Professional Documents
Culture Documents
Libro Modulo III Capítulo 3 - 9 (Koch y Macdonald)
Libro Modulo III Capítulo 3 - 9 (Koch y Macdonald)
Libro Modulo III Capítulo 3 - 9 (Koch y Macdonald)
MANAGING
NONINTEREST INCOME AND
NONINTEREST EXPENSE
Chapter 3
A common view among bank managers
and analysts is that banks must rely less on
net interest income and more on noninterest
income to be more successful.
The highest earning banks will be those that
generate an increasing share of operating revenue
from noninterest sources.
NIM rose from 1990 to 1994, on average, and has fallen sharply
thereafter for both banks under $100 million in assets and larger
banks.
It is widely recognized that the days of record-
breaking net interest margins for banks are long gone.
NIMs have
fallen sharply
since 1994 for
both banks
under $100
million in
assets and
larger banks.
50.00%
25.00%
20.00%
Jul-94
Jul-95
Jul-96
Jul-97
Jul-98
Jul-99
Jul-00
Jul-01
Nov-94
Nov-95
Nov-96
Nov-97
Nov-98
Nov-99
Nov-00
Nov-01
Mar-94
Mar-95
Mar-96
Mar-97
Mar-98
Mar-99
Mar-00
Mar-01
Mar-02
Net operating revenue equals the sum of net interest income
and noninterest income.
Composition of noninterest income
…biggest contributors are deposit service charges
and ‘other.’ (other includes items such as safe deposit boxes, bank drafts, etc.)
Percent of Total Noninterest Incom e
Fiduciary Incom e
Net Gains On Asset
Sales
Net Gains/Losses On
Sales Of Other Assets
Trading Gains & Fees
2. Occupancy expense
rent and depreciation on buildings and
equipment
Efficiency ratio
= nonint. Exp. (net int. inc. + nonint. inc.)
67
Assets<$1 Billion Assets>$1 Billion
Efficiency ratio %
65
63
61
59
57
55
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Assets<$1 Billion 68 65.3 65.5 64.6 63.1 62 61.7 62.6 62.6 62.7 64.1 62 63 63
Assets>$1 Billion 67.7 64.4 63.3 63.1 61.4 60.5 58.6 60.7 57.9 57.7 56.6 54.9 55 55.5
Operating risk ratios
…differentiate performance attributable to cost
controls versus fee generation.
The lower the operating risk ratio, the better
the bank‘s operating performance
because it generates proportionately more of
its revenues from fees, which are more
stable and thus more valuable.
RORAC = income
allocated risk capital
Productivity ratios
…indicate how efficiently banks are using their
employees relative to capital assets.
0 10 20 30 40 50 60 70 80 90 100
Percentage offering various products
Aggregate results from total customer
account profitability indicates…
A small fraction of customers contribute the bulk of
bank profits.
PRICING FIXED-INCOME
SECURITIES
Chapter 4
Future value and present value
PV(1+i) = FV1
Example: 1,000 PV and 1,080 FV means:
i = $80 / $1,000
= 0.08 = 8%
If we invest $1,000 at 8% for 2 years:
$1,000 (1+0.08) (1+0.08)
= $1,080 (1.08)
= $1,166.40
In general, the future value is…
FVn = PV(1+i)n
Alternatively, the yield can be found as:
i = [FVn / PV](1/n) - 1
Example:
$1,000 invested for 6 years at 8%:
FV6 = $1,000(1.08)6 = $1,586.87
Example:
Invest $1,000 for 6 years,
Receive $1,700 at the end of 6 years.
What is the rate of return?
i = [$1,700 / $1,000](1/6) - 1 = 0.0925
Future value and present value
…multiple payments
The cumulative future value of a series of cash flows
(CFVn) after n periods is:
CFVn =CF1(1+i)n +CF2(1+i)n-1 +...+CFn(1+i)
The present value of a series of n cash flows:
PV = [CF1 / (1+i)] + [CF2 / (1+i)2] + [CF3 / (1+i)3]
. . . +[CFn / (1+i)n]
Example:
rate of interest = 10%, what is the PV of a security that
pays $90 at the end of the next three years plus $1,000
at the end of three years?
