B A N K F I N A N C I A L S TAT E M E N T A N A LY S I S , R AT I O A N A LY S I S A N D

P E R F O R M A N C E A N A LY S I S

Financial Institution Financial Statement Analysis

Assets

Current Assets / Liquid Assets

 Cash and cash due from Central Bank; cash on deposit in postal banking accounts; Due from Banks; Interest-
bearing deposits in other banks
 Cash held in trust: may be on the behalf of a third party or the result of a merger/acquisition and may have
restrictions encumbering its usage.
 Fed Funds Sold: Federal funds, or fed funds, are unsecured loans of reserve balances at Federal Reserve Banks
that depository institutions make to one another. Banks keep reserve balances at the Federal Reserve Banks to meet
their reserve requirements and to clear financial transactions. Transactions in the fed funds market enable depository
institutions with reserve balances in excess of reserve requirements to lend them, or ?sell? as it is called by market
participants, to institutions with reserve deficiencies. Fed Funds are sold daily to various financial institutions
(commercial banks, thrift institutions, agencies and branches of foreign banks in the United States, federal agencies,
and government securities dealers) throughout the United States. The most common duration or term for fed funds
transaction is overnight, though longer-term deals are arranged. The rate at which these transactions occur is called
the fed funds rate.

Fed funds transactions can be initiated by either a funds lender or a funds borrower. An institution seeking to lend fed
funds identifies a borrower directly, through an existing banking relationship, or indirectly, through a fed funds broker.
The most commonly used method to transfer funds between depository institutions is for the lending institution to
authorize its district Federal Reserve Bank to debit its reserve account and to credit the reserve account of the
borrowing institution.

Most overnight loans are booked without a contract. The borrowing and lending institutions exchange verbal
agreements based on various considerations, particularly their experience in doing business together, and limit the
size of transactions to established credit lines in order to minimize the lender's exposure to default risk.

Overnight fed funds transactions under a continuing contract are renewed automatically until termination by either the
lender or the borrower. This type of agreement is used most frequently by correspondent banks that borrow overnight
fed funds from a respondent bank.

 Due From Banks: demand and time deposits with other banks (does not include loans to banks that may be
termed time deposits due from banks) and although there is a slight element of risk involved, it is still considered
cash.
 Negotiable Certificates of Deposit, which should be stated at the lower of cost or net realizable value.
 Marketable Securities: U.S. Treasury and other U.S. government agencies, States and political subdivisions,
exchange listed (publicly traded) securities such as corporate bonds equities, Asset-backed securities Mortgage-
backed securities. This account is also sometimes known as Securities Available-for-Sale (amortized; price
movements in these securities are dependent upon the movement in market interest rate).

During 2009, many banks in the United States have purchased mortgage-backed securities issued and guaranteed
by the Government National Mortgage Association (Ginnie Mae / GNMA), which are also backed by the FHA, in
order to improve the bank's balance sheet as they are seen as high quality compared to other securities (due to the
federal government guarantee) and also because they receive a zero risk weighting under regulatory guidelines and
improve the bank's capital ratios. However, it is some what manipulative of the capital ratio as the replacing FNMA,
FHLMC and private label securities with GNMA securities will quickly improve the capital ratios even as loans in the
bank's portfolio are deteriorating.

Loans less than one year

 Advances to customers
 Accounts receivable - trade

 Securities held under Reverse Repurchase Agreements: the financial institution "lent" out cash and took
securities at a discounted value as security, which are recorded as receivables.

Please also see A Guide to Repurchase Agreements

Loans or Receivables (of various maturities in excess of one year) will represent one of the main business activities
of the the bank and may account for the largest percentage of total assets. A loan is an extension of credit resulting
from direct negotiations between a lender and a borrower. Loans may be held until maturity, may be sold in whole or
a portion to third parties, and may also be obtained through purchase in whole or in portion from third parties.
 What is in the portfolio? Corporate / commercial loans (secured / unsecured, fixed-term / revolving)? Construction
loans (this is one of the riskiest types of loan), Commercial lease financing, Mortgages (residential or commercial),
secured loans, loans to public authorities, consumer loans such as credit card, home equity and personal loans;
consumer lease financing?
 Collateralized loans mean that the grantor has in its possession (or a fiduciary, administrator, trustee) readily
marketable or highly liquid instruments (cash, CDs, stocks and bonds). Sufficient margin on collateralized credits
should also be provided (due to interest rate and market sensitivity).
 Secured loans are secured by assets that are not readily marketable and/or under the control of the recipient of
the loan (UCC filings on receivables, pledges of inventory, equipment, assignment of real estate mortgages or rents,
contracts). Pledge of inventory and real estate should be adequately insured and in the name the Grantor.
 Loans secured by real estate are loans predicated upon a security interest in real property. A loan predicated upon
a security interest in real property is a loan secured wholly or substantially by a lien on real property for which the lien
is central to the extension of the credit
 Shown net of Allowance of Losses (the reserve set aside that represents an amount considered by management
to be adequate to cover estimated losses in the loan portfolio).

What is the difference between Loan Loss Reserve and Loan Loss Provision? The Reserve is the balance sheet
component that has already been established (to cover actual or anticipated deterioration of the loan assets). The
provision is the income statement component amount that is charged against earnings and will be added to the
Reserves (thus increasing the Reserve account).

 Due from parental holding company or related company (unsecured? rate?)

 What are maturities (mix should slant to the short-term).
 What is the performance of the portfolio? Delinquencies, charge-offs and provisioning? How quickly does the bank
classify a loan as over due / delinquent. and / or non-performing (30 days or 180 days)?
 If loan quality deteriorates, then the resultant for increased provisioning will result in lower earnings for the year (or
coming years if deterioration continues in a recession or high interest rate environment).
 Credit quality concerns are cyclical as banks over-lend to sectors experiencing growth and then that growth stops
(LDC/less developed countries, commercial real estate, consumer loan/credit card portfolio).

Legal lending limits:

The legal lending limit for national banks is set forth at 12 U.S.C. § 84. Specifically, 12 U.S.C. § 84(a) indicates that
loans to one borrower generally cannot exceed 15% of the bank?s capital and that lenders can make additional loans
to a borrower totaling up to 10% of the bank?s capital if those additional loans are fully secured by ?readily
marketable collateral.? The legal lending limit also generally applies to Federal Deposit Insurance Corporation-
insured thrift institutions. See 12 U.S.C. § 1464(u). Respective state law applies legal lending limits to state-regulated
banks.

What does capitalized interest mean? It means that uncollected interest has been added to the principal balance of
the loan.
What happens when a loan goes bad? When a loan (or other investment) is deemed uncollectible, the financial
institution must remove it from the asset side of the balance sheet and from the Reserve for Loan Losses Account or
an appropriate expense account.

 Derivative Contracts for managing (positioning or hedging) exposure to market risk (including interest rate risk
and foreign exchange risk), cash flow risk, and other risks in operations and for trading. The accounting and reporting
standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for
hedging activities are set forth in FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging
Activities," as amended. Statement No. 133 requires all derivatives to be recognized at their fair value.

The accounting standard for fair value measurements that should be applied in accounting pronouncements that
require or permit fair value measurements is FASB Statement No. 157, ?Fair Value Measurements? (FAS 157),
which defines fair value and establishes a framework for measuring fair value. The definition of fair value for an asset
or liability is the price that would be received to sell the asset or paid to transfer the liability in an orderly transaction
between market participants (not a forced liquidation or distressed sale) in the asset?s or liability?s principal (or most
advantageous) market at the measurement date. The transaction is assumed to occur based on an exit price notion
versus an entry price.

 Mortgage Servicing Rights (MSRs): Many banks that originate primary residential mortgages and then sell them
into the secondary market retain the servicing rights of the mortgage. This means that for a fee the bank collects the
monthly payment from the mortgagee and passes on the principal and interest components of the payment to the
trust that owns the mortgage and then also makes the insurance and real estate tax payments from the escrow
account that is maintained.

Mortgage servicing rights represent a future stream of payments. The on-balance sheet carrying value of these
MSRs is still subject to a fair value test under FAS 140, Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities. The value of the MSRs are affected by the prepayment speed of the underlying
mortgages being serviced because if they pay off faster than had been assumed then there are fewer mortgages to
be serviced and a resultant lower income stream than had been anticipated. Thus, in a declining interest rate
environment where home owners are refinancing to a lower rate or selling and purchasing a new home and the
original MSR is rapidly losing mortgages from the original group to be serviced the bank must now write down the
value of the MSR portfolio. Conversely, in a rising interest rate environment the MSRs tend to have a stable or
increasing value as the maturity of the MSRs lenghten (as no one is refinancing).

