Bank Analysis School

Bank Analysis School

August 20-29, 2024 Live Virtual

@ www.csbs.org ♦ @csbsnews

CONFERENCE OF STATE BANK SUPERVISORS 1300 I Street NW / Suite 700 / Washington, DC 20005 / (202) 296-2840

August 20-29, 2024 Bank Analysis School Live Virtual

ATTENDEES California Department of Financial Protection and Innovation Castillo, Josue

josue.castillo@dfpi.ca.gov ivan.dolgonos@dfpi.ca.gov nancy.fong@dfpi.ca.gov raine.hu@dfpi.ca.gov shubo.jiang@dfpi.ca.gov eduardo.ramirez@dfpi.ca.gov matthew.reed@dfpi.ca.gov kira.sahaida@dfpi.ca.gov maria.shimohara@dfpi.ca.gov

Dolgonos, Ivan Fong, Nancy

Hu, Raine

Jiang, Shubo

Ramirez, Eduardo Reed, Matthew

Sahaida, Kira

Shimohara, Maria

Hawaii Division of Financial Institutions Mannschatz, Denis

dmannsch@dcca.hawaii.gov

Indiana Department of Financial Institutions Davis, Levi

ledavis1@dfi.in.gov

Iowa Division of Banking Giles, Katie

katie.giles@idob.state.ia.us

Kansas Office of the State Bank Commissioner Lacy, Robin

robin.lacy@osbckansas.org

Minnesota Department of Commerce Dombrock, Chad

chad.dombrock@state.mn.us amanda.iwanski@state.mn.us andrew.mihalchick@state.mn.us matthew.riehle@state.mn.us emma.thoms-warzecha@state.mn.us

Iwanski, Amanda Mihalchick, Andrew Riehle, Matthew

Thoms-Warzecha, Emma

New York State Department of Financial Services Brennan, Eric

eric.brennan@dfs.ny.gov john.duffy@dfs.ny.gov loreen.lambert@dfs.ny.gov douglas.schenk@dfs.ny.gov

Duffy, John

Lambert, Loreen Schenk, Douglas

Utah Department of Financial Institutions Feinauer, Jonathan

jrfeinauer@utah.gov alisonhansen@utah.gov jasonmiller@utah.gov dasorenson@utah.gov

Hansen, Alison Miller, Jason Sorenson, Darl

INSTRUCTORS Georgia Department of Banking & Finance Ward, Chris

cward@dbf.state.ga.us

Montana Division of Banking & Financial Institutions Greyn, Carra

cgreyn@mt.gov

Ohio Division of Financial Institutions Studer, Amy

amy.studer@com.ohio.gov

CSBS STAFF Hoyle, Katie

khoyle@csbs.org

Richardson, Amy Romano, Chris

arichardson@csbs.org cromano@csbs.org

Bank Analysis School Live Virtual August 20-29, 2024

Week 1 Tuesday, August 20, 2024 12:30 pm – 1:00 pm

Introductions and Welcome

Reg Overview (Amy Studer/ Carra Greyn)

1:00 pm – 1:45 pm

1:45 pm – 2:00 pm 2:00 pm – 3:00 pm

Break

Earnings (Chris Ward)

Independent/ Group Work – Earnings Case Study

3:00 pm – 4:30 pm

Wednesday, August 21, 2024 12:30 pm – 1:00 pm

Prior Day Review

Capital (Amy Studer)

1:00 pm – 2:00 pm

2:00 pm – 2:15 pm

Break

Asset Quality (Carra Greyn)

2:15 pm – 3:00 pm

Independent/ Group Work – Risk Weightings Exercise & Capital Case Study & Asset Quality Case Study

3:00 pm – 4:30 pm

Thursday, August 22, 2024 12:30 pm – 1:00 pm

Prior Day Review

Liquidity (Carra Greyn)

1:00 pm – 2:15 pm

2:15 pm – 2:30 pm

Break

Liquidity (cont.) (Carra Greyn)

2:30 pm – 3:00 pm

Investments (Chris Ward)

3:00 pm – 3:30 pm

Independent/ Group Work – Case Bank Liquidity Analysis & Watch IRR Video Series

3:30 pm – 4:30 pm

Week 2 Tuesday, August 27, 2024 12:30 pm – 1:00 pm

Prior Class Review

Review of IRR Videos and STMR Presentation (Chris Ward)

1:00 pm – 1:45 pm

1:45 pm – 2:00 pm

Break/Ice Breaker

IRR – Continue presentation and walk through Case Bank Information (Chris Ward)

2:00 pm – 3:00 pm

Independent/ Group Work – Rate IRR & Capital Comment

3:00 pm – 4:30 pm

Wednesday, August 28, 2024

Management (Amy Studer)

12:30 pm – 1:30 pm

1:30 pm – 1:45 pm

Beak/Ice Breaker

Communication (Amy Studer)

