THE INSTITUTE OF FINANCE MANAGEMENT

INSTITUTE OF FINANCE MANAGEMENT CHUO CHA USIMAMIZI WA FEDHA

AFU 08609: TREASURY MANAGEMENT

LECTURE NOTES
MANAGEMENT OF THE BANK’S BALANCE SHEET

LEARNING OUTCOMES

1.1 THE FINANCIAL STATEMENTS OF THE BANK

The two most important financial statements for a banking firm—its balance sheet, or Report of
Condition, and its income expense statement, or Report of Income—may be viewed as a list of
financial inputs and outputs, as Table 1–1 shows. The Report of Condition shows the amount and
composition of funds sources (financial inputs) drawn upon to finance lending and investing
activities and how much has been allocated to loans, securities, and other funds uses (financial
outputs) at any given point in time. In contrast, the financial inputs and outputs on the Report of
Income show how much it has cost to acquire funds and to generate revenues from the uses the
financial firm has made of those funds. These costs include interest paid to depositors and other
creditors of the institution, the expenses of hiring management and staff, overhead costs in acquiring
and using office facilities, and taxes paid for government services. The Report of Income also shows
the revenues (cash flow) generated by selling services to the public, including making loans and
servicing customer deposits. Finally, the Report of Income shows net earnings after all costs are
deducted from the sum of all revenues, some of which will be reinvested in the financial firm for
future growth and some of which will flow to stock-holders as dividends.

1.2 FINANCIAL STATEMENTS OF A BANK COMPARED TO NONFINANCIAL FIRM

The balance sheets of financial firms are frequently dominated on the asset side by loans (credit) and
investments in government and corporate bonds and stock and on the liability side by deposits and
non deposit borrowings from the financial markets to support their lending and investing. Revenues
of financial firms typically are led by interest earnings and dividends plus fees for financial services
provided, while expenses are usually led by the interest cost of borrowing loanable funds followed by
employee wages, salaries, and benefits. In contrast, nonfinancial firms’ balance sheets typically have
their assets led by plant and equipment, accounts receivable from sales of goods and services on
credit, and inventories of raw materials and goods for sale. Their liabilities, including both short- and
long-term debt, include accounts payable to acquire supplies needed in production and borrowings
from financial firms to meet payrolls, pay taxes, and handle other expenses. (Thus, loans extended by
financial firms, recorded as assets, are recorded as liabilities for the nonfinancial firms receiving
those loans.) Revenues for nonfinancial companies usually flow in from sales of goods and
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nonfinancial services (accounts receivable), while employees’ wages, salaries and benefits,
depreciation of plant and equipment, and the cost of borrowing often lead the expense list.

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1.3 THE BALANCE SHEET
The balance sheet is a statement of a company’s assets and liabilities as deter-mined by accounting
rules. It is a snapshot of a particular point in time, and so by the time it is produced it is already out of
date. However, it is an important information statement. A number of management information ratios
are used when analyzing the balance sheet.

For a bank, there are usually five parts to a balance sheet, split up in such a way to show separately:
 Lending and deposits, or traditional bank business;
 Trading assets;
 Treasury and inter-bank assets;
 Off-balance-sheet assets;
 Long-term assets, including fixed assets, shares in subsidiary companies, together with equity
and Tier 2 capital.

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The actual balance sheet of a retail or commercial bank will differ significantly from that of an
investment bank, due to the relative importance of their various business lines, but the basic layout
will be similar.

1.3.1 THE PRINCIPAL TYPES OF ACCOUNTS

A balance sheet, or Report of Condition, lists the assets, liabilities, and equity capital (own-ers’
funds) held by or invested in a bank or other financial firm on any given date. Because financial
institutions are simply business firms selling a particular kind of product, the basic balance sheet
identity: ASSETS = LIABILITIES + EQUITY must be valid for financial-service providers,
just as would be true for nonfinancial companies.

Assets on the Balance Sheet

For banks and other depository institutions the assets on the balance sheet are of four major types:
1. Cash in the vault and deposits held at other depository institutions (C),
2. Government and private interest-bearing securities purchased in the open market (S),
3. Loans and lease financings made available to customers (L), and
4. Miscellaneous assets (MA).

Liabilities on the Balance Sheet

1. Liabilities fall into two principal categories:
2. Deposits made by and owed to various customers (D) and
3. Non-deposit borrowings of funds in the money and capital markets (NDB).

Equity Capital
Finally, equity capital represents long-term funds the owners contribute (EC)

Therefore, the balance sheet identity for a depository institution can be written:
C + S + L + MA = D + NDB + EC

Cash assets
Cash assets (C) are designed to meet the financial firm’s need for liquidity (i.e., immediately
spendable cash) in order to meet deposit withdrawals, customer demands for loans, and other
unexpected or immediate cash needs.

Security holdings
Security holdings (S) are a backup source of liquidity and include investments that provide a source
of income.

Loans (L) & Miscellaneous assets (MA)

Loans (L) are made principally to supply income, while miscellaneous assets (MA) are usually
dominated by fixed assets (plant and equipment) and investments in subsidiaries (if any).

Deposits (D) & Non-deposit borrowings (NDB)

Deposits (D) are typically the main source of funding for banks, and comparable institutions with
non-deposit borrowings (NDB) carried out mainly to supplement deposits and provide the additional
liquidity that cash assets and securities cannot provide.

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Equity capital
Finally, equity capital (EC) supplies the long-term, relatively stable base of financial support upon
which the financial firm will rely to grow and to cover any extraordinary losses it incurs.