PV = 90/(1.1) + 90/(1.1)2 + 1090/(1.1)3 = $975.13
Simple interest versus compound interest
Example:
$1,000 invested for 1 year at 8% with interest
compounded monthly:
FV1 = 1,000 (1 + 0.08/12)12 = 1083.00
The effective annual rate of interest, i* can be
calculated from:
i* = (1 + i/m)m - 1
In this example:
i* = (1 + 0.08/12)12 - 1 = 8.30%
The effect of compounding on future value
and present value
A. What is the future value after 1 year of $1,000 invested at an 8% annual nominal rate?
B. What is the present value of $1,000 received at the end of 1 year with compounding at 8%?
6
470 10,000
Price
t
6
$9,847.73
t 1 1.05 1.05
How do I calculate these values?
1. Figure out how to input these values into your
financial calculator
• Easy and Quick
• Can lead to reliance on faulty numbers if you
enter values improperly
• What happens, if you are like me, and you
lose the calculator manual in a few months?
• Still
prone to entry error, but doable on any
calculator and in any introductory Finance text.
On the prior page, “i” represents the periodic rate.
Here is the general formula:
1
1 (1 r / m) n*m FV
PMT *
r / m (1 r / m ) n*m
(1 r / m) n*m 1
PMT *
r / m
Price and yield relationships for option-
free bonds that are equivalent except for
the feature analyzed
Relationship Impact
Market interest rates and bond prices vary Bond prices fall as interest rates rise and rise as
inversely. interest rates fall.
For a specific absolute change in interest rates, the
proportionate increase in bond prices when rates For the identical absolute change in interest rates, a
fall exceeds the proportionate decrease in bond bondholder will realize a greater capital gain when
prices when rates rise. The proportionate rates decline than capital loss when rates increase.
difference increases with maturity and is larger
the lower a bond's periodic interest payment.
Investors can realize greater capital gains and
Long-term bonds change proportionately more in capital losses on long-term securities than on short-
price than short-term bonds for a given change in term securities when interest rates change by the
interest rates from the same base level. same amount.
Discount Bond
Yield to maturity > coupon rate
Premium Bond
Yield to maturity < coupon rate
Relationship between price and interest rate on
a 3-year, $10,000 option-free par value bond that
pays $470 in semiannual interest
For a given absolute change
$’s in interest rates, the
percentage increase in a
bond’s price will exceed the
percentage decrease.
$’s
For a given coupon rate, long-term
bonds price changes proportionately
more in price than do short-term
bonds for a given rate change.
10,275.13
10,155.24
10,000.00
9,847.73 9.4%, 3-year bond
9,734.10
ΔP
P %ΔΔ
DUR @ @
Δi Δi
1+ i
Price (value) changes
Longer maturity/duration larger changes in price for
a given change in i-rates.
If YTM = 5%
1000 face value, 10% coupon, 3 year, 5% YTM
3127.31
D = 2.75 years
1136.16
Measuring duration
If YTM = 20%
1000 face value, 10% coupon, 3 year, 20% YTM
2131.95
D = 2.68 years
789.35
Measuring duration
1000
|-------|-------|-------|
0 1 2 3
1000 3
(1.12) 3
D 3 (by definition )
1000
(1.12) 3
Compare price sensitivity
Chapter 8
The composition of bank liabilities
There are many different types of liabilities.
Some offer transaction capabilities with
relatively low or not interest.
Net indirect costs are those cost not directly related to the
product such as salaries to manage the bank or general
overhead cost applicable to all products at the bank.
Small time deposits
Eurocurrency
…financial claim denominated in a currency other than that
of the country where the issuing institution is located.
250 4500
$ Billions of FHLB Advances Outstanding
3000
150
2250
100
1500
50
750
0 0
Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec-
91 92 93 94 95 96 97 98 99 00 01
A recent trend is banks using longer-
term FHLB advances as a more
permanent source of funding.
The interest cost compares favorably with
the cost of jumbo CDs and other purchases
liabilities.
The range of potential maturities allows
banks to better manage their interest rate
risk.