1:45 pm – 2:45 pm

Independent/ Group Work – Assign & Support Ratings for Case Bank

2:45 pm – 4:30 pm

Thursday, August 29, 2024 12:30 pm – 1:30 pm

Group Work – Prepare Presentation

Present/Discuss Case Bank Ratings

1:30 pm – 2:00 pm

Jeopardy Review Game

2:00 pm – 2:45 pm

Conclusion

2:45 pm – 3:00 pm

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Bank Analysis School August 20-29, 2024

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Zoom Features

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Schedule Week 1

August 20: 12:30 PM – 4:30 PM ET August 21: 12:30 PM – 4:30 PM ET August 22: 12:30 PM – 4:30 PM ET Week 2 August 27: 12:30 PM – 4:30 PM ET August 28: 12:30 PM – 4:30 PM ET August 29: 12:30 PM – 3:00 PM ET

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Chief Analyst Montana Division of Banking & Financial Institutions Carra Greyn

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Regional Supervisor Ohio Division of Financial Institutions Amy Studer

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Supervisory Examiner Georgia Department of Banking and Finance Chris Ward

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Introductions

NAME

STATE

EXPERIENCE

FUN FACT ABOUT YOURSELF

WHAT DO YOU HOPE TO LEARN DURING THIS CLASS?

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Bank Analysis School Quick Reference Guide

Topic

Title/Description

Location / Link

CSBS UBPR Ratio Flow Chart for Earnings Analysis Intended to aid in navigating the UBPR, analyzing key ratios, and calculating “core” earnings. Municipal Bond Job Aid Resource to help understand and analyze municipal bonds. FDIC Municipal Bond Technical Assistance Videos Five videos (55 minutes total) discussing Municipal bonds. Supervisory Insights – Summer 2013 Contains an article covering securities pre-purchase analysis and ongoing monitoring expectations. FIL-51-2013: Uniform Agreement on the Classification and Appraisal of Securities Held by Financial Institutions Assists in determining if securities should be adversely classified. CSBS Capital Information Sheet Resource to understand components of capital, key ratios, etc. FIL-84-2008: Liquidity Risk Management Outlines content to be included in Contingency Funding Plans. FIL-13-2010: Funding and Liquidity Risk Management States that all banks need a Contingency Funding Plan and outlines expectations surrounding cash flow projections and stress-testing. FIL-2-2010: Joint Interagency Advisory on Interest Rate Risk Management Many exam recommendations are based on this guidance. FDIC Interest Rate Risk Technical Assistance Videos Eight short videos (6-12 minutes each) covering interest rate risk. Winter 2014 Supervisory Insights Entire issue is dedicated to interest rate risk. Page 25 is a step-by-step checklist for completing an in-house independent review. FDIC Supervisory Insights Newsletters covering relevant banking topics (can subscribe). Basics for Bank Directors Resource which explains basic banking and regulatory concepts. Sensitivity to Market Risk Analysis Guide Guide for analyzing this component. Community Bank Leverage Ratio Fact Sheet CSBS Liquidity Analysis Guide

Course binder

EARNINGS

Municipal Bond Job Aid (csbs.org) Technical Assistance Videos (fdic.gov) Supervisory Insights Summer 2013 (fdic.gov)

INVESTMENTS

FIL-51-2013 (fdic.gov)

Course binder

CAPITAL

CBLR Fact Sheet (csbs.org)

Course binder

FIL-84-2008 (fdic.gov)

LIQUIDITY

FIL-13-2010 (fdic.gov)

Course binder

FIL-2-2010 (fdic.gov)

SENSITIVITY TO MARKET RISK

Technical Assistance Videos (fdic.gov) Supervisory Insights-Winter 2014 (fdic.gov)

Supervisory Insights (fdic.gov)

OTHER/ GENERAL RESOURCES

Basics for Bank Directors (kansascityfed.org) Bank Accounting Advisory Series (occ.gov)

OCC Bank Accounting Advisory Series Addresses key accounting concepts in a Q&A format.

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Regulatory & Examination Process Overview

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ZOOM POLL How many banks failed in the 6-year period of 2007 through 2012? (a) 0 – 50 (b) 51 – 250

(c) 251 – 400 (d) Over 400

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Bank Failures are not Uncommon

157

140

Failed Banks

92

51

25

24 18

7 4 11

8 5 8

3 4 0 0 3

0 4 4 0 0 5 1

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23

59

39

88

70

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# of FDIC-Insured Institutions on Problem Bank List

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Commonalities of Failed Banks Summary Analysis of Failed Bank Reviews report from the Office of the Inspector General Aggressive growth Concentration in construction and land development loans Reliance on noncore funding Poor risk management Compensation incentives encouraging risk-taking 1 2 3 4 5

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How do Banks Fail?