1.3.2 ASSETS OF THE BANKING FIRM

Cash and Due from Depository Institutions

The first asset item normally listed on a banking firm’s Report of Condition is cash and due from
depository institutions. This item includes cash held in the bank’s vault, any deposits placed with
other depository institutions (usually called correspondent deposits), cash items in the process of
collection (mainly uncollected checks), and the banking firm’s reserve account held with the Central
Bank. The cash and due from depository institutions account is also referred to as primary reserves.
This means that these assets are the first line of defense against customer deposit withdrawals and the
first source of funds to look to when a customer comes in with a loan request.

Investment Securities: The Liquid Portion

A second line of defense to meet demands for cash is liquid security holdings, often called secondary
reserves or referenced on regulatory reports as ―investment securities available for sale.‖ These
typically include holdings of short-term government securities and privately issued money market
securities, including interest-bearing time deposits held with other banking firms and commercial
paper. Secondary reserves occupy the middle ground between cash assets and loans, earning some
income but also held for the ease with which they can be converted into cash on short notice.

Investment Securities: The Income-Generating Portion

Bonds, notes, and other securities held primarily for their expected rate of return or yield are known
as the income-generating portion of investment securities. (These are often called held-to-maturity
securities on regulatory reports.) Investment securities may be recorded on the books of a banking
firm at their original cost or at market value, whichever is lower. Of course, if interest rates rise after
the securities are purchased, their market value will be less than their original cost (book value).

Trading Account Assets

Securities purchased to provide short-term profits from short-term price movements are not included
in ―Securities‖ on the Report of Condition. They are reported as trading account assets. If the
banking firm serves as a security dealer, securities acquired for resale are included here. The amount
recorded in the trading account is valued at market.

Loans and Leases

By far the largest asset item is loans and leases, which often account for half to almost three-quarters
of the total value of all bank assets. A bank’s loan account typically is broken down into several
groups of similar type loans. For example, one commonly used breakdown is by the purpose for
borrowing money. In this case, we may see listed on a banking firm’s balance sheet the following
loan types:

 Commercial and industrial (or business) loans.

 Consumer (or household) loans; on regulatory reports these are referenced as Loans to
Individuals.

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  Real estate (or property-based) loans.
 Financial institutions loans (such as loans made to other depository institutions as well as to
nonbank financial institutions).
 Foreign (or international) loans (extended to foreign governments and institutions).
 Agricultural production loans (or farm loans, extended primarily to farmers and ranch-ers to
harvest crops and raise livestock).
 Security loans (to aid investors and dealers in their security trading activities).

Leases (usually consisting of the bank buying equipment for its business customers and making that
equipment available for the customer’s use for a stipulated period of time in return for a series of
rental payments—the functional equivalent of a regular loan).

Loan Losses
Depository institutions are allowed to build up a reserve for future loan losses, called the allowance
for loan losses (ALL), from their flow of income based on their recent loan-loss experience. The
ALL, which is a contra-asset account, represents an accumulated reserve against which loans
declared to be uncollectible can be charged off. This means that bad loans normally do not affect
current income. Rather, when a loan is considered uncollectible, the accounting department will write
(charge) it off the books by reducing the ALL account by the amount of the uncollectible loan while
simultaneously decreasing the asset account for gross loans. The allowance for possible loan losses is
built up gradually over time by annual deductions from current income. These deductions appear on
the banking firm’s income and expense statement (or Report of Income) as a noncash expense item
called the provision for loan losses (PLL). For example, suppose a banking firm anticipated loan
losses this year of TZS1 million and held TZS100 million already in its ALL account. It would take a
non-cash charge against its current revenues, entering TZS1 million in the provision for loan loss
account (PLL) on its Report of Income.

Specific and General Reserves

Many financial firms divide the ALL account into two parts: specific reserves and general reserves.
Specific reserves are set aside to cover a particular loan or loans expected to be a problem or that
represent above-average risk. Management may simply designate a portion of the reserves already in
the ALL account as specific reserves or add more reserves to cover specific loan problems. The
remaining reserves in the loan loss account are called general reserves. This division of loan loss
reserves helps managers better understand their institutions need for protection against current or
future loan defaults.

Unearned Income
This item consists of interest income on loans received from customers, but not yet earned under the
accrual method of accounting banks use today. For example, if a customer receives a loan and pays
all or some portion of the interest up front, the banking firm cannot record that interest payment as
earned income because the customer involved has not yet had use of the loan for any length of time.
Over the life of the loan, the bank will gradually earn the interest income and will transfer the
necessary amounts from unearned discount to the interest income account.

Nonperforming (noncurrent)
Loans Banks have another loan category on their books called nonperforming (noncurrent) loans,
which are credits that no longer accrue interest income or that have had to be restructured to
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accommodate a borrower’s changed circumstances. A loan is placed in the nonperforming category
when any scheduled loan repayment is past due for more than 90 days. Once a loan is classified as
―nonperforming,‖ any accrued interest recorded on the books, but not actually received, must be
deducted from loan revenues. The bank is then forbidden to record any additional interest income
from the loan until a cash payment actually comes in.

Bank Premises and Fixed Assets

Bank assets also include the net (adjusted for depreciation) value of buildings and equipment. A
banking firm usually devotes only a small percentage (less than 2 percent) of its assets to the
institution’s physical plant— that is, the fixed assets represented by buildings and equipment needed
to carry on daily operations.

Goodwill and Other Intangible Assets

Most banking firms have some purchased assets lacking physical substance. Goodwill occurs when a
firm acquires another firm and pays more than the market value of its net assets (assets less
liabilities). Other intangible assets include mortgage servicing rights and purchased credit card
relationships.

All Other Assets

This account includes investments in subsidiary firms, customers’ liability on acceptances
outstanding, income earned but not collected on loans, net deferred tax assets, excess residential
mortgage servicing fees receivable, and all other assets.