Marginal Cost
Interest Rate + Servicing costs + Acquisiti on costs + Insurance
1 - % of funds in nonearning assets
Example:
Marginal costs of a hypothetical NOW account
Assume:
market interest rate = 2.5%
servicing costs = 4.1%
acquisition costs = 1.0% of balances
deposit insurance costs = 0.25% of balances
percentage in nonearning assets = 15.0%
(10% required reserves and 5% float.)
The estimated marginal cost is 9.24%:
$700,000 $10,000,000
7
$9,900,000 t
7
t 1 (1 k d ) (1 k d )
or k d 7.19%
Cost of equity
… conceptually, the marginal cost of equity
equals the required return to shareholders
It is not directly measurable because
dividend payments are not mandatory.
$1.10
ke 0.10
$24
14.58%
Capital asset pricing model (CAPM)
… this model relates market risk, measured by
Beta (), to shareholders’ required returns.
Formally, the required return to shareholders (ke')
equals the riskless rate of return (rf) plus a risk
premium (r) on common stock reflecting
nondiversifiable market risk:
ke rf ρ
The risk premium equals the product of a security‘s
Beta and the difference between the expected
return on the market portfolio (km) and the
expected riskless rate of return (rf).
Beta measures a stock‘s historical price volatility
relative to the price volatility of the market portfolio
as:
Covariance [individua l security(i ) return, market return]
βi
Variance(m arket return)
Estimate the required return to
shareholders for individual securities
k e, i rf βi (k m - rf )
Example:
…CAPM estimate for the bank’s cost of equity
Assume:
a bank‘s estimate equals 1.42
assume the differential between the market return
(km) and risk-free return (rf) is expected to average 5
percent, with the Treasury bill rate expected to equal
6 percent
The CAPM estimate for the bank‘s cost of equity is:
ke = 0.06 + 1.42 (0.05) = 13.1%
This cost of equity should be converted to a pretax
equivalent, 19.85,% assuming a 34% marginal tax rate.
Targeted return on equity model
…investors require higher pretax returns on
common stock than on debt issues because of the
greater assumed credit risk.
Many banks use a targeted return on equity
guideline based on the cost of debt plus a
premium to evaluate the cost of equity.
Targeted net income
Targeted ROE
Stockholde rs Equity
This return is then converted to a pretax
equivalent yield.
Targeted income before taxes
Pretax required return
Stockholde rs Equity
It assumes that the market value of bank
equity equals the book value of equity.
Cost of preferred stock:
Preferred stock has characteristics of debt and
common equity.
It represents ownership with investors‘ claims
superior to those of common stockholders but
subordinated to those of debtholders.
Like common stock, preferred stock pays dividends
that may be deferred when management determines
that earnings are too low.
The marginal cost of preferred stock (kp) can be
approximated in the same manner as the return on
common equity; however, dividend growth is zero:
where
Dp Dp = contractual dividend payment,
kp Pp = net price of preferred stock,
Pp
Trust preferred stock
…a hybrid form of equity capital at banks
Trust preferred stock is recent innovation in capital financing.
Attractive because it effectively pays dividends that are tax
deductible.
To issue the securities, a bank or bank holding company
establishes a trust company.
The trust company sells preferred stock to investors and
loans the proceeds of the issue to the bank.
Interest on the loan equals dividends paid on the preferred
stock.
This loan interest is tax deductible such that the bank
effectively gets to deduct dividend payments as the
preferred stock.
The after tax cost of trust preferred stock would be:
ktp =
D tp (1 t) where
Dtp = contractual dividend payment on
trust preferred,
Ptp Ptp = net price of trust preferred stock,
Weighted marginal cost of total funds:
…the best cost measure for asset-pricing purposes
is a weighted marginal cost of funds (WMC)
This measure recognizes both explicit and
implicit costs associated with any single
source of funds.