Interest rate risk materializes

Asset quality issues

Fraud

or

or

Weak earnings

RISK MANAGEMENT PRACTICES

Capital

Liquidity

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Today’s Risks ( 2024 FDIC Risk Review) • Interest Rate Environment - Net Interest Margin Compression • Credit risk (CRE) • Liquidity, Deposits, Funding • Cyber threats • Crypto-Asset Risks • Nonbank Growth

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Examination Process Examinations are the fact-finding function of bank supervision. Purpose of examination is to assess: •Adequacy of capital for the risk profile of the bank •Asset quality •Ability of management, and compliance with applicable laws and regulations •Earnings performance and future prospects •Ability to meet the demands of depositors and other creditors •Degree of exposure to interest rate risk

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Types of Examinations

Full-scope vs. Limited

Joint vs. Independent vs. Concurrent

Risk-focused: To effectively evaluate the safety and soundness of the bank by focusing resources on the highest risk areas

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Examination Key Roles

EXAMINER-IN-CHARGE (EIC)

LOAN-IN-CHARGE/ ASSET MANAGER (LIC/AM)

DETAIL-IN-CHARGE/ OPERATIONS MANAGER (DIC/OM)

TEAM MEMBER (TM)

REVIEWER

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Operations Manager

Responsibilities: •Pre-Planning Phase •On-Site Phase •Wrap-Up Phase

Get familiar with Examination Tools Suite (ETS)

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Course Objectives

• Lecture and real-world stories/examples • Case studies and exercises • Uniform Bank Performance Report (UBPR) – Locate and analyze key ratios

Analyze and assess risk

Assign and support ratings

• Uniform Financial Institution Rating System Definitions (UFIRs)

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Group Work / Case Study

The class is designed around Sunny State Bank, our case bank. Each day you will have independent study time and group time to discuss that day’s component assignment. Next Wednesday , your group will discuss and come to a consensus on the CAMELS and Composite rating for Sunny State Bank. Thereafter, each group will receive a component to present via a PowerPoint slide. Presentations will be next Thursday . You will use all your class materials, including the Sunny State UPBR and UFIRS Rating Definitions. Detailed instructions for the presentations will be provided next Wednesday .

Risk Review 2024

Risk Review 2024

TABLE OF CONTENTS

INTRODUCTION................................................................................................................................ 1

SECTION 1: Executive Summary....................................................................................................... 3

Key Risks to Banks................................................................................................................................... 3 SECTION 2: Overview of Conditions and Banking Performance........................................................ 5 Economic and Financial Markets Conditions......................................................................................... 5 Banking Performance Overview........................................................................................................... 10 SECTION 3: Market Risks.................................................................................................................15 Liquidity, Deposits, and Funding.......................................................................................................... 15 Net Interest Margins and Interest Rate Risk......................................................................................... 21 SECTION 4: Credit Risks...................................................................................................................27 Commercial Real Estate........................................................................................................................ 27 Residential Real Estate.......................................................................................................................... 33 Consumer. ............................................................................................................................................. 37 Agriculture............................................................................................................................................. 41 Small Business...................................................................................................................................... 46 Corporate Debt and Leveraged Lending.............................................................................................. 49 Nonbanks. ............................................................................................................................................. 53 Energy.................................................................................................................................................... 56 SECTION 5: Operational and Cyber Risks ........................................................................................59

SECTION 6: Climate-Related Financial Risks....................................................................................61

SECTION 7: Crypto-Asset Risks .......................................................................................................67

ACRONYMS AND ABBREVIATIONS....................................................................................................69

GLOSSARY OF TERMS......................................................................................................................71

2024 Risk Review | i

INTRODUCTION

The FDIC was created in 1933 to maintain stability and public confidence in the nation’s financial system. A key part of accomplishing this mission is the FDIC’s work to identify and analyze risks that could affect the safety and soundness of banks. The Risk Review summarizes the FDIC’s assessment of risks in economic and market conditions affecting the banking industry. The analysis pays particular attention to risks that may affect community banks, as the FDIC is the primary federal regulator for most community banks and has a unique perspective on these institutions. 1 The 2024 Risk Review provides an overview of banking risks in 2023 in five broad categories: market risks, credit risks, operational risks, crypto-asset risks, and climate-related financial risks. The market risks areas

discussed are liquidity, deposits and funding, and net interest margins and interest rate risk. The credit risks areas discussed are commercial real estate, residential real estate, consumer, agriculture, small business, corporate debt and leveraged lending, nonbanks, and energy. The discussion of operational risks examines the potential negative impact to banks from cyber threats and illicit activity. The crypto asset risks section discusses the FDIC’s approach to understanding and evaluating crypto-asset-related markets and activities. The discussion of climate related financial risks focuses on the physical risk of severe weather and climate events to the banking system. Monitoring these risks is among the FDIC’s top priorities.

1 “Community banks” are FDIC-insured institutions that meet the criteria developed for the FDIC Community Banking Study, published in December 2012 and updated in 2020. At year-end 2023, there were 4,587 banks, of which 4,140 were deemed to be community banks.

