JUNIOR FINANCE

TBS 2013-2014

TUTORIAL 2
QUESTIONS

1. What are the major categories of bank assets and their approximate percentage
contribution to total resources? What are the major categories of bank liabilities? What are
the fundamental differences between them?
a) Bank assets: Cash and due (20%), Loans and Leases, Securities (70%) and other assets
(10%)
b) Bank Liabilities: Deposits, borrowed funds and Equity capital, all of them are funding
sources for the bank. Deposits are considered as retail funding (jumbo CDs not included).
Borrowed funds are wholesale funding from Central Banks, Capital or Money Market. Equity
capital is the stockholders investment. It is not considered as a debt.

2. Banks typically differentiate between interest and noninterest income and expense. What
are the primary components of each? Define net interest income (NIM) and burden. What
does a banks efficiency ratio measure?
a) interest income is generated by the main activity of the bank. All forms of personal and
commercial loans, mortgages and securities.
b) Bank non interest income derived primarily from fees. Examples of non-interest income
include deposit and transaction fees, insufficient funds (NSF) fees, annual fees, monthly
account service charges, inactivity fees, check and deposit slip fees, etc.
c) Interest expense primarily includes interest expense related to banking deposits and
investment certificates. It also represents interest payable on any type of borrowings
bonds, loans, convertible debt or lines of credit.
d) non interest expense is operating cost that a financial institution must incur, such as
anticipated bad debt provisions. Noninterest expenses can include employee salaries and
benefits, equipment and property leases, taxes, loan loss provisions and professional service
fees.
e) NIM The difference between the interest earned and interest paid is its net interest
income. Net interest margin measures net interest income as a percentage of interestearning assets. The higher this percentage, the better a bank is at managing its assets and
interest requirements.
f) Burden is the gap between non interest expense and non interest income per one dollar of
total assets.

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g) banks efficiency ratio: the proportion of non interest expense in the total operating
income The lower the ratio, the better. An increase in the efficiency ratio indicates either
increasing costs or decreasing revenues.

3. Using PNC in Exhibit 2.2 as a typical large bank, which balance sheet accounts would be
affected by the following transactions? Indicate at least two accounts with each transaction.
a. Arturo Rojas opens a money market deposit account with $5,000. The funds are
loaned in the overnight market for one week.
Balance sheet : Liabilities: Money Market deposit accounts +5.000
Assets: LN &LS in domestic off.: +5.000
b. Just as a real estate developer pays off a strip shopping mall loan, a new resident
optometrist takes out a mortgage on a home.
No transaction, both of these 2 operations are related to real estate loans
c. The bank hires an investment banker to sell shares of stock to the public. It plans to
use the proceeds to finance additional commercial loans.
No transaction

4. Arrange the following items into an income statement. Label each item, place it in the
appropriate category, and determine the banks bottom-line net income.
a. Interest paid on time deposit under $100,000, $23.000 (IE)
b. Interest paid on jumbo CDs $101,000, $56.000 (IE)
c. Interest received on U.S. Treasury and agency securities $44,500 (II)
d. Fees received on mortgage originations $23,000 (No II)
e. Dividends paid to stockholders of $0.50 per share for 5,000 shares (Balance sheet
account)
f. Provisions for loan losses $18,000 (NIE)
g. Interest and fees on loans $189,700 (II)
h. Interest paid on interest checking accounts $33,500 (IE)
i. Interest received on municipal bonds $60,000 (II)
j. Employee salaries and benefits $145,000 (NIE)

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k. Purchase of a new computer system $50,000 (Balance sheet account)

l. Service charge receipts from customer accounts $41,000 (No II)
m. Occupancy expense for bank building $22,000 (NIE)
n. Taxes of 34 percent of taxable income are paid (NIE)
o. Trust department income equals $15,000 (No II)

5. What are the primary sources of risk bank managers face? Describe how each potentially
affects bank performance. Provide one financial ratio to measure each type of risk and
explain how to interpret high versus low values.
a) credit risk: is associated with the quality of individual assets and the likelihood of default.
Assets with poor quality means a potential default or delay in payment which can alter the
bank performance, if provision for loan losses/Loans ratio is high it means that the risk of
default of payment is high.
b) liquidity risk: Banks inability to meet payment or clearing obligations in a timely and costeffective manner may affect bank performance. Liquid assets/total Assets, high ratio means
that bank is able to meet its obligations or any unexpected withdrawal.
c) operational risk: operating expenses might vary significantly from what is expected,
producing a decline in net income and bank value, efficiency ratio measures the bank
expense control: NIE/TOI. This ratio has to be low
d) market risk: is the current and potential risk to earnings and stockholders equity resulting
from adverse movements in market rates or prices. Changes of prices and interest rates alter
the bank net worth. GAP between RSA and RSL, with a positive gap any increase in interest
will increase net income