1.3.3 LIABILITIES OF THE BANKING FIRM

Deposits
The principal liability of any bank is its deposits, representing financial claims held by businesses,
households, and governments against the banking firm. In the event a bank is liquidated, the proceeds
from the sale of its assets must first be used to pay off the claims of its depositors. Other creditors
and the stockholders receive whatever funds remain. There are five major types of deposits:

Noninterest-bearing demand deposits, or regular checking accounts, generally permit unlimited

check writing. But, under federal regulations, they cannot pay any explicit interest rate (though many
banks offer to pay postage costs and offer other ―free‖ ser-vices that yield the demand-deposit
customer an implicit rate of return).

Savings deposits generally bear the lowest rate of interest offered to depositors but may be of any
denomination (though most depository institutions impose a minimum size requirement) and permit
the customer to withdraw at will.

NOW accounts, which can be held by individuals and nonprofit institutions, bear interest and permit
drafts (checks) to be written against each account to pay third parties.

Money market deposit accounts (MMDAs) can pay whatever interest rate the offering institution
feels is competitive and have limited check-writing privileges attached.
No minimum denomination or maturity is required by law, though depository institutions must
reserve the right to require seven days’ notice before any withdrawals are made.

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Time deposits (mainly certificates of deposit, or CDs) usually carry a fixed maturity (term) and a
stipulated interest rate but may be of any denomination, maturity, and yield agreed upon by the
offering institution and its depositor.

The bulk of deposits are held by individuals and business firms. However, governments (federal,
state, and local) also hold substantial deposit accounts, known as public fund deposits.

Borrowings from Non-deposit Sources

Although deposits typically represent the largest portion of funds sources for many banks, sizable
amounts of funds also stem from miscellaneous liability accounts. All other factors held equal, the
larger the depository institution, the greater use it tends to make of non-deposit sources of funds. One
reason borrowings from nondeposit funds sources have grown rapidly in recent years is that there are
no reserve requirements or insurance fees on most of these funds, which lowers the cost of non-
deposit funding. Also, borrowings in the money market usually can be arranged in a few minutes and
the funds wired immediately to the depository institution that needs them.

1.3.4 EQUITY CAPITAL FOR THE BANKING FIRM

The equity capital accounts on a depository institution’s Report of Condition represent the owners’
(stockholders’) share of the business. Every new financial firm begins with a minimum amount of
owners’ capital and then borrows funds from the public to ―lever up‖ its operations. In fact, financial
institutions are among the most heavily leveraged (debt-financed) of all businesses. Their capital
accounts normally represent less than 10 percent of the value of their total assets. Bank capital
accounts typically include many of the same items that other business corporations display on their
balance sheets. They list the total par (face) value of common stock outstanding. When that stock is
sold for more than its par value, the excess market value of the stock flows into a surplus account.
Not many banking firms issue preferred stock, which guarantees its holders an annual dividend
before common stockholders receive any dividend payments. Usually, the largest item in the capital
account is retained earnings (undivided profits), which represent accumulated net income left over
each year after payment of stockholder dividends. There may also be a contingency reserve held as
protection against unforeseen losses and treasury stock that has been retired.

1.4 THE INCOME STATEMENT

An income statement, or Report of Income, indicates the amount of revenue received and expenses
incurred over a specific period of time. There is usually a close correlation between the size of the
principal items on a bank’s balance sheet (Report of Condition) and the size of important items on its
income statement. After all, assets on the balance sheet usually account for the majority of operating
revenues, while liabilities generate many of a bank’s operating expenses.

The principal source of bank revenue generally is the interest income generated by earning assets—
mainly loans and investments. Additional revenue is provided by the fees charged for specific
services (such as ATM usage). The major expenses incurred in gene-rating this revenue include
interest paid out to depositors; interest owed on non-deposit borrowings; the cost of equity capital;
salaries, wages, and benefits paid to employees; overhead expenses associated with the physical
plant; funds set aside for possible loan losses; and taxes owed. The difference between all revenues
and expenses is net income.

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Thus: Net Income = Total Revenue Items – Total Expense Items

The previous chart on revenue and expense items reminds us that financial firms interested in
increasing their net earnings (income) have a number of options available to achieve this goal:

1. increase the net yield on each asset held;

2. redistribute earning assets toward those assets with higher yields;
3. increase the volume of services that provide fee income;
4. increase fees associated with various services;
5. shift funding sources toward less-costly borrowings;
6. find ways to reduce employee, overhead, loan-loss, and miscellaneous operating expenses; or
7. reduce taxes owed through improved tax management practices.

Of course, management does not have full control of all of these items that affect net income. The
yields earned on various assets, the revenues generated by sales of services, and the interest rates that
must be paid to attract deposits and non-deposit borrowings are determined by demand and supply

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forces in the marketplace. Over the long run, the pub-lic will be the principal factor shaping what
types of loans the financial-service provider will be able to make and what services it will be able to
sell in its market area. Within the broad boundaries allowed by competition, regulation, and the
pressures exerted by public demand, however, management decisions are still a major factor in
determining the particular mix of loans, securities, cash, and liabilities each financial firm holds and
the size and composition of its revenues and expenses.

Interest Income
Not surprisingly, interest earned from loans and security investments accounts for the majority of
revenues for most depository institutions and for many other lenders as well. It must be noted,
however, that the relative importance of interest revenues versus noninterest revenues (fee income) is
changing rapidly, with fee income generally growing faster than interest income on loans and
investments as financial-service managers work hard to develop more fee-based services.

Interest Expenses
The number one expense item for a depository institution normally is interest on deposits. For the
banking company we have been following interest on deposits accounted for more than 72 percent of
this bank’s total interest costs. Another important interest expense item is the interest owed on short-
term borrowings in the money market—mainly borrowings of federal funds (reserves) from other
depository institutions and borrowings backstopped by security repurchase agreements—plus any
long-term borrowings that have taken place (including mortgages on the financial firm’s property and
subordinated notes and debentures outstanding).