2024 Risk Review | 1

SECTION 1 Executive Summary

Key Risks to Banks Market risks posed challenges for the banking industry in 2023 with higher interest rates, an inverted yield curve, declining deposits, higher cost of funding, and compressing net interest margins for some banks. The decline in bank deposits and a shift toward higher-yielding deposit accounts put upward pressure on bank cost of funds and interest expense. In response, many banks reduced securities to fund deposit outflows, pledged securities to ensure access to liquidity lines, and turned to higher-cost borrowings to cover anticipated liquidity needs. Community banks increased their reliance on wholesale funding to support strong loan growth, resulting in weakened liquidity positions to year-end levels not seen since 2009. The industry’s net interest margin increased in 2023 despite rising funding costs and an inverted yield curve, but margin changes varied across the industry. Banks continued to hold an elevated share of long-term assets overall, putting pressure on margins in a higher-rate environment, but some banks began to sell off lower-yielding securities to reinvest at higher rates. Net interest margin compression contributed to a larger share of unprofitable community banks in 2023. Credit risks varied by loan type in 2023, with greater asset quality deterioration occurring in commercial real estate and consumer loans. • Commercial Real Estate: Most commercial real estate markets were resilient in 2023, but markets for office and retail malls were weak. While commercial real estate loan quality overall remained favorable at year-end 2023, weakness emerged, particularly among office properties in large bank portfolios. The ability to refinance commercial real estate loans remains a challenge to borrowers and the banking industry amid high interest rates, softening property values, and emerging credit weakness.

Economic conditions remained strong in 2023, and financial market conditions improved toward the end of the year. Economic growth exceeded expectations in 2023 despite higher interest rates. Inflation moderated in 2023 but remained above the Federal Reserve’s 2 percent target rate, keeping monetary policy tight and interest rates elevated. Labor market conditions slowed but remained tight, which supported consumer incomes. Financial markets were volatile in 2023, but conditions were more favorable toward the end of the year as equity markets rebounded and corporate bond market conditions improved. Treasury yields were volatile during the year and the yield curve remained inverted. Bank stocks underperformed in 2023. The banking industry demonstrated resilience after a period of stress in early 2023 as full-year net income remained high, overall asset quality metrics were favorable, and liquidity stabilized. The banking industry’s earnings remained high in 2023 as higher net interest income more than offset higher provision expense. For community banks, net income declined because of higher noninterest expense, lower net interest income, greater losses on the sale of securities, and increased provisions. Though unrealized losses on securities moderated substantially in the fourth quarter, they remained elevated in 2023. Deposit levels declined during the year, affecting liquidity positions, but increased in the fourth quarter for the first time in seven quarters. While bank lending slowed in 2023, growth remained positive and asset quality remained favorable. Capital levels increased in 2023. The number of problem banks at year-end represented 1.1 percent of total banks, which is near the low end of the typical range for non-crisis periods.

2024 Risk Review | 3

• Residential Real Estate: High mortgage rates contributed to a slowdown in housing activity in 2023, but housing prices increased during the year as the supply of homes for sale remained tight. Affordability of homes decreased, especially for first-time buyers. Credit quality remained sound, but early signs of stress emerged, particularly at community banks. standards and households reduced their demand for loans. Household balance sheets were solid in 2023 with higher net worth, but household savings declined despite higher incomes. Consumer loan performance weakened in 2023, led by credit card and auto loans. • Agriculture: Agricultural conditions remained strong and supported agricultural lending, favorable asset quality, and higher loan concentrations at banks. • Small Business: Small businesses reported challenges of high inflation and tight labor markets, but steady consumer spending helped support business conditions in 2023. Small business asset quality remained relatively sound. • Corporate Debt and Leveraged Lending: Corporate debt increased in 2023 as market conditions improved, while bank lending to businesses continued to tighten. Leveraged loan default rates have increased but remain near the long-term average. Higher interest rates may continue to challenge some borrowers, but limited near-term corporate debt maturities should mitigate some risks in the short term. • Consumer: Consumer loan growth at banks slowed in 2023 as banks tightened lending

• Nonbanks: Bank lending to nonbanks moderated in 2023. Despite favorable asset quality measures, sudden changes in market conditions may pose potential indirect and direct risks to nonbanks and their lenders. • Energy: Economic conditions in energy-producing states were generally favorable in 2023, buoyed by higher U.S. oil production. Bank loan exposure to oil and gas firms continued to decline. Community bank asset quality in energy-producing states deteriorated slightly, but loan delinquency rates remained low by historical standards. Operational and Cyber Risks: Ransomware and supply chain attacks continue to threaten banks and their third parties. Geopolitical events continued to increase the likelihood of cyber-attacks on banks. Check fraud continued to rise, despite a general decline in the use of checks. Adoption of quantum computing and artificial intelligence can pose new risks to critical infrastructure systems. Climate-Related Financial Risks: In 2023, the number of billion-dollar climate events was the highest since 1980. While insurance policies may cover some or all of the loss associated with many severe climate and weather events, policies are becoming more expensive or unavailable, increasing risks to the banking industry. Crypto-Asset Risks: While limited, crypto-asset related activities can pose novel and complex risks to the U.S. banking system that are difficult to fully assess. The FDIC, in coordination with the other federal banking agencies, took steps in 2023 to closely monitor crypto-asset-related activities of banking organizations.

4 | 2024 Risk Review

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Bank Analysis School Earnings

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Why is earnings performance important?

