FINC 433 - Exam 2 Review. Questions with Answers. Complete Solutions Guide.

FINC 4331 Exam 2 Review:

Chapter 3

 Problem 1 from your book is restated here for emphasis:
o Evaluate the performance of Community National Bank
relative to peer banks, using the data in Exhibits 3.2, 3.4, 3.7,
3.8 and 3.9, at end of review (and others if you need them).




 Did the bank perform above or below average that year?
Conduct a return on equity decomposition analysis for the
year in question, identifying where the bank's performance
compared favorably and unfavorably with peer banks.




 Compare the bank's risk measures with those of peer
banks. Did it operate with more or less relative risk in
each risk category? What are the implications of any
significant differences?

,  What recommendations would you make to adjust the
bank's risk and return profile to improve its performance
relative to its peers?Co




 Also for practice, understand and be able to explain the book’s
analysis of PNC Bank that starts on page 121. Understand Exhibit 3.8
and others related to this.

Problem 1 in the text goes through a peer analysis for Community Bank,
and the chapter and slides run through a peer analysis of PNC. You should
spend time going through both ­ the solution to Problem 1 is posted online.




 Understand the balance sheet of an “average” bank and the relative
amounts of each type of asset, liability and equity account. (This is
related to Exhibit 3.2 in your text and slides).

 Assets of a bank, two big categories, Loans is one big category. Investment securities
is the other big category. Investments are primarily used for liquidity, not

, necessarily used for income. Loans used for income, but unfortunately loans are
extremely illiquid. So banks ESPCIALLY Smaller banks carry investment
securities.
 Allowance for loan and lease losses, smaller banks are usually going to have a larger
reserve account and riskier loans because they are not geographically diversified well.
Usually small banks will have a lot more individual loans because they can trade on that
although we don’t see that here.

 Small banks typically use lots more treasuries (see liquidity stuff). Municipal bonds are
not as attractive as they used to be, 1996 Tax Reform act took a lot of the tax benefits of
munis. Munis are not safe or really good securities to invest in. Small banks are NET
Providers of Fed Funds.

 Small banks USUALLY are going to have in proportion: Slide 35

 Small banks have more demand deposits, and transactions accounts, because they are
more about being convenient in the community and location.

 Slide 39: Large bank is going to have lower NIM because they invest in a lot of different
stuff across the board, less risky loans. Higher charge offs either from loans or
securitization. Lower capital because large banks can issue stock much easier.
 Be able to come up with numbers and ratios and explain those numbers and ratios.
Exhibit 3.12. SLIDE 57. On average, all banks have an ROE of about 9.29%. Equity
capital ratio at 10.24%. Net Interest Margin is 3.35% overall but littler banks have higher
net interest margin. Earning assets to total, many more in smaller banks. Efficiency ratio
74% for smaller banks versus 58%for bigger banks, a higher efficiency ratio is BAD.
Efficiency Ratio lower is better. Charge offs to loan and lease loss; net charge offs far less
than 1%. Loss allowance for net loan and leases. Net Loans and leases to deposits for the
banking industry as a whole is 89.45%. Capital Ratios, Core capital leverage ratio, little
banks have 13%. Tier 1 risk based capital ratio and Total risk based capital ratio almost
20% for little banks because they have no risk.

 Small Banks
o Still run according to the principles and economics of 100 years ago
 All about transactions accounts, small loans
 Location is important
 Service is important
 Hard to raise equity capital
 Hard to diversify assets, too concentrated, very profitable
 Large Banks
o Run same as any other diversified firm, almost
 Can get some scope and scale economies

,  Can issue capital easily, but they compete on Wall Street with other firms
for investors
 Cam manage risk better, usually

 Large
o Large depository institutions have a greater reliance on highly rate­
sensitive borrowings. (volatile borrowings/purchased liabilities/hot
money)
o Large depository institutions also issue commercial paper through
their holding companies.
 Small
 Bank Assets
o Either “Loans” or “Investments,” those are the two main categories
o Loans
 Real Estate (mostly consumer)
 Commercial & Industrial (these are what we mean when we
say “bank loans” for small to medium businesses)
 Individual
 Agricultural
 Other loans in domestic offices
 Loans and leases in foreign offices
 Adjustment to Loans: Allowance for Loan and Lease Losses
(ALL) is a contra­asset account
 Gross Loans and Leases account on B/S minus
o Unearned Income
o Allowance for Loan & Lease Losses (or ALL)*
equals
 Net Loans and Leases account on B/S
o *Note that the ALL is also called the Loan &
Lease Loss Reserve (LLR) and Loan & Lease
Loss Allowance (ALL) by your book, in
different places.
o Investments or Investment Securities » (See Ch. 16 for more detail)
 Short­Term Investments –
 One­year or less
 – Examples: