in international or national markets. This fact forces the financial analyst to fall back on surrogates for market-value indicators in the form of various profitability ratios. a. Return on Equity Capital (ROE) - is a measure of the rate of return flowing to shareholders. It approximates the net benefit that the stockholders have received from investing their capital in the financial firm. Net income Return on equity capital = ------------------------- Total equity capital b. Return on Assets (ROA) - is primarily an indicator of managerial efficiency; it indicates how capable management has been in converting assets into net earnings. Net income Return on assets = ----------------------------- Total assets c. Net interest margin - measures how large a spread between interest revenues and interest costs management has been able to achieve by close control over earning assets and pursuit of the cheapest sources of funding. (Interest income – Interest expense) Net interest margin = ------------------------------- Total assets d. Net Noninterest Margin - measures the amount of non-interest revenues stemming from service fees the financial firm has been able to collect relative to the amount of non- Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 27 BANKING AND FINANCIAL INSTITUTION PROF. 2 interest costs incurred (including salaries and wages, repair and maintenance of facilities, and loan loss expenses). ( Noninterest revenues - Provisions for loans and lease losses – noninterest expenses) Net noninterest margin = ---------------------------------------------------------------------------------------- Total Assets e. Earnings Spread - measures the effectiveness of a financial firm’s intermediation function in borrowing and lending money and also the intensity of competition in the firm’s market area. Earnings Total interest income Total interest expense = ---------------------------- - ------------------------------------------- Spread Total earning assets Total interest bearing Liabilities What Profitability Measures Can Tell us It tells us much about the causes of earning difficulties and suggests where management need to look for possible cures for any earning problems that will surface. Watch illustrative videos on these links: https://www.investopedia.com/terms/r/ratioanalysis.asp https://www.investopedia.com/articles/stocks/07/bankfinancials.asp https://www.investopedia.com/terms/e/efficiencyratio.asp Measuring Risk in Banking and Financial Services Risk to the manager of a financial institution or to a regulatory supervising financial institutions means the perceived uncertainty associated with a particular event. Types of Risk encountered daily by Financial Institutions 1. Credit Risk The probability that some of the institution’s assets, especially its loans will decline in value and perhaps become worthless. Because Financial firms tend to hold little owners’ capital relative to the aggregate value of their assets, only a small percentage of the total loans needs to turn bad to push them to the brink of failure. The following are four of the most widely used ratio indicators of credit risk: a. Nonperforming assets/Total loans and leases Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 28 BANKING AND FINANCIAL INSTITUTION PROF. 2 b. Net charge-offs of loans/Total loans and leases c. Annual provision for loan losses/Total loans and leases or relative to equity capital d. Allowance for loan losses/Total loans and leases or relative to equity capital e. Nonperforming assets/Equity capital Nonperforming assets are income-generating assets, including loans, that are past due for 90 days or more. Charge-offs are loans that have been declared worthless and written off the lender’ s books. If some of these loans ultimately generate income, the amounts recovered are deducted from gross charged-offs to yield net charge-offs. As the ratio rise , exposure to credit risk grows, and failure of a lending institution may be just around the corner. Annual Provision for loans losses and Allowance for loan losses - reveal the extent to which a lender is preparing for loan losses by building up its loan loss reserves through annual charges against current income. Another popular and long-standing credit risk measure is the ratio of: Total loans/total deposits As this ratio grows, examiners representing the regulatory community may become more concerned because loans are usually among the riskiest of all assets for depository institutions, and, therefore, deposits must be carefully protected. A rise in bad loans or declining market values of otherwise good loans relative to the amount of deposits creates greater depository risk. 2. Liquidity Risk The danger of not having sufficient cash and borrowing capacity to meet customer withdrawals, loan demand, and other cash needs. Faced with this type of risk, financial institutions are forced to borrow emergency funds at excessive cost to cover its immediate cash needs, reducing its earnings. Somewhat more common is a shortage of liquidity due to unexpected heavy deposit withdrawals, which forces a depository institution to borrow funds at an elevated interest rate, higher than the interest rates other institutions are paying for similar borrowings. 3. Market Risk In market-oriented economies, where most of the world’s leading financial institutions offer their services today, the market values of assets, Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 29 BANKING AND FINANCIAL INSTITUTION PROF. 2 liabilities, and net worth of financial service providers are constantly in a state of flux due to uncertainties concerning market rates or prices. Market risk is composed of both price risk and interest rate risk. 3.1 Price Risk Especially sensitive to these market-value movements are bond portfolios and stockholders’ equity, which can dive suddenly as market prices move against a financial firm. 3.2 Interest Rate Risk The impact of changing interest rates on a financial institutions’ margin of profit. 4. Foreign Exchange and Sovereign Risk As the value of a financial institution’s assets denominated in foreign currencies may fall, forcing a write down of those assets on its balance sheet. Under what is often called sovereign risk foreign governments may face domestic instability and even armed conflict, which may damage their ability to repay debts owed to international lending institutions. 