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3 From a bank regulator’s standpoint, the essential purpose of bank earnings, both current and accumulated, is to absorb losses and augment capital . ” - FDIC Risk Management Manual

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Learning Objectives 1 – How Banks Make Money

2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

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Banks are the “Middleman” Connecting Depositors and Loan Customers

BANK

Funding (savers)

Assets (borrowers)

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Net Interest Income is the “Bread and Butter” for Most Community Banks

Interest income (assets) - Interest expense (liabilities) = Net interest income

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What percentage of Sunny State Bank’s total income (Adjusted Operating Income) is from Net Interest Income?

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Net Interest Margin is the “Profit Margin”

Net Interest Income Average Earning Assets

NET INTEREST MARGIN

=

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Learning Objectives

1 – How Banks Make Money 2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

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Some Banks Focus More on Noninterest Income than Others

Sunny State Bank

Another Bank

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Noninterest Income Can Be Volatile

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Advice for Evaluating Noninterest Income

1. Determine the sources of noninterest income (UBPR Page 3 and/or general ledger)

2. Consider volatility and future prospects

3. Consider the relationship to overhead costs (Overhead Less Noninterest Income Ratio on UBPR Page 3)

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Earnings

Asset Quality Problems

• Provisions • Collection Expenses (legal fees, extra staff) • Nonearning Assets (nonaccrual loans, OREO)

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Provisions Decimated Earnings During the Financial Crisis

All Commercial Banks in the U.S.

1.00%

Net Income/ Average Assets

0.80%

0.60%

0.40%

0.20%

Provisions/ Average Assets

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Income Statement (Broad Categories) Interest Income (loans & investments) Interest Expenses (deposits & borrowings) - Net Interest Income = Noninterest Income (service charges, many other types) + Noninterest Expenses (personnel, occupancy, other) - Provision Expenses “X” Factor - Other Items (securities gains/losses, taxes) + or - = Net Income

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Learning Objectives

1 – How Banks Make Money 2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

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Reconciling Performance Changes

% AVERAGE ASSETS Net Interest Income + Noninterest Income - Noninterest Expenses

12/31/23

12/31/22

EFFECT -2bps -10 bps -48 bps +8 bps

2.41% 0.62% 1.66% 0.03% 1.35%

2.43% 0.72% 1.18% 0.11% 1.86%

- Provisions

Pretax Net Operating Income

Net effect -52 bps

What is the main reason pretax earnings declined in 2023?

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Reconciling Performance to Peer

% AVERAGE ASSETS Net Interest Income + Noninterest Income - Noninterest Expenses

BANK 2.41% 0.62% 1.66% 0.03% 1.35%

PEER

EFFECT -73bps -21 bps +78 bps +2 bps

3.14% 0.83% 2.44% 0.05% 1.59%

- Provisions

Pretax Net Operating Income

Net effect -16 bps

What is the main reason pretax earnings is worse than peer? Is there an area the bank is performing better than peer?

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Don’t Over-Rely on Peer Comparisons

Peer comparison data are not included in the rating system. The principal reason is to avoid over reliance on statistical comparisons to justify the component rating being assigned. “ ” ” - FDIC Risk Management Manual

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Management conversation topics • Past performance • Competitive environment/challenges • Budget & strategic initiatives

Keep in mind the general ledger is much more detailed than the UBPR

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Determine “Core” Earnings

“

The quality of earnings may be diminished by undue reliance on extraordinary gains, nonrecurring events, or favorable tax effects.

” ” - FDIC Risk Management Manual

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Learning Objectives

1 – How Banks Make Money 2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

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Budget Review

BOARD INVOLVEMENT/ OVERSIGHT

PROCESS AND ASSUMPTIONS

ACCURACY

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Learning Objectives

1 – How Banks Make Money 2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

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Net income

Earnings Feed Capital Earnings flow into capital

- Dividends = Retained earnings (part of capital)

Capital

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Demands on Earnings

Shareholders

Regulators

• Return on investment • Cover tax liability (Sub. S banks) • Service holding company debt

• Augment capital

• Absorb losses

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Learning Objectives

1 – How Banks Make Money 2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

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High risk, High potential return

Return

Credit risk Liquidity risk Interest rate risk

Low risk, Low return

Risk

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How would you rate Earnings? Bank A

• Total assets $500 million and ROAA of 1.00% Bank B • Consistently profitable with no changes to product lines for many years. • Modest growth rate. • Capital ratios have been steadily increasing.

• Total assets $500 million and ROAA of 1.00% • Recently launched new high yielding but high-risk lending program which is rapidly growing. • Capital ratios have been falling due to the rapid growth. • Allowance has been dwindling due to loan losses.

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Please share a take-away from this session.

(Chatstorm)

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Learning Objectives

1 – How Banks Make Money 2 – Income Statement 3 – UBPR Ratio Analysis 4 – Budget 5 – Impact on Capital 6 – Risk vs. Return

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Independent / Group Work

• Analyze the Earnings component for Sunny State Bank.

• See Earnings Analysis sheet.

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How Would You Rate Sunny State Bank?

