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How Will Banking Turmoil Impact Agency M&A Trends?

By anyone's standards, these are tough times for the banking industry.  The subprime credit crisis and record losses in trading activities are among the issues that have taken a heavy toll on recent bank financial performance.

Why should these problems matter to independent insurance agents?  Because in 2007, when many of these problems first hit the headlines, the number of agency acquisitions by banks was down one-third from its peak reached in 2000.  It's yet to be seen if the banking industry will return to its previous level of agency deals.

Will the lessons of this challenging period change the banking industry's interest in the insurance distribution business?  If so, will we see a surge in agency acquisitions by banks, or will we see declining interest?

First, let's take a hard look at how bad it really is for the banking business these days.  The following are a few indicators of how deep the impact has been.

• Industry Bottom Line:  Net income for the fourth quarter of 2007 was the lowest reported by the banking industry in 16 years.
• Margins:  Nearly 60 percent of banks saw a decline in net interest margin during the fourth quarter of 2007, as the average NIM fell to 3.3 percent - the second-lowest level reported since 1989.
• Individual Earnings:  Over half of all FDIC-insured institutions reported a year-over-year decline in net income in 2007.  For those with assets over $10 billion, one-in-four reported a net fourth-quarter loss.

Another example of the challenges facing the financial markets is the stunning collapse of Bear Stearns earlier this year.  Though not a commercial bank, Bear Stearns once was one of the nation's largest investment banks.  It was also one of the largest underwriters of mortgage bonds.  Its enormous exposure to mortgage-related risk was its ultimate undoing.

To be fair, performance has not suffered for all banks.  But it has for many, and the end of the suffering will not come quickly.  Credit problems in the real estate market will take time to unwind.  There will be ample time for reflection.

So, as banks lick their wounds and prepare for the future, what effect will we see in terms of the impact on the acquisition of insurance agencies?

Evidence over the near term may be difficult to interpret.  As the banking industry wrestles with current bad-loan write-offs and the expectation of more to come, conventional wisdom is that most banks will be in a capital-preservation mode.  This suggests that merger and acquisition activity will take a back seat. 

But agency deals are usually less capital-intensive than bank deals.  Will this exempt them from the M&A respite?  Probably not.  The uncertainties of the current economy, combined with balance sheet pressures for banks, are enough to diminish M&A activity across the board.

For now, expect less focus on deals of all types-including agency deals.  Therefore, don't look for a surge in bank-agency acquisitions in 2008.

However, what about the longer-term effect?  Some banks are using this time to reconsider their growth strategies, and they are rethinking and challenging some old beliefs.  Here are two conclusions reached by more than a few banks as they consider the current state of their industry.

A "Stick to Your Knitting" Strategy is High-Risk.  In recent years, as banks have ventured beyond the traditional loan-and-deposit world of traditional banking, there have been plenty of naysayers.  Critics charge that banks should stick to their knitting, focus on the business they know best, and not venture onto less familiar turf.  It's too risky, these observers warn.

However, ironically, the current problems for banking originated largely from their lending practices.  That's their core business-their knitting right?

Therefore, defenders of the stick-to-your-knitting approach must now acknowledge both the inherent risk of the lending business and the difficulty posed by the largest net interest margin in 19 years.  They then must argue that the risk-reward ratio for bank can't be improved upon through greater expansion into fee businesses.  This is a tough argument to make.  As one bank executive put it, "strategic revenue diversification is no longer a luxury."

Lower-Risk, Fee-Based Business Are Key.  Understandably, "risk management" is a current catchphrase in banking.  Revenue diversification will be part of the solution.  But to improve its risk-reward scenario, a bank will need to take a thoughtful, strategic approach to diversification that fairly anticipates the impact of entry or expansion in a particular line of business. 

There is not a one-size-fits-all answer.  Diversification into fee-based businesses in which they believe they can achieve meaningful scale while maintaining reasonable risk.  Against this scorecard, the agency business gets mixed results.

• It scores well on risk, it's a one-sale business that produces recurring revenue.  Banks understand this since the lending business operates the same way:  Get the business on the books and expect revenue for years to come.
• It is not as operationally or technologically intensive as banking, and doesn't have many of the diversification alternatives available to banks.
• Scale is another matter.  As evidenced by their agency divestitures, some very large banks have concluded they can't achieve scale in the insurance business.  But scale is relative and is achievable in insurance for all but the largest banks.

So where does this leave independent agencies looking to do deals with banks?  Here's what we know:

• Pain is causing banks to take a hard look at their future growth strategies.
• More diversification is needed.
• Fee-based business with low-risk and scalability is the answer.

This sounds like a formula that could lead growing numbers of smaller and midsize banks into the independent insurance agency business over the next few years.

Review of Financial Performance of AccessBank (from CBJ December Issue)

Brien Desilets examines the rise and transformation of one of Azerbaijan’s most successful banks, from its creation in 2002 as the Micro Finance Bank to Azerbaijan through its rebranding as today’s AccessBank. He looks at why this financial institution has attracted such widespread praise, and what challenges the future may bring.

With the full support of multilateral and bilateral agencies, including the bank’s shareholders and lenders, AccessBank of Azerbaijan has been pointed to as a shining example of a successful emerging market financial institution. Its assets have risen from just over $20 million at the end of 2005 to more than $350 million today. The number of client accounts increased from just under 7,000 at the end of 2005 to more than 100,000 today. Fitch has given the bank the highest rating of any private bank in Azerbaijan, indeed the highest possible rating for Azerbaijan, matching the country ceiling of BB+.

The bank completed its debut bond issue in February 2008. This was the first bond issue on international capital markets by an Azerbaijani company, raising $25 million. Since its opening, the bank has expanded its services to include new savings products, loans money transfer services for businesses and individuals, electronic payment cards and an ATM and POS network. It has been viewed as a success story, not only in the microfinance industry, but also in the wider arena of emerging market banking.

This article provides a comprehensive analysis of the bank, from its creation by international financial institutions (IFI) to the equity involvement of AccessHolding Microfinance AG of Germany to its financial performance through the current financial crisis to its challenges ahead.
 

The history of AccessBank

AccessBank was created under a joint initiative by the European Bank for Reconstruction and Development (EBRD), KFW Development Bank, International Finance Corporation (IFC), Black Sea Trade and Development Bank (BSTDB) and LFS Financial Systems (LFS). The creation of the bank can be seen as part of a wider program by these International Financial Institutions (IFI).  EBRD has been involved in 18 microfinance institutions in the region in which it operates. Seventeen of these have been greenfield operations in which a bank was created from the ground up.

When embarking upon such operations, EBRD first assesses the market for suitable partners. If none can be found, it works with other IFIs to establish a bank. Recent projects include the Belarus Small Business Bank which was established in 2008, and has met with success in 2009 in spite of the financial crisis. AccessBank Tajikistan, a sister bank of the Azerbaijan bank, is expected to open its doors in the next few months. The establishment of KMB Bank in Russia in the wake of the 1998 financial crisis set a precedent for similar transactions in the region. KMB Bank was subsequently bought by Italy’s Banca Intesa and now boasts assets of more than $1 billion. Other activities in the sector include 13 banks in the Western Balkans under the ProCredit Holdings Company, as well as ProCredit in Ukraine and Xacbank in Mongolia.