Net Interest Income

Total interest expenses are subtracted from total interest income to yield net interest income. This
important item is often referred to as the interest margin, the gap between the interest income the
financial firm receives on loans and securities and the interest cost of its borrowed funds. It is usually
a key determinant of profitability. When the interest margin falls, the stockholders of financial firms
will usually see a decline in their bottom line—net after-tax earnings—and the dividends their
stockholders receive on each share of stock held may decrease as well.

Loan Loss Expense

As we saw earlier in this chapter, another expense item that banks and selected other financial
institutions can deduct from current income is known as the provision for loan and lease losses. This
provision account is really a noncash expense, created by simple book-keeping entry. Its purpose is
to shelter a portion of current earnings from taxes to help prepare for bad loans. The annual loan loss
provision is deducted from current revenues before taxes are applied to earnings. Expensing
worthless loans usually must occur in the year that troubled loans are judged to be worthless. The
largest banking companies are required to use the specific charge-off method.

Noninterest Income
Sources of income other than interest revenues from loans and investments are called noninterest
income (or fee income). The financial reports that banks are required to submit to regulatory
authorities apportion this income source into four broad categories, as noted in the adjacent box. The
breakdown includes:
1. Fees earned from fiduciary activities (such as trust services)
2. service charges on deposit accounts;

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Trading account gains and fees; and
(4) additional noninterest income (including revenues from investment banking, security brokerage,
and insurance services).

Noninterest Expenses
The key noninterest expense item for most financial institutions is wages, salaries, and employee
benefits, which has been an important expense item in recent years as leading financial firms have
pursued top-quality college graduates to head their management teams and lured experienced senior
management away from competitors. The costs of maintaining a financial institution’s properties and
rental fees on office space show up in the premises and equipment expense. The cost of furniture and
equipment also appears under the noninterest expense category, along with numerous small expense
items such as legal fees, office supplies, and repair costs.

Net Operating Income and Net Income

The sum of net interest income (interest income interest expense) and net noninterest income
(noninterest income noninterest expense provision for loan losses) is called pretax net operating
income. Applicable federal and state income tax rates are applied to pretax net operating income plus
securities gains or losses to derive income before extraordinary items.

1.5 MEASURING THE PERFORMANCE OF THE BANK

What do we mean by the word perform when it comes to financial firms? In this case performance
refers to how adequately a financial firm meets the needs of its stockholders (owners), employees,
depositors and other creditors, and borrowing customers. At the same time, financial firms must find
a way to keep government regulators satisfied that their operating policies, loans, and investments are
sound, protecting the public interest. The success or lack of success of these institutions in meeting
the expectations of others is usually revealed by a careful study of their financial statements.

In this section we take a detailed look at the most widely used indicators of the quality and quantity
of bank performance.

1.5.1 STOCK VALUES AND PROFITABILITY RATIOS

How can we use financial statements, particularly the Report of Condition (balance sheet) and Report
of Income (income statement), to evaluate how well a financial firm is performing? What do we look
at to help decide if a financial institution is facing serious problems that its management should deal
with? The first step in analyzing financial statements is to determine the objectives. Performance
must be directed toward specific objectives. A fair evaluation of any financial firm’s performance
should start by evaluating whether it has been able to achieve the objectives its management and
stockholders have chosen. Certainly many financial institutions have their own unique objectives.
Some wish to grow faster and achieve some long-range growth objective. Others seem to prefer the
quiet life, minimizing risk and conveying the image of a sound institution, but with modest rewards
for their shareholders.

STOCK VALUES
While all of the foregoing goals have something to recommend them, increasingly larger financial-
service corporations are finding they must pay close attention to the value of their stock. Indeed, the
basic principles of financial management, as that science is practiced today, suggest strongly that
attempting to maximize a corporation’s stock value is the key objective that should have priority over

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all others. If the stock fails to rise in value commensurate with stockholder expectations, current
investors may seek to unload their shares and the financial institution will have difficulty raising new
capital to support its future growth. Clearly, then, management should pursue the objective of
maximizing the value of the financial firm’s stock. What will cause a financial firm’s stock to rise in
value? Each institution’s stock price is a function of the value of stock given by:

Stock Value = Expected Stream of Future Stockholder Dividends/Discount Factor

General Formula I: Constant Expected Dividend Payments

Po = D/ke…………………………………………………………………………………………….(2–1)

where (D) represents stockholder dividends expected to be paid in future periods, discounted by a
minimum acceptable rate of return (ke) tied to the financial firm’s perceived level of risk. The
minimum acceptable rate of return, ke, is sometimes referred to as an institution’s cost of equity
capital and has two main components:

 the risk-free rate of interest (often proxied by the current yield on government bonds) and
 the equity risk premium (which is designed to compensate an investor for accepting the risk
of investing in a financial firm’s stock rather than in risk-free securities).

The value of the financial firm’s stock will tend to rise in any of the following situations:
1. The value of the stream of future stockholder dividends is expected to increase, due perhaps
to recent growth in some of the markets served or perhaps because of profitable acquisitions
the organization has made.
2. The financial organization’s perceived level of risk falls, due perhaps to an increase in equity
capital, a decrease in its loan losses, or the perception of investors that the insti-tution is less
risky overall (perhaps because it has further diversified its service offerings and expanded the
number of markets it serves) and, therefore, has a lower equity risk premium.
3. Market interest rates decrease, reducing shareholders’ acceptable rates of return via the risk-
free rate of interest component of all market interest rates.
4. Expected dividend increases are combined with declining risk, as perceived by investors.