5. Off-balance Sheet Risk One of the newest from of risk faced by leading financial institutions which is associated with the rapid build up of financial contracts that obligate a financial firm to perform in various ways but are not recorded on its balance sheet. 6. Operational (Transactional) Risk It refers to uncertainty regarding a financial firm’s earnings due to failures in computer systems, errors, misconduct by employees, floods, lightning strikes, and similar events. 7. Legal and Compliance Risks Legal Risk creates variability in earnings resulting from actions taken by our legal system. Compliance Risk reaches beyond violations of the legal system and includes violations of rules and regulations. 8. Reputation Risk It is the uncertainty associated with public opinion. The very nature of a financial firm’s business requires maintaining the confidence of its customers and creditors. Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 30 BANKING AND FINANCIAL INSTITUTION PROF. 2 9. Strategic Risk Variations in earnings due to adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. This risk category can be characterized as the human element in making bad long-range management decisions that reflect poor timing, lack of foresight, lack of persistence, and lack of determination to be successful. 10. Capital Risk The impact of all risks that can affect a financial firm’s long-run survival. Watch illustrative videos on these links: https://www.investopedia.com/terms/r/risk.asp https://www.investopedia.com/terms/r/riskmanagement.asp https://www.investopedia.com/terms/c/creditrisk.asp https://www.investopedia.com/terms/l/liquidityrisk.asp Risk Management For Changing Interest Rates: Asset-Liability Management and Duration Techniques Financial institutions have not always possessed a completely integrated view of their assets and liabilities. Today, Financial-service managers have learned to look at their asset and liability portfolios as an integrated whole, considering how their institution’s whole portfolio contributes to the firm’s broad goals of adequate profitability and acceptable risk. This type of coordinated and integrated decision making is known as asset-liability management (ALM) – It provides financial institutions with defensive weapons to handle such challenging events as business cycles and seasonal pressures and with offensive weapons to shape portfolios of assets and liabilities in ways that promote each institution’s goals. Watch illustrative videos on these links: https://www.youtube.com/watch?v=8QjCdwhPT8U https://www.youtube.com/watch?v=fZ5_V4RW5pE 1. Asset-Liability Management Strategy Confronted with fluctuating interest rates and intense competition for funds, financial firms began to devote greater attention to opening up new sources of funding and monitoring the mix and cost of their deposit and non-deposit liabilities. The new strategy was called Liability management. Its goal was simply to gain control over their fund sources comparable to the control financial managers had long exercised over their assets. The key control lever was price – the interest rate and other terms offered on deposits and other borrowings to achieve the volume, mix, and cost desired. Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 31 BANKING AND FINANCIAL INSTITUTION PROF. 2 Watch illustrative video on this link: https://financetrainingcourse.com/education/alm/ 2. Fund Management Strategy - The maturity of liability management techniques, coupled with more volatile interest rates and greater risk, eventually gave birth to the fund management approach. This view is a more balanced approach to asset- liability management that stresses several key objectives: a. Management should exercise as much control as possible over the volume, mix, and return or cost of both assets and liabilities in order to achieve the financial institution’s goals. b. Management’s control over assets must be coordinated with its control over liabilities so that the asset management and liability management are internally consistent and do not pull against each other. Effective coordination in managing assets and liabilities will help to maximize the spread between revenues and costs and control risk exposure. c. Revenues and costs arise from both sides of the balance sheet. Management policy needs to be developed that maximize returns and minimize costs from supplying services. Watch illustrative video on this link: https://www.investopedia.com/terms/a/assetmanagement.asp Interest Rate Risk: One of the Greatest Management Challenges When Interest rates change in the financial marketplace, the sources of revenue that financial institution receive – especially interest income on loans and investment securities – and their most important source of expenses-interest cost on borrowings-must also change. Moreover, changing interest rates also change the market value of assets and liabilities, thereby changing the financial institution’s net worth- that is, the value of the owner’s investment in the firm. Thus, changing interest rates impact both the balance sheet and the statement of income and expenses of financial firms. Watch illustrative video on this link: https://www.investopedia.com/terms/i/interestraterisk.asp Forces Determining Interest Rates The rate of interest on any particular loan or security is ultimately determined by the financial marketplace where suppliers of loanable funds (credit) interact with demanders of loanable funds (credit) and the interest rate (price of credit) tends to settle at the point where the quantities of loanable funds demanded and supplied are equal. Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 32 BANKING AND FINANCIAL INSTITUTION PROF. 2 The Measurement of Interest Rates Interest Rates are the price of credit, demanded by lenders as compensation for the use of borrowed funds. In simplest terms the interest rate is a ratio of the fees we must pay to obtain credit divided by the amount of credit we obtained. The Components of Interest Rates Over the years many financial managers have tried to forecast future movements in market interest rates as an aid to combating interest rate risk. However, the fact that interest rates are determined by the interactions of thousands of credit suppliers and demanders makes consistently accurate rate forecasting virtually impossible. Adding to the forecasting problem is the fact that any particular interest rate attached to a loan or security is composed of multiple elements or Risk premiums to compensate lenders building blocks including: who accept risky IOUs for their Nominal (Published) default (credit) risk, Risk-free realInterest Market interest inflation risk, term = rat + or maturity risk, rate liquidity risk, cal e(such as the on a risky loan or risk, etc. Inflation security adjusted return on Not only does the risk- free interest rate change over time with shifts in government bonds) the demand and supply for loanable funds, but the perceptions of lenders and borrowers in the financial marketplace concerning each of the risk premiums that make up any particular market interest rate on a risky loan or security also change over time, causing market interest rates to move up or down, often erratically. Risk Premiums The default-risk premium component of the interest rate charged a risky borrower will increase, raising the borrower’s loan rate (all other factors held constant). Similarly, an announcement of rising prices on goods and services may trigger lenders to expect a trend toward higher inflation , reducing the purchasing power of their loan income unless they demand from borrowers a higher inflation-risk premium to compensate for their projected loss in purchasing power. According to the so called Fisher effect nominal (published) interest rates are equal to the sum of the real interest rate (or purchasing power return) on a loan plus the expected rate of inflation over the life of a loan. Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 33 BANKING AND FINANCIAL INSTITUTION PROF. 2 Many loan and security interest rates also contain a premium for liquidity risk, because some financial instruments are more difficult to sell quickly at a favorable price to another lender. Another rate-determining factor is call risk, which arises when a borrower has the right to pay off a loan early, possibly reducing the leader’s expected rate of return if market interest rates have fallen. Financial instruments with a greater call risk tend to carry higher interest rates, other factors held equal. Yield Curves Another key component of each interest rate is the maturity, or term, premium. Longer term loans and securities often carry higher market interest rates than short term loans and securities due to maturity risk because of greater opportunities for loss over the life of a longer- term loan. Maturity Gap and Yield Curve Most lending institutions experience a positive maturity gap between the average maturity of their assets and the average maturity of their liabilities. It happens when the net interest margin (interest revenues are greater than interest expenses), in which it tends to generate higher earnings. In contrast, a negative net interest margin is when there is downward pressure on the earnings of financial firms that borrow short and lend long. The Concept of Duration as a Risk-Management Tool Duration It is a value and time weighted measure of maturity that considers the timing of all cash inflows from earning assets and all cash outflows associated with liabilities. It measures the average maturity of a promised stream of future cash payments (such as the payment streams that a financial firm expects to receive from its loans and security investments or stream of interest payments it must pay out to its depositors) In effect, duration measures the average time needed to recover the funds committed to an investment. It is also a measure of average maturity. Price Sensitivity to Changes in Interest Rates and Duration The important feature of duration from a risk-management point of view is that it measures the sensitivity of the market value of financial instruments to changes in interest rates. The percentage change in the market price of an asset or a liability is equal to its duration times the relative change in interest rate attached to that particular asset or liability. Limitations of Duration Gap Management Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 34 BANKING AND FINANCIAL INSTITUTION PROF. 2 Finding assets and liabilities of the same duration that fit into a financial- service institution’s portfolio is often a frustrating task. It would be much easier if the maturity of a loan or security equaled its duration. Watch illustrative video on this link: https://www.investopedia.com/terms/d/duration.asp ACTIVITY 4 I: MULTIPLE CHOICE Direction: Read the following questions carefully. Select the best answer in the choices given for each item. Write the letter of your choice on the space provided before each number. ______1. Another name for the balance sheet is ___________________________________. Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 35 BANKING AND FINANCIAL INSTITUTION PROF. 2 a. statement of financial position b. statement of operations c. none of the choices ______2. The balance sheet heading will specify a _________________________________. a. period of time b. point in time c. none of the choices ______3. Which of the following is a category or element of the balance sheet? a. expenses b. gains c. liabilities ______4. Which of the following is an asset account? a. accounts payable b. prepaid insurance c. unearned revenue ______5. What is the normal balance for stockholders' equity and owner's equity accounts? a. debit b. credit c. none of the choices ______6. What is the normal balance for contra asset accounts? a. debit b. credit c. none of the choices ______7. Deferred credits will appear on the balance sheet with the ________________________. a. assets b. liabilities c. owner’s/stockholder’s equity ______8. What do we call a financial statement owned by its members? a. bank b. credit union c. insurance ______9. What do we call a deposit that does not appear on the bank statement? a. cleared deposit b. outstanding deposit c. uncleared deposits ______10. What do we call a financial institution owned by its shareholders? a. bank b. credit union c. insurance company II: ESSAY Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 36 BANKING AND FINANCIAL INSTITUTION PROF. 2 1. Is it possible to combine the ethics of banking procedures in the field of banking operations with the sources of financial crises? (10 pts.) 2. Were the credit risk management systems improved in banks after 2008? (10 pts.) Esquivel – Santos, Ph.D., Virola, MBA & Mallare, MBA Page 37