• Earnings are strong; more than sufficient to support operations and maintain adequate capital and ALLL. 1 • Earnings are satisfactory; sufficient to support operations and maintain adequate capital and ALLL. 2 3 • Earnings are deficient; insufficient to support operations, capital, and ALLL. Significant negative trends and/or erratic fluctuations. Nominal or unsustainable earnings with intermittent losses. 4 • Earnings are critically deficient. Losses represent a distinct threat to viability. 5 • Earnings need to be improved; may not fully support operations and provide for accretion of capital ALLL.

UBPR EARNINGS RATIO FLOW CHART

Return on Average Assets (ROAA) [page 1]

Noninterest Income to Average Assets [page 1]

Provision Expenses to Average Assets [page 1]

Net Interest Margin (NIM) [pages 1 & 12]

Realized Securities Gains/ Losses to Average Assets [page 1]

Noninterest Expenses to Average Assets [page 1]

Provision Amounts [page 2]

Securities Gains/Losses Amounts [page 2]

Ratios/Amounts: [page 3]: Personnel Expense Occupancy Expense Other Operating Expense

Yield on Earning Assets [pages 1 & 12] Int. Exp. To Avg. Earning Assets [pages 1 & 12] Loans to Assets [page 1] Yield on Loans [pages 3a & 12] Yield on Securities [pages 3a & 12] Cost of Funds [pages 3a & 12]

Ratios/Amounts [page 3]:

Fiduciary Activities Deposit Service Charges Securities Brokerage Insurance Commissions/Fees Net Servicing Fees Gains on Loan sales Other Noninterest Income

ANALYSIS TIPS:  Consider level, trend, and why  Adjust for non-recurring items

Efficiency Ratio [page 3]

 Be selective with peer comparisons  Consider seasonality when reviewing mid-year figures  Consider competitive environment and strategic initiatives  Consult source data (general ledger)  UBPR User’s Guide shows how ratios are calculated

Items which may contribute to a higher level of nonearning assets: Cash and Due [page 4] Nonaccrual Loans [page 8] OREO [page 4] Premises/Fixed Assets [page 4]

Average Earning Assets to Average Assets [page 1]

Average Interest-Bearing Funds to Average Assets [page 1]

APPENDIX A: Explanation of key ratios Source: FDIC Risk Management Manual of Examination Policies (lightly edited)

Net Income to Average Assets Ratio This ratio is also known as the Return on Assets (ROA) ratio and consists of bottom line after-tax net income, including securities gains/losses and extraordinary items, as a percentage of average assets. The ROA is a common starting point for analyzing earnings because it gives an indication of the return on the bank’s overall activities. A typical ROA level is different, depending on the size, location, activities, and risk profile of the bank. For example, a "community" bank with a few branches may regularly achieve an ROA ratio that exceeds those realized by large wholesale banks. Although the ROA provides an overall performance measure, the individual components comprising the ROA need to be reviewed. Net Income Adjusted Subchapter S to Average Assets Ratio In general, institutions that elect to operate as Subchapter S (Sub S) corporations are treated as pass-through entities and are not subject to Federal income taxes at the corporate level. Therefore, an adjustment to net income is needed to improve the comparability between banks that are taxed at the corporate level and those that are not. Refer to the UBPR User’s Guide for specific information. Net Interest Income (TE) to Average Earnings Assets Ratio This ratio is also known as the Net Interest Margin (NIM). The ratio is comprised of annualized total interest income on a tax-equivalent (TE) basis, less total interest expense, divided by average earnings assets. TE adjustments are made to enable meaningful comparisons for banks that have tax-exempt income. These adjustments are discussed in detail in the UBPR User’s Guide. Consideration should be given to the impact of tax-free investments and the related adjustment(s) made to the ratio(s) when material. This ratio indicates how well management employed the earning asset base. It is useful for measuring the profitability of the bank’s primary activities (buying and selling money) because the denominator focuses strictly on assets that generate income. While a higher NIM ratio is generally favorable, it can also be reflective of a greater degree of risk within the asset base. For example, a high NIM ratio could indicate management is making a large number of “high-interest, high-risk” loans (for example, subprime loans). Although an increase in the NIM would be evident, this would not necessarily be an improvement. The sub-components of the NIM – the ratios of Interest Income to Average Earnings Assets, Interest Expense to Average Earning Assets, and yields and costs related to specific asset and liability categories - can be analyzed to determine the root causes of NIM changes. These ratios may change for a variety of reasons, for example, management may have restructured the balance sheet, the interest rate environment may have changed, or bank loan and deposit pricing became more or less competitive. Various other issues specific to Sub S corporations may also exist. For instance, several states do not recognize Federal Sub S elections. Therefore, Sub S institutions may remain subject to State corporate income taxes.

