What is the rate of asset growth and how would you characterize this growth

What is this Project’s Objective? This project is designed to improve your ability to analyze a particular bank’s performance. The emphasis should be to explore your bank from a regulator’s point of view. In that respect you should address the six CAMELS components and try to identify any “red flags” that could indicate potential problems in your bank. The Excel file under the name of “Bank Financial Analysis” should be used to capture the financial data for your bank and to show the associated financial ratios. You should be able to find all your data in your bank’s Uniform Bank Performance Report (UBPR) which is available at www.ffiec.gov. Your written report should be no less than 5 pages long (typed, double-spaced) not including the Excel worksheet. The six CAMELS components are: Capital adequacy; Asset quality; Management quality; Earnings record; Liquidity position; and Sensitivity to market risk. Following is a more detailed listing of the items that you need to address:

A. Liquidity Consider your bank’s Uniform Bank Performance Report (UBPR) and provide an overview of your bank’s liquidity by reviewing the following areas:

1. Liquidity and Funding Ratios especially the Net Non-Core Funding Dependence and Loan to Assets Ratios – The first ratio measures the degree to which the bank is funding longer-term assets (loans, securities that mature in more than one year, etc.) with non-core funding. Non-core funding includes funding that can be very sensitive to changes in interest rates such as brokered deposits, CDs greater than $100,000, and borrowed money. Higher ratios reflect a reliance on funding sources that may not be available in times of financial stress or adverse changes in market conditions. What are the trends in these ratios? How do they compare to the peer?

2. The availability of liquid assets readily convertible to cash without undue loss- Consider Federal funds sold, available for sale securities, loans for sale, etc.

3. Core deposit/asset growth – Are core deposits capable of funding anticipated asset growth?

4. Diversification of funding sources – A bank with strong liquidity has a strong core deposit base, established borrowings lines, and procedures in place for acquiring internet-based or other forms of emergency borrowing.

5. External Forces – Economic conditions, competition, marketing efforts, etc. have a material impact on the need for liquidity going forward.

You should also take a look at your textbook’s continuing case assignment for chapter 11 which discusses various bank liquidity indicators.

B. Sensitivity to Market Risk Sensitivity to Market Risk – refers to the risk that changes in market conditions could adversely impact earnings and/or capital. Market Risk encompasses exposures associated with changes in interest rates, foreign exchange rates, commodity prices, equity prices, etc. While all of these items are important, the primary risk in most banks is interest rate risk (IRR). In the most simplistic terms, interest rate risk is a balancing act. Banks are trying to balance the quantity of


repricing assets with the quantity of repricing liabilities. For example, when a bank has more liabilities repricing in a rising rate environment than assets repricing, the net interest margin (NIM) shrinks. Conversely, if your bank is asset sensitive in a rising interest rate environment, your NIM will improve because you have more assets repricing at higher rates. Use your textbook’s continuing case assignment for chapter 7 and discuss sensitivity to market risk for your institution. In this section look for red flags such as a substantial change in the NIM – Look for substantial decreases or increases in the NIM. Changes in both directions could indicate that the bank is taking on more IRR than expected. Keep in mind, however, that significant changes in the NIM are not necessarily related to IRR. Changes in the balance sheet such as changing the percentage of earning assets, changing the risk profile, or changing the quantity of non-interest bearing funds can all affect the NIM. It should be noted that there are many ways to monitor exposure to IRR. Measurement systems vary in complexity from very simple methods such as a gap model, to very sophisticated models such as a simulation or duration analysis. A simple gap model is presented below to show the exposure that we are trying to measure. Repricing Time Frame

Account Balance 0-12 months

1-5 years >5 years

Cash 13,000 Investments 26,000 10,000 12,000 4,000 Loans 170,000 94,000 68,000 8,000 Federal funds 1,200 1,200 0 0 Premises 2,000 0 0 0 Other Assets 5,000 0 0 0

Totals 217,200 105,200 80,000 12,000 Deposits 160,000 132,000 28,000 0 Borrowings 35,000 20,000 15,000 0 Other Liabilities 4,000 0 0 0

Totals 199,000 152,000 43,000 0 Gap (RSA-RSL) (46,800) 37,000 12,000 Cumulative Gap (46,800) (9,800) 2,200 Gap Ratio (Gap/Earning Assets)


The chart above shows a gap ratio of negative 23.7%, indicating a significant amount of liability sensitivity over the next 12 months. During this time, management will have to reprice approximately $152 million in liabilities but will have only $105 million in assets reprice. This chart

suggests that a rising interest rate environment would have a negative impact on interest margins. Specifically, with an additional $46.8 million in liabilities repricing, the model predicts that a 100 basis point rise in rates would cost the bank an estimated $468,000 in income.