In the case of Azerbaijan, EBRD conducted its feasibility study in 2001 and the Micro Finance Bank of Azerbaijan was established in October 2002. With the IFIs as shareholders, the new bank needed a management team. Through an international competitive procurement, LFS Financial Systems GmbH was chosen. LFS is a German consulting and management company specializing in microfinance. Initially, LFS supplied nearly the entire management team; now only one expatriate remains on the managerial staff. LFS also took an equity stake in the bank.

In 2006, LFS established AccessHolding Microfinance AG along with other international investors. With AccessHolding, LFS is able to expand its role beyond providing consulting services to taking equity stakes in microfinance institutions. In April 2007, AccessHolding took just under a 10% stake in AccessBank of Azerbaijan; this stake increased to a little more than 16.5% in December 2007. AccessHolding’s other investments include microfinance banks in Africa (Liberia, Madagascar, Nigeria and Tanzania) and a new project under development with EBRD – AccessBank of Tajikistan.  The current shareholders of Azerbaijan’s AccessBank are EBRD (20%), IFC (20%), BSTDB (20%), KfW (20%), AccessHolding (16.53%) and LFS Financial Systems GmbH (3.47%).

The participation of AccessHolding as an equity investor led the bank to change its name from Micro Finance Bank of Azerbaijan to AccessBank. The rebranding of the bank along with the name change has attracted additional customers. As Chikako Kuno, Director of EBRD’s Small Business Finance team, reports, “Many businesses in Azerbaijan don’t think of themselves as micro or small and are not likely to approach a microfinance bank for lending. The name change helped to attract these customers.”

Technical Assistance from the European Commission and later KfW accompanied the equity investments by the IFIs. AccessBank has had a demonstration effect in Azerbaijan, showing the profitability of lending to small businesses and entrepreneurs. EBRD is now engaged with seven other banks and six nonbank financial institutions (NBFI) in Azerbaijan, providing technical assistance and loans to support microfinance.

AccessBank was ranked 11th out of the country’s 46 banks in terms of assets with two percent of total banking sector assets and was ranked 10th in terms of sector loan portfolio, with 2.3% of the sector loan portfolio at the end of 2008. Today its rank has increased to 6th in terms of both assets and loans. It is one of the few 100% foreign-owned banks in Azerbaijan. Among the leading microfinance institutions (including 12 banks and 20 NBFIs) tracked by the Azerbaijan Micro Finance Association, AccessBank held a 38% market share in 2008, up from 30% in 2007. Finca trails a distant second at 12%.
 

Macroeconomic environment

Azerbaijan is an oil-exporting country, distinguishing it from some of its neighbors in the Caucasus and Central Asia region. The economy received a major boost when the Baku-Tbilisi-Ceyhan pipeline opened in June 2006. GDP growth was higher than 35% in 2006, 24% in 2007 and 11% in 2008. Oil and gas comprised 62% of GDP in 2008, the same year in which Azerbaijan reached a $40 billion trade surplus.

High growth and the trade surplus has led to currency appreciation and inflation. The local currency, the manat, appreciated five percent against the US dollar in 2006, three percent in 2007 and five percent again in 2008. (The Azeri Manat (AZM) was replaced by the Azeri New Manat (AZN) with an exchange of 5,000:1 in 2006.) Official inflation was 16.7% in 2007 and 21% in 2008, slowing toward the end of the year as oil prices dropped.

Azerbaijan Banking Sector

The banking sector in Azerbaijan is dominated by the International Bank of Azerbaijan (IBA) and by Kapital Bank. IBA’s share of total banking assets stood at 47% in 2006 and 39% in 2007, and then rose to 43% at the end of 2008 as a result of the global financial crisis.

At the time of AccessBank’s creation, EBRD’s strategy included increasing diversity in the banking sector to provide alternatives to the state-owned bank. At the time of its intervention, the banking sector was characterized by low capitalization and limited transparency. EBRD’s strategy also included a focus on small business and microfinance. “The loan/GDP ratio is low for the region, never mind comparisons to Western Europe or the US. There is a lot of room for financial intermediation,” says EBRD’s Kuno.

The current financial crisis has led some of Azerbaijan’s banks to halt their lending activities and many, failing to find additional funds for refinancing, have had to repay loans. The Central Bank of Azerbaijan reacted by eliminating the five percent reserve requirement on foreign borrowings, reducing the required deposit reserve from 12 to half a percent and extending loans to certain banks. In general, however, Azerbaijan has fared much better than other countries, particularly emerging markets, in the financial crisis.  The table below shows some key banking sector indicators.

AccessBank’s financial performance

In general, AccessBank’s financial performance has been impressive. With the full support of multilateral and bilateral agencies, including the bank’s shareholders and lenders, AccessBank has grown in the spotlight as a shining example of a successful emerging market financial institution. Total assets grew more than 153% in 2006, 140% in 2007 and 81% in 2008.  In the same years, customer deposits increased by more than 483%, 282% and 90%, respectively. The number of deposit accounts increased from 1,336 in 2005 to 28,158 in 2008. The bank’s operating expenses, however, increased by only 155% in 2006, then less than 90% in both 2007 and 2008. Shareholder equity increased by nearly 140% in 2007 and 154% in 2008.

Portfolio at risk (30 days) peaked at 0.56% in 2008.  This was due to the fact that the bank had not written off any loans since 2006 and that some of its borrowers were facing financial difficulties.  The key results of the bank’s performance are show in the table below.

AccessBank also provided some loan data as of end-October 2009:

• The overall average loan size is $3.600
• 95% of loans are less than $10,000 and of those, the average is less than $3,000
• 3.4% are small loans of $20,000-100,000 with an average of $40,000
• Some loans are medium-sized, but these are very few and limited.

AccessBank was rated at BB+ by Fitch Ratings. This is the highest rating for a private bank in Azerbaijan[2] and indeed the highest possible rating since it matches the country ceiling. Very few banks in Azerbaijan have ratings and, of those, most are rated B-. “This provides a lot of confidence to investors,” notes Walid Fayad, a banker with EBRD who works directly with AccessBank.

The bank completed its debut bond issue in February 2008. This was the first bond issue on international capital markets by an Azerbaijani company, raising $25 million through a Luxembourg-based Special Purpose Vehicle. In November 2008, the EBRD arranged the bank’s first syndicated loan, raising another $28 million. Since its opening, the bank has expanded its services to include new savings products, loans money transfer services for businesses and individuals, electronic payment cards and an ATM and POS network. In general, it has been viewed as a success story not only in the microfinance industry but also in the wider arena of emerging market banking.

While the bank’s performance has been impressive, there are some areas of concern. One of them is the bank’s source of funds for lending. Traditional banks receive deposits and then on-lend them to other customers, channeling money from savers to investors. AccessBank’s model is to borrow money internationally, combine it with equity from international investors (many of them lenders as well – approximately 17% of borrowings come from shareholders) then to on-lend it domestically. This is clear from the graph below. The bank’s total loan portfolio as a percentage of international borrowing plus equity increased from 81.6% in 2005 to 98.3% in 2008. Meanwhile, the ratio of lending to customer deposits has decreased from more than 26 in 2005 to 7.6 in 2008.