Noninterest Income to Average Assets Ratio This ratio is comprised of annualized income from bank services and sources other than interest-bearing assets, divided by average assets. Level, trend, and overall contribution of noninterest income to earnings performance should be analyzed. If the contribution represents a major portion of the bank’s total revenue, specific sources of noninterest income need to be identified. An assessment as to whether or not these sources are core versus nonrecurring should be made. Noninterest income is largely of a fee nature; service charges on deposits, trust department income, mortgage servicing fees, and certain types of loan and commitment fees. The results of trading operations and a variety of miscellaneous transactions are also included. In some institutions, noninterest income is being relied upon more heavily as banks are attempting to diversify their earnings streams. Noninterest Expense to Average Assets Ratio This ratio is also referred to as the Overhead ratio and is calculated by annualizing expenses related to salaries and employees benefits, expenses of premises and fixed assets, and other noninterest expenses, divided by average assets. Levels and trends of each component should be assessed and the types of expenses representing the largest overhead components should be determined. Examples of the type of costs that may lead to an inordinately high level of overhead expenses include: excessive salaries and bonuses, sizable management fees paid to the bank holding company, and high net occupancy expenses caused by the purchase or construction of a new bank building. Other related ratios such as average personnel expense per employee, average assets per employee, and the efficiency ratio may provide useful information. The level of these ratios and the overall effect on earnings performance should be analyzed. If significant, specific sources of noninterest expense need to be identified. An assessment as to whether these sources are core versus nonrecurring should be considered during the earnings analysis. Provision for Loan and Lease Losses (PLLL) to Average Assets Ratio This ratio shows the annualized percentage of PLLL in relation to average assets. Material changes in the volume of PLLL (either positively or negatively) should be investigated. Higher provisions should result if the loan mix changes significantly from loans with lower to higher historical loss experience (e.g., from one-to-four family mortgage loans to commercial loans) or if economic conditions have declined and have produced a deterioration of loan quality. In situations where the economy is improving and loan quality is stabilizing or improving, lower PLLLs may be appropriate. When assessing the PLLL, examiners need to determine whether the level of the ALLL is appropriate to absorb estimated credit losses inherent in the loan and lease portfolio. An ALLL that is not at an appropriate level may be due to any one or a combination of reasons. For example, an ALLL that is below an appropriate level may be caused by a decline in loan quality identified during the examination, an inaccurate ALLL methodology, or an attempt by management to manipulate earnings. If the ALLL is deemed to be materially insufficient during the examination, management will be required to take an additional PLLL to bring the ALLL to an appropriate level, thereby increasing the bank’s expenses and adversely affecting earnings. Earnings ratios affected by this charge to the PLLL should be adjusted and reflected in the earnings analysis.

Realized Gains/Losses on Securities to Average Assets Ratio(s) The ratio of securities gains/losses to average assets shows the annualized percentage of net realized gains or losses on available-for-sale and held-to-maturity securities in relation to average assets. The level, trend, and overall contribution that securities transactions have on earnings performance should be analyzed. Bank management may purchase and sell securities for many reasons, but most banks limit investment activity to ensure adequate liquidity is available to meet unanticipated funding needs and to invest excess funds (i.e., when loan demand is low). Examiners should determine whether management actively engages in the sale of securities. When management actively manages their portfolio, this securities activity should be considered part of the bank’s core operations. Examiners should assess management’s strategies and their implementation. For example, examiners should be alert for instances where investments with unrealized gains are sold while those with unrealized losses are held and should ascertain the reasons for these transactions. Examiners should consider these types of instances when assessing earnings prospects. While actively selling securities may not be part of a bank’s core operations, there are many reasons why management may sell securities. Among the reasons for which management may sell securities that would not be part of a bank’s normal operations would be when management needs to restructure the portfolio to maintain or change portfolio duration, to maintain or change portfolio diversification, or to take advantage of some tax implications or some other combination of these reasons. When not part of a bank’s core operations, examiners should eliminate the gains or losses adjusted for taxes so as to not distort core operating results. The elimination of these gains or losses allows for level and trend analysis of core operations.

APPENDIX B: Income s tatement di agram

Interest income (primarily from loans and investments)

Net interest income

Interest expense (from deposits and borrowings)

Deposit service charges

Fiduciary (trust) income

Securities brokerage income

Noninterest income

Insurance commissions/fees

Mortgage banking income (fees from loan sales and servicing)

Net income

Other noninterest income

Personnel expense

Overhead costs

Occupancy expense

Other operating expense

Provision expense

Realized securities gains/losses

Taxes

APPENDIX C: Adjusting the ROAA Ratio for non-recurring items

If the bank is a C-Corporation: Actual net income + or - Nonrecurring items

(subtract nonrecurring income, or add back nonrecurring expenses)

Tax effect 1 (Add back taxes paid on nonrecurring income, or subtract the amount of taxes that would have been incurred if not for nonrecurring expenses) = Adjusted net income Annualize the adjusted net income (if necessary) / Average assets = Adjusted Core ROAA Ratio

+ or -

If the bank is an S-Corporation: Pre-tax net operating income + or - Nonrecurring items

(subtract nonrecurring income, or add back nonrecurring expenses)

=

Adjusted pre-tax net operating income Annualize the adjusted pre-tax net operating income (if necessary) X 1 minus the tax rate 1 (this captures the estimated tax effect) / Average assets = Adjusted Core ROAA Adj. Sub S Ratio

1 The tax rate in almost all cases will be 21 percent. Refer to the tax rate table in the Appendix of the UBPR User’s Guide for additional information.