Research evidence over the years has found the stock values of financial institutions to be especially
sensitive to changes in market interest rates, currency exchange rates, and the strength or weakness of
the economy that each serves. Clearly, management can work to achieve policies that increase future
earnings, reduce risk, or pursue a combination of both actions in order to raise its company’s stock
price.

EXAMPLE 2-1: Calculating the Value of Stock

Suppose a bank is expected to pay a dividend of TZS5 per share in period 1 and subsequent future
periods. The appropriate discount rate to reflect shareholder risk is 10 percent.

Required:
Calculate the current bank’s stock price

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SUGGESTED ANSWER
The bank’s stock price must be valued at
Po = TZS5/0.10TZS50 per share

General Formula II: Constant Growth in Future Expected Dividends

The formula for the determinants of a financial firm’s stock price presented in Equation (2–1)
assumes that the stock may pay dividends of constant amounts over time. However, if the dividends
paid to stockholders are expected to grow at a constant rate over time, perhaps reflecting steady
growth in earnings, the stock price equation can be greatly simplified into:

Po = D1/(ke – g)……………………………………………………………………...…………….2 - 2

where D1 is the expected dividend on stock in period 1, ke is the rate of discount reflecting the
perceived level of risk attached to investing in the stock, g is the expected constant growth rate at
which all future stock dividends will grow each year, and r must be greater than g.

EXAMPLE 2-2: Calculating the Value of Stock

Suppose a bank is expected to pay a dividend of TZS5 per share in period 1, dividends are expected
to grow 6 percent a year for all future years, and the appropriate discount rate to reflect shareholder
risk is 10 percent.

Required:
Calculate the current bank’s stock price

SUGGESTED ANSWER
The bank’s stock price must be valued at

Po TZS5/(0.10 - 0.06) TZS125 per share

General Formula II: Investors with Limited Time Horizon

The two stock-price formulas discussed above assume the financial firm will pay divi-dends
indefinitely into the future. Most capital-market investors have a limited time horizon, however, and
plan to sell the stock at the end of their planned investment horizon. In this case the current value of a
corporation’s stock is determined from:

D1 D2 Dn Pn
Po    ......  
1  ke) 1  ke)
1 2
(1  ke) n
(1  ke) n

where we assume an investor will hold the stock for n periods, receiving the stream of dividends D 1
D 2, . . . , Dn, and sell the stock for price Pn at the end of the planned investment horizon.

EXAMPLE 2-3: Calculating the Value of Stock

Suppose an investor expects ABC Commercial Bank to pay a TZS5 dividend at the end of period 1,
TZS10 at the end of period 2, and then plan to sell the stock for a price of TZS150 per share.

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Required:
If the relevant discount rate to capture risk is 10 percent, calculate the current value of the bank’s
stock.

SUGGESTED ANSWER
TZS 5 TZS 10 TZS 150
Po     TZS 140.91
1  0.1) (1  0.1)
1 2
(1  0.1) 2

NOTE:
Financial firms are generally very reliable in paying out dividends to their stockholders. Their dividend
rate (i.e., annual dividends/stock price per share) tends to be higher than the average for nonfinancial
companies.

1.5.2 PROFITABILITY RATIOS: A SURROGATE FOR STOCK VALUES

While the behavior of a stock’s price is, in theory, the best indicator of a financial firm’s performance
because it reflects the market’s evaluation of that firm, this indicator is often not available for smaller
banks and other relatively small financial service corporations because the stock issued by smaller
institutions is frequently not actively traded in international or national markets. This fact forces the
financial analyst to fall back on surrogates for market-value indicators in the form of various
profitability ratios.

Key Profitability Ratios

Among the most important ratio measures of profitability used today are the following:

Return on Equity Capital (ROE)

ROE = Net Income/Total Equity Capital

Return on Assets (ROA)

ROA = Net Income/Total Assets

Net Interest Margin (NIM)

NIM = [Interest Income – Interest Expense]/Total Assets

Net Non-Interest Margin (NNIM)

NNIM = [Noninterest Revenues – Provision for Loan & Lease Losses – Noninterest Expenses]/Total Assets

Net Operating Margin (NOM)

NOM = [Total Operating Revenue – Total Operating Expenses]/Total Assets
= Pretax Net Operating Income/Total Assets

Earnings per Share (EPS)

EPS = Net Income/Common Equity Shares Outstanding

Like all financial ratios, each of these profitability measures often varies substantially over time and
from market to market.

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1.5.3 INTERPRETING PROFITABILITY RATIOS

Return on Assets (ROA)

The, return on assets (ROA) is primarily an indicator of managerial efficiency; it indicates how
capable management has been in converting assets into net earnings.

Return on Equity (ROE)

Return on equity (ROE) is a measure of the rate of return flowing to shareholders. It approximates
the net benefit that the stockholders have received from investing their capital in the financial firm
(i.e., placing their funds at risk in the hope of earning a suitable profit).

The Net Operating Margin, Net Interest Margin, and Net Noninterest Margin
They are efficiency measures as well as profitability measures, indicating how well management and
staff have been able to keep the growth of revenues (which come primarily from loans, investments,
and service fees) ahead of rising costs (principally the interest on deposits and other borrowings and
employee salaries and benefits).

 The Net Interest Margin measures how large a spread between interest revenues and interest
costs management has been able to achieve by close control over earning assets and pursuit
of the cheapest sources of funding.
 The net noninterest margin, in contrast, measures the amount of non-interest revenues
stemming from service fees the financial firm has been able to collect relative to the amount
of noninterest costs incurred (including salaries and wages, repair and maintenance of
facilities, and loan loss expenses). Typically, the net noninterest margin is negative:
Noninterest costs generally outstrip fee income, though fee income has been rising rapidly in
recent years as a percentage of all revenues.