From a long-term sustainability perspective, it would be desirable for this last figure to continue to fall so AccessBank could become a true bank, independent of international financing and serving the fundamental banking role of channeling domestic savings into investments. “The bank currently has a deposit to loan ratio of twenty-seven percent,” notes Oksana Pak, Senior Banker with EBRD, “its sustainability requires a higher level.”

The bank has benefited from some unique events and conditions over the past few years, most importantly the opening of the Baku-Tbilisi-Ceyhan pipeline and the depreciation of the US dollar. The pipeline provided a one off (although certainly significant) boost to Azerbaijan’s GDP.

This growth has already cooled from 35% in 2006 to 11% in 2008 and is expected to cool further this year and next, to around 7.5%. The pipeline was opened at a good time for oil prices but those prices may not stay high forever and Azerbaijan’s economy is highly dependent on those prices. While the Azerbaijan manat has indeed appreciated against the US dollar, much of that can be attributed to the dollar’s decline rather than to the manat’s climb. This has provided extra comfort for AccessBank since a major share of its international borrowing is in US dollars. A falling dollar makes for easy repayment of dollar loans. A rising dollar would do just the opposite. This is again one reason for the bank to focus on increasing deposits, so it can source its liabilities in the same currency as its assets. The bank has moved to hedge its currency risk in its borrowing by sourcing two loans in the local currency – in November 2007 and August 2008. Still, it would seem that if the Azerbaijan economy were performing as well as the figures indicate, there should be sufficient depositors and savers interested in financial intermediation. The bank has also developed new products, namely term deposits, that should help to address this issue as well.

Another area for concern is the significant increase in impaired loans. These rose from approximately AZN 3.5 million in 2007 to AZN 12.0 million in 2008, or from 3.1 to 5.8% of the total loan portfolio. The bank reports that this change has come solely from accounting policy changes imposed by external auditors in response to the global crisis and is not a reflection of a deteriorating portfolio. The indication in the financial statements that these loans are fully collateralized by marketable real estate or 100% guarantees by AA rated banks does not provide much comfort with the effects of the US subprime crisis fresh in the minds of most analysts and investors. The bank should adjust its estimates of collateral coverage as real estate prices change. The financial statements indicate that these loans are not overdue or in arrears, but still this increase is significant especially considering the slowing growth of the overall economy, and given that the bank’s major increases in lending has been fueled by foreign borrowing over the past few years.

In general, term risk is not a major area for concern since most of the bank’s loans (71%) carry terms of less than one year while most of its borrowings are in the range of three to six years. Interest rate risk is also not a major issue since the bank is borrowing at rates around 10% and lending at rates around 30%. However, looking forward to 2010 AccessBank has at least $43 million in principal due on its borrowings. An additional $128 million in principal is due in subsequent years with interest payments of $20 million per year. When added to the $43 million in principal payments over the coming year, it means that total debt service in 2010 is approximately $63 million. Should the bank’s impaired loans deteriorate into portfolio at risk or worse, the bank may face cash flow challenges in 2010.

In response to this observation, AccessBank General Manager Andrew Pospielovsky noted: “We follow a very conservative liquidity and refinancing policy to ensure that we never have cash flow challenges.  Today, we have over $60 million in liquid assets — fully covering all our principal and interest repayments over the next 12 months. We also have very good relations with our refinancing partners and have over $70 million in refinancing loans either signed or in process. Lastly, we now receive around $25 million in loan repayments every month – ensuring very strong cash flow. We take pride in the fact that throughout the crisis we have never stopped lending and our portfolio has grown every single month.”

“The bank needs to follow a safe trajectory and make sure internal infrastructure keeps pace with the growth of its business,” notes EBRD’s Kuno. She says that the bank has been able to maintain portfolio quality in the past, even through the financial crisis, and it needs to ensure its ability to maintain that quality moving forward.

The EBRD’s Fayad also notes the availability of qualified personnel as a challenge moving forward:  “The best and brightest have been selected and put in senior management positions.  As the bank grows, it needs to fill new positions in its ranks. Due to the rather limited availability of highly experienced bankers in Azerbaijan, the bank has focused on training and promoting from within.”

As far as an exit strategy for the IFIs, EBRD says is interested in exiting its investment once the bank has matured to a suitable level.  An example is KMB Bank in Russia which was sold to Italy’s Banco Intesa, now has assets of more than $1 billion and continues to focus on small business lending.

Financial Performance of Halyk Bank in first six months of 2006

Almaty, August 1, 2006 – Mr. Grigoriy Marchenko, Chairman of Management Board of JSC Halyk Bank, announced results of the Bank’s performance in H1 2006.

Halyk Group Financial Group, led by Halyk Bank, is reaching new heights in its performance. Halyk Bank once again confirms its status of a successful bank, being a stable and reliable financial instution of the country.

On 18 July 2006, Standard & Poor’s upgraded Halyk Bank’s long-term rating from “ВВ” to “BВ+”, affirming at the same time the bank’s short-term rating at “В”, outlook stable. On 1 June 2006, S&P’s issued a report on achievements and performance of biggest banks in Kazakhstan, Russia and Ukraine. Halyk Bank was named best in terms of ROA (Return on Average Assets) and net interest margin.

Euromoney rated Halyk Bank as “The best bank in Kazakhstan in 2006”. The Banker included Halyk Bank into the list of 1,000 biggest banks of the world, where the Bank occupies 658th place in terms of first level capital. Russian “Commersant-Bank” published a ranking by Interfax Center for Economic Analysis (CEA Interfax) of 1,000 biggest banks in CIA on the results of 2005, where Halyk Bank takes 12th place in terms of assets.

In May 2006 Halyk Bank successfully allocated 300 million US dollar 7-year eurobonds. Taking into account 5-year securities issued in 2004, the Bank established yield curve which is stably traded with discount in relation to liabilities of its main competitors: JSC Kazkommertsbank, JSC Bank TuranAlem, JSC ATF Bank and JSC Alliance Bank. Results testify that investors consider both positive financial results and quality of loans, as well as conservative approach of Halyk Bank to external borrowing.

The bank retains leading positions in the domestic market of retail bank services to be confirmed by the following facts.
Profit of Halyk Bank in H1 of the current year made more than 7.5 billion KZT, with a growth of 62.8% as compared to H1 2005. Assets reached 762.7 billion KZT, having increased from the beginning of the year by 36.5 % or by 204.1 billion KZT. The Bank’s Own (balance) capital increased by 12.1% and reached 67.5 billion KZT.
Loans to customers (loan portfolio (gross)) increased by 9% to reach 466.9 billion KZT. Out of which retail customer loans increased by 14.7% to make 184.6 billion KZT.
Deposit base makes 485.4 billion KZT, out of which retail deposits made 171.6 billion KZT, with a gain of 31.1% in January–June 2006. On H1 2006 results, the increase in the volume of Halyk Bank’s deposits was practically equal to aggregate increase of those of Kazkommertsbank and TuranAlem Bank.