Federal Home Loan Bank capital stock

 Often a component of U.S. banks' balance sheets.
 Fixed Assets
 Leasehold and freehold land and buildings (at historical cost or at revised market value at time of statements, less
depreciation and amortization).
 Tangible fixed assets: fixtures, equipment, motor vehicles (depreciated or amortized).

Investments
 Brady bonds (should not be carried at a value not exceeding their secondary market value).
 Investments in subsidiaries.

Other Assets
 Bank-Owned Life Insurance

Other real estate owned ("OREO")

 Foreclosed property held by the bank.
 Deferred Taxes

Deferred Tax Assets (DTA) - as a result of the financial crisis during 2008 through 2010, U.S. regulators have
allowed banks to book losses that can be utilized to reduce future income tax payments as an asset on the bank's
balance sheet. The accounting treatment of determining the asset size is somewhat discretionary, which is based on
management's estimate of future earnings and projected tax liabbilities. In the event that the United States enacts tax
reform, which would result in a corporate tax rate lower than the present 35% rate, then the present value of the DTA
would be lower as the actual future tax liability would be lower, hence a lower tax deduction would be necessary (at a
35% tax rate, the deduction is worth $350,000 per $1.0 million in positive earnings; at a tax rate of 25%, the
deduction is now only worth $250,000 per $1.0 million in positive earnings, thus the bank would be required to write-
down the value of the DTA at the moment of corporate tax reform).

Intangibles and Goodwill

 Goodwil is generated when a bank purchases a operating company in excess of its book value. U.S. Banks are
required under GAAP accounting guidelines to perform goodwill impairment tests periodically.

Liabilities

Current Liabilities
 Due to customers (onsight or time deposits) / Deposits: Savings accounts, regular checking accounts, NOW
accounts, money market deposit accounts, CDs.
 Core Deposits consist of all interest-bearing and noninterest-bearing deposits, except certificates of deposit over
$100,000. They include checking interest deposits, money market deposit accounts, time and other savings, plus
demand deposits.

Core deposits represent the most significant source of funding for a bank and are comprised of noninterest-bearing
deposits, interest-bearing transaction accounts, non-brokered savings deposits and non-brokered domestic time
deposits under $100,000. The branch network is a bank's principal source of core deposits, which generally carry
lower interest rates than wholesale funds of comparable maturities.

It can be difficult for a bank to attract deposits in a mature market except by increasing savings rates. However, that
action can result in a reduction of the bank's net interest income. In addition, if the bank offers a higher rate to new
customer accounts then it can alienate existing customers (who may withdraw their depost permanently or seek to
open a new account in order to obtain the higher rate). Another problem with deposits is that there tends to be a
maturity mismatch with long-term assets.

 Brokered Deposits represent funds which the bank obtains, directly or indirectly, by or through any deposit
broker for deposit into one or more deposit accounts. Thus, brokered deposits include both those in which the entire
beneficial interest in a given bank deposit account or instrument is held by a single depositor and those in which the
deposit broker sells participations in a given bank deposit account or instrument to one or more investors. Fully
insured brokered deposits are brokered deposits that are issued in denominations of $100,000 or less or that are
issued in denominations greater than $100,000 and participated out by the deposit broker in shares of $100,000 or
less.
 Due to banks (on-sight or time deposits)
 Commercial Paper consists of short-term negotiable promissory notes issued in the United States, which rollover
every 30 to 270 days and are usually not collateralized.
 Short-term borrowings are usually from banks, securities dealers, the Federal Home Loan Bank, unsecured
federal funds borrowings, which generally mature daily.
 Fed Funds Purchased are short-term, unsecured borrowings.
 Advances from a Federal Home Loan Bank are fully collateralized by loans on the bank's asset-side of the
balance sheet.
 Dividend payable (preferred stock dividend in arrears)
 Derivative Contracts for managing (positioning or hedging) exposure to market risk (including interest rate risk
and foreign exchange risk), cash flow risk, and other risks in operations and for trading. The accounting and reporting
standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for
 hedging activities are set forth in FASB Statement No. 133, "Accounting for Derivative Instruments and Hedging
Activities," as amended. Statement No. 133 requires all derivatives to be recognized at their fair value.

Long-Term Liabilities

 Notes payable

 Mortgages payable, which may have been incurred for commercial property where either the headquarters, offices
or branches of the bank are located.

 Covered Bonds, which is bank debt backed by a pool of pledged, secured, qualifying collateral, usually bank
loans. However, principal amortization and interest is usually satisfied by the cash flow of the bank, not the cash flow
of the assets in the cover pool. The cover pool is usually structured to allow a revolving schedule of similar quality
loans to be added to / withdrawn from the pool. The purchaser of the bond usually also has full recourse to the
financial institution if the collateral assets in the pool are insufficient to redeem the principal and full interest of the
bond (however, any claim will rank pari passu with all other senior unsecured creditors). The covered bond remains
an on-balance sheet obligation of the financial institution.

 Subordinated Note (or debenture) is a form of debt issued by a bank or a consolidated subsidiary. When issued by
a bank, a subordinated note or debenture is not insured by a federal agency, is subordinated to the claims of
depositors, and has an original weighted average maturity of five years or more. Such debt shall be issued by a bank
with the approval of, or under the rules and regulations of, the appropriate federal bank supervisory agency.

 Contingent Core Tier 1 Capital / CoCos is debt that will automatically convert into equity shares of the bank if
the bank's core capital ratio declines below a specific level.

 Accrued/deferred taxes

Stockholder's Equity / Share Capital

 Common shares (authorized and outstanding). Is there a tier system of voting shares and common shares?

Why is it a poor decision for banks to buy back shares on the open market in order to increase the market price of the
common equity? Because corporate stock purchases actually reduce capital (instead of increasing retained
earnings). Why is it an even worse decision of taking on debt to buy back shares on the open market? Because the
bank is actually increasing leverage while it is simultaneously reducing capital.

 Preferred shares (restrictions?). Preferred stock is a form of ownership interest in a bank or other company which
entitles its holders to some preference or priority over the owners of common stock, usually with respect to dividends
or asset distributions in a liquidation.
 Some trust related preferred securities may have equity characteristics and are treated favorably under Tier 1
guidelines; and may have lower interest costs. The instruments are deeply subordinated (just ahead of common
stock) and have long maturities although they may have call provisions. Dividend payments may have some
favorable tax treatment for the issuers. However, these securities generally have debt-like characteristics. The bank
is unlikely to defer dividend payments due to the message it may send to other sources of funding.

 Retained Earnings: equity will increase if retained earnings are increasing.

 Subordinated, perpetual notes

 Trust Preferred Securities / TruPS. TruPS were approved by the Federal Reserve in 1996 as Tier 1 capital
(maximum 25.0% of tier 1 capital). The Trust issuer is usually a wholly-owned subsidiary of a bank holding company,
or a direct subsidiary of the bank. The Trust sells securities to investors and then uses the proceeds from the sale to
purchase subordinated debentures of the parent holding company or bank. The Trust uses the interest payments that
it receives from the purchased debentures to make payments to the holders of its preferred securities. A TruPS issue
is subordinate to all debt on a financial institution's balance sheet, but is senior to both preferred and common equity
issues. A TruPS issue usually has a term of 30 years, and are non-amortizing instruments that pay quarterly or semi-
annual interest in the form of a dividended payment (the dividend payment can be deferred for up to five years).
TruPS issued by small financial institutions were pooled / securitized in CDOs during the early to mid-2000's (larger
financial institutions had issued TruPS individually since 1996). When the financial crisis and recession 2008 - 2010
commenced many financial institutions suspended the interest / dividend payment and the CDOs, which had
originally been rated Triple-A, either substantially lost value or defaulted.