Another traditional measure of earnings efficiency is the earnings spread, or simply the spread,
calculated as follows:

Earnings Spread = [Total Interest Income/Total Earning Assets] – [Total Interest Expense/Total Interest Bearing
Liabilities]

The spread measures the effectiveness of a financial firm’s intermediation function in bor-rowing and
lending money and also the intensity of competition in the firm’s market area. Greater competition
tends to squeeze the difference between average asset yields and average liability costs. If other
factors are held constant, the spread will decline as competition increases, forcing management to try
to find other ways (such as generating fee income from new services) to make up for an eroding
earnings spread.

Relationship between ROE and ROA

ROE = ROA X Total Assets/Total Equity Capital

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In fact, the ROE–ROA relationship illustrates quite clearly the fundamental trade-off the managers of
financial-service firms face between risk and return. For example, a bank whose ROA is projected to
be 1 percent this year will need TZS10 in assets for each TZS1 in capital to achieve a 10 percent
ROE. That is, following Equation:

ROE = ROA X Total Assets/Total Equity Capital

= 0.01 x TZS10 x 100/TZS1 = 10%

Indeed, we could construct a risk-return trade-off table like the one following that will tell us how
much leverage (debt relative to equity) must be used to achieve a financial institution’s desired rate
of return to its stockholders.

In contrast, with a 20 to 1 assets-to-capital ratio a financial firm can achieve a 10 percent ROE
simply by earning a modest 0.5 percent ROA. Clearly, as earnings efficiency represented by ROA
declines, the firm must take on more risk in the form of higher leverage to have any chance of
achieving its desired rate of return to its shareholders (ROE).

Another highly useful profitability formula focusing upon ROE is this one:

ROE = Net Profit Margin x Assets Utilization Ratio x Equity Multiplier

Where:

 Net Profit Margin (NPM) = Net Income/Total Operating Revenue

 Degree of Asset Utilization (AU) = Total Operating Revenues/Total Assets

 Equity Multiplier (EM) = Total Assets/Total Equity Capital

Each component of this simple equation is a telltale indicator of a different aspect of a financial
firm’s operations.

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If any of these ratios begins to decline, management needs to pay close attention and assess the
reasons behind that change. For example, of these three financial ratios the equity multiplier (EM), or
assets to equity ratio, is normally the largest, averaging 10X or more for most banks. Bigger banks
sometimes operate with multipliers of 20X or more. The multiplier is a direct measure of financial
leverage—how many dollars of assets must be supported by each dollar of equity (owners’) capital
and how much of the financial firm’s resources, therefore, must rest on debt. Because equity must
absorb losses on assets, the larger the multiplier, the more exposed to failure risk the financial
institution is. However, the larger the multiplier, the greater the potential for high returns for the
stockholders.

The net profit margin (NPM), or the ratio of net income to total revenues, is also subject to some
degree of management control and direction. It reminds us that financial-service corporations can
increase their earnings and the returns to their stockholders by successfully controlling expenses and
maximizing revenues. Similarly, by carefully allocating assets to the highest-yielding loans and
investments while avoiding excessive risk, management can raise the average yield on assets (AU, or
asset utilization).

EXAMPLE 2-4: Calculating the Value of Stock

Suppose a bank’s Report of Condition and Report of Income show the following figures:

Net Income = TZS100 million

Total Operating Revenue = TZS3,930
Total Assets = TZS12,200
Total Equity Capital = TZS730

Required:
Calculate the bank’s ROE

SUGGESTED ANSWER:

ROE = Net Profit Margin x Assets Utilization Ratio x Equity Multiplier

= TZSTZS100m/TZS3,930 x 3,930/TZS12,200 x TZS12,200/TZS730
= 0.0254 x 0.32 x 16.71
= 0.1358 or 13.58%

Where:
 Net Profit Margin (NPM) = Net Income/Total Operating Revenue
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  Degree of Asset Utilization (AU) = Total Operating Revenues/Total Assets
 Equity Multiplier (EM) = Total Assets/Total Equity Capital

1.5.4 RETURN ON ASSETS AND ITS PRINCIPAL COMPONENTS

We can also divide a financial firm’s return on assets (ROA) into its component parts, as shown in
Table. Actually, ROA is based on three simple component ratios:

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Such a breakdown of the components of return on assets (ROA) can be very helpful in explaining
some of the recent changes that financial-service providers have experienced in their financial
position. The foregoing analysis reminds us that achieving superior profitability for a financial
institution depends upon several crucial factors:

 Careful use of financial leverage (or the proportion of assets financed by debt as opposed to
equity capital).
 Careful use of operating leverage from fixed assets (or the proportion of fixed-cost inputs
used to boost operating earnings as output grows).
 Careful control of operating expenses so that more dollars of sales revenue become net
income.
 Careful management of the asset portfolio to meet liquidity needs while seeking the highest
returns from any assets acquired.
 Careful control of exposure to risk so that losses don’t overwhelm income and equity capital.

1.6 MEASURING RISK IN BANKING

Risk to the manager of a financial institution or to a regulator supervising financial institutions means
the perceived uncertainty associated with a particular event. For example, will the customer renew
his or her loan? Will deposits and other sources of funds grow next month? Will the financial firm’s
stock price rise and its earnings increase? Are interest rates going to rise or fall next week, and will a
financial institution lose income or value if they do?

Bankers, are usually interested in achieving high stock values and high profitability, but none can fail
to pay attention to the risks they are accepting to achieve these goals. Earnings may decline
unexpectedly due to factors inside or outside the financial firm, such as changes in economic
conditions, competition, or laws and regulations. For example, recent increases in competition have
tended to narrow the spread between earnings on assets and the cost of raising funds. Thus,
stockholders always face the possibility of a decline in their earnings per share of stock, which could
cause the bank’s stock price to fall, eroding its resources for future growth.