Reference Information

During first six months of 2006 all three international rating agencies upgraded Halyk Bank’s ratings:
In 2006 Standard & Poor’s raised twice long-term rating from “ВВ-” to “ВВ+”: on 10th February and on 18th July 2006. In S&P’s opinion “…Halyk Bank’s ratings have been increased taking into consideration that the Bank has a clear strategy aimed at building a group for rendering financial services on the domestic market. Despite the growing competition, Halyk Bank is continuously increasing its profitability and capitalization, which are today the highest among big and medium Kazakhstan banks. Halyk Bank has such advantages before competitors as availability of “cheaper” funding sources in the form of attracted deposits (available through extensive Halyk Bank’s branch network) and the opportunity to work with a higher margin”. On 30 May 2006, Moody’s upgraded the Bank’s Eurobonds rating from “Baa2” to “Baa1”. Earlier this year, on 23 February 2006, Fitch increased long-term foreign currency rating from “BB” to “BB+”. Both agencies note the extensive branch network, improvement of financial results, as well as possibility of state support in case of need due to strategic importance of the Bank to the country.

Since the beginning of the year Halyk Bank has retained leadership on the deposit market, both in terms of volume of the portfolio and absolute gain. During first six months of the year, the deposit portfolio increased by 40.7 billion KZT to make 171.6 billion KZT. The Bank’s share of retail deposits has increased from the beginning of the year from 21.93% to 22.91%. Moreover, Halyk Bank retains leading positions in mortgage lending among second tier banks, owning more than 29% of market share. Currently, the mortgage portfolio of the bank makes approximately 79 billion KZT. Customer loans have increased from the beginning of the year by 19 billion KZT (with balance of principal receivables) to make 70 billion KZT. Loans to companies have increased by 5.6% to make 282.4 billion KZT.

The number of Halyk Bank’s effective charge cards makes 2.5 million. Let us remind that the Bank is the undisputed leader on the domestic market of charge cards.
Charge card service network comprises of more than 800 Automatic Teller Machines and about 3,500 POS-terminals and imprinters.

Halyk Bank’s branch nework includes 549 subdivisions, out of which 19 are oblast and regional branches, 126 district branches and 404 cash settlement divisions.

The number of clients of Internet-banking reached 8,896. During H1 2006, the web-site of the “Internet-Banking” system, www.mybank.kz, was visited 40,981 times. This is 34% more than results of the similar period of 2005. Besides Kazakhstanis (20% of all visitors), the highest percentage of users are from European Union, United States, Russia and other countries. Internet accounts of our clients in H1 2006 were directly accessed from the territory of 11 countries (Kazakhstan, Europian Union, United States, Russia etc.).

As of 1 July 2006 (after 14 months of operation), the Mobile banking system has been used by more than 82,000 clients (growth in H1 2006 made 47,000). In terms of growth rate Halyk Bank is absolutely the best bank among five CIS countries where VISA has launched this project. Moreover, in March, “Mobile banking” became the most popular remote bank service in the Republic of Kazakstan.

Syndicate Bank profits fall 18.5% on higher provisions

Our Bureau

Bangalore, May 4

Despite a 57 per cent increase in net interest income, Syndicate Bank's net profits fell 18.5 per cent during the fourth quarter of financial year 2009-10.

A bank release said that net profits were lower “mainly due to higher provisions towards wage arrears, taxes, etc”.

The provision made towards taxes during the quarter at Rs 121.07 crore (Rs 26.56 crore), up almost 4.6 times. The bank has also made provision of Rs 34 crore (Rs 15 crore) towards arrears of wages during the quarter.

The board of directors has recommended a 30 per cent dividend for the year. On Tuesday, the bank's shares ended down 2.48 per cent at Rs 90.35 on the BSE.

The bank's NPA coverage ratio is 73.3 per cent.

For the fiscal ended March 31, 2010, the bank's net profit was down 11 per cent at Rs 813.32 crore (Rs 912.82 crore), mainly due to higher provisions towards taxes at Rs 360.71 crore (Rs 111.92 crore) and wage arrears at Rs 220 crore (Rs 75 crore).

Bank of India net slips 67 pc

Mumbai , Jan. 22 

LED by a significant decline in its profit on sale of securities, Bank of India has recorded a 67 per cent drop in net profit at Rs 75.03 crore for the third quarter ended December 31, 2004, against Rs 228.54 crore in the corresponding period the previous year.

During this period, profit on sale of securities declined by Rs 154.12 crore, a release said.

Total deposits of the bank grew to Rs 7,7029 crore (Rs 6,9291 crore), while total advances increased to Rs 5,42,18 crore (Rs 4,54,22 crore).

Retail credit grew to Rs 9,540 crore (Rs 6,965 crore). Housing loans at Rs 2,332 crore constituted 5.92 per cent of non-food credit.

Priority sector advances grew by 16.50 per cent to Rs 16,147 crore, while agriculture advances increased by 15.59 per cent to Rs 5,835 crore.

Capital adequacy ratio of the bank stood at 11.9 per cent after allocating increased risk weights on housing loan and consumer credit including personal loans and credit cards portfolio of the bank.

Gross NPAs declined to Rs 3,649 crore (Rs 3,975 crore), while net NPAs declined to Rs 2,028 crore (Rs 2,177 crore).

Yes Bank is amongst the youngest prominent Private Sector Banks in India and many of you might have noticed its recent Television Ads being shown on several channels including Business News channels. Started by a group of extremely experienced Bankers led by Mr. Rana Kapoor, Yes Bank always aimed at becoming one of the best Private Sector Banks backed by a very strong Technology Platform. Its journey over the last 5-6 years has been exactly as per what Mr. Rana Kapoor had projected it to be. Yes Bank has now grown at a rapid pace to become one of the most respected Banks in the country.

In the initial formative years, Yes Bank focused on corporate and institutional Banking business. It launched new Branches at a measured pace just to have a presence in all the important cities where small to medium sized organisations were present. Yes Bank provided innovative services to help small & medium sized organisations grow their business. Yes Bank virtually partnered them by offering Banking services as well as Financial Advisory services. As the organisations grew, so did their relationship with Yes Bank. Yes Bank’s strong Advisory-based Banking services has helped the bank maintain healthy levels of fee-income over the years. Yes Bank took more than 3 years to reach the figure of 25 operational Branches. The Branch Network increased at a faster pace over the next 3 years to reach a figure of 150 operational branches as of now. And now the Bank is aggressively getting into the retail Banking business and increase its Branch Network by nearly 100 new branches in just 1 year.

Yes Bank’s Financial Performance has been proof of its calculated yet superior growth performance over the years. Yes Bank’s Total Income has multiplied over 10 times from a level of Rs. 290 crores in FY’2005-06 to a figure of Rs. 2945 crores in FY’2009-10. During the same period, its Net Profit has multiplied almost 9 times to reach a figure of Rs. 478 crores last fiscal. Thanks to its strategy advantage, Yes Bank has managed to post vastly superior growth rates even during the last 12-18 months, when the global economy has seen several challenges. Its superior performance has been reasonably well rewarded by Global investors with handsome recovery in valuations after the huge crackdown it saw during the October’08 collapse. Have a look at the following charts:

As you can see from the above charts, Yes Bank’s Financial Performance has been strong and the progress has been steady. Yes Bank has continued to post robust growth rates even after the Economic crises situation between October’08 to March’09. Yes Bank has posted a strong growth of 21% in its Total Income and a much stronger growth of over 57% in its Net Profit over the last 12 months on a Y-o-Y basis. Yes Bank’s share price and hence its Market Cap and Valuation had taken a very bad beating during the crises period. But thanks to its continued growth in Business performance, its Market Cap recovered smartly post March’09 and is now above what it was before the crises period. Look at its P/E Ratio. The Ratio had fallen to about 5 at the end of March’09, but has risen to about 19 by June’10.

