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Project 1: Read the article “Analyzing a Bank’s Financial Statements” by Hans Wagner, and answer following questions.please follow the requirementsProject 2: Answer the questions. project_1.docx analyzing_bank_financial_statements__2017_.docx project_2.docx Unformatted Attachment Preview Deliverable: A maximum of two (2) typed page-write-up (12-point font size, single-spaced) including any references. Use bullet points, as necessary. Provide answers below questions. 1. [8 points] Refer to the article “Analyzing a Bank’s Financial Statements” by Hans Wagner, which is posted on the course site in BU MyCourses (Blackboard) under the Project 1 folder under “Term Projects.” After reading the article, answer the questions below. In answering the questions, you are encouraged to use input from the article and from your own research or experience. A. What is(are) the primary determinant(s) of a bank interest rate risk? B. If you were a bank owner or executive, what shape of the Yield Curve would you consider as favorable for the bank’s economic performance? Why? C. When interest rates in the economy are changing, maybe because of the change in the Federal Reserve monetary policy, interest rates on which category – bank deposits or bank loans – tend to adjust more slowly? D. Under what conditions an increase in interest rates may also expose banks to credit risk? E. What type of risk a bank is exposed to when interest rates are falling? Example. F. Based on the sample balance sheet in the article, how did FI Bank performed between “prior period” and “current period,” based on average Net Income/Yield? G. What are the advantage(s) and disadvantage(s) of high provision (allowance) for loan losses in a bank? H. Indicate which of the following is a “flow” quantity and which is a “stock” quantity: (1) Provision for loan losses (2) Allowance for loan and lease losses 2. [5 points] List (bullet points) 5 ways/methods commercial banks use to manage credit risk and interest rate risk. 3. [7 points; 3, 1, 1, 2 points respectively] In the last couple of years Wells Fargo, one of the largest banks in the U.S., has been accused of bank scandals. [Hint: Internet research is recommended.] A. What are the three (3) most serious scandalous activities? B. What were some of the consequences/costs of these activities? C. How was Wells Fargo prepared to deal with these problems? (to avoid significant impact on its financial performance, for example?) D. What is your own opinion about these scandals and the responses to them? 1 Analyzing A Banks Financial Statements By Hans Wagner | Updated January 20, 2017 — 6:00 AM EST SHARE Financial statements for banks present a different analytical problem than statements for manufacturing and service companies. As a result, analysis of a banks financial statements requires a distinct approach that recognizes a banks unique risks. Banks take deposits from savers and pay interest on some of these accounts. They pass these funds on to borrowers and receive interest on the loans. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers. This ability to pool deposits from many sources that can be lent to many different borrowers creates the flow of funds inherent in the banking system. By managing this flow of funds, banks generate profits, acting as the intermediary of interest paid and interest received, and taking on the risks of offering credit. Leverage and Risk Banking is a highly-leveraged business requiring regulators to dictate minimal capital levels to help ensure the solvency of each bank and the banking system. In the U.S., a banks primary regulator could be the Federal Reserve Board, the Office of the Comptroller of the Currency, the Office of Thrift Supervision or any one of 50 state regulatory bodies, depending on the charter of the bank. Within the Federal Reserve Board, there are 12 districts with 12 different regulatory staffing groups. These regulators focus on compliance with certain requirements, restrictions and guidelines, aiming to uphold the soundness and integrity of the banking system. As one of the most highly regulated banking industries in the world, investors have some level of assurance in the soundness of the banking system. As a 1 result, investors can focus most of their efforts on how a bank will perform in different economic environments. Below is a sample income statement and balance sheet for a large bank. The first thing to notice is that the line items in the statements are not the same as your typical manufacturing or service firm. Instead, there are entries that represent interest earned or expensed, as well as deposits and loans. Figure 1: The Income Statement 2 Figure 2: The Balance Sheet As financial intermediaries, banks assume two primary types of risk as they manage the flow of money through their business. Interest rate risk is the management of the spread between interest paid on deposits and received on loans over time. Credit risk is the likelihood that a borrower will default on a loan or lease, causing the bank to lose any potential interest earned as well as the principal that was loaned to the borrower. As investors, these are the primary elements that need to be understood when analyzing a banks financial statement. 3 Interest Rate Risk The primary business of a bank is managing the spread between deposits (liabilities, loans and assets). Basically, when the interest that a bank earns from loans is greater than the interest it must pay on deposits, it generates a positive interest spread or net interest income. The size of this spread is a major determinant of the profit generated by a bank. This interest rate risk is primarily determined by the shape of the yield curve. As a result, net interest income will vary, due to differences in the timing of accrual changes and changing rate and yield curve relationships. Changes in the general level of market interest rates also may cause changes in the volume and mix of a banks balance sheet products. For example, when economic activity continues to expand while interest rates are rising, commercial loan demand may increase while residential mortgage loan growth and prepayments slow. Banks, in the normal course of business, assume financial risk by making loans at interest rates that differ from rates paid on deposits. Deposits often have shorter maturities than loans and adjust to current market rates faster than loans. The result is a balance sheet mismatch between assets (loans) and liabilities (deposits). An upward sloping yield curve is favorable to a bank as the bulk of its deposits are short term and their loans are longer term. This mismatch of maturities generates the net interest revenue banks enjoy. When the yield curve flattens, this mismatch causes net interest revenue to diminish. A Banking Balance Sheet The table below ties together the banks balance sheet with the income statement and displays the yield generated from earning assets and interestbearing deposits. Most banks provide this type of table in their annual reports. The following table represents the same bank as in the previous examples: 4 Figure 3: Average Balance and Interest Rates First of all, the balance sheet is an average balance for the line item, rather than the balance at the end of the period. Average balances provide a better