6. Bank L operates with an equity-to-asset ratio of 6 %, while Bank S operates with a similar
ratio of 10 %. Calculate the equity multiplier for each bank and the corresponding return on
equity if each bank earns 1.5 % on assets. Suppose, instead, that both banks report an ROA
of 1.2 %. What does this suggest about financial leverage?
a) EM of Bank L = Assets/Equity = 1/6% = 16,67
EM of Bank S = 1/10% = 10
b) ROE Bank L = ROA*EM = 1,5% * 16,67= 25%
ROE Bank S = ROA*EM = 1,5%*10 = 15%
c) ROE Bank L = 1,2%*16,67 = 20%
ROE Bank S = 1,2%*10 = 12%

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d) we notice that the EM of Bank L > EM of Bank S, Bank L has a lower capital to assets as
cushion for any loss risk, hence it represents a higher risk of insolvency than Bank S.
Bank L offers a better a return on investment to its stockholders 25% than Bank S does
(15%). Although the same return on assets, the 2 banks offer different ROE because of EM.
The bank with higher EM so with higher financial leverage offers a better ROE but presents a
higher risk of insolvency
We notice that the decline of ROA of 0,3% had a larger impact on the difference between
the 2 banks ROE about 8% (20%-12%) because of the EM magnified this ROA decline.
In sum, with high financial leverage, a bank offers a better return on investment for its
stockholders but do not preserve them from insolvency risk. Moreover, with a high financial
leverage, any change in ROA will be amplified in the ROE.
7. Define each of the following components of the return on equity model and discuss their
interrelationships:
a. ROE : return on any dollar invested in the company
b. ROA : return on any dollar of assets
c. EM : the assets financed by one dollar of equity
d. ER : the expenses generated per one dollar of assets
e. AU : income revenue generated per one dollar of total assets
ROE = ROA*EM, for a high ROE we need to higher NI or to low equity (undertaking higher
risk)
ROE = (AU-ER)*EM, for a high ROE we need to higher NoII and II and keep down the
expenses, or to low equity (undertaking higher risk)

8. Explain why profitability ratios at small banks typically differ from those at the largest
money center banks.
Small banks generated higher ROAs, on average, and generally assumed less risk. This has
changed with increased competition, expansion into new product and geographic markets,
and more recent economic events. Today, it appears that the most profitable banks (by ROA)
are those in the $1 billion to $10 billion asset size category but the highest return to
shareholders ROE is produced by the largest banks.
The low return to the smallest banks can be attributed to their extremely low noninterest
income, while the largest banks lower return can be attributed to their low average net
interest margin and slightly higher noninterest expense.

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9. Regulators use the CAMELS system to analyze bank risk. What does CAMELS stand for and
what financial ratios might best capture each factor?
C: capital adequacy, signals the institutions ability to maintain capital commensurate with
the nature and extent of all types of risk, EM or Equity/assets
A: asset quality reflects the amount of existing credit risk associated with the loan and
investment portfolio as well as off-balance sheet activities. Net charges off/LN&LS
M: management of quality reflects the adequacy of the board of directors and senior
management systems and procedures to identify, measure, monitor, and control risks
E: earnings dont reflect only the quantity and trend in earnings, but also the factors that may
affect the sustainability or quality or earnings. ROE, ROA, Earnings/assets
L: Liquidity reflects the adequacy of the institutions current and prospective sources of
liquidity and funds. Net no core fund dependence: short term borrowing short term
investment < 0 is a good indicator sine it reflects a greater capacity to acquire additional
assets and liabilities
S: sensitivity to the market risk reflects the degree to which changes in interest rates, foreign
exchange rates, commodity prices, and equity prices can adversely affect earnings or
economic capital.
See exhibit 2.8
10. Rank the following assets from lowest to highest liquidity risk:
a. Three-month Treasury bills
e. Three-month Treasury bill pledged as collateral
b. Four-year car loan with monthly payments
d. One-year individual loan to speculate in stocks
f. one-year construction loan
g. five-year municipal bond
c. Five-year Treasury bond

