UBFB3023 Commercial

Bank Management

Lecture 2: Banking
Performance Analysis
and Bank Risks
Learning Goals

• Financial statement of the bank

• Banking profit, liquidity and risks
• Profitability ratios
• Market ratios
• DuPont Model
Balance Sheet

• Assets: What the bank owns

• Liabilities: What the bank owes
• Equities: Ownership interest of stockholders

Assets = Liabilities + Equities

Bank Assets

1. Cash, statutory reserve with BNM and due

from banks
• Cash for daily operations.
• Non-interest bearing statutory reserve with BNM.
• Deposits placed with other financial institutions.
Bank Assets

2. Loans, Advances and Financing

• Largest categories of assets.
• Least liquid assets because difficult to recall
instantly.
• Types of loans (Overdraft, term loan, staff loan,
hire purchase, mortgage loan, etc).
• Often categorise to economic sectors (agriculture,
manufacturing, real estate, households, etc).
Bank Assets

3. Trading securities
• Marketable securities purchased for resale in a
short term (T-Bills, commercial paper, etc).
4. Investment securities
• Securities held for capital growth or earn interest
(Shares, T-Bonds, etc).
5. Other assets
• Bank premises and equipment, prepaid expenses
as well as foreclosed properties.
Bank Liabilities

1. Deposits from customers

• Demand deposits/current account/checking
account.
• Saving account.
• Fixed deposits/time deposits.
• Negotiable Certificate of Deposits (NCD)
2. Deposits and placement by others Financial
Institutions.
Bank Liabilities

3. Repurchase agreement (REPO)

• Obligation on securities sold and agreed to buy
back.
4. Other Liabilities
• Proposed dividend.
• Deferred taxes.
Bank Equity

1. Stockholders’ Equity
• Ownership interest in the bank.
• Common and preferred stock (listed at par).
• Surplus account/Share premium.
• Represent the amount of proceeds received by the
bank in excess of par when it issue the stock.
2. Retained earnings
• Accumulated net income not paid out as cash
dividends.
Bank Equity

• Classification of Capital Stock

• Common Stock
• Stock with ownership interest and bearing ultimate risk
and rewards (residual) of company performance.
• Preferred Stock
• Stock with features not possessed by common stock
which include:
• Priorities in claims (Divided/liquidation)
• Convertible
• Call provisions
• No-voting rights
Contingencies Liabilities

• Bank make various commitment and bear the

liabilities of the contingencies concerned in their
ordinary conduct of businesses.
• For example: Bank customer intending to open a
petrol station may request a bank to issue a
bank guarantee as required by the oil company.
• Bank provides guarantee to the oil company that
it will bear the customer’s liability that may
arise in future.
Contingencies Liabilities

• Bank only admits it will bear the contingent

liability and no actual business transactions
have yet to take place.
• This transaction known as off balance sheet
item.
• Other examples: Letter of credit, foreign
exchange contract, etc.
Income Statement

• Interest Income
• Income generated from interest activities (loans).
• Interest Expense
• Expenses incurred from interest activities (deposits).
• Net interest Income
Income Statement

• Non-interest Income
• Income generated from fees activities (annual fees).
• Non-interest Expense
• Expenses incurred from operation of the banks
(utilities).
• Bank’s burden
Income Statement

• Loan-loss provisions
• Management’s estimation of potential lost from bad
loans.
• Securities gains or losses
• Taxes
Interest Income (II)

• Sum of interest income derived from interest

earning assets:
• Loans (Housing loan, term loan, overdraft, etc).
• Deposits held at other institutions.
• Trading account securities/investment securities.
Interest Expense (IE)

• Sum of interest paid on all interest-bearing

liabilities:
• Deposits from customers (Saving account).
• Long term debt (Bond).
• Deposit and placement by other financial institutions.
Non-interest Income (OI)

• Consist of fee income, investment income and

other income.
• Fee Income
• Commission, service charge, guarantee fee, etc.
• Investment Income
• Profit from trading securities (capital gain).
• Other Income
• Rental income, gain from disposal of fixed asset, etc.
Non-interest Expense (OE)

• Personnel expense
• Salaries and benefits paid to bank employees.
• Occupancy expense
• Rent and depreciation on equipment and premises.
• Other operating expenses
• Technology expenditures.
• Utilities.
• Etc
Loan-loss Provisions (LLP)

• Allocating a portion of income to the loan loss

reserve to protect against potential loan losses.
• The greater the size of loan portfolio, the higher
the loan-loss provisions.
• A requirement by the regulator to set aside part
of the income to absorb potential losses.
Securities Gains or losses (SG/SL)