In my previous report I had compared HDFC Bank and Axis Bank. Both of them are more than 5 times larger than Yes Bank. Being smaller in size Yes Bank has the potential to grow at a faster pace than both HDFC and Axis Bank for many more years. In terms of quality of growth as well as assets Yes Bank is in no way inferior to the two larger Banks. Hence Yes Bank deserves a valuation on par with the best in the industry. HDFC Bank is currently commanding the highest P/E Ratio of over 30 and I feel Yes Bank too deserves a P/E Ratio of between 25 to 30 levels. Now lets try to estimate its 12-months Fair Value Price Target. Yes Bank posted a Net Profit of Rs. 477 crores in April’09 to March’10 period. We can safely expect it to grow by about 40% over the next 12 months to reach a figure of Rs. 665 crores. At a P/E Ratio of 25 to 30, its Market Cap should rise to be in the region of Rs. 16,000 to 20,000 crores over the next 12 months. This should translate into a share price of around Rs. 475-500/-. That means a potential appreciation of upto 80-85% over the next 12 months.

 

HDFC Bank and Axis Bank are No. 2 & No. 3 Banks in the Private sector. In terms of Stock Market performance, HDFC Bank has always been valued at nearly twice that of Axis Bank. The same holds true even today. But the Question is: Is HDFC Bank doing business that is double that of Axis Bank ? Both these banks started operations in the year 1994, after the Government of India allowed new private banks to be established. Both of them have been backed by large Financial Institutions. As the name suggests, HDFC Bank’s promoter is HDFC, which is India’s largest Housing Finance Company. Axis Bank was formerly known as UTI Bank, because it was once majorly promoted by Unit Trust of India. Even today, the Specified Undertaking of the UTI, i.e. SUUTI is still amongst the largest shareholders of the Axis Bank. Both the Banks are run by independent professional & aggressive managements.

To compare the operational size of the two Banks, HDFC Bank has spread its Branch Network to over 1700 branches and 4300 ATMs. HDFC Bank has done 2 acquisitions in the last few years which has helped it reach this figure. On the other hand Axis Bank has done pure organic expansion to reach a figure of over 1000 Branches and over 4400 ATMs. Both the banks have growing their business at a rate higher than industry average and the growing Indian economy has helped several Banks in their growth plans. Over the last 5 years, both the banks have seen their Total Income and Net Profit multiply between 6-7 times. But it is interesting to see the gap between the two Banks. Five years ago, i.e. in FY’2004-05 HDFC Bank’s Total Income was 60% higher than Axis Bank, while its Net Profit was almost 100% higher. But in FY’2009-10, the gap in Total Income is just 28% and the same in Net Profit is just 17%. Over the years the gap is narrowing because of Axis Bank’s superior growth performance.

Now it is interesting to study their recent performance and their corresponding valuations. I have summarized the same in the following charts:

1) HDFC Bank Progress Analysis :

 

 

HDFC Bank’s 12-months Total Income & EBITDA flattened and has seen a gradual decline over the last few quarters mainly because of changes in interest rates over the last 12-18 months. The business volume has registered healthy double digit growth. It is reflected in the strong growth in its Net Profit. HDFC Bank’s 12-months Net Profit has risen by over 40% over the last 5 quarters. But the even more interesting factor to watch is the valuation HDFC Bank enjoys from the market. Before the October’2008 collapse, HDFC Bank always enjoyed a P/E ratio of somewhere around 30. Now look at the P/E Ratios graph. Over the last 5 quarters, the P/E ratio has been steadily climbing and has now reached over 30. What does this mean? An expansion in P/E ratio in subsequent quarters means the share price has been rising faster than the Bank’s Profit growth. After looking at HDFC Bank’s charts, it will be interesting to compare it with Axis Bank’s charts.

2) Axis Bank’s Progress Analysis :

Axis Bank’s growth story has been better than HDFC Bank’s growth for the past 5-6 years. And it has not changed over the last 5-6 quarters as well. Axis Bank’s Net Profit has jumped over 50% in the last 5 quarters, substantially better than HDFC Bank’s performance. Even the Total Income & EBITDA performance has been marginally superior. But inspite of superior Financial Performance, Axis Bank has always traded at a discount to HDFC Bank’s valuation. Look at the P/E Ratios graph. Eventhough Axis Bank’s P/E Ratio has improved substantially over the last 5 quarters, at 20 it is still way below the P/E Ratio enjoyed by HDFC Bank. Does this make sense? Axis Bank’s Financial Performance is superior. Axis Bank is not far from overtaking HDFC Bank to become India’s No. 2 Private Sector Bank, either in terms of Total Income or Net Profit. So, there is no major size advantage with HDFC Bank. Considering all this, I think it is time the valuation ratios also change in Axis Bank’s favour. Either the P/E ratio enjoyed by Axis Bank should rise or HDFC Bank’s P/E ratio should come down. The latter is unlikely to happen, hence in all probability, it will be Axis Bank’s P/E ratio that will rise faster in the coming quarters. That means Axis Bank’s stock should substantially outperform HDFC Bank’s stock in the coming few quarters.

A Comparison of Financial Performance in the Banking Sector: Some Evidence from Omani Commercial Banks

The purpose of this study is to classify the commercial banks in Oman in cohesive
categories on the basis of their financial characteristics revealed by the financial ratios. A
total of five Omani commercial banks with more than 260 branches were financially
analyzed, and simple regression was used to estimate the impact of asset management,
operational efficiency, and bank size on the financial performance of these banks. The
study found that the bank with higher total capital, deposits, credits, or total assets does not
always mean that has better profitability performance.

The banking sector is considered to be an important source of financing for most businesses. The
common assumption, which underpins much of the financial performance research and discussion, is
that increasing financial performance will lead to improved functions and activities of the
organizations. The subject of financial performance and research into its measurement is well advanced
within finance and management fields. It can be argued that there are three principal factors to improve
financial performance for financial institutions; the institution size, its asset management, and the
operational efficiency. To date, there has been little published studies to explore the impact of these
factors on the financial performance, especially the commercial banks.
This study proposes that there are measurable linkages among bank's size, asset management, the
operational efficiency, and the financial performance. The purpose of this study is to analyze the
financial data of Omani commercial banks for the financial periods 1999-2003. in addition, to examine
the relationships among measures such as bank's size, operational efficiency, asset management, return
on assets ( ROA), interest income, and to discuss their impact on the bank's performance. Financial
analysis is used to quantitatively examine the differences in performance among commercial banks in
Oman, and the banks are ranked based on their financial measures and performance for each bank.
Therefore, the objectives of this study are to classify the commercial banks in Oman on the basis of
their financial characteristics as a guide line for future development, and to assess their financial
performance. In order to evaluate the internal performance of a commercial bank, financial indicators
are constructed from the bank financial statements. Financial ratios like ROA, asset utilization, and
operational efficiency are calculated, Also, measures as assets size, and the interest income size are
used to assess the performance of a commercial bank. However, it is hypothesized for this study that
there exist positive correlations among return on assets, asset management, operational efficiency, bank
size, and the interest income size. In addition, there exist an impact of asset management, operational
efficiency, and the bank's size on the financial performance of the bank.Thus, this study is organized as
follows: the next section following the introduction discusses the relevant literature. The third section
defines the banking sector in Oman. Methodology of the study is described in fourth section. The fifth
section provides details of the results and analysis of the available data, and the final section presents
the main conclusions.