11. In each pair below, indicate which asset exhibits the greatest credit risk. Describe why.
a. Commercial loan to a Fortune 500 company or a loan to a corner grocery store
b. Commercial loans to two businesses in the same industry; one is collateralized by
accounts receivable from sales, while the other is collateralized by inventory as work-inprocess
c. Five-year Ba-rated municipal bond or a five-year agency bond from the Federal
Home Loan Mortgage Corporation (Freddie Mac)

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d. One-year student loan (college) or a one-year car loan

12. What ratios on common-sized financial statements would indicate a small bank versus a
large, multibank holding company? Cite at least five.
The largest banks generally employ fewer people per dollar of assets than smaller banks.
The largest banks are generally offering very standardized loans and deposit products, hence
competition is steep and margins small
smaller banks generally operate with proportionately more core deposits and fewer volatile
liabilities as compared with the largest banks.
largest banks report much higher net charge-offs than smaller banks
larger banks operate with less equity and more debt

13. In some instances, when a bank borrower cannot make the promised principal and
interest payment on a loan, the bank will extend another loan for the customer to make the
payment.
a. Is the first loan classified as a nonperforming loan?
b. What is the rationale for this type of lending?
No, the loan extended by the bank will allow the borrower to pay the first loan
therefore it is not considered as non performing loan. Bank discretion management
would keep down non performing or past due loans ratio. First, nonperforming loans
are understated on the balance sheet, so that credit risk is actually higher than it
appears. Second, interest accrued but not collected increases net interest income,
thus overstating NIM, ROA, and ROE.
c. What are the risks in this type of lending?
The default risk of the borrower is certain and the bank management would hide it.
Bad or poor quality of bank assets.

14. Suppose that your bank had reported a substantial loss during the past year. You are
meeting with the banks board of directors to discuss whether the bank should make its
traditional (twenty-five years straight) dividend payment to common stockholders. Provide
several arguments that the bank should authorize and make the dividend payment. Then,

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provide several arguments that it should not make the payment. What should decide the
issue?
Against dividend payment:
leakage of capital that is better utilized if it is retained by the company. This retained capital
can then be used to make further investment in its business hopefully enhancing growth
and rewarding investors with an overall higher total return.
For dividend payment:
Rewarding stockholders and maintaining a stable relationship. To prove to the stockholders
those losses tend to be transitory driven by special items

15. Explain how each of the following potentially affects a banks liquidity risk:
a. Most (95 %) of the banks securities holdings are classified as held-to-maturity: A
held to maturity security is an equity security that is purchased with the intention of
holding the investment to maturity. This type of security is reported at amortized
cost on a banks financial statements . This item affects dramatically the liquidity of
the bank
b. The banks core deposit base is a low (35 percent) fraction of total assets: Banks
count on core deposits as a stable source of funds for their lending base. core
deposits are generally less vulnerable to changes in short-term interest rates than
CDs or money market accounts. This item affects dramatically the liquidity of
the bank. The greater are the core deposits in the funding mix, the lower are the
unexpected deposit withdrawals and potential new funding requirements; hence, the
greater is the banks liquidity.
c. The banks securities all mature after eight years.: long term investment which may
affect the liquidity of the bank
d. The bank has no pledged securities out of the $10 million in securities it owns. No
pledged securities can be sold if the bank needs cash

PROBLEMS

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1. Evaluate the performance of Community National Bank relative to peer banks using the
data in Exhibits 2.2, 2.3, 2.6, 2.7, and 2.8. Did the bank perform above or below average in
2004 ? Did it operate with more or less relative risk?
a. Conduct a return on equity decomposition analysis for 2004, identifying where the
banks performance compared favorably and unfavorably with peer banks.
b. Compare the banks risk measures with those of peer banks. What are the
implications of any significant differences?
c. What recommendations would you make to adjust the banks risk and return
profile to improve its performance?

2. The summary UBPR page for Citibank, NA is shown in the Appendix. Average total assets
for Citibank were quite high as of December 31, 2004. Use the data from December 31,
2004, to explain whether this bank was a high- or low-performance bank. Discuss specifically
(1) financial leverage, (2) expense control, and (3) the contribution of interest and
noninterest income to overall bank profitability.
List three areas that management should focus on to improve performance. Using the
limited information provided, evaluate Citibanks credit, liquidity, and capital risk.