analytical framework to help understand the banks financial performance. Notice that for each average balance item there is a corresponding interest-related income, or 5 expense item, and the average yield for the time period. It also demonstrates the impact that a flattening yield curve can have on a banks net interest income. The best place to start is with the net interest income line item. The bank experienced lower net interest income even though it had grown average balances. To help understand how this occurred, look at the yield achieved on total earning assets. For the current period, it is actually higher than the prior period. Then examine the yield on the interest-bearing assets. It is substantially higher in the current period, causing higher interest-generating expenses. This discrepancy in the performance of the bank is due to the flattening of the yield curve. As the yield curve flattens, the interest rate that the bank pays on shorter-term deposits tends to increase faster than the rates it can earn from its loans. This causes the net interest income line to narrow, as shown above. One way banks try to overcome the impact of the flattening of the yield curve is to increase the fees they charge for services. As these fees become a larger portion of the banks income, it becomes less dependent on net interest income to drive earnings. Changes in the general level of interest rates may affect the volume of certain types of banking activities that generate fee-related income. For example, the volume of residential mortgage loan originations typically declines as interest rates rise, resulting in lower originating fees. In contrast, mortgage-servicing pools often face slower prepayments when rates are rising, since borrowers are less likely to refinance. As a result, fee income and associated economic value arising from mortgage servicing-related businesses may increase or remain stable in periods of moderately rising interest rates. When analyzing a bank, you should also consider how interest rate risk might act jointly with other risks facing the bank. For example, in a rising rate environment, loan customers may not be able to meet interest payments because of the increase in the size of the payment or a reduction in earnings. The result will be a higher level of problem loans. An increase in interest rates exposes a bank with a 6 significant concentration in adjustable rate loans to credit risk. For a bank that is predominately funded with short-term liabilities, a rise in rates may decrease net interest income at the same time that credit quality problems are on the rise. Credit Risk Credit risk is most simply defined as the potential of a bank borrower or counterparty to fail in meeting its obligations in accordance with agreed terms. When this happens, the bank will experience a loss of some or all of the credit it provided to its customer. To absorb these losses, banks maintain an allowance for loan and lease losses. In essence, this allowance can be viewed as a pool of capital specifically set aside to absorb estimated loan losses. This allowance should be maintained at a level that is adequate to absorb the estimated amount of probable losses in the institutions loan portfolio. Actual losses are written off from the balance sheet account allowance for loan and lease losses. The allowance for loan and lease losses is replenished through the income statement line item provision for loan losses. Figure 4 shows how this calculation is performed for the bank being analyzed. Figure 4: Loan Losses Investors should consider a couple points from Figure 4. First, the actual writeoffs were more than the amount management included in the provision for loan losses. While this in itself isnt necessarily a problem, it is suspect because the flattening of the yield curve has likely caused a slowdown in the economy and put pressure on marginal borrowers. 7 Arriving at the provision for loan losses involves a high degree of judgment, representing managements best evaluation of the appropriate loss to reserve. Because it is a management judgment, the provision for loan losses can be used to manage a banks earnings. Looking at the income statement for this bank shows that it had lower net income due primarily to the higher interest paid on interest-bearing liabilities. The increase in the provision for loan losses was 1.8\%, while actual loan losses were significantly higher. Had the banks management just matched its actual losses, it would have had a net income that was $983 less (or $1,772). An investor should be concerned that this bank is not reserving sufficient capital to cover its future loan and lease losses. It also seems that this bank is trying to manage its net income. Substantially higher loan and lease losses would decrease its loan and lease reserve account to the point where this bank would have to increase the future provision for loan losses on the income statement. This could cause the bank to report a loss in income. In addition, regulators could place the bank on a watch list and possibly require that it take further corrective action, such as issuing additional capital. Neither of these situations benefits investors. Overall, a careful review of a banks financial statements can highlight the key factors that should be considered before making a trading or investing decision. Investors need to have a good understanding of the business cycle and the yield curve; both have a major impact on the economic performance of banks. 8 Deliverable: A maximum of two (2) typed page-write-up (12-point font size, single-spaced) including any references. Use bullet points, as necessary. Provide answers below questions. 1. [10 points in total] Some global efforts have led to the creation of international rules for bank supervision. [References: Textbook and Internet research] A. [1 point] What is the key organization that has led these efforts, which resulted in the adoption, by several nations, of the approach to the calculation of risk-weighted assets and risk-weighted capital ratio for banks? _________________________________________________________________. B. [1 point] Where is the above organization located? _____________________________. C. [1 point] What is the name of the official document which contains the rules for calculating these risk-adjusted assets and capital ratio? ___________________________________________________________________ D. [4 points] What are the current major asset categories and associated weights for risk calculation purposes? E. [3 points] Outline the key provisions of the latest framework, which was put forth in aftermath of the recent global financial crisis that began around 2007. 2. Suppose that Oldhat Financial starts its first day of operations with $9 million in capital. A total of $130 million in checkable deposits is received. The bank makes a $25 million commercial loan and another $50 million in mortgages with the following terms: 200 standard, 30-year, fixed-rate mortgages with a nominal annual rate of 5.25\%, each for $250,000. Assume that required reserves are 8\%. A. [5 points] What does the bank balance sheet look like? B. [1 point] How well capitalized is the bank? 1 C. [4 points] Calculate the risk-weighted assets and risk-weighted capital ratio after Oldhat’s first day. 2 ... Purchase answer to see full attachment