C. Earnings In this section, you need to evaluate earnings by assessing:

• The level, trend, and stability of earnings – Look for earnings fluctuations and try to determine the cause of those fluctuations.

• The quality and sources of earnings – Are the primary sources of income from normal banking activities that you can rely on in the future? Try to assess the amount that is attributable to non-recurring sources – like extraordinary gains or investment trading activities.

• The ability to augment capital through retained earnings – This factor is very important, especially in times of rapid growth or increasing risk.

• The exposure to market risks – For most banks, this exposure is centered in interest rate risk. Maintaining higher levels of interest rates risk can create dramatic swings in income and could have negative implications for future earnings.

• The provisions for loan losses – If the allowance for loan losses is not adequate for the risk identified in the loan portfolio, additional provisions will be necessary, which will lower net income.

Look at your bank’s Uniform Bank Performance Report and focus on some key earnings ratios that will help you monitor earnings performance. One fairly standard approach to this analysis is to follow what regulators typicaly refer to as the “Earnings Analysis Trail”. It focuses on the following five items found on the Summary Ratios page of the UBPR under Earnings and Profitability. Net Income Logically, the first item to look at is the bottom line to determine how well the bank is doing overall. The line item listed as Net Income in the Earnings and Profitability section is also known as Return on Assets (ROA). The ratio is calculated by dividing net income (after all expenses and taxes) by average assets. Net Interest Income The second step on this earnings analysis trail is the line item Net Interest Income (NII). This ratio is calculated by subtracting total interest expense from total interest income and dividing the result by average assets. Non-Interest Income The line item for Non-Interest Income mainly consists of service charges and miscellaneous account fees and is usually the second major type of bank income. Like the other ratios we have seen, this ratio is measured as a percentage of average assets. Overhead Expenses Overhead is accounted for as Non-Interest Expense on the UBPR. This item includes all operating expenses except for interest expense and provisions for loan losses. This line item includes expenses such as salaries, depreciation, consulting fees, and supplies. This ratio is more fully detailed on page 4 of the UBPR.

Provision for Loan Losses Another item that you need to discuss in the Earnings and Profitability section is the Provision for Loan Losses. Your main concern here is whether the provisions are adequate to maintain the Allowance for Loan Losses at an appropriate level. If the allowance is too low relative to risk in the loan portfolio, additional provisions will be necessary, which must be taken out of earnings.

As you are discussing earnings and profitability, you should specifically address any items with significant changes. In that respect, you could answer questions such as:

– What has caused the change in net income? What is the reason for the increase or decrease in overhead expenses?

– Review the following ratios:

• Yield on Total Loans • Personnel Expenses as a Percent of Average Assets

– Has the yield on total loans and leases increased or decreased during this period? At the same time what happened to the interest income as a percent of average assets (Summary Page)?

– What are the reasons for the rise or drop in Non-Interest Expense?

Finally, use your textbook’s continuing case assignment for chapter 6 and discuss some of the remaining profitability ratios shown there such as ROE; and the breakdowns of ROA; ROE; and net profit margin for your institution. D. Asset Quality The assessment of asset quality involves much more than simply calculating past due and adverse classification ratios. In addition to assessing trends in classified assets, delinquent loans, and credit concentrations, the asset quality component takes into account management’s ability to underwrite and administer credits in a prudent and sound manner. In that respect, the regulators will examine a bank’s loan policies, loan portfolios and the adequacy of the allowance for loan and lease losses

The UBPR is a good starting point to begin extracting asset quality information. It is a very useful tool for identifying trends or outlying performance issues relative to a group of similar banks. Examiners use the UBPR to plan for examinations by identifying areas with potential credit exposure. Nonetheless, the UPBR will only take you so far in painting a picture of asset quality.