Clarifying the value of Stockholder's Equity. Equity invested into any type of financial institution is an accounting
entry. It is not a situation where there is a separate account where segregated cash and assets are held
independently for an emergency of what is indicated on the balance. Rather, equity is utilized to purchase / invest in
assets from which the financial institution can generate revenue. Thus, the value of Equity is only as good as the
quality of the Assets that have been purchased. That is why one of the first considerations of analyzing Equity is
to deduct Intangible Assets (can not be monetaized) to determine Tangible Net Worth. Then, Non-Performing Assets
must be deducted, along with any other other asset they may not be able to be monetized, or then any assets that
need to be discounted from the book entry value on the balance sheet (either due to questionable value, market
 conditions or time constraint). The first test is always to determine if there are sufficient enough Assets that could be
sold quickly to cover short-term liquidity needs (anything from 72 hours to 28 days). The second test is to determine
whether there are sufficient enough high quality assets, after deducting intangibles and / or discounting assets, in an
amount that exceeds Liabilities by a minimum percentage (which is the same as the basic accounting equation of
Assets - Liabilities = Stockholder's Equity). Indicating that the financial institution has sufficient Equity based on
computing a ratio without examining the quality of the Assets is a mistake. The value of Assets are always
questionable, the value amount of Debt is not.

Income Statement

Income
 Interest income (gross or net?): is adversely affected by falling long and short-term interest rates.

Interest expense
 Subtracted from Interest Income Only
 The cost of funds the company borrows on a short- and long-term basis, buys in the money markets, or takes in
from depositors. Competition for customer funding will increase interest expense, placing pressure on margins. Some
banks and financial services companies will also break out the average annual interest rate paid on the various
sources of funds.
 If interest expense is increasing is competition forcing the bank to pay more for deposits? Is management relying
on high cost funds instead of alternative lower-cost funds to meet the bank?s funding needs?

Net Interest Income

 This is interest income minus interest expense.
 Even a small decline in net interest income can result in a large decline in net income if not offset by a decline in
expenses.
 See how to determine Net Interest Margin below.

Non-interest Income
 It is important that banks develop/increase revenues derived from non-interest sources (bank services, fees such
service charges on deposits, trust income, mortgage servicing fees, securities processing and brokerage services,
results of trading operations) that have more stable growth rates and are not tied to loan growth cycles, and can
provide an offset if loan growth slows.

Other Income
 Dividend income: from third party investment or subsidiary/affiliate?
 Net/gain loss from securities trading: volatility from year to year.
 Foreign exchange: based on customer activity and volatility in the market.
 Sale of investments: is it exceptional?
 Net commission/fee income; based on transactions such as insurance brokering, stock-broking
 Related party transaction(s)
 Watch-out for financial institutions that utilize "gain on sale" accounting which means that the company records the
sale of a loan immediately but the actual profit is received over the life of the loan. The profit is the difference
between the spread that the loan is sold at to the investor and what the seller receives from the Obligor. The problem
is that the application of estimated future interest rates (and default rates) is incorrect and the loans are over-valued
compared to where interest rates may actually be during the life-time of the loan and whether it will prepay if rates
decline, and/or if the loan will default and become un-collectible.

Non-interest expense
 Personnel costs

As part of the $787 billion U.S. economic stimulus package passed in February 2009, there is a stipulation that all
banks that receive infusions from the government's $700 billion financial rescue fund must restrict executive
compensation to those persons earning $1 million or more per year in salary may receive only $500,000 in additional
bonus compensation. The prohibition does not apply to bonuses that were negotiated as part of an executive's
compensation contract signed prior to Feb. 11, 2009. www.ustreas.gov/press/releases/tg15.htm

 Premises / branch operating expenses (rent).

 Systems development costs, merger of networks: as companies must compete based on the ability to provide
state-of-the art trading, retail access and information service, these costs have risen.
 Overseas expansion: as the percentage of non-U.S. income rises, this cost increases as facilities expand.
Operating income
 After expenses but before provisions and taxes and extraordinary items.

Extraordinary / Non-recurring Items

 Material events and transactions that are unusual and infrequent.
 Profit (gains) or loss on sale of fixed assets.

Provision (for loan losses)

 Changing market conditions where the bank operates may result in a deterioration of loan and lease assets, which
may result in actual and anticipated losses (write-down or write-off of the asset's value). The accumulated loss may
exceed the existing Loan Reserve thus earnings may have to added to the Loan Reserve account to either increase
or replenish the amount to meet an acutal or anticipated loss.

Taxation
 Current taxation (tax payable on recognized income for the fiscal year, which was paid to federal, state and local,
and foreign revenue authorities).
 Deferred taxation

Footnotes
Allowance for losses (Loan Loss Account) - is a reserve account that is set aside by management to cover an
estimate of losses (charge-offs) in the loan portfolio. The loan loss account has an opening balance at the beginning
of the year, it receives additional provisions based on actual losses and anticipated losses for the coming year; has
actual charged-off loans subtracted from the account and then has a closing balance for the year).

Classified Loans - loans that have been determined to be not collectable for the full amount due to the deteriorating
performance and/or condition of the borrower. The "classification" is based upon internal examination and rating
system (based on generally accepted industry practices) such as non-performing accrual, non-accrual. The Office of
the Comptroller of the Currency (OCC) also rates loans are classified as substandard, doubtful, and loss.

Asset & Liability Management

Ideally, banks want to match the maturity of assets (loans, investments) with the maturity of liabilities

(demand deposits, timed deposits, borrowed funds). Related to the maturity structure, the interest rate paid

on liabilites to borrow the funding must be less than the interest rate on earned on the assets (interest rate

charged to the borrower). The failure to carefully mangage this situation can result in asset?liability mismatch,

interest rate risk, liquidity risk.

Call Report

In the United States, banks must file on a quarterly basis a Consolidated Report of Condition and Income (Call

Report; Form Number: FFIEC 031 for banks with domestic and foreign offices and FFIEC 041 for banks with

domestic offices only). These information collections are mandatory: 12 U.S.C. 161 (for national banks), 12

U.S.C. 324 (for state member banks), and 12 U.S.C. 1817 (for insured state nonmember commercial and

savings banks) and are submitted by the banks to their respective regulator, which includes the Office of the

Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve and the Federal Deposit

Insurance Corporation (FDIC). The Thrift Financial Report (Form Number: OTS 1313) that used to be submitted

to the Office of Thrift Supervision (U.S. Treasury) is no lomger utilized since the merger of the OTS into the
OCC. The agencies are proposing several changes to the FFIEC Call Report.

Consolidated Report of Condition and Income: edocket.access.gpo.gov/2009/pdf/E9-19911.pdf

What happens to a bank when a regulator steps in and seizes a financial istitution and
appoints the FDIC as Receiver of the failed institution?
 All creditors must submit their claim in writing, with proof of the claim, to the Receiver
by a specific date (referred to as the Bar Date).
 The FDIC arranges for a transfer of the deposits to another insured institution (deposits
normally are sold at percentage of their notional amount).
 U.S. Federal law 12 U.S.C. Section 1822(e) requires that depositors must claim ownership
of the deposit transferred to the new institution within 18 months (failure to do so will result
in the funds being transferred to the FDIC).
 The deposits can be claimed by simply making a deposit or withdrawal from the account,
executing a new signature card and entering into a new deposit account with the new
institution, providing the new institution with a change of address card, or writing to the new
institution and indicating that one wishes to keep the account active.
 Any checks (cashier check, money order, interest check, expense check) issued by the
failed institution must also be claimed within 18 months.
 The FDIC will attempt to sell assets, primarily outstanding loans, to the institution
purchasing the deposits and / or branches (the institution purchases the real estate or the
institution will assume the lease obligation for the branch and may retain some of the
employees) at par or at a reasonable discount.
 The FDIC will allow borrowers whose loan has not been purchased by another institution
the opportunity to find another bank who will take over the loan.
 The FDIC may bundle any left over loans and conduct an on-line auction and the loans are
then sold to the highest bidder. Those borrowers who are current merely send their monthly
payment to the new institution. Those borrowers who are in default under the terms of the
loan documentation may have the loan accelerated (demand for payment in full) and / or have
the collateral seized if the loan cannot quickly be worked out.

CAMELS

The CAMELS approach was developed by bank regulators in the United States as a means of measurement of

the financial condition of a financial institution. (Uniform Financial Institutions Rating System established by the

Federal Financial Institutions Examination Council)

The acronym CAMELS stands for:

 Capital Adequacy
 Asset Quality
 Management
 Earnings (Profitability)
 Liquidity & Funding
 Sensitivity to Market Risk (losses arising from changes in market prices)

CAMELS analysis requires:

 financial statements (the last three years and interim statements for the most recent 12-month period)
 cash flow projections
 portfolio aging schedules
 funding sources
 information about the board of directors
 operations/staffing
 macroeconomic information
In reviewing ratios the credit analyst needs to keep 2 concepts in mind:
 Level or whether the ratio for a given fiscal period is either equal to or exceeds (which can
be both positive or negative depending on the ratio) the established parameters of what is
considered a generally acceptable position for that specific ratio.
 Trend or whether the fiscal to fiscal comparison period indicates that the level of the ratio
is improving or deteriorating.