• Bank sells securities from its investment portfolio

prior to final maturity at prices above (below) the
initial or amortized cost to the bank.
• Similar to investment income under OI.
• Note: Don’t duplicate the entries.
Net Income (NI)
NI = NII - Burden - LLP + SG(L) - T
• NII (Net interest income) = Interest Income (II) –
Interest Expense (IE)
• Burden = Non-interest expense (OE) – Non-
interest income (OI)
• LLP (Loan-loss provisions)
• SG(L) (Securities gains/losses)
• T (Taxes)
Bank Performance

• Net interest margin (NIM)

• NIM = NII / Earning Assets (EA)
• Measure the net interest income (NII) on income
producing assets.
• Net non-interest margin (NNIM)
• NNIM = NNII / EA
• Measure the net non-interest income (NNII) on
income producing assets.
Bank Performance

• Earnings Base
• EB = EA / Total Assets (TA)
• Measure whether one bank has more or less assets
earning interest than peers.
• Burden ratio
• Burden ratio = (OE – OI) / TA
• Measure the amount of non-interest expense covered
by fees, service charges, securities gains and other
income as a fraction of total assets.
Bank Performance

• Efficiency ratio (EFF)

• EFF = OE / (II + OI)
• Measure a bank’s ability to control non-interest
expense relative to net operating income.
• Return on Equity (ROE)
• ROE = Net Income (NI) / Total Equities (TE)
• Measure a bank’s ability to generate income to the
shareholders.
Bank Performance

• Return on Assets (ROA)

• ROA = NI / TA
• Measure a bank’s utilisation of the assets in
generating the income for the bank.
• Degree of Leverage (DoL)
• DoL = Total Liabilities (TL) / TA
• DoL = TL / TE
• Measure a bank’s risk taking.
Bank Performance Model
 DuPont Model

• DuPont Model analysis = Net profit margin (NPM)

x Asset Utilisation (AU) x Equity Multiplier (EM)
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝐷𝑢𝑃𝑜𝑛𝑡 = × ×
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

• Is this refer to ROE?

DuPont Model

• DuPont analysis is referring to ROE, however in

details analysis (expansion analysis).
• Analysts could easily determine which ratio
(NPM, AU, EM) responsible to the changes of
ROE the most.
• Drawbacks?
Asset Management

• Asset management of a bank signifies how the

bank invest its assets/funds to maximize its
shareholders’ wealth.
• As the liquidity and profitability differ from one
asset to another, banks must take into
consideration the liquidity-profitability (LP)
dilemma.
Elements of Asset Liquidity

• An asset is considered liquid if it can be turned

into cash without heavy losses.
• A liquid asset is one than can be sold easily and
has a ready and stable market.
• Example: If market price of an asset is RM100
and if it can be sold at RM95, the asset is
considered liquid.
Liquidity-Profitability Dilemma

• Exist because
• Each products by the banks (assets, liabilities) has
their own characteristics (maturity, return, etc) which
generally classified into liquidity and profitability.
• Shareholders of the bank expect to maximise wealth
(profitability).
• Depositors expect to withdraw the money easily
(liquidity).
Liquidity-Profitability Dilemma

• Exist because
• Regulator (BNM) expect satisfactory liquidity to
safeguard depositors’ welfare and at the same time
expects reasonable return for the benefits of the
shareholders, depositors and banks.
• The conflict of the goals by shareholders,
depositors and regulators create the Liquidity-
Profitability dilemma.
Importance of Bank Liquidity

• 5 factors that explain why bank must have

adequate liquidity
1. Confidence factor
2. Relationship factor
3. Force sale factor
4. Risk premium factor
5. Last chance factor
Importance of Bank Liquidity

• 5 factors that explain why bank must have

adequate liquidity
1. Confidence factor
• To build financial market confidence in banks so that
the bank will be able to obtain financing in future.
• Indication to financial market and general public that is
strong and secure.
Importance of Bank Liquidity

• 5 factors that explain why bank must have

adequate liquidity
2. Relationship factor
• To gain trust of deposits and borrowers and develop
long term relationship with them.
• Inadequate liquidity can cause a bank to lose its
customers and in turn reduce its capability to compete.
Importance of Bank Liquidity

• 5 factors that explain why bank must have

adequate liquidity
3. Force sale factor
• To avoid selling valuable assets to fulfil liquidity needs
of depositors and borrowers.
• Without sufficient liquidity, a bank may need to force sell
its assets at a loss in order to provide the required
liquidity.
Importance of Bank Liquidity

• 5 factors that explain why bank must have

adequate liquidity
4. Risk premium factor
• To pay low risk premium for financing.
• Banks with high credit integrity are charged low default
risk premium by money market and capital market.
• Banks with high risk premium are forced to pay higher
cost in order to procure funds from the financial market.
Importance of Bank Liquidity

• 5 factors that explain why bank must have

adequate liquidity
5. Last chance factor
• To enable the bank to use the financing facility offered
by BNM.
• Commercial banks have the opportunity to borrow
short term from BNM through discount window when
they are faced with temporary financial difficulty.