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Sample Paper on Intersession: Assignment 2 – Risk Components and Economic Value

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Sample Paper on Intersession: Assignment 2 – Risk Components and Economic Value

1.      Which of the banks has a lower credit risk profile as measured by charge-offs over the last two years?  Provide the banks’ charge-off rates (as a percent of loans) in support of your answer.  Conclude on the impact of loan quality on each bank’s “quality” of 2015 earnings in your answer. Which bank seems better positioned with respect to quality of earnings for 2016?

Answer: The charge-off rates (as a percentage of loans) for the five banks are as it follows;

A look at the above charge-off rates indicates that bank 4 has the lowest credit risk profile. This is in relation to the fact that it has a rate of 44.5 percent whereas other banks have higher rates. The high charge-off rates means that the banks might be writing off loans as uncollectable. Based on this understanding, the quality of earning for bank 2 might be affected more than the earnings for other banks. The quality of earning for banks 1, 3 and 5 might be affected in the same way because these banks have the same charge-off rates. If this is to continue, then bank 4 would be the best positioned bank with respect to quality of earnings for 2016.

 

 

 

 

 

 

 

 

 

 

 

 

 

2.      The adequacy of a bank’s allowance for loan and lease losses is a key factor in managing credit risk.  Comparing the two bank’s ALLL, does one bank appear to have established a more adequate allowance than the other?  What factors did you consider in comparing the banks’ ALLL?  A complete explanation must include a discussion of both the current (12/31/15) state and performance results of the last two years (e.g., changes in the loan portfolio; charge-offs; provision expense; ALLL as it relates to loans, charge-offs, non-performing loans, etc)

Answer: in the current quarter, bank 3 has an ALLL of 75.12 and a reserve adequacy of 232.21 percent. In the previous quarter, it had an ALLL of 101.10 and a reserve adequacy of 294.55 percent. On the other hand, bank 4 has an ALLL of 59.54 and a reserve adequacy of 187.60 percent in the current quarter. In the previous quarter, it had an ALLL of 100.46 percent and a reserve adequacy of 298.52 percent. Based on these figures, it appears that in the current quarter bank 3 has established a more adequate allowance than bank 4.   

 

In comparing the banks’ ALLL, I considered the following factors. First, I considered the charge-offs for the two banks. I established that bank 3 has a charge-off of $16,664,000 whereas bank 4 has a charge-off of $16,602,000. This translates to a charge-off rate of 44.7 percent for bank 3 and a charge-off rate of 44.5 percent for bank 4. Second, I considered the loan portfolios for the two banks and their charge-offs. I established that bank 3 has a loan portfolio of $37,311,000 and a charge-off of $16,664,000 whereas bank 4 has a loan portfolio of $37,345,000 and a charge-off of $16,602,000. Third, I considered the size of non-performing loans. I established that bank 3 has a non performing loan of size 28.47 whereas bank 4 has a non performing loan of size 27.98.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

3. Review the market risk and interest rate risk sections of the 10-K’s for each bank. 

a.)   For each bank, determine if the Bank is asset or liability sensitive and the basis for you conclusion (include numbers and/or percentages from the 10-K disclosures in support of your conclusion).

b.)   Explain in your own words the results of each bank’s Rate Shock Analysis at 12/31/15.

c.)    Assess if each bank’s appetite for interest rate risk (risk tolerance) is best characterized as high,  medium or low, based on the results and analysis of the Rate Shock Simulation summarized in the 10-Ks.

Answer: a.) from my own analysis, it appears that the two banks are both asset sensitive. This is in relation to the fact that they both base their shock analysis on interest rates. Bank 3 on its part sets its risk up to a maximum of 200 basis points whereas bank 4 sets its risk up to 300 basis points.

 

b.) the results for the rate shock have enabled the two banks to strike a balance between risk and investments.    

 

c.) based on the rate shock simulation, bank 4 appears to have a medium risk tolerance. This is in relation to the fact that the bank is willing to take risk up to 300 basis points. Accordingly, it has established two simulation methods that are aimed at offsetting declines in deposits through short-term borrowing. Bank 3, on the other hand, appears to have a low risk tolerance because it is willing to take risk up to 200 basis points. This means that the bank is unwilling to take more risks (Greuning, Brajovic, & Johnson-Calari, 2003). Therefore, its risk tolerance is low as compared to bank 4.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

4.      Review management’s discussion of liquidity risk and liquidity risk management.  What metrics seem most useful to gauge the level of liquidity risk each bank has accepted?  Which bank has more liquidity risk?  Why do you conclude that?

 

Answer: A review of management’s discussion indicates that bank 3 addresses liquidity risk by selling its assets, borrowing and through deposits. On the other hand, bank 4 addresses this risk by holding liquid assets in its reserve account.