US Bank ScoreBoards small business financial performance

U.S. Bank is helping small businesses make smarter decisions about the financial operations of their business with an online reporting tool, called ScoreBoard. The tool provides trending and reporting data that allows customers to monitor their own credit card spending and also compare their card sales data to industry trends.

ScoreBoard is an application available to U.S. Bank's small business credit cardholders and merchant customers who process credit, debit and electronic check transactions through U.S. Bank Merchant Services.

Available through the customer's existing online account access tools, ScoreBoard features easy-to-read charts and graphs that provide a monthly snapshot of their credit card purchases and payments. It also gives customers insight into their merchant accounts, tracking sales transactions when customers use a card for payment of goods and services. In addition, U.S. Bank business cardholders can use ScoreBoard to download customizable reports for their specific business needs.

"ScoreBoard is unique because it gives our small business customers the ability to monitor their own spending and insight into how their sales trends compare to similar merchants in their business category," said Pam Joseph, U.S. Bancorp Payment Services vice chair. "For our customers who have a U.S. Bank credit card and merchant account, the tool provides a comprehensive view of their business trends."

Business owners who have a U.S. Bank-issued small business credit card can access ScoreBoard through their existing Internet Banking platform. They can use ScoreBoard to:

* Monitor card spending by an individual employee cardholder or for their entire business.
* Review transactions over various time periods and categories, such as travel, office supplies, home improvement and gas purchases.
* Examine their purchase activity by volume, average ticket price or merchant name.

Merchants who process their payments through U.S. Bank Merchant Services can use ScoreBoard to:

* Review sales by volume, average ticket price, or payment type over various time periods.
* Determine their growth rate for card sales over a selected period of time.
* Benchmark their card sales performance against other small businesses in their industry or geographic area by looking at Scooking aking at ScoreBoard's overview of consumer spending trends. 

Evaluating the financial performance of bank branches

We evaluate the financial performance of most of the branch offices of a large European savings bank for a recent accounting period. We employ a complementary pair of nonparametric techniques to evaluate their financial performance, in terms of their ability to conserve on the expenses they incur in building their customer bases and providing customer services. We find variation in the ability of branch offices to perform this task, and agreement on the identity of the laggard branches. We then employ parametric techniques to determine that the list of indicators on which their financial performance is evaluated can be reduced without statistically significant loss of information to bank management. Both findings suggest ways in which the bank can increase the profitability of its branch network.

Evaluating the Financial Performance of Bank Branches

In this paper we evaluate the financial performance of virtually all of the branch offices of a large European savings bank for a recent sixmonth accounting period. We employ a complementary pair of nonparametric techniques to evaluate their financial performance, in terms of their ability to conserve on the expenses they incur in the process of building their customer bases and providing customer services valued by the bank. We find substantial variation in the ability of branch offices to perform this task, and substantial agreement on the identity of the branches at the bottom of the performance distribution. We then employ parametric techniques to determine that the list of indicators on which their financial performance is currently evaluated can be substantially reduced without statistically significant loss of information to bank management. Both findings suggest ways in which the bank can increase the profitability of its branch network.

Empirical Study of post-takeover performance in banking industry: comparison between U.S. and European bank acquisitions.

Takeover is a business activity which really started in the beginning of the eighties and which still takes a strong part in the business and financial area all over the world. According to our studies as the desire for further acknowledgements and the desire of building a career around financial activities, this study has been naturally conducted in the banking area.

Regarding the steady use of acquisition like a powerful process with some positive and negative sides, we decided to implement a comparison of different mergers and acquisitions in the banking industry in the United States and Europe. This comparison has been supported and based on the third main topic of our study: performance.

These large and complex subjects combined together lead to the following hypotheses:

Hypothesis 1: Performance is not improved after takeover in the banking industry.

Hypothesis 2: The level of post takeover performance is the same in the U.S. as in the European bank acquisitions.

Based on the historical data and knowledge, the United States was the pioneer in the development of such gathers in the banking sector. Considering the United States as a reference, a first purpose was to compare them with the bank mergers and acquisitions in Europe. Stating on some possible differences as increasing our own knowledge have been some others purposes which have supported our work.

A first large part of our work was focused, through a large literature review, on the enhancement of our knowledge as the statements of the basis and support for the analysis.

To illustrate and to try to answer our research question, we have conducted our study based on a sample of 20 acquisitions which were achieved in the banking industry between March 1998 and May 2004. 10 of these acquisitions had been achieved in the United States as the 10 remaining acquisitions had been executed in Europe.

The analysis has been achieved by collecting data in Thomson Datastream Advance.

Based on a quantitative method, we applied two financial models: The Market Model (MM) and the Market-Adjusted Returns Model (MAR) supported by the Cumulative Abnormal Returns Method (CARs).

The post-takeover study has been delimited on a period of 42 months after the public announcement.

The study and the comparison between the United States and Europe have shown some differences between the two areas. Nevertheless it seems that negative abnormal returns are usually the case after such takeovers on the whole period studied. Some positive abnormal returns have been recorded at different points in the time into the studying period.

According to the models we applied, the US banks results seem to be better than the ones of European banks: the differences range from 5,58 to 16,65 points under the MM, and from 1,66 to 18,08 points under the MAR model.

Implementation of IAS 36 by Swedish Banks : Interest Rate Swaps in Hedging Applications

In 2005, all groups listed on European stock exchanges are required to prepare their consolidated financial statements according to International Financial Reporting Standards (IFRS). IFRS are different from local regulations across Europe in many aspects, and observers expect the transition process thorny and resource-draining for the companies that undertake it.

The study explores transition difficulties by Swedish bank groups on the way of implementing IAS 39, Financial Instruments: Recognition and Measurement. Deemed the most controversial and challenging standard for adoption by the financial sector, it indeed poses new demandson classification, recognition and measurment of financial instruments, and sets out new hedge accounting rules, previously unseen in Swedish practice. Additionaly, the structure of bank's balance sheets makes IAS 39 also the central one among all other standards in terms of numbers of balance sheet items it impacts.

The study uses qualitative method to explore whether transition to IAS 39 is likely to improve transparency in reporting derivatives. Focus is on use of interest rate swaps as hedging instruments in mitigation of interest rate risk.

It is concluded that differences between two reporting frameworks have been well understood by the banks early in the implementation process. A negative feature of the standard is increased volatility in earnings as a result of more wide-spread reliance on fair value measurement method. This accounting volatility impedes comparability of performance results, as well as conceals true efficiency of economic hedge relationships. To some degree, the volatility can be minimized by the application of hedge accounting. However, a bank must methodically follow a set of rigourous if hegde accounting is to be adopted. Fair value is a more straightforward alternative to hedge accounting , but it brings in additional concerns, and has not yet been endorsed in the EU.