In addition, individual ratios must not be reviewed in isolation to other ratios and what is the
present strategy of the management of the financial institution.

Capital Adequacy

On Septmber 3, 2009, the U.S. Department of Treasury proposed that

capital requirements for all banking firms should be increased, and capital
requirements for financial firms that could pose a threat to overall
financial stability should be higher than those for other banking firms.
www.treas.gov/press/releases/docs/capital-statement_090309.pdf

The Office of the Comptroller of the Currency along with other agencies
are requesting comments regarding a proposal to modify general risk-
based and advanced risk-based capital adequacy frameworks to eliminate
the exclusion of certain consolidated asset-backed commercial paper
programs from risk-weighted assets due to the implementation of the
Financial Accounting Standard Board?s (FASB) Statement of Financial
Accounting Standards No. 166, Accounting for Transfers of Financial
Assets, an Amendment of FASB Statement No. 140 and Statement of
Financial Accounting Standards No. 167, Amendments to FASB
Interpretation No. 46(R). www.occ.gov/ftp/release/2009-101a.pdf

In August 2009, the FDIC approved guidelines to allow private-equity

investors to acquire the deposit liabilities and assets of failed banks
operating under FDIC receivership (includes a Minimum Tier 1 leverage
ratio of 10.0%). www.fdic.gov/news/board/Aug26no2.pdf

Capital Adequacy is a measurement of a bank to determine if solvency can be maintained due to risks that

have been incurred as a course of business. Capital allows a financial institution to grow, establish and

maintain both public and regulatory confidence, and provide a cushion (reserves) to be able to absorb potential
loan losses above and beyond identified problems. A bank must be able to generate capital internally, through

earnings retention, as a test of capital strength. An increase in capital as a result of restatements due to

accounting standard changes is not an actual increase in capital.

The Capital Growth Rate, which is calculated by subtracting prior-period equity capital from current-period

equity capital, then dividing the difference by prior-period equity capital, indicates that either earnings are

extremely good, minimal dividends are being extracted or additional capital funds have been received through

the sale of new stock or a capital infusion, or it can mean that earnings are low or that dividends are excessive.

The capital growth rate generated from earnings must be sufficient to maintain pace with the asset growth

rate.

The 1988 Basel Committee Capital Accord established a benchmark for measuring bank capital (and for

correctly calculating / risk weighting assets, which became the denominator of the capital ratio):
BIS Tier 1 (core capital): total own funds (allotted, called up and fully paid, ordinary share capital/common stock net
of any shares held; perpetual, non-cumulative, preferred shares, including such shares redeemable at the option of
the issuer; disclosed equity reserves in the form of general and other reserves created by appropriations of retained
earnings, share premiums and other surplus; published interim retained profits verified by external auditors, minority
interests arising on consolidation from interests in permanent shareholder's equity; fund for general banking risks)
must be at least 4% of total risk weighted positions. Germany, Belgium, the Netherlands, and the UK maintain hidden
reserves.

The only intangibles that the FDIC allows to be included in Tier 1 regulatory capital are purchased mortgage servicing
rights and purchased credit card relationships (cannot account for more than 50% of an institution's Tier 1 capital
unless those grandfathered in from February 19, 1992).

BIS Tier 2 (supplemental): total own funds (plus value adjustments; reserves arising from the revaluation of tangible
fixed assets and financial fixed assets; hybrid capital instruments) must be at least 8% of total risk weighted
positions.

In the United States, Capital Adequacy is regulated by Office of the Comptroller of the Currency (OCC), the

Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC) and

the Office of Thrift Supervision (OTS).

 The OCC supervises the capital adequacy of national banks and federal branches of
foreign banking organizations.
 The Federal Reserve Board supervises the capital adequacy of state-chartered banks that
are members of the Federal Reserve System (state member banks).
 The FDIC supervises the capital adequacy of state-chartered banks that are not members
of the Federal Reserve System.
 The Office of Thrift Supervision (OTS) supervises the capital adequacy of all federally
chartered and many state-chartered savings associations.
The 1988 Basel Accord serves as the basis for current U.S. capital regulations. The 1988 Accord required that

internationally active banking organizations adopt the new capital rules, but some countries, including the

United States, chose to apply the 1988 Basel framework to all banks and thrifts. As indicated above, in the

United States Tier I capital must constitute at least 50% of a bank?s total capital. Total of Tier 2 capital is

limited to 100% of Tier 1 capital. The add-back of the allowance for loan and lease losses is limited to 1.25%

of weighted-risk assets.

The Basel / U.S. baking regulation guidelines for a "Well Capitalized institution"
 5% or better Tier 1 Leverage Ratio (the ratio of Tier 1 capital to average total assets)
  6% or better Tier 1 risk-based ratio (the ratio of Tier 1 capital to total risk-adjusted assets, with assets categorized
by risk level)
 10% or better total risk-based ratio (the ratio of total capital to total risk-adjusted assets).

FDIC guidelines for a "Adequately Capitalized institution"

 4% or better Tier 1 Leverage Ratio
 4% or better Tier 1 risk-based ratio
 8% or better total risk-based ratio

In the United States, a bank is expected to meet a minimum ratio of qualifying total capital to risk-weighted

assets of 8.0%, of which at least 4.0% should be in the form of core capital (Tier 1). Any bank that does not

meet the minimum risk-based capital ratio, or whose capital is otherwise considered inadequate, generally will

be expected to develop and implement a capital plan for achieving an adequate level of capital (usually under

the terms of an FDIC Order to Cease and Desist). The concept of prompt corrective action by the FDIC was

introduced with the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). When a bank

becomes ?Undercapitalized? (below "Adequately Capitalized") in many cases it means that unless it can rapidly

turn the operation around it will be shut down by the respective supervisors. While "Undercapitalized" a bank:
 must cease paying dividends
 is generally prohibited from paying management fees to a controlling person
 must file and implement a capital restoration plan
 cannot accept, renew or roll over any brokered deposit. Effective yield on deposits
solicited by the bank cannot be more than 75 basis points or .75% over local market yields for
comparable size and maturity deposits.
When a bank becomes ?Critically Undercapitalized? in many cases it means that unless it can rapidly turn the

operation around it will be shut down by the respective supervisors. A critically undercapitalized bank must be

placed in receivership within 90 days unless the FDIC and the bank?s primary federal regulator concur that

other action would better achieve the purposes of prompt corrective action. Additionally, a "Critically

Undercapitalized" bank is prohibited, unless it obtains prior written FDIC approval, from:
 entering into any material transaction not in the usual course of business
 extending credit for any highly leveraged transaction (any transaction in which the
borrower has very little equity)
 paying excessive compensation or bonuses
 paying interest on new or renewed deposits that would increase the bank?s weighted
average cost of funds significantly above prevailing interest rates in its normal markets.
FDIC 2000 Rules and Regulations, Part 325 - Capital Maintenance (12 C.F.R. Part 325)

www.fdic.gov/regulations/laws/rules/2000-4400.html

FDIC 2000 Rules and Regulations, Appendix A to Part 325 - Statement of Policy on Risk-Based Capital

www.fdic.gov/regulations/laws/rules/2000-4600.html

In the United States, Supplemental or Tier 2 Capital consists, within certain specified limits, of such things

as the allowance for loan losses, hybrid capital instruments, and subordinated debt. These supplemental items

are often forms of debt that are subordinate to claims of depositors and the FDIC. As such, they provide

depositor protection and are included in bank capital.

The regulatory treatment of Tier 2 capital is such that securities issued in a subordinate position for regulatory

capital purposes have their capital value amortized over the last five years of the security. This was solved in

1997 through a "10 non-call five/seven step-up." A call provision is put in from one day after year five or year

seven and the bank is allowed to call it with five full years as 100% capital treatment. A coupon step-up is put

in at the end of year five or seven to allow for the bond to roll over for a further five year period.

The sum of Tier I and Tier 2 capital, less certain deductions, represents a bank?s total capital.

It should be noted that in the United States, The Gramm-Leach-Bliley Act (GLB Act) currently requires a bank

holding company (BHC) to keep its subsidiary depository institutions ?well capitalized? and ?well managed? in

order to qualify as a financial holding company (FHC). FHC status allows a BHC to engage in riskier financial

activities such as merchant banking, insurance underwriting, and securities underwriting and dealing. The GLB

Act does not, however, require an FHC to be ?well capitalized? or ?well managed? on a consolidated basis.

Contingent Core Tier 1 Capital / CoCos is debt that will automatically convert into equity shares of the

bank if the bank's core capital ratio declines below a specific level. This is a hybird form of capital, which may

be drawn upon in the event that the bank's balance sheet or earnings are under pressure. However, the

amount of equity capital that is provided my be insufficient or it may send the wrong signal to the marketplace

with regard to the financial health of the bank.

Risk Weighting Assets

The Basel I guidelines on risk weighting asset classes has been revised by the Basel II
framework.

Please also see A Guide to the 2004 Capital Accord of the Basel Committee (Basel II)

Capital Adequacy ratio which is calculated by dividing the bank's core capital by the bank's total risk-weighted

assets, then multiply by 100.

Core Capital Adequacy ratio which is calculated by dividing the bank's risk-based capital by the bank's total

risk-weighted assets, then multiply by 100.

The BIS Risk-weighted Assets guidelines were adopted by the Board of Governors of the federal Reserve (Code

of Federal Regulations Title 12, Volume 5; Revised as of January 1, 2002). These guidelines are used to

evaluate capital adequacy based primarily on the perceived credit risk associated with balance sheet assets, as

well as certain off-balance sheet exposures such as unused loan commitments, letters of credit, and derivative

and foreign exchange contracts. The risk-based capital guidelines are supplemented by a leverage ratio

requirement. To be "well capitalized" under Federal bank regulatory agency definitions, a bank holding

company must have a Tier 1 ratio of at least 6%, a combined Tier 1 and Tier 2 ratio of at least 10%, and a

leverage ratio of at least 3%, and not be subject to a directive, order, or written agreement to meet and

maintain specific capital levels.

Risk-weighted 0%
1. Cash (including domestic and foreign currency owned and held converted into U.S. dollar equivalents)
2. Securities issued by and other direct claims on the U.S. Government or its agencies (to the extent such securities
or claims are unconditionally backed by the full faith and credit of the United States Government).
3. Securities issued by and other direct claims on the central government of an OECD country
4. Notes and obligations issued by either the Federal Savings and Loan Insurance Corporation or the Federal
Deposit Insurance Corporation and backed by the full faith and credit of the United States Government
5. Deposit reserves at, claims on, and balances due from Federal Reserve Banks
6. The book value of paid-in Federal Reserve Bank stock
7. That portion of assets that is fully covered against capital loss and/or yield maintenance agreements by the
Federal Savings and Loan Insurance Corporation or any successor agency
8. That portion of assets directly and unconditionally guaranteed by the United States Government or its agencies, or
the central government of an OECD country

Risk-weighted 20%
1. Cash items in the process of collection
2. That portion of assets collateralized by the current market value of securities issued or guaranteed by the United
States government or its agencies, or the central government of an OECD country
3. That portion of assets conditionally guaranteed by the United States Government or its agencies, or the central
government of an OECD country
4. Securities (not including equity securities) issued by and other claims on the U.S. Government or its agencies
which are not backed by the full faith and credit of the United States Government
5. Securities (not including equity securities) issued by, or other direct claims on, United States Government-
sponsored agencies
6. That portion of assets guaranteed by United States Government-sponsored agencies
7. That portion of assets collateralized by the current market value of securities issued or guaranteed by United
States Government-sponsored agencies
8. Claims representing general obligations of any public-sector entity in an OECD country, and that portion of any
claims guaranteed by any such public-sector entity
9. Bonds issued by the Financing Corporation or the Resolution Funding Corporation
10. Balances due from and all claims on domestic depository institutions. This includes demand deposits and other
transaction accounts, savings deposits and time certificates of deposit federal funds sold, loans to other depository
institutions, including overdrafts and term federal funds, holdings of the savings association's own discounted
acceptances for which the account party is a depository institution, holdings of bankers acceptances of other
institutions and securities issued by depository institutions, except those that qualify as capital
11. Deposit reserves at, claims on and balances due from the Federal Home Loan Banks
12. Claims on, or guaranteed by, official multilateral lending institutions or regional development institutions in which
the United States Government is a shareholder or contributing member
13. That portion of assets collateralized by the current market value of securities issued by official multilateral lending
institutions or regional development institutions in which the United States Government is a shareholder or
contributing member
14. All claims on depository institutions incorporated in an OECD country, and all assets backed by the full faith and
credit of depository institutions incorporated in an OECD country. This includes the credit equivalent amount of
participations in commitments and standby letters of credit sold to other depository institutions incorporated in an
OECD country, but only if the originating bank remains liable to the customer or beneficiary for the full amount of the
commitment or standby letter of credit. Also included in this category are the credit equivalent amounts of risk
participations in bankers' acceptances conveyed to other depository institutions incorporated in an OECD country.
However, bank-issued securities that qualify as capital of the issuing bank are not included in this risk category
15. Claims on, or guaranteed by depository institutions other than the central bank, incorporated in a non-OECD
country, with a remaining maturity of one year or less

Risk-weighted 50%
1. Revenue bonds issued by any public-sector entity in an OECD country for which the underlying obligor is a public-
sector entity, but which are repayable solely from the revenues generated from the project financed through the
issuance of the obligations
2. Qualifying mortgage loans and qualifying multifamily mortgage loans
3. Privately-issued mortgage-backed securities (i.e., those that do not carry the guarantee of a government or
government sponsored entity) representing an interest in qualifying mortgage loans or qualifying multifamily
mortgage loans. If the security is backed by qualifying multifamily mortgage loans, the savings association must
receive timely payments of principal and interest in accordance with the terms of the security. Payments will generally
be considered timely if they are not 30 days past due

Risk-weighted 100%
1. Consumer loans
2. Commercial loans
3. Home equity loans
4. Non-qualifying mortgage loans
 5. Non-qualifying multifamily mortgage loans
6. Residential construction loans
7. Land loans, except that portion of such loans that are in excess of 80% loan-to-value ratio
8. Nonresidential construction loans, except that portion of such loans that are in excess of 80% loan-to-value ratio
9. Obligations issued by any state or any politica1 subdivision thereof for the benefit of a private party or enterprise
where that party or enterprise, rather than the issuing state or political subdivision, is responsible for the timely
payment of principal and interest on the obligations, e.g., industrial development bonds
10. Debt securities not otherwise described in this section
11. Investments in fixed assets and premises
12. All repossessed assets or assets that are more than 90 days past due
13. Indirect ownership interests in pools of assets. Assets representing an indirect holding of a pool of assets, e.g.,
mutual funds, are assigned to risk-weight categories under this section based upon the risk weight that would be
assigned to the assets in the portfolio of the pool. An investment in shares of a mutual fund whose portfolio consists
primarily of various securities or money market instruments that, if held separately, would be assigned to different
risk-weight categories, generally is assigned to the risk-weight category appropriate to the highest risk-weighted
asset that the fund is permitted to hold in accordance with the investment objectives set forth in its prospectus

Off-balance sheet items are included in determining risk-weighted assets after reduction by specific reserves.

Risk-weighted 0%
 1. Letters of credit, guarantees or guarantee-type instruments secured by deposits with the issuing bank

Risk-weighted 20%
 1. Unused, non-callable credit lines with original maturity up to one year
 2. Revocable letters of credit

Is the bank increasing its capital from the growth of retained earnings? Does it have the ability to raise capital?

Banks, securities firms and finance companies should show increasing capital due to the growth of principal

risk-taking/trading and the growth of derivatives business which results in these firms taking more off-balance

sheet risk. Banks and Investment Banks must also allocate capital to new/growing international operations.

Leverage is the relationship between the risk-weighted assets of a bank and its equity. Securities firms look at

Net Assets divided by Equity as Leverage.

Key Ratios for Examining Capital Adequacy

Equity Capital

Equity Capital / Average Assets

 This is a primary measurement for judging capital strength.