Among the more popular measures of overall risk for a financial firm are the following:

 Standard deviation (σ ) or variance ( σ2) of stock prices.

 Standard deviation or variance of net income.
 Standard deviation or variance of return on equity (ROE) and return on assets (ROA).

The higher the standard deviation or variance of the above measures, the greater the overall risk.
Each of these forms of risk can threaten a financial firm’s day-to-day performance and its long-run
survival.

The most important types of risk encountered daily by banks include:

1. Credit Risk
2. Liquidity Risk
3. Market Risk
4. Foreign Exchange Risk

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CREDIT RISK
The probability that some of a financial institution’s assets, especially its loans, will decline in value
and perhaps become worthless is known as credit risk. Because banks tend to hold little owners’
capital relative to the aggregate value of their assets, only a small percentage of total loans needs to
turn bad to push them to the brink of failure. The following are five of the most widely used ratio
indicators of credit risk:

1. Nonperforming assets / Total loans and leases.

2. Net charge-offs of loans / Total loans and leases.
3. Annual provision for loan losses / Total loans and leases or relative to equity capital.
4. Allowance for loan losses / Total loans and leases or relative to equity capital.
5. Nonperforming assets / Equity capital.

Nonperforming assets are income-generating assets, including loans, that are past due for 90 days or
more. Charge-offs, on the other hand, are loans that have been declared worth-less and written off the
lender’s books. If some of these loans ultimately generate income, the amounts recovered are
deducted from gross charge-offs to yield net charge-offs. As these ratios rise, exposure to credit risk
grows, and failure of a lending institution may be just around the corner. The final two credit risk
indicator ratios reveal the extent to which a lender is preparing for loan losses by building up its loan
loss reserves (the allowance for loan losses) through annual charges against current income (the
provision for loan losses).

Another popular and long-standing credit risk measure is the ratio of • Total loans/total deposits. As
this ratio grows, examiners representing the regulatory community may become more concerned
because loans are usually among the riskiest of all assets for banks, and, therefore, deposits must be
carefully protected. A rise in bad loans or declining market values of otherwise good loans relative to
the amount of deposits creates greater depositor risk.

LIQUIDITY RISK
Financial-service managers are also concerned about the danger of not having sufficient cash and
borrowing capacity to meet customer withdrawals, loan demand, and other cash needs. Faced with
liquidity risk a financial institution may be forced to borrow emergency funds at excessive cost to
cover its immediate cash needs, reducing its earnings. Very few banks ever actually run out of cash
because of the ease with which liquid funds can be borrowed from other institutions. Somewhat more
common is a shortage of liquidity due to unexpectedly heavy deposit withdrawals, which forces a
depository institution to borrow funds at an elevated interest rate, higher than the interest rates other
institutions are paying for similar borrowings. Indicators of exposure to liquidity risk include the
ratios of

1. Purchased funds (including Eurodollars, federal funds, security RPs, large CDs, and
commercial paper)/Total assets
2. Cash and due from balances held at other depository institutions/Total assets
3. Cash assets and government securities/Total assets.

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MARKET RISK
In market-oriented economies, where most of the world’s leading financial institutions offer their
services today, the market values of assets, liabilities, and net worth of financial service providers are
constantly in a state of flux due to uncertainties concerning market rates or prices. Market risk is
composed of both price risk and interest rate risk.

Price Risk
Price Risk Especially sensitive to these market-value movements are bond portfolios and
stockholders’ equity (net worth), which can dive suddenly as market prices move against a financial
firm. Among the most important indicators of price risk in banks’ management are:

1. Book-value assets/Estimated market value of those same assets.

2. Book-value equity capital/Market value of equity capital.
3. Market value of bonds and other fixed-income assets/Their value as recorded on a bank’s
books.
4. Market value of common and preferred stock per share, reflecting investor perceptions of a
bank’s risk exposure and earnings potential.

Interest Rate Risk

Movements in market interest rates can also have potent effects on the margin of revenues over costs
for both banks and their competitors. For example, rising interest rates can lower the margin of profit
if the structure of a bank’s assets and liabilities is such that interest expenses on borrowed money
increase more rapidly than interest revenues on loans and security investments.

The impact of changing interest rates on a financial institution’s margin of profit is called interest
rate risk. Among the most widely used measures of interest-rate risk exposure are the ratios:

1. Interest-sensitive assets/Interest-sensitive liabilities: when interest-sensitive assets exceed

interest-sensitive liabilities in a particular maturity range, a financial firm is vulnerable to
losses from falling interest rates. In contrast, when rate-sensitive liabilities exceed rate-
sensitive assets, losses are likely to be incurred if market interest rates rise.

2. Uninsured deposits/Total deposits: where uninsured deposits are usually government and
corporate deposits that exceed the amount covered by insurance and are usually so highly
sensitive to changing interest rates that they will be withdrawn if yields offered by
competitors rise even slightly higher.

With more volatile market interest rates in recent years, bankers and their competitors have
developed several new ways to defend their earnings margins against interest-rate changes, including
interest-rate swaps, options, and financial futures contracts.

FOREIGN EXCHANGE AND SOVEREIGN RISK

Foreign Exchange and Sovereign Risk

The rapid expansion of international finance around the globe has opened up new service markets,
but it has also increased financial firms’ exposure to loss due to volatile foreign market conditions,
changing government rules, and sometimes political instability over-seas. Fluctuating currency prices

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generate foreign exchange risk as the value of bank’s assets denominated in foreign currencies may
fall, forcing a write-down of those assets on its balance sheet.

Sovereign Risk
Under what is often called sovereign risk foreign governments may face domestic instability and
even armed conflict, which may damage their ability to repay debts owed to international lending
institutions. Management must learn how to assess and monitor these risks and how to hedge their
financial firm’s assets when market conditions deteriorate.