 

Several metrics would be most useful to gauge the level of liquidity risk that each bank has accepted. The first metric would the amount of money each bank has borrowed. This amount of money indicates the extent at which a bank is willing to take risk. The higher the amount of borrowing the higher the risk the bank has accepted (Papadopoulos, & Papadopoulos, 2014). Looking at this figure, it appears that bank 3 has borrowed up to $1,206,022,000 whereas bank 4 has borrowed up to $793,225,000. Based on these figures, it would appear that bank 3 has accepted more liquidity risk than bank 4 with regard to borrowing. However, this is not the only metric to be considered.

The second metric to consider would be the amount of cash the bank holds at any given time. The higher the cash the lower the risk the bank has accepted. The third metric to consider would be the liquidity assets a bank holds at any given time. If a bank holds huge liquidity assets at any given time, then it means that the bank is unwilling to accept higher liquidity risks. Conversely, if the bank does not hold huge liquidity assets, then it means that it has accepted a higher liquidity risk. Banks with lots of liquidity assets would appear to be liquid (Koch, & MacDonald, 2015). As a result, a bank with lots of liquidity asset would appear to be accepting low level of liquidity risk, and vice versa.         

 

Overall, based on the Camels ratings for the two banks, I would say that bank 3 has more liquidity risk than bank 4. This is in relation to the fact that bank 3 has a current liquidity of 2 and a previous liquidity of 5 whereas bank 4 has a current liquidity of 1 and a previous liquidity of 1.5.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 


You have been provided with financial data for 5 BankCom banks. You will, however, be examining only 2 of them: Banks 3 and 4.  The data includes:

 

Public Report Pack including:

·         Comparative financial statements for the banks;

·         General economic data;

·         Comparative financial performance review

 

Private Report Packs for Banks 3 and 4 including:

·         CEO Report

·         Chief Lending Officer (CLO) Report

·         Chief Deposits Officer (CDO) Report

·         Chief Risk Officer (CRO) Report

               

 

5.      Which of Bank 3 or 4 has done a better job at increasing shareholder wealth over the most recent quarter?  Provide the banks’ total shareholder returns in support of your answer.

 

Answer: to answer this question, I will base my argument on the total shareholder return because we want to know the way the banks have performed in terms of increasing returns for shareholders. I will utilize the following formula       

Where dividends represent dividends paid at the end of the year

Price(begin) represents the price of the share at the beginning of the quarter

Price(end) represents the price of the share at the end of the current quarter 

0.255

In terms of percentage, it appears that bank 3 was able to increase returns for its shareholders by 36.3 percent whereas bank 4 did so by 25.5 percent. Based on these figures, it would be reasonable to conclude that bank 3 did a better job than bank 4 at increasing the wealth for its shareholders over the recent quarter.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

6.      The banks use RAROC as a guide for pricing loans.  The last page of the CLO report shows the RAROCs the banks would have earned on loans of different credit bands if loans in that band had been made.  As a consultant to each of Banks 3 and 4, what recommendations would you make to the bank with respect to their loan pricing and on other issues related to RAROC?

Answer: based on RAROC’s figures provided at the last page of CLO report, I would advise the banks in the following manner. First, I would advise the banks to embrace this pricing method in their loan practices. Second, I would advise the banks to look at the figures provided in this report and consider using them in their loans to improve their performances.

 

At an individual level, I would advise bank 3 to desist from offering residential loan because it appears that this type of loan would not be profitable for the bank. I would also advise the bank to desist from offering consumer loans such as HELOC and auto because these loans would also not be profitable. Overall, I would advise the bank to focus its attention on commercial loans because these would be profitable for the bank.

With regard to bank 4, I would advise this bank to desist from offering consumer loans that would not be profitable. Such loans would include construction loan, multifamily loan and auto loan among other loans with negative loan type average. While doing this, I would advise the bank to offer consumer loans with positive loan type average. In addition, I would advise the bank to offer commercial loans because they would be profitable.    

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

7.      The Banks 3 and 4 internally report Economic Value Added to the CEO. 

a.      Have they been successful at adding economic value this quarter?  Explain which of the banks has done a better job and why?

b.      What specific operating features of the banks have contributed to the differences between the EVAs of the banks this quarter?  A complete explanation must include a discussion of both the numerator and denominator of RAROC as well as other relevant aspects of EVA.

c.       What specific recommendations would you make to each bank in order to improve EVA in coming quarters?

Answer: looking at CEOs’ reports for the two banks, it appears that the two banks have been successful at adding economic value this quarter. This is in relation to the figure of economic valued added each bank recorded this quarter in relation to the one recorded in the previous quarter. For bank 3, although the figure that was reported this quarter was negative since it is in brackets, it is clear that the figure is far much better than the previous one. Indeed, a figure of (18.13) is far much better than a figure of (281.40). Therefore, the bank has been successful at adding economic value this quarter. The same applies to bank 4 that has a figure of 14.07 this quarter in comparison to a figure of (334.95) reported in the previous quarter. Based on the two figures that the two banks have recorded this quarter, bank 4 has done a better job than bank 3. The simple reason for my argument is that bank 4 has recorded a positive figure of 14.07 whereas bank 3 has recorded a negative figure of 18.13.