 Equity capital is defined as the total of common stock, surplus, perpetual preferred stock,
undivided profits and capital reserves before FASB 115 & 133 adjustments.
 Intangibles and net unrealized holding gains (losses) on available-for-sale securities are
excluded from Capital.

Tier 1 Leveage Ratio

Tier 1 Capital / Total Tangible Assets (Total Assets less Goodwill and Intangibles)

 Utilized by federal and state banking agencies to determine one of the components of
capital adequacy ("Well Capitalized" is equal to or greater than 5%).
 The greater the number the more capital there is to cover problems on the asset side of the
blance sheet.
 For most small to medium-sized banks, Tier 1 Capital generally consists of only common
equity, which is the sum of common stock, surplus and retained earnings.

Tier 1 Risk-based Capital Ratio

Tier 1 Capital / Total Risk-adjusted Assets

 Required to be a minimum 6.0% to be "Well Capitalized"

 Risk-adjusted assets go through the analysis and "weighting" process outlined at the top of
this section.

Tier 2 Risk-based Capital Ratio or Total Risk Capital Ratio

Tier 2 Capital / Total Risk-adjusted Assets

 Required to be a minimum 8.0% to be "Well Capitalized"

 For most small banks supplemental / Tier 2 capital is usually the loan loss reserve

Texas Ratio

Delinquent Loans + Non-performing Assets / Capital + Loan Loss Reserves.

 If the ratio is 100% or higher then the bank may be in imminent danger of failing.
 If the ratio is between 50% and 100% then a capital infusion is necessary. The ratio is a
quick way to determine the bank's ability to absorb losses.

Asset Quality

The Assets of a bank are:

 Cash (unrestricted)
 Fed funds sold
 Trading portfolio (securities, although banks also tend to include derivative contracts in this category)
 Securities (available for sale are liquid; held to term as less liquid)
 Loans (various counterparties, collateral and maturities; lease contracts may also be included in this category)
 Fixed assets (some banks own their headquarters and/or branches, as opposed to leasing, which can be sold to
raise cash)

Asset Quality evaluates risk (and there must be some risk to earn a return), controllability, adequacy of loan

loss reserves, and acceptable earnings; and the affect of off-balance sheet earnings and loss. The quality of a

bank's assets hinges on their ability to be collected a during and at maturity. Thus, one must examine the

portfolio quality, the portfolio classification system (aging schedule and the methodology to classifying a

receivable) and the fixed assets (the productivity of the long-term assets, for instance the branch network). It

is also necessary to determine the liquidity and the maturity structure of various Assets. Investing in assets is

how a bank primarily earns a return. How well are these assets going to perform?
Earning Assets: interest bearing financial instruments which are principally commercial, real estate, and

consumer loans; investment securities and trading account securities; money market investments; lease

finance receivables; time deposits placed in foreign banks.

Risk-based / Risk Weighted Assets: Some investments and loans are riskier than others and regulators realize

that there should be a flexible scale of allocating bank reserve capital to these various types of assets. For

instance, a bank that has U.S Treasury securities in its portfolio of securities does not have to assign any

capital reserve for this particular asset.

Risk assets: loans to affiliates, other loans, interest receivables and other assets.

Loans are usually the largest asset category for a bank:

 Change in loan volume, why has it grown or contracted, what percentage has it grown/contract?
 Loan mix: what part of the portfolio is growing (consumer vs. commercial)
 Is the bank overly exposed in one sector (i.e. commercial real estate, industry sector, country) and what is the
environment for the performance and value of the assets?

Title 12 USC 85 regulates the maximum rate of interest that national

banks may charge on most types of loans. Banks that charge a higher
rate violate the law and may trigger the penalties for usury described in
12 USC 86. Section 85 authorizes national banks to charge interest on
loans at the rates allowed by the states in which the bank is located. A
national bank is considered to be located in states in which it has either
its main office or a branch. If state law permits state lenders to make
loans without interest rate limitations, then national banks may make the
same types of loans without interest rate limitations. Section 85 also
provides that on all loans, national banks may charge 1.0% more than
the discount rate on 90-day commercial paper in effect at the Federal
Reserve bank in the district in which the bank is located. For example, if
the discount rate is 7.0%, than national banks may charge 8.0%,
discounted in advance, without regard to state usury laws. Under section
85, a national bank may charge the maximum rate of interest permitted
by state law for any state-chartered or state-licensed lending institution.
A national bank that charges a higher interest rate on a specified class of
loans, as allowed by state law, is subject to the provisions relative to that
class of loans that are material to the determination of the interest rate.
For example, when a state law allows finance companies to charge 20
percent on certain loans, but limits state banks to 16 percent, national
banks may charge 20 percent. However, national banks would be limited
to charging the higher rate only on the same size and type of loans that
finance companies are allowed to make. Title 12 USC 85 permits national
banks to charge interest rates as permitted by a state in which the bank
is located. For an intrastate bank, that is the state where its main office is
located. For an interstate bank, that also generally will be the state in
which the bank has its main office though, in some circumstances, an
interstate national bank may be required, or may have the authority, to
charge rates permitted by a state in which one or more of its branches is
located.
What percentage of loans (either separate portfolios of consumer loans and commercial loans and/or

combined) are delinquent 30 day? What percentage of total loans are delinquent 90 days? What percentage of

total loans are non-performing (over 90-day, non-accrual and restructured).

What is the percentage of charge-offs to total loans (consumer and commercial receivbles)? What is the

percentage change of charge-offs from the previous fiscal period?

Loan Loss Reserve: is created and built up by placing operating income (provisions) in an account on the

asset-side of the blanace sheet, and which must be a sufficiently funded amount to cover actual or anticipated

losses.
 Also referred to as the Allowance for Loan and Lease Losses (ALLL).
 Specific reserves against identified impaired loans are specifed in Statement of Financial Accounting Standards
No. 114 (Accounting by Creditors for Impairment of a Loan?an amendment of FASB Statements No. 5 and 15) and
tatement of Financial Accounting Standards No. 118 (Accounting by Creditors for Impairment of a Loan-Income
Recognition and Disclosures?an amendment of FASB Statement No. 114)

If there is a problem with the repayment of a loan, the interest will sometimes be capitalized. Interest begins

accruing on a loan as soon as it is disbursed. The interest can be repaid as scheduled or it can be capitalized,

which means that the interest will continue to accrue and will be added to the loan principal amount thereby

increasing the loan principal amount, which is then the new balance that is used to compute interest for the

next period. The net effect of capitalization is that it increases the total amount paid over the lifetime of the

loan.

Asset Growth Rate: computed by subtracting prior-period total assets from current-period total assets, then

dividing the difference by prior-period total assets, indicates the state of economic condition and/or the

philosophy (which wants to rapidly increase or slowly increase the asset side of the balance sheet).

Key Ratios for Examining Asset Quality

Loan Loss Reserves to Total Loans Ratio

Loan Loss Reserves / Total Loans

 This is a primary measurement for judging capital strength.

 Traditionally the amount is a minimum 1.0% but it is not sure if it is adequate unless it is
compared to Provisions/Total loans: percentage of provisions from fiscal income statement as
a percentage of the portfolio.
 Intangibles and net unrealized holding gains (losses) on available-for-sale securities are
excluded from Capital.

Coverage Ratio

Loan Loss Reserves / Non-Performing or Non-current Loansand leases

 Non-performing or Non-current loans consist of loans that are 90 days or more overdue
and still accruing and nonaccrual loans.
 Also sometimes known as the coverage ratio, should be in excess of 1.5x

Overdue Loans to Total Loan Ratio

Total Loans 30-89 Days Past Due / Total Loans

 Indicates that either credit underwriting standards are inappropriate or collection

procedures are inadequate.

90-Day Overdue Loans to Total Loans Ratio

Total Loans 90-Days Past Due / Total Loans

 Indicates that the loan portfolio may be experiencing some deterioration through either
poor underwriting and/or collections.

Management Structure

 Is the bank newly privatized from government ownership?

 What is the ownership structure of the bank? (Government support? Independently capitalized or a branch? Can
rely on parent support implicit/explicit?)
 Is as small branch network a constraint on business?
 Loan portfolio management, credit administration, policy development, employee training, loan workout
 Is it possible to determine Governence, Audit oversight and Strategic planning?

Earnings (Profitability)

Earnings determine the ability of a bank to increase capital (through retained earnings), absorb loan losses,

support the future growth of assets, and provide a return to investors. The largest source of income for a bank

is net interest revenue (interest income from lending activity less interest paid on deposits and debt). The
second most important source is from investing activity. A substantial source of income also comes from

foreign exchange and precious metal trading, and commissions/transaction fees and trust operations.