Several financial ratios relating to asset quality are available in the UBPR. These ratios provide detail on balance sheet composition, off-balance sheet commitments, delinquencies, charge-offs, and portfolio mix. Four ratios to focus on when assessing asset quality include:

1. Asset Growth Rate – This ratio details the change in total assets over the past 12 months.

2. Non-current Loans and Leases to Gross Loans and Leases – This ratio reflects the percentage of loans that are 90 days or more past due, or are no longer accruing interest.

3. Net Losses to Average Total Loans and Leases – This ratio presents the level of net losses, on an annualized basis, as a percentage of the total portfolio. It takes into consideration any recoveries on prior period losses.

4. Loan and Lease Allowance to Total Loans – This ratio measures the allowance available to absorb loan losses relative to total loans outstanding.

In relation to these ratios, answer the following questions:

– Asset Growth Rate – What is the rate of asset growth and how would you characterize this growth?

– What category dominated asset growth? – Non-current Loans to Gross Loans – How would you characterize the level of

delinquencies? – Net Losses to Average Total Loans – What has the trend been? – Loan and Lease Allowance to Total Loans and Leases – What conclusions can you draw

about the adequacy of the allowance?

Of course, UBPR analysis is a starting point. You should also review your textbook which discusses the various bank assets in more detail. E. Capital After reviewing the previous four components, you should have developed a good idea as to what this bank’s risk profile looks like. You will know whether they have weak or strong earnings record, any asset quality or liquidity problems and what the exposures are. The level of capital that would be considered satisfactory will vary according to the level of risk in a bank. Of course, the higher the risk, the greater the level of support required. Keep this in mind when you look at your bank’s Uniform Bank Performance Report (UBPR). Even though a given bank’s capital ratios are higher than peer, it does not mean that the bank has satisfactory capital. Peer ratio comparisons don’t consider your bank’s risk profile and don’t provide a conscious assessment of a bank’s capital position. It is not unusual that a bank with greater than peer capital levels might receive a lower capital rating. Basically, capital adequacy is examined relative to a given bank’s risk profile and when you assess capital you need to consider any factor that impacts the bank. A short list of things that may impact the need for more or less capital include:

1. The quality, type, and diversification of assets – If your bank has high levels of classifications, sub-prime loans, high or unmonitored concentrations, aggressive underwriting, etc., you’ll need higher levels of capital.

2. The quality of management – If the institution operates with bare minimum staffing levels or lower quality management, the risk profile is higher, requiring higher levels of capital.

3. The quantity and quality of earnings available for capital augmentation – When we talk about the quality of earnings, we consider whether earnings are from core banking operations or from anomalies such as gains on the sale of assets. The quantity of earnings is important because we are concerned with the bank’s ability to augment capital via retained earnings.

4. Exposure to changing interest rates – Higher/lower interest rate risk impacts the risk profile and thus the need for more or less capital.

5. Anticipated growth (strategic plan/budget) – Regulators are concerned with what the capital needs will be going forward. This is assessed relative to earnings available for augmentation, as well as existing levels of capital.

6. Local economic conditions – If the bank’s market is limited to one economic area or one industry, the risk profile is greater. The greater the diversification, the lower the risk.

7. Dividend requirements to shareholders or a holding company – Again, regulators are interested in what’s available for capital augmentation to support growth and the risk profile.

The above items are all qualitative factors. You should also use quantitative factors to assess capital. Some key ratios are provided in your UBPR, and include the following:

1. Tier 1 Leverage Capital Ratio (Tier 1 Capital/Average Assets) 2. Tier 1 Risk-Based Capital Ratio (Tier 1 Capital/Risk Weighted Assets) 3. Total Risk-Based Capital Ratio (Total Capital/Risk Weighted Assets)

Your textbook provides definitions of the various capital categories in chapter 15.

As you are reviewing your bank’s capital ratios, you should pay particular attention to the following:

– The level of the capital ratios – How do they compare to peer? – What are the trends? – Which of these ratios showed the most significant change? – Why would one capital ratio show a greater change than another?

Additionally, look to the growth rate section.

– Can you explain any significant changes in the capital ratios? – What asset category dominated the growth or drop in total assets in recent times? – If it’s loan growth or decline does this loan change affect your bank’s risk profile?

You should also take a look at your textbook’s continuing case assignment for chapter 15 which covers bank capital.

