Bank
Management
Review
IDC
Financial Publishing, Inc.
IDC
Management Review
Peoples
Bank located in Paris, TX received an IDC rank of 277, which placed
it in the “Superior” group.
Information in this
report is based on the bank’s September 30, 2003 quarterly
statement of Condition & Income as filed to the FDIC.
IDC ranks are based on
the bank’s performance of financial ratios.
Ranks range from 1 – 300 (the best).
Categories
of IDS Ratings
Superior (200 –
300): Banks rated
Superior are simply the best by all measures.
In addition to favorable capital ratios, most consistently
generate a return on equity (ROE)
above cost of equity (COE).
Excellent
(165 – 199): Banks
rated excellent are strong institutions.
Their ratios reflect quality management both from a balance
sheet and income performance standpoint.
Operating expenses and costs of funding are under control,
producing a healthy return on equity (ROE).
Average
(125 – 164): Banks
rated Average meet industry capital standards.
When compared to excellent and superior rated banks, most
exhibit lower quality loans and narrower profit margins.
The marginal problems of the average bank require shifts in
policies and practices to raise asset quality or improve profits.
Below
Average (75 – 124): Banks
rated Below Average represent institutions under strain.
Average loan delinquency is high.
In many, excess nonperforming assets are above the loan loss
reserve and threaten equity capital.
Return on financial leverage is negotiable, on average, due
to narrow (or negative) leverage spreads.
Banks are also rated Below Average if they are deemed
“Adequately Capitalized” per FDIC capital definitions.
Lowest
Ratios (2 – 74): The
Lowest Ratios group contains some banks with less than the minimum
capital required. In
many, increasing loan loss provisions expand net losses on the
income statement and, along with the excess of net charge-offs,
reduce capital ratios. A
high number of failed banks were rated Lowest Ratios prior to
failure. Banks are also
rated Lowest Ratios if they are deemed “Under Capitalized” or
“Significantly Under Capitalized” per FDIC capital definitions.
Banks are also rated Lowest Ratios if they are deemed
“Adequately Capitalized” and have a high volatility in operating
profit margins. Finally,
banks which met the profile of past bank failures due to a lack of
core deposits, higher risk assets, and potentially a lack of
staffing to manage risks are capped at 72 or 73.
Rank
of One (1): Banks
in the Rank of One group have the highest probability of failure.
Loans 90-days past due and nonperforming assets, on average,
exceed the loan loss reserve and equity capital by a wide margin.
Without major balance sheet improvement, these banks will
fail. Banks are also
rated Rank of One if they are deemed “Critically Under
Capitalized” per FDIC capital definitions.
Since 1985, over 90
percent of the banks that failed were ranked below 50 by IDS prior
to failure. The vast
majority of these failed banks were ranked one.
Any future capital additions or losses or dramatic reductions
or increases in nonperforming assets (delinquent loans) can change
the bank’s rank.
Fundamentals
of IDC’s Analysis... IDC’s
CAMEL
IDS
has developed its own version of the commonly cited
“CAMEL” approach to choose the financial rations that
have the greatest impact on the quality of an institution.
CAMEL is an acronym that defines a number of areas in which
the institution has to perform well in order to be profitable:
Capital adequacy, Asset quality, Margins, Earning asset
returns, and Leverage and Liquidity.
In
the following summary, we quantify the performance of Peoples Bank
in each area and examine those figures in relationship to each
other.
“C”
Capital Adequacy
An
institution must have enough capital (its own money, invested in
business) so that there is a solid cushion available in hard times
– for instance, if the loan defaults increase.
That’s why we look at the percent of Equity Capital a bank
has, relative to its total assets.
Equity capital represents the amount that an institution’s
assets exceed what it owes to depositors and creditors.
Other capital ratios include Tier I (Equity Capital) and Tier
II (Equity Capital plus secondary capital, like long-term debt) as a
percent of risk-adjusted assets.
Federal regulations define risk-adjusted assets as a measure
of potential safety or risk. Federal
regulators consider these capital ratios important measurements and
have set minimum levels that institutions must stay above.
Capital
Adequacy ranges from best to worst as follows:
Well Capitalized, Adequately Capitalized, Under Capitalized,
and Significantly or Critically Under Capitalized.
Peoples Bank is
deemed to be more than “ Well Capitalized.”
It has a strong Tier I equity capital to assets ratio and a
total risk-based capital ratio substantially above regulatory
requirements. Strong
capital is combined with superior earning power to build new equity
capital (retained
earnings) from operating profit.
The bank’s strong capital position and current earning
power are sufficient to withstand severe economic risks.
“A”
Asset Quality
Asset
quality measures how effective an institution is at lending money to
people who are willing and able to pay it back.
To see if it’s doing this well, we look at how many
delinquent (bad) and nonperforming loans it
has on its books, relative to its capital and to the loan loss reserve, which is the fund it has set aside to cover
losses from bad loans. This
measures the institution’s asset quality, and consequently the
risk to its capital, given delinquent or nonperforming loans
default. Seldom do other rating services, relying only on capital
adequacy, scrutinize this factor adequately.