New banks, or De Novo banks, are usually not profitable for the first two to three years as they develop their

core business operations, hire employees, open branches and may also have to pay a higher interest rate to

attract deposits. What the analyst should look at in this case is the "burn rate" (on a monthly and quarterly

basis), which is an indication of how much of the initial equity investment (stockholder's equity) is being used

up to cover operating expenses. What needs to be demonstrated is that income is increasing faster than

expenses and the monthly and quaterly losses are decreasing, hence equity is not decreasing as rapidly.

Overall, the issues to consider include:

 What is the concentration of business: retail, trade finance, corporate, mortgage, merchant, personal, investment,
portfolio management, asset financing, leasing, advisory, nominee and custodial services, executor and trustee?
 Are the bank's core earnings in its home market only?
 What is the ratio between interest and non-interest income sources?
 Is operating income declining compared to previous periods due to insufficient revenue or higher operating
expense?
 Is net income low due to non-accrual loans?
 Is an improvement in revenue and earnings coming from extraordinary / non-recurring items? Would the
elimination of this one-time item actually result in a loss? Is the increase in earnings derived from the adoption of new
accounting standards?

The need to charge provisions for loan and lease losses against earnings can also reduce profitability, at lease

on a quarterly basis. The bank's management has to look at what type of loans are in the portfolio, what the

preformance is of the portfolio and what is happening with national, regional and local economic conditions.

For instance, recession, increase in bankruptcies, increase in unemployment, local corporate layoffs and plant

closings, drought, low farm prices, and so on suggest rising numbers of delinquent loans that the bank must

correctly estimate and have sufficent reserves thus provisions may be taken against earnings just as the

bank's revenues may be declining. Conversely, if economic conditions are deteriorating and the bank is not

provisioning for anticipated losses in order to maintain profitability then problems may develop during the

next fiscal period.

Key Ratios for Examining Profitability

Net Interest Margin

Net Interest Income (annualized) / Average Interest Earning Assets

 This is net interest income expressed as a percentage of average earning assets.

 Net interest income is derived by subtracting interest expense from interest income.
 Indicates how well management employed the earning asset base (the denominator
focuses strictly on assets that generate income).
 May come under pressure from offering preferential rates to customer base, a low level of
growth in savings and the higher percentage of more expensive wholesale funds available.
The lower the net interest margin, approximately 3.0% or lower, generally it is reflective of a
bank with a large volume of non-earning or low-yielding assets.
 Conversely, are high or increasing margins the result of a favorable interest rate
environment, or are they the result of the bank moving out of safe but low-yielding, low-
return securities into higher-risk, higher yielding and less liquid loans or investment
securities?

Return on Average Assets (ROAA)

Net operating income (annualized) after taxes (including realized gain or loss on investment securities) / Total

Average Assets (assets at the previous fiscal year plus assets at this current fiscal year divided by 2) for a

given fiscal year

 Actual net income should be examined for the inclusion of extraordinary earnings (which
may be excluded).
 This measures how the assets are utilized by indicating the profitability of the assets base
or asset mix.
 Ranges from approximately 0.60% to under 2.0% for U.S. Banks. Historically in the U.S.
the benchmark was 1.0% or better for the bank to be considered to be doing well. De novo
banks are usually below the 1.0% benchmark.
If the bank is a Subchapter S Corp. then the coporation is treated as a pass-through entity and is not subject

to Federal income taxes at the corporate level. Therefore, an adjustment to net income is needed to improve

the comparability between banks that are taxed at the corporate level and those that are not.

Return on Average Equity (ROAE)

Net operating income after taxes (including realized gain or loss on investment securities) / Total (average)

equity (common stock) for a given fiscal year

 This ratio is affected by the level of capitalization of the financial institution.

 Measures the ability to augment capital internally (increase net worth) and pay a dividend.
 Measures the return on the stockholder's investment (not considered an effective measure
of earnings performance from the bank's standpoint).
 In the long run, a return of around 15% to 17% is regarded as necessary to provide a
proper dividend to shareholders and maintain necessary capital strengths.
Adjusted ROE or ROAE: Net income / Total equity plus loan loss reserves in excess of 10% of equity.

Return on Earning Assets (ROEA)

Revenue from loans, securities, cash equivalents and earning assets (including non-interest) before interest

expense / Earning Assets

 Measures the results of operations prior to funding costs and as if the operations were
totally funded by equity.

Operating Profit Margin

Operating profits (before the loan loss provision and excluding gains or losses from asset sales and

amortization expense of intangibles) / Net operating revenues (interest income less interest expense plus

noninterest income)

 This ratio measures the percent of net operating revenues consumed by operating
expenses, providing the remaining operating profit (the higher the margin the more efficient
the bank).
 Inverse of the efficiency ratio.

Non-interest Income to Average Assets Ratio

Non-Interest Income (annualized) / Total Average Assets

 Non-interest income is income derived from fee-based banking services such as service
charges on deposit accounts, consulting and advisory fees, rental of safe deposit boxes and
other fee income, fiduciary, brokerage and insurance activities.
 Realized gains on the sale of securities is excluded.
 It is important that a bank devlop non-interest income sources but it should become a
major portion of the bank's total revenue unless it really is an annual core business operation.

Average Collection of Interest (Days)

Accrued Interest Receivable / Interest Income x 365

 This is a measurement of the number of days interest on earning assets remains

uncollected and indicates that volume of overdue loans is increasing or repayment terms are
being extended to accommodate a borrower's inability to properly service debt.

Overhead Ratio

Total Non-Interest Expenses (annualized) / Total Average Assets

 Non-interest expenses (annualized), which are the normal operating expense associated
with the daily operation of a bank such as salaries and employee benefits plus occupancy /
fixed asset costs plus depreciation and amortization.
 These costs tend to rise faster than income in a time of inflation or if the institution is
expanding by the purchase or construction of a new branches.
 Provisions for loan and lease losses, realized losses on securities and income taxes should
not be included in non-interest expense.

Efficiency Ratio

Total Non-interest expenses / Total Net Interest Income (before provisions) plus Total Non-Interest Income

 Efficiency improves as the ratio decreases, which is obtained by either increasing net
interest income, increasing non-interest revenues and/or reducing operating expenses.
 Non-interest expenses (expenses other than interest expense and loan loss provisions, such
as salaries and employee benefits plus occupancy plus depreciation and amortization) tend to
rise faster than income in a time of inflation.
 This is a measure of productivity of the bank, and is targeted at the middle to low 50%
range. This may seem like break-even but it is not; what this is saying is that for every dollar
the bank is earning it gets to keep 50 cents and it has to spend 50 cents to earn that dollar. The
ratio can be as low as the mid to low 40% range, which means that for every dollar the bank
earns it gets to keep 60 cents and spends 40 cents, a very efficient bank.
 Ratios in excess of 75% mean the bank is very expensive to operate.

Liquidity & Funding

Liquidity and Funding are related, however they are separate situations. Funding is what a bank relies upon to

grow its business and the asset side of the balance sheet above and beyond what could be accomplished with

just equity. Funding is provided by deposits, short-term debt and longer-term debt. Funding means access to

capital.

Liquidity is what a bank requires if Funding is interrupted and the bank must still be able to meet certain

obligations (bank's ability to repay depositors and other creditors without incurring excessive costs). What is

the liability structure / composition of the institution?s liabilities, including their tenor, interest rate, payment

terms, sensitivity to changes in the macroeconomic environment, types of guarantees required on credit

facilities, sources of credit available to the institution and the extent of resource diversification.

A bank's least expensive means of funding loan growth is through deposit accounts. When this is not available,

banks must rely on more expensive funding sources such as borrowing funds at wholesale rates or liquidating

investment securities portfolios. The best type of deposits are "core" deposits, which are balances that are left

at the bank due to convenience (the depositor resides in the area) or through loayalty. Non-core deposits /

funding are sources that can be very sensitive to changes in interest rates such as brokered deposits, CDs

greater than $100,000, and borrowed money.

The Deposit Growth Rate, which is computed by subtracting prior-period total deposits from current-period

total deposits, then dividing the difference by prior-period total deposits, indicates how a bank is funding the

asset side of its balance sheet.