It is additionally argued that recognition of all derivatives on BS and measurement at fair value are two important features of IAS 39 that indeed increases reporting transparency by minimizing risk of undisclosed hidden losses.

Performance of Islamic Banking and Conventional banking in Pakistan : a Comparative Study

Islamic banking and finance in Pakistan started in 1977-78 with the elimination of interest in compliance with the Principles of Islamic Shari’ah in Islamic banking practices. Since then, amendments in financial system to allow the issuance of new interest-free instrument of corporate financing, promulgation of ordinance to permit the establishment of Mudaraba companies and floatation of Mudaraba Certificates, constitution of Commission for Transformation of Financial System (CTFS), and the establishments of Islamic Banking Department by the State Bank of Pakistan are some of the key steps taken place by the governments.

The aim of this study is to examine and to evaluate the performance of the first Islamic bank in Pakistan, i.e. Meezan Bank Limited (MBL) in comparison with that of a group of 5 Pakistani conventional banks. The study evaluates performance of the Islamic bank (MBL) in profitability, liquidity, risk, and efficiency for the period of 2003-2007. Financial ratios (12 in total) such as Return on Asset (ROA), Return on Equity (ROE), Loan to Deposit ratio (LDR), Loan to Assets ratio (LAR), Debt to Equity ratio (DER), Asset Utilization (AU), and Income to Expense ratio (IER) are used to assess banking performances. T-test and F-test are used in determining the significance of the differential performance of the two groups of banks. The study found that MBL is less profitable, more solvent (less risky), and also less efficient comparing to the average of the 5 conventional banks. However, there was no significant difference in liquidity between the two sets of banks. The reasons are due to the facts that conventional banks in Pakistan have longer history and experience in doing banking business and hold dominating position in the financial sector with its large share in the overall financial assets of Pakistan, as compared to Islamic banks, which in true sense, started only a few years back with all letter and spirit.

USING THE BALANCED SCORECARD TO ACCESS PERFORMANCE OF BANKS IN GHANA

Using Balanced Scorecard to assess performance of banks in Ghana Author: Abu Yahaya Supervisor: Eva Lovstal Department: School of Management, Blekinge Institute of Technology Course: Master’s thesis in Business Administration, 15 credits (ECTS). Background and Problem Discussion: The effect of non-financial variables on the financial performance of banks in Ghana can become significant. The information of how customer satisfaction, internal business processes, organizational learning and growth influences financial indicators is therefore of great importance in assessing performance of banks in Ghana. Purpose: The purpose of this thesis is to create a model to be able to assess performance of banks in several dimensions and measures using the Balanced Scorecard framework. Method: Quantitative and inductive methods. Primary data is financial and non-financial statistics collected from public institutions and sources, staffs and customers of Barclays Bank Ghana limited, Ecobank Ghana Limited and United Bank for Africa (Ghana) Limited. Theory: The theory section looks at different concepts and relevant theories that come up when analyzing bank’s financial results and how they are being impacted by other non-financial perspectives. I have therefore chosen the most common concept for the theory section. Analysis: I have used a model to examine how the balanced scorecard can be used to assess performance of banks in several dimensions and measures in order to provide additional information to all stakeholders - internally and externally. The chosen scenario shall then be used to determine if BSC can provide additional information with respect to the performance of the selected banks. Conclusion: The analyzed banks showed only marginally the impact of non-financial perspectives on financial performance. Analysis also showed that in assessing performance of banks some critical non-financial factors such as customer satisfaction, efficient internal processes and the quality of staff play a crucial role. Of specific interest is the turn-around-time on loan processing and disbursement which is a core function of the banks and for which all the selected banks failed to adequately address. But the study also revealed that the BSC framework indeed provides additional information when used to assess the performance of banks in Ghana.

Financial Development and Economic Growth: The Case of Chinese Banking Sector

China’s economy has developed rapidly since the introduction of market reforms in 1978. In parallel came the reforms within the financial sector and the most of financial intermediation between savings and investment has been channelled through the banking sector. Thus far studies on the finance-growth nexus in China have focused on the financial sector as a whole. This thesis aims to determine the impact of different banking institutions on economic growth and assess the compatibility of state financial policies with country’s economic performance. The empirical analysis is performed using annual data for the period 1978 to 2005. Using the Granger-causality test procedure under vector autoregressive model I examine the relationship between economic growth and, respectively, different types of banks and different types of loans. The procedure provides evidence that presence and direction of causality is affected by the type of bank as well as type of loan. There is two-way causality between economic growth and policy banks as well as rural credit cooperatives. The development of state-owned commercial banks and other commercial banks merely follows economic growth. Furthermore, loans to construction sector Granger cause growth and there is a one-way causality between growth and loans to commercial sector. The fact that policy banks manage to positively influence China’s development might indicate that state policies concerning financial sector and economic growth are successful. However to sustain the growth it is important to further develop financial services, ensure better credit allocation and improve access to financing for private as well as small and medium-sized enterprises.

Sphere Performance and the Financial Crisis 2008-2009 - Evidence from the OMXS

Influential sphere ownership and its implications on company performance, is an area of continuous research. Previous literature focuses on agency costs and how these are affected by family ownership related to firm performance, but also on banking-relationships, and investment horizons. We have studied the performance of Investor, Industrivärden and Kinnevik firms and non-sphere firms listed on the OMXS Large Cap and Mid Cap from the first quarter 2006 to the third quarter 2009, thus we will be able to study how the sample firms in general and the sphere firms in particular were affected by the crisis starting in early 2008. We find evidence that the Investor and the Industrivärden firms did not experience as heavy declines in excess stock returns as the other firms during the crisis, confirming some branches of agency cost theory’s claim that they are more stable. These firms also report higher debt ratios; Investor has a higher ratio for the entire period and for Industrivärden we find an increase for the crisis period. For Kinnevik, we cannot find any difference from the non-sphere firms, which suggests that spheres can take advantage of their bank relations. It seems like sphere firms acted very conservatively regarding investments during the crisis, which gives no support to arguments of extended investment horizons, but that is a matter of concern in the definition of efficient investments during the crisis. What we have seen though is that the firms invest in general in accordance with the industry they operate in.

Analyzing A Bank's Financial Statements

Banks take deposits from savers, paying interest on some of these accounts. They pass these funds on to borrowers, receiving interest on the loans. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers. This ability to pool deposits from many sources that can be lent to many different borrowers creates the flow of funds inherent in the banking system. By Financial statements for banks present a different analytical problem than manufacturing and service companies. As a result, analysis of a bank's financial statements requires a distinct approach that recognizes a bank's somewhat unique risks. (To learn more about reading financial statements, see What You Need To Know About Financial Statements and our Advanced Financial Statement Analysis tutorials.)

managing this flow of funds, banks generate profits, acting as the intermediary of interest paid and interest received and taking on the risks of offering credit.

Leverage and Risk

Banking is a highly leveraged business requiring regulators to dictate minimal capital levels to help ensure the solvency of each bank and the banking system. In the U.S., a bank's primary regulator could be the Federal Reserve Board, the Office of the Comptroller of the Currency, the Office of Thrift Supervision or any one of 50 state regulatory bodies, depending on the charter of the bank. Within the Federal Reserve Board, there are 12 districts with 12 different regulatory staffing groups. These regulators focus on compliance with certain requirements, restrictions and guidelines, aiming to uphold the soundness and integrity of the banking system. (To read more about leverage, see When Companies Borrow Money.)