Nonperforming
loans are nonaccrual loans and restructured loans and leases, and
all other real estate owned (excluding direct and indirect
investments in real estate ventures).
That is, they are so troubled that the institution does not
expect repayment in full. (IDC
is not able to determine the underlying collateral value of
nonperforming loans based on regulatory information available.)
Nonperforming
loans can have a major impact on both the institution’s
profitability and its capital adequacy. Nonaccrual loans are loans
that are delinquent for a period beyond 90 days.
The regulators require that interest payments can no longer
be accrued. Because
some of these loans don’t pay interest, revenues are reduced.
If the full amount of principal on these loans cannot be
recovered, the institution must reserve for and then charge-off (or
expense) these loans in addition to any legal and collection fees.
Any time that too many bad loans force an institution to
charge-off more money than it has provided for the expense item
called “loan loss provision,” its net income is reduced by that
amount – what looked like a profit can turn into a loss.
If
nonperforming loans are greater than loan loss reserves, the
institution may have to make up the difference out of its equity
capital. If its capital
or collateral value is not adequate for this task, the institution
may be in danger of failure.
Asset
quality ranges from best to worst as follows:
High, Average, Limited, and Poor.
Peoples Bank
has “high” asset quality. Nonperforming
loans present little or no danger to its capital position.
“M”
Margins
An institution must price
its loans and services in addition to investment yields so that
there is an adequate difference between what it earns on assets and
what it pays savers in interest on deposits and borrowings.
There must be enough total revenues after interest costs to
cover operating expenses. The
money left over, after tax, should earn a fair rate of return on
equity capital.
All of these differences
between revenues and expenses are called Margins.
And management is measured at the margins.
Together, they determine the overall profitability of the
institution. By looking
at each of several margin measurements individually, we can learn a
great deal about an institution’s operating and financial
strategies.
Here, we examine three
kinds of margins: Operating
Profit Margin, Leverage Spread, and Return on Equity as compared to
Cost of Equity Capital. Margins
range from best to worst as follows:
Wide, Average, Narrow, and Negative.
First, we will review the
Operating Profit Margin and Leverage Spread of Peoples Bank.
Operating
Profit Margin is defined as net operating revenue less operating
costs (excluding the loan loss provision) divided by net operating
revenues (net interest income plus non interest income).
This ratio allows us to focus on how well the institution is
controlling its operating costs, which is key to profitability.
Peoples
Bank
has a “Narrow” margin between operating profits and net
operating revenues, demonstrating a high cost of operation.
Peoples Bank
has a “high” standard deviation or volatility in the operating
margin indicating a complex or high risk profit structure.
Leverage
Spread is the difference between after-tax operating income
relative to the cost of funding.
Peoples Bank has a “Wide” margin between after-tax operating returns and funding
costs, indicating that it makes very effective use of leveraged
funds.
The final kind of margin
we examine is Return on Equity versus Cost of Equity Capital (ROE vs. COE).
Return on equity measures the percent return the institution
earns, overall, on its own equity investment – it is the final
measure of profitability. The
cost of equity capital is the return a prudent investor would
require for investments of comparable risk.
Return on equity can be
measured in two ways: First
is Book ROE, which simply divides net income by equity capital.
The second way, developed by IDC, is the net operating profit
ROE (NOPAT ROE) which divides the sum of net income plus loan loss
provision minus net charge-offs by equity capital plus the loan loss
reserve. This method
adjusts ROE for the actual loan loss experience to the money the
institution has set aside to cover it.
If the provision exceeds actual losses, ROE is increased by
that amount and vice versa. This
method also excludes nonrecurring (one time) income or loss whereas
Book ROE ignores these impacts, whether positive or negative.
We compare NOPAT ROE to
cost of equity capital. An
ROE above COE adds value to a financial institution.
In comparison, an institution destroys value with an ROE
below the cost of equity capital.
Peoples
Bank
has a return on equity capital above estimated cost of equity
capital, providing superior growth from operating profit and
enhancing shareholder value and safety.
“E”
Earning Asset Return
An institution must
control its operating (non-interest) expenses so that they do not
consume a disproportionate part of its revenues.
We can determine how well it’s doing this by looking at how
much money is left from all revenues (from loans, investments, and
services) after both operating expenses and taxes have been paid,
and a provision set aside for loan losses. This ratio measures the institution’s “Return on Earning
Assets.”
Earning asset returns
measure the institution’s operating strategy.
They measure what the bank’s performance would have been if
all the money lent or used to pay funding costs were its own (i.e.,
no interest had to be paid on saver’s deposits or borrowings).
By temporarily ignoring the role that leverage plays, we get
a better picture of how well it’s managing its operating business.