F. Management This section is a review of your bank’s management including its directors. In general, the bank directors are responsible for formulating sound policies, setting strategic direction, and effectively supervising its management team; whereas the management team is responsible for implementing those policies in managing day-to-day operations. It is important to clearly differentiate between the board’s and the management team’s responsibilities. The primary responsibilities of the board members are to:

• Establish clear direction, policies, and risk limitations for the bank – Directors should not be involved in the day-to-day operations of the bank, but need to establish policies that give clear guidance with regard to acceptable activities, procedures, and risk limitations.

• Hire qualified senior officers – Senior officers should have a proven ability to operate departments or institutions of similar complexity and share the same attributes as directors (personal integrity, knowledge of trade area, capacity for sound business judgment, etc.).

• Ensure that management operates the bank within the established policies and risk limitations: Since directors are not typically involved in day-to-day activities, this is accomplished by:

o Implementing an effective internal audit and review program o Establishing an effective management reporting system (board packages,

committee minutes, UBPR analysis, etc.) o Reviewing regulatory examination reports o Staying involved by visiting the bank, attending meetings (especially with

regulators and auditors), and by asking questions

Examiners evaluate and rate management on a variety of factors and criteria, many of which are listed below. Basically they consider how well the board and senior management:

• Plan for and oversee operations – This includes funding strategies, portfolio management, compliance, information technology, new business activities, etc. The best managed banks have an active and fully informed board that is encouraged to ask questions during board meetings and requires management to fully assess operations when doing their strategic planning.

• Identify, measure, monitor, and control risks – Examiners will consider management practices when rating all of the CAMELS components; however, the management component rating encompasses the assessment of risk management practices throughout all operational areas.

• Establish and implement adequate policies, procedures, and controls – Policies can be effective tools for the board, senior officers, and employees, but only if they truly reflect the needs of the bank.

• Provide for an effective audit program – An effective audit program is one that is comprehensive, independent, objective, and overseen by an audit committee comprised of outside directors. These audits provide an opportunity to validate management’s procedures and to ensure that the information supplied by management is accurate. Here, it is important to make sure that the audit committee is the primary contact with auditors and that management does not have an overwhelming influence on those auditors.

• Avoid dominant influence or concentration of authority – Allowing an officer or director to have a dominant influence can overwhelm even the best control systems. This can be a leading cause of poor bank performance and one that has contributed to several bank failures.

• Provide for management depth and succession – The loss of key officers will disrupt any bank’s operations, so it is important to determine whether the bank is prepared for this loss by identifying and grooming key individuals.

• Avoid self-dealing – All of the regulatory agencies have regulations that govern transactions between financial institutions and their insiders and affiliates. Essentially, these laws require that the bank interests are first and that appropriate disclosures are been made.

Essentially rating of this component reflects the board’s and management’s ability to identify, measure, monitor, and control the risks associated with an institution’s activities and to ensure safe, sound, and efficient operations in compliance with applicable laws and regulations. While directors may not need to be actively involved in day-to-day operations, they must provide clear guidance regarding acceptable risk exposure levels and ensure that appropriate policies, procedures, and practices have been established. Senior management is responsible for developing and implementing policies, procedures, and practices that translate the board’s goals, objectives, and risk limits into prudent operating standards. While some of the required information for an appropriate evaluation of management is not available to the general public, you should still try to assess the management component by reviewing any evidence that you are able to locate about the following factors:

• The level and quality of oversight of all institution activities by the board of directors and management

• The ability of the board of directors and management, in their respective roles, to plan for, and respond to, risks that may arise from changing business conditions or the initiation of new activities or products

• The adequacy of, and conformance with, appropriate internal policies and controls • The accuracy, timeliness, and effectiveness of management information systems • The adequacy of audits and internal controls • Compliance with laws and regulations • Responsiveness to recommendations from auditors and supervisory authorities • Management depth and succession • The extent that the board of directors and management is affected by, or susceptible to,

dominant influence or concentration of authority • Reasonableness of compensation policies and avoidance of self-dealing • Demonstrated willingness to serve the legitimate banking needs of the community • The overall performance of the institution and its risk profile


In this section, you should summarize your findings in the form of strengths and weaknesses and provide any Recommendations that you might have for your institution.

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