Weighted
Component Marginal
Average Percent Interest Marginal Cost of
Liabilities and Equity Amount of Total Cost Costs Funds
Demand deposits $ 25,890 28.5% 9.8% 0.0278
Interest checking $ 6,461 7.1% 4.0% 12.4% 0.0088
Money market demand accounts $ 12,831 14.1% 4.8% 8.0% 0.0113
Other savings accounts $ 3,640 4.0% 5.8% 7.1% 0.0028
Time deposits < $100,000 $ 19,383 21.3% 6.3% 7.8% 0.0166
Time deposits > $100,000 $ 10,465 11.5% 6.5% 6.8% 0.0079
Total deposits $ 78,670 86.5%
Federal funds purchased $ 182 0.2% 6.5% 6.5% 0.0001
Other liabilities $ 4,550 5.0% 0.0% 0.0000
Total liabilities $ 83,402 91.7%
Stockholders' equity $ 7,599 8.4% 18.9%* 19.7% 0.0164
Total liabilities and equity $ 91,001 100.0%
Chapter 9
Why worry about bank capital?
…capital reduces the risk of failure by acting as a
cushion against losses and by providing access to
financial markets to meet liquidity needs.
While bank capital-to-asset ratios averaged near 20% at the turn
of the century, comparable ratios today are closer to 8 percent.
15.00% Historical Trends in Bank Capital Growth Rate in Total Capital
13.00%
Total Capital to Total Assets
11.00%
9.00%
7.00%
5.00%
3.00%
1.00%
-1.00%
Risk-based capital standards
During the last half of the 1980s, for
example, all U.S. banks were required to
meet a 5.5% minimum primary capital
requirement and a 6 percent minimum total
capital requirement.
0.011 (1 0.4) 0
DTA/TA
0.07 0.011 (1 0.4)
.1041 or 10.41%
Weakness of risk-based capital standards
Current standards only account for credit and
market risk at large banks with extensive trading
operations.
The new Basel II also accounts for operational risk.
Case 1: 8% asset growth, dividend payout = 40%, and capital ratio = 8%.
What is ROA?
ROA(1 0.40) 0
0.08
0.08 ROA(1 0.40)
Solve for ROA 0.99%
Case 2: 12% asset growth, dividend payout = 40%, and capital ratio = 8%.
What is required ROA to support the 12% asset growth?
ROA(1 0.40) 0
0.12
0.08 ROA(1 0.40)
Solve for ROA 1.43%
Case 3: ROA = 0.99%, 12% asset growth, and capital ratio = 8%.
What is the required dividend payout to support the 12% asset growth?
0.0099(1 DR) 0
0.12
0.08 0.0099(1 DR)
Solve for DR 13.42%
Case 4: ROA = 0.99%, 12% asset growth, capital ratio = 8%, and dividend payout = 40%.
What is the required external capital to support the 12% asset growth?
0.0099(1 0.40) ΔEC/TA
0.12
0.08 0.0099(1 0.40)
Solve for DEC/TA 0.29%
ΔEC $294,720
The effect of capital requirements on
bank operating policies:
limiting growth
1.00%
0.75%
0.50%
0.25%
0.00%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
-0.25%
Year
-0.50%
At the beginning of 2002, over 93% of
banks are listed in the lowest category and
pay no FDIC insurance premiums.
Supervisory Subgroups
Capital Group A B C
Well capitalized 0 bp 3 bp 17 bp
Adequately capitalized 3 bp 10 bp 24 bp
Undercapitalized 10 bp 24 bp 27 bp
Problems with deposit insurance
Government backed deposit insurance
provides for stability of the financial
system by reducing or preventing banking
panics and protecting the less
sophisticated depositor — but this comes
at a price.
Problems with deposit insurance
…First, deposit insurance acts similarly to bank
capital and is a substitute for some functions of
bank capital.
Investors or depositors look to the company‘s capital as a
safety net in the event of failure.
Lower capital levels mean firms must pay a risk premium to
attract funds or they will find it difficult to borrow money.
A large portion of funds come from insured depositors
who do not depend on the bank‘s capital position
A large number of depositors, therefore, do not require a risk
premium to be paid by the bank.
High failure rates during the 1980s and the insurance funds
demonstrate that premiums were inadequate.
Problems with deposit insurance
… The final historical problem with deposit
insurance is that premiums were not assessed
against all of a bank’s insured liabilities.
Many liabilities that the federal government effectively
guaranteed should have required insurance premiums.