To do this, we calculate
the bank’s after-tax return on earning assets by subtracting
operating expenses, loan loss provisions, and taxes from all
revenues (including non-interest income and gains or losses on
investments). We adjust
this after-tax return to reflect the difference between the loan
loss provision and the net charge-offs of loans.
Return on earning assets consists of operating income less
operating expense and income taxes, but excludes the cost of funding
liabilities.
Return on assets ranges
from best to worst as follows:
High, Average and Low.
Peoples Bank has a High” after-tax return
on earning assets (ROEA).
Now let’s take a look
at each of the components of return on earning assets and how the
bank performed.
Current
yield on loans. This
includes interest income from loans divided by the average book
value of loans. Peoples
Bank
earned a “High” yield on loans.
Loan
loss provision. This
expense on the income statement accounts for probable losses as a
result of future loan defaults.
High levels indicate that the bank expects future loan losses
to increase. The
loan loss provision as a percent of earning assets is “High” for
this bank, reflecting above average future loan loss expectations.
Non-interest
income. This is
revenue and income (or loss) from sources other than loans and
investments, such as income from fees.
This bank’s ratio of
non-interest income as a percent of earning assets is “High.” It is an important part of its revenue source and
profitability.
Non-interest
expense. The
expense ratio equals operating costs divided by average earning
assets. This allows us to focus on how well the bank is controlling
its operating costs. This bank’s ratio of
non-interest expense to earning assets is “High.”
Adjustment
to net income. In
this measurement, we focus on how much of the loan loss provision
was added to net income. This
bank’s adjustment provides a modest addition to net income, as the
loan loss provision exceeds net loan charge-offs.
“L”
Leverage and Liquidity
Leverage returns along
with liquidity make up the “L” in IDC’s CAMEL analysis.
First we will look at the institution’s Return on Financial
Leverage.
Return
on Financial Leverage – A Measure of the Financial Strategy. Return on Financial Leverage measures the efficiency with
which the institution uses deposits, borrowings, and other forms of
debt to leverage its equity capital and reserves.
Return on financial leverage is the product of leverage spread and leverage
multiplier.
Leverage spread compares
the after-tax return on earning assets (the measurement of the
operating strategy) to the after-tax cost of funding these earning
assets. Leverage
multiplier is the amount of deposits and borrowings used in
relationship to equity capital and loan loss reserves provided by
the institution. Financial strategy determines how much to leverage capital
and at what cost.
Ratios of Leverage
Spread, Leverage Multiplier and Return on Financial Leverage range
from best to worst as follows:
High, Average, Low, and Negative.
Peoples
Bank
has a “High” return on financial leverage.
The cost of funding is “Average,” its leverage spread is
“High,” and its leverage multiplier is “Low.”
Liquidity
measures (1) balance sheet cash flow as a percent of the Tier I
capital and (2) illiquid loans as a percent of stable deposits and
borrowings plus excess liquidity.
The large potential risk is the transfer of consumer
deposits from stable low paying deposits to large deposits or
borrowings. This can
occur as consumers transfer deposits outside the banking system,
requiring banks to attract new funds by increasing deposits over
$100,000 or borrowing funds. The
loss of stable low-cost deposits or excessive lending is reflected
as a lack of liquidity by an increase to over 100% in the percentage
of illiquid loans to stable deposits and borrowings plus excess
liquidity. Negative
balance sheet cash flow indicates the inability of the change in
retained earnings to finance the change in growth producing assets
(plant and equipment, investments in unconsolidated subsidiaries,
and other long term assets) or the change in liabilities (excluding
retained earnings) is larger than the change in investments and
loans. A negative
balance sheet cash flow ratio of –66% to –100%, coupled with a
high percentage of loans to earning assets, illustrates a lack of
liquidity. A percentage
more negative than –100% is a severe illiquid position, especially
if nonperforming loans are in excess of 3% of total loans.
Peoples Bank has a percentage of balance sheet cash flow to Tier I capital between a
negative 66% and a positive 66% illustrating ample liquidity.
The percentage of illiquid loans
to stable deposits and borrowings plus excess liquidity is
less than 100% and illustrates ample liquidity.
In summary, Peoples Bank
received an IDC rank of 277, which placed it in the Superior group.
The Federal Deposit
Insurance Corporation (FDIC) and US Government insure all deposits
up to $100,000.
This report was
prepared by IDC Financial Publishing, Inc. of Hartland, Wisconsin.
For more information on this or other institutions, contact
IDC at 1-800-525-5457 or by e-mail at idcfp@execpc.com.
Ranks
provide IDC’s opinion about the relative value of financial
ratios, and are subject to limitations in their use.
In IDC’s opinion, the selected ratios provide an ample
financial picture for rating a bank. However, the quality of
individual banks can also be influenced by factors not taken into
account in this analysis. The
quality of a bank is not fixed over time; ranks may change with
changes in management, strategy, or external conditions.
The
data for calculations and ranks and other information is obtained
from sources believed to be reliable and accurate.
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