OFF-BALANCE-SHEET RISK

One of the newest forms of risk faced by leading banks is associated with the rapid build-up of
financial contracts that obligate a bank to perform in various ways but are not recorded on its balance
sheet. Examples include standby credit agreements, in which a financial firm guarantees repayment
of a customer’s loans owed to other businesses; loan commitments, in which a bank pledges to
extend credit over a set period of time as needed by its customers; and financial futures and options,
in which prices and interest rates are hedged against adverse market movements. Today the volume
of these off-balance-sheet commitments far exceeds the volume of conventional assets that do appear
on a financial firm’s balance sheets.

OPERATIONAL (TRANSACTIONAL) RISK

Operational risk refers to uncertainty regarding a financial firm’s earnings due to failures in computer
systems, errors, misconduct by employees, floods, lightning strikes, and similar events. The broad
group of actions included in this risk definition often decrease earnings due to unexpected operating
expenses. Some analysts say that operational risk is the risk of loss due to anything other than credit
or market risk. Others say it includes legal and compliance risk, but not reputation or strategic risk.
The consolidation and convergence of financial firms and the complexity of today’s financial-
services technology has made operational risk a broad risk category that needs to be addressed by
both managers of financial firms and government regulators. Today, acts of terrorism such as 9/11
and natural disasters such as hurricanes, earth-quakes, and tsunamis can lead to great loss for any
financial firm. These natural and not-so-natural disasters may close financial institutions for extended
periods and interrupt their service to customers. Foregone income from such disasters is
unpredictable, resulting in unexpected operating expenses and greater variability in earnings. A
bank’s owners, employees, customers, or outsiders may violate the law and perpetrate fraud, forgery,
theft, misrepresentation, or other illegal acts, sometimes leading to devastating losses to otherwise
well-managed financial institutions.

LEGAL AND COMPLIANCE RISKS

Legal risk creates variability in earnings resulting from actions taken by our legal system.
Unenforceable contracts, lawsuits, or adverse judgments may reduce a financial firm’s revenues and
increase its expenses. Lawyers are never cheap and fines can be expensive! In a broader sense
compliance risk reaches beyond violations of the legal system and includes violations of rules and
regulations. For example, if a depository institution fails to hold adequate capital, costly corrective
actions must be taken to avoid its closure.

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REPUTATION RISK
Negative publicity, whether true or not, can affect a financial firm’s earnings by dissuading
customers from using the services of the institution, just as positive publicity may serve to promote a
financial firm’s services and products. Reputation risk is the uncertainty associated with public
opinion. The very nature of a financial firm’s business requires maintain-ing the confidence of its
customers and creditors.

STRATEGIC RISK
Variations in earnings due to adverse business decisions, improper implementation of decisions, or
lack of responsiveness to industry changes are parts of what is called strategic risk. This risk category
can be characterized as the human element in making bad longrange management decisions that
reflect poor timing, lack of foresight, lack of persistence, and lack of determination to be successful.

CAPITAL RISK
The impact of all the risks examined above can affect a financial firm’s long-run survival, often
referred to as its capital risk. Because variability in capital stems from other types of risk it is often
not considered separately by government regulatory agencies. However, risks to the capital that
underlies every financial firm captures the all-important risk of insolvency or ultimate failure. For
example, if a bank takes on an excessive number of bad loans or if a large portion of its security
portfolio declines in market value, generating serious capital losses when sold, then its equity capital,
which is designed to absorb such losses, may be overwhelmed. If investors and depositors become
aware of the problem and begin to withdraw their funds, regulators may have no choice but to
declare the institution insolvent and close its doors. Capital risk can be measured approximately by:

 The interest rate spread between market yields on debt issues (such as capital notes and CDs
issued by depository institutions) and the market yields on government securities of the same
maturity. An increase in that spread indicates that investors in the market expect increased
risk of loss from purchasing and holding a financial institution’s debt.

 Stock price per share/Annual earnings per share. This ratio often falls if investors come to
believe that a financial firm is undercapitalized relative to the risks it has taken on.

 Equity capital (net worth)/Total assets, where a decline in equity funding relative to assets
may indicate increased risk exposure for shareholders and debtholders.

 Purchased funds/Total liabilities. Purchased funds usually include uninsured deposits and
borrowings in the money market from banks, nonbank corporations, and govern-mental units
that fall due within one year.

 Equity capital/Risk assets, reflecting how well the current level of a financial institution’s
capital covers potential losses from those assets most likely to decline in value.

Risk assets consist mainly of loans and securities and exclude cash, plant and equipment, and
miscellaneous assets. Some authorities also exclude holdings of short-term government securities
from risk assets because the market values of these securities tend to be stable and there is always a
ready resale market for them. Concern in the regulatory community over the risk exposure of
depository institutions has resulted in heavy pressure on their management to increase capital.
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Other Goals in Banking and Financial-Services Management
In an effort to maximize profitability and the value of the shareholders’ investment in a finan-cial
institution, many financial firms recognize the need for greater efficiency in their opera-tions. This
usually means reducing operating expenses and increasing the productivity of their employees
through the use of automated equipment and improved employee training. The government
deregulation movement has forced depository institutions, for example, to pay higher interest costs
for their funds and encouraged management to reduce noninterest costs, especially employee salaries
and benefits and overhead costs.

Among the most revealing measures of operating efficiency and employee productivity for a
financial institution are its

A rise in the value of the operating efficiency ratio often indicates an expense control problem or a
falloff in revenues, perhaps due to declining market demand. In contrast, a rise in the employee
productivity ratio suggests management and staff are generating more operating revenue and/or
reducing operating expenses per employee, helping to squeeze out more product with a given
employee base.

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