 

The specific operating features of the banks that have contributed to the differences between the EVAs are the specific components that make EVA. These components relate closely to the components of RAROC. Accordingly, while evaluating these components it would be important to consider the numerators and denominators of RAROC. Mathematically, we can express EVA as it follows.

 On the other hand, we can express RORAC as it follows.

Looking at the two equations, it is clear that adjusted income appears on both equations. This means that a change in this component affect the two. Indeed, an increase in adjusted income increases both RAROC and EVA whenever other factors remain constant. Conversely, a decrease in adjusted income decreases both RAROC and EVA whenever other factors remain constant as well. This indicates that there is a direct relationship between RAROC and EVA. Based on this understanding, if you look at the numerator and denominator of RAROC, you will realize the following. First, you will realize that adjusted income comprises of spread, which is the direct income from loan, fees that can be attributed directly to loan, expected loss and operating costs. Mathematically, adjusted income can be expressed as it follows.

. Second, you will realize that there is capital at risk, which is the capital reserved to cover losses. Starting with the numerator that can be broken down into spread, fees, operating costs and expected loss, each bank has its own operating costs and expected loss. In addition, each bank charges its own fee on various types of loans and the spreads are also different. At the same time, capital risks for the two banks are different thereby the difference between the EVAs of the two banks. With regard to ROE that appears on the formula of EVA, there is no doubt that each bank has its own ROE figure. Bank 3 on its part has a ROE of 14.54 percent whereas bank 4 has a ROE of 24.64 percent. This ROE figure definitely affects the figure of EVA for each bank; thus, the difference between the EVAs.

 

In order to improve EVA in coming quarters, I would recommend that the two banks need to reduce their operating costs and expected losses while at the same time maximize their fees and spreads. Doing this would automatically increase adjusted income that would in return increase EVA. I would also recommend the banks to reduce their capital risks so that they can increase their RAROCs.

 

 

8.      The reports at your disposal include accounting (book)-based performance data, market valued-based performance data and economic value-based performance data for Banks 3 and 4.  In what ways do the 3 performance models agree or disagree with respect to each bank?  Explain.

Answer: For bank 3, accounting-based performance data indicates that the bank might be making more profits than it made in the previous quarter. The ROE figure in particular which has risen from -98.99 percent to 14.54 percent indicates that the bank could be making more profit than it did in the previous quarter. The same results are also shown by ROA and profit margin which have improved significantly. ROA figure currently stands at 1.09 percent from -4.13 percent whereas profit margin currently stands at 20.34 percent from -67.84 percent. This is a strong indication that the bank is currently making more profits than it did in the previous quarter.

The market based data which indicates that the price of the bank’s share has risen from $19.50 to $26.18 also demonstrates that the bank’s performance has also improved. Lastly, the bank’s EVA figure that has improved from (281.40) to (18.13) together with RAROC figure that has risen from -43.7 percent to 10.5 percent also indicate that the bank’s performance has improved. In general, the three performance models agree that the bank’s performance has improved in the current quarter.

 

For bank 4, accounting-based performance data indicates that the bank is currently profitable than it was in the previous quarter. This is in relation to the fact that the figures for both ROE and ROA have improved significantly. In the previous quarter, the bank’s ROE figure was at -83.83 percent, but its current figure is at 24.64 percent. This is a significant improvement for ROE. For ROA, the bank had a figure of -5.68 percent in the previous quarter, but the current figure is at 1.7 percent. Once again, this is an improvement for the bank. The profit margin which current stands at 33.51 percent from -117.40 percent equally indicates that the bank is currently profitable than it was in the previous quarter.

The market-based data that shows the price of the bank’s share rise from $24.77 to $31.099 also indicates that the bank is performing better than it performed in the previous quarter. Lastly, the economic value-based performance data for the bank’s RAROC and EVA indicate that the bank is performing better. This is relation to the fact that the current RAROC figure stands at 18.1 percent from the previous figure of -60.4 percent whereas the EVA figure currently stands at 14.07 percent from the previous figure of (334.95). Overall, the three performance models agree that the bank’s performance is improving.         

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References

Greuning, H., Brajovic, B., & Johnson-Calari, J. (2003). Analyzing and managing banking risk: A framework for assessing corporate governance and financial risk. Washington, D.C: The World Bank.

Koch, T., & MacDonald, S. (2015). Bank management. Australia: Cengage learning.

Papadopoulos, A., & Papadopoulos, A. (2014). Macroeconomic analysis and international finance. Bingley: Emerald group publishing limited.

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