Funding sources also include:

 Net earnings
 Issuance of common and preferred securities
 Trust preferred securities
 Commercial paper
 Senior debt
 Subordinated debt
 Securitizing various financial assets including credit card receivables and other receivables generally secured by
collateral such as single-family residences and automobiles
 Monetizing investment securities
Liquidity refers to reserves of cash, securities, a bank's ability to convert an asset into cash, and unused bank

lines of credit. The faster the conversion the more liquid the asset. Illiquidity is a risk in that a bank might not

be able to convert the asset to cash when most needed. Moreover, having to wait for the sale of an asset can

pose an additional risk if the price of the asset decreases while waiting to liquidate. Thus, if loans or assets are

illiquid then liquidity is also limited, especially if the loans exceed stable deposits and available lines of credit.

Liquidity must be sufficient to meet all maturing unsecured debt obligations due within a one-year time horizon

without incremental access to the unsecured markets.

Probably the most critical issue to examine for a bank is the ability to meet obligations. If earnings are poor

and liquidity is high, the bank's lending may be too conservative, with a high proportion of proceeds from

deposits are invested in low yielding liquid assets. If earnings are low and liquidity is low, then the bank may

have an aggressive lending policy coupled with heavy borrowing. It examines "internal" sources of funds:

maturing loans and marketable securities; and "external" sources of funds: is the bank dependent on large

deposits from a single source or does it have a large and stable retail funding base? (single sources should not

exceed 10% of short-term liabilities).

Liquidity Gap Analysis is an attempt to measure future funding needs of a bank by comparing the amount of

assets and liabilities maturing over time.

The overall goal of management in the asset/liability/capital structure of the institution is to maximize the

return earned from the assets, with the lowest risk profile and default ratio, and also minimize the cost of

funds as much as possible to widen the spread between earnings and expenses (manage the net interest

margin); and to utilize leverage over invested capital.

Liquidity Management: "cash-out" or the risk of being illiquid when cash is needed.
 Sources and uses of funds approach: liquidity required for deposit withdrawals and loan demand.
 Structure of deposits approach: focuses on the stability of deposit liabilities.

Awareness of gap management: gap analysis is a measurement of interest rate sensitivity of assets and

liabilities. If a company has a negative duration gap that means that its assets are paying off faster than its

liabilities. The response can either be defensive or aggressive with regard to managing the spread between the

yields of the institution's assets and their income from service sales and the cost of carrying on their

operations, especially the return paid to savers to attract deposits and equity investments.

Management's goal for assets:

Primary reserves
 Sufficient cash on hand to cover customer deposits and withdrawals or clearing and collecting check payments;
and maintain contemporaneous reserve requirements.
 Cash in the vault is not earning interest.
 Cash/total assets ratio rises in relation to the size of the institution.

Secondary reserves
 Marketable securities portfolio: short-term and liquid for cash needs and pledging collateral.
 U. S. Treasury: relatively short-term maturities, increasing to 20% of total assets due to favorable tax and capital
reserve treatment.
 Securities of states and municipalities: declined due to less favorable tax and capital treatment.
Loans
 At a rate in excess of the cost of funds, to borrower with a good credit profile.
 Rates on corporate loans have been declining due to disintermediation/competition.
 Real estate loans have the highest margin but are less liquid and riskier.
 Total loans tend to approximate 60% of the total assets.

Liquidity Management related to assets: match maturity of assets with liquidity needs.
 The historical decline in liquid assets on hand is related to better management.
 Anticipation of deposit and loan changes.
 If the bank invests for yield, it will not be able to cover demands.
 Could be covered by liquidation of assets and borrowings.
 Commercial loan theory: confine loans to short-term, self-liquidating commercial loans.
 Money market approach: hold money market instruments such as Treasury bills, CP or banker's acceptances.

Management's goal for liabilities: to also manage sources of funds (not just uses of funds/asset management)

to meet liquidity requirements; and increase income potential.

Funding requirements.
 Customer deposits: the least expensive source of funding for the institution. The institution is seeking "core
deposits," or passive accounts that stay with the institution out of loyalty or convenience (checking accounts, savings
certificates and regular savings accounts). What happens if a bank experiences a credit ratings downgrade: deposits
from local municipalities, state governments, escrow accounts and fiduciary deposits must be withdrawn if the
downgrade results in a non-investment grade rating.
 Non-deposit borrowed funds: cost more than customer deposit funds
 Federal funds for short-term liquidity.
 CDs if funding is needed for a longer period

Liquidity Management related to Liabilities:

 Interest rates may be higher when the institution seeks to acquire funds.
 Requires that the financial condition of the bank be strong.

Management's goal for Capital: provide the buffer to absorb losses, must maintain adequate equity capital to

satisfy regulatory requirements, and have a financial condition that allows it to borrow funds.
 Must meet BIS risk assets to capital guidelines: 4% Tier one, 8% including Tier two capital; risk weighted asset
categories.
 If condition has weakened, then funds will cost more.

It is poor liquidity, as opposed to poor asset quality or inadequate capital, that leads to most bank failures.

Key Ratios for Examining Liquidity

Loans as a Percentage of Deposits

Loans (gross) / Total Deposits

 Indicates the percentage of a bank's loans funded through deposits (measures funding by
borrowing as opposed to equity)
 Maximum 80% to 90% (the higher the ratio the more the institution is relying on
borrowed funds)
 However, cannot also be too low as loans are considered the highest and best use of bank
funds (indicates excess liquidity).
 Between 70% to 80% indicates that the bank still has capacity to write new loans.
 A high loan-to-deposit ratio indicates that a bank has fewer funds invested in readily
marketable assets, which provide a greater margin of liquidity to the bank.
Liquid Assets to Total Deposits

Liquid Assets / Total Deposits

 Measures deposits matched to investments and whether they could be converted quickly to
cover redemptions.

BOPEC

BOPEC was the former bank holding company examination ratings system. Bank Holding Companies (BHC) are

usually the stock-issuing entity within a banking organization and the BHC can have a number of operating

subsidiaries. BOPEC was designed to examine the subsidiary operations as the condition of a BHC is closely

related to the condition of its subsidiary banks. The examination of the bank holding company by federal

regulators in the United States would rate banks on a scale from 1 to 5 with 1 being the highest rating and 5

being close to insolvency. The system was replaced by RFI/CD (see next below).

BHC's Bank subsidiaries condition

Other nonbank subsidiaries / affiliates condition

Parent company condition

Earnings Comsolidated poistion of the parent

Capital Consolidated position of the parent

RFI/CD

As of January 2005, the BHC evaluation system was revised to the acronym RFI/CD which stands for:

Risk management (R) such as policies, procedures, limits, risk monitoring and managment information

systems.

Financial condition (F) such as Capital, Asset Quality, Earnings and Liquidity.

Impact (I) of the parent company and nondepository entities on subsidiary depository institutions.

Composite rating (C), which is the BHC's overall evaluation and rating of its managerial and financial condition

and an assessment of future potential risk to its subsidiary depository institution(s).

Depository institutions (D), which is the assessment of the subsidiary depository institutions by the primary

regulator.

Book Value

If the financial istitution had to be shut down immediately, the book value of the financial institution is equal to

the Total Assets minus Liabilities, Preferred Stock, and Intangible Assets. However, this is a straight arithmetic
exercise. The reality is that a distressed bank has impaired or hard to sell assets and it is not likely that

another bank or investor is going to purchase them at par. Thus, the assets must be examined to determine

whether there are any secured lenders who have a claim on assets, what type of securities is the financial

institution holding in its portfolio and what is the present performance of the loan portfolio. The fixed assets

are not going to be readily marketable and the fixtures and furniture will either disappear with employees or be

of salvage value only. Liabilities usually tend to be definite in value while assets tend to have fluctuating or

questionable value.

Issues Affecting Banks

 Further disintermediation of bank assets: trend toward the securitization of assets by corporate customers (banks
will decrease as primary suppliers of credit to high quality borrowers. This means that a higher proportion of bank's
remaining credit exposure will be to less marketable credits where there is less demand and less hedging
instruments available) and the increasing use of mutual funds and private pension funds by consumer customers.
 The continuing increase in non-bank competitors offering similar services.
 Continued deregulation and globalization of services.
 Increased technological innovation and technology costs in order to compete effectively.
 How to differentiate and appropriately price services such as origination, structuring and administration.
 Consistent risk pricing and Basle Committee capital requirements for credit risk.