As one of the most highly regulated banking industries in the world, investors have some level of assurance in the soundness of the banking system. As a result, investors can focus most of their efforts on how a bank will perform in different economic environments.

Below is a sample income statement and balance sheet for a large bank. The first thing to notice is that the line items in the statements are not the same as your typical manufacturing or service firm. Instead, there are entries that represent interest earned or expensed as well as deposits and loans. (To find out more about balance sheets and income statements, see Find Investment Quality In The Income Statement, Understanding The Income Statement, Reading The Balance Sheet and Breaking Down The Balance Sheet.)

Figure 1: The Income Statement

Figure 2: The Balance Sheet

As financial intermediaries, banks assume two primary types of risk as they manage the flow of money through their business. Interest rate risk is the management of the spread between interest paid on deposits and received on loans over time. Credit risk is the likelihood that a borrower will default on its loan or lease, causing the bank to lose any potential interest earned as well as the principal that was loaned to the borrower. As investors, these are the primary elements that need to be understood when analyzing a bank's financial statement.

Interest Rate Risk
The primary business of a bank is managing the spread between deposits (liabilities, loans and assets). Basically, when the interest that a bank earns from loans is greater than the interest it must pay on deposits, it generates a positive interest spread or net interest income. The size of this spread is a major determinant of the profit generated by a bank. This interest rate risk is primarily determined by the shape of the yield curve. (For more insight, see The Impact Of An Inverted Yield Curve and Trying To Predict Interest Rates.)

As a result, net interest income will vary, due to differences in the timing of accrual changes and changing rate and yield curve relationships. Changes in the general level of market interest rates also may cause changes in the volume and mix of a bank's balance sheet products. For example, when economic activity continues to expand while interest rates are rising, commercial loan demand may increase while residential mortgage loan growth and prepayments slow.

Banks, in the normal course of business, assume financial risk by making loans at interest rates that differ from rates paid on deposits. Deposits often have shorter maturities than loans and adjust to current market rates faster than loans. The result is a balance sheet mismatch between assets (loans) and liabilities (deposits). An upward sloping yield curve is favorable to a bank as the bulk of its deposits are short term and their loans are longer term. This mismatch of maturities generates the net interest revenue banks enjoy. When the yield curve flattens, this mismatch causes net interest revenue to diminish.

A Banking Balance Sheet
The table below ties together the bank's balance sheet with the income statement and displays the yield generated from earning assets and interest bearing deposits. Most banks provide this type of table in their annual reports. The following table represents the same bank as in the previous examples:

Figure 3: Average Balance and Interest Rates

First of all, the balance sheet is an average balance for the line item, rather than the balance at the end of the period. Average balances provide a better analytical framework to help understand the bank's financial performance. Notice that for each average balance item there is a corresponding interest-related income, or expense item, and the average yield for the time period. It also demonstrates the impact a flattening yield curve can have on a bank's net interest income.

The best place to start is with the net interest income line item. The bank experienced lower net interest income even though it had grown average balances. To help understand how this occurred, look at the yield achieved on total earning assets. For the current period, it is actually higher than the prior period. Then examine the yield on the interest-bearing assets. It is substantially higher in the current period, causing higher interest-generating expenses. This discrepancy in the performance of the bank is due to the flattening of the yield curve.

As the yield curve flattens, the interest rate the bank pays on shorter term deposits tends to increase faster than the rates it can earn from its loans. This causes the net interest income line to narrow, as shown above. One way banks try to overcome the impact of the flattening of the yield curve is to increase the fees they charge for services. As these fees become a larger portion of the bank's income, it becomes less dependent on net interest income to drive earnings.

Changes in the general level of interest rates may affect the volume of certain types of banking activities that generate fee-related income. For example, the volume of residential mortgage loan originations typically declines as interest rates rise, resulting in lower originating fees. In contrast, mortgage servicing pools often face slower prepayments when rates are rising, since borrowers are less likely to refinance. As a result, fee income and associated economic value arising from mortgage servicing-related businesses may increase or remain stable in periods of moderately rising interest rates.

When analyzing a bank you should also consider how interest rate risk may act jointly with other risks facing the bank. For example, in a rising rate environment, loan customers may not be able to meet interest payments because of the increase in the size of the payment or a reduction in earnings. The result will be a higher level of problem loans. An increase in interest rates exposes a bank with a significant concentration in adjustable rate loans to credit risk. For a bank that is predominately funded with short-term liabilities, a rise in rates may decrease net interest income at the same time credit quality problems are on the increase. Credit Risk
Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. When this happens, the bank will experience a loss of some or all of the credit it provided to its customer. To absorb these losses, banks maintain an allowance for loan and lease losses.

In essence, this allowance can be viewed as a pool of capital specifically set aside to absorb estimated loan losses. This allowance should be maintained at a level that is adequate to absorb the estimated amount of probable losses in the institution's loan portfolio.

Actual losses are written off from the balance sheet account "allowance" for loan and lease losses. The allowance for loan and lease losses is replenished through the income statement line item "provision" for loan losses. Figure 4, below, shows how this calculation is performed for the bank being analyzed.

Figure 4: Loan Losses

There are a couple of points an investor should consider from Figure 4. First, the actual write-offs were more than the amount management included in the provision for loan losses. While this in itself isn't necessarily a problem, it is suspect because the flattening of the yield curve has likely caused a slow-down in the economy and put pressure on marginal borrowers.

Arriving at the provision for loan losses involves a high degree of judgment, representing management's best evaluation of the appropriate loss to reserve. Because it is a management judgment, the provision for loan losses can be used to manage a bank's earnings. Looking at the income statement for this bank shows that it had lower net income due primarily to the higher interest paid on interest-bearing liabilities. The increase in the provision for loan losses was a 1.8% increase, while actual loan losses were significantly higher. Had the bank's management just matched its actual losses, it would have had a net income that was $983 less (or $1,772).

An investor should be concerned that this bank is not reserving sufficient capital to cover its future loan and lease losses. It also seems that this bank is trying to manage its net income. Substantially higher loan and lease losses would decrease its loan and lease reserve account to the point where this bank would have to increase the future provision for loan losses on the income statement. This could cause the bank to report a loss in income. In addition, regulators could place the bank on a watch list and possibly require that it take further corrective action, such as issuing additional capital. Neither of these situations benefits investors.

Conclusion
A careful review of a bank's financial statements can highlight the key factors that should be considered before making a trading or investing decision. Investors need to have a good understanding of the business cycle and the yield curve - both have a major impact on the economic performance of banks. Interest rate risk and credit risk are the primary factors to consider as a bank's financial performance follows the yield curve. When it flattens or becomes inverted a bank's net interest revenue is put under greater pressure. When the yield curve returns to a more traditional shape, a bank's net interest revenue usually improves. Credit risk can be the largest contributor to the negative performance of a bank, even causing it to lose money. In addition, management of credit risk is a subjective process that can be manipulated in the short term. Investors in banks need to be aware of these factors before they commit their capital.