Strategic Planning continued from pg. 5

Rating Earnings

Knowing whether your earnings are adequate for current operations and sufficient to maintain capital and loan loss reserves going forward is an important responsibility for bank directors and management. Let’s consider two insured institutions, each with $500 million in total assets and each with an ROA of one percent. Earnings should be rated the same at each bank, right? Not necessarily. Let’s first look at how examiners rate earnings. The Uniform Financial Institutions Rating System (UFIRS) was adopted by the Federal Financial Institutions Examination Council (FFIEC) on November 13, 1979, and was updated effective January 1, 1997. 4 Under the UFIRS, each financial institution is assigned a composite rating based on an evaluation and rating of six essential components of an institution’s financial condition and operations. These component factors address the adequacy of capital, the quality of assets, the capability of management, the quality and level of earnings, the adequacy of liquidity, and the sensitivity to market risk. Evalu ations of the components take into consideration the institution’s size and sophistication, the nature and complexity of its activities, and the institu tion’s risk profile. The UFIRS states that the rating of the earnings component reflects not only the quantity and trend of earnings, but also factors that may affect the sustainability or quality of earnings. The quantity as well as the quality of earnings can be affected by excessive or inadequately managed credit risk that may result in loan losses, high administration costs, and require addi tions to the allowance for loan and lease losses (ALLL), or by high levels of market risk that may unduly expose an institution’s earnings to volatility in interest rates. The quality of earnings may also be diminished by undue reli ance on non-recurring or volatile earnings sources, such as extraordinary gains on asset sales, nonrecurring events, or favorable tax effects. Future earnings may be adversely affected by an inability to forecast or control funding and operating expenses, improperly executed or ill-advised busi ness strategies, or poorly managed or uncontrolled exposure to other risks. According to the UFIRS, the rating of an institution’s earnings is based on, but not limited to, an assessment of the following evaluation factors: „ „ The level of earnings, including trends and stability. „ „ The ability to provide for adequate capital through retained earnings. „ „ The quality and sources of earnings. „ „ The level of expenses in relation to operations. „ „ The adequacy of the budgeting systems, forecasting processes, and management information systems in general. „ „ The adequacy of provisions to maintain the allowance for loan and lease losses and other valuation allowance accounts. „ „ The earnings exposure to market risk such as interest rate, foreign exchange, and price risks. Now, let’s look at what Interagency Guidelines say about how a bank’s board and management should be evaluating earnings. The FDIC issued Part 364 of its Rules and Regulations to implement standards for safety and soundness required by Section 39 of the FDI Act. 5 Appendix A to Part 364 – Interagency Guidelines Establishing Standards for Safety and Soundness – sets forth the safety-and-soundness standards that we use to identify and

address problems at insured depository institutions before capital becomes impaired. 6 Appendix A outlines procedures that banks should employ to periodically evaluate and monitor earnings to ensure earnings are sufficient to maintain capital and loan loss reserves. At a minimum, this analysis should: „ „ Compare recent earnings trends relative to equity, assets, or other commonly used benchmarks to the institution’s historical results and those of its peers; „ „ Evaluate the adequacy of earnings given the size, complexity, and risk profile of the institution’s assets and operations; „ „ Assess the source, volatility, and sustainability of earnings, including the effect of nonrecurring or extraordinary income or expenses; „ „ Take steps to ensure earnings are sufficient to maintain adequate capital and reserves after considering asset quality and growth rate; and „ „ Provide periodic earnings reports with adequate information for management and the board of directors to assess earnings performance. Now, let’s return to our two $500 million banks that each have a one percent ROA, but this time, with a little more information. The first bank’s ROA had been hovering at about 0.8 percent for several years, but increased due to income from a new program of high yielding, but high-risk lending the bank launched about a year ago. The new lending program has grown rapidly. The bank’s loan loss reserve has been dwin dling due to increasing loan losses related to the program, and the capital ratio has been falling due to the growth. Also, the bank’s board has not placed limits on loan growth, and management has been unable or unwilling to forecast how large the high-risk loan portfolio will become. The second bank has not changed its lending product line for a number of years and has grown steadily, maintaining around a one percent ROA during that time, including through several business cycles. Management and the bank’s board have recently decided to launch a new product line and have forecasted the effects on earnings, the loan loss reserve, and capital over the next three years. The board has placed limits on the size of the new product line and risk tolerance “circuit breakers” so new lending will stop if the income it produces isn’t sufficient to build the additional loan loss reserves and capital needed for the new activity. Now, would you rate earnings the same at both banks? No, and here’s why. Although these are just thumbnails and we don’t have all the facts, the first bank appears to have some credit-risk issues and risk-management problems that would indicate earnings may be falling short of what they need to support operations and build capital and reserves. And, they don’t appear to be doing an adequate job of monitoring the adequacy of earnings, contrary to the expectations in Appendix A to Part 364. On the other hand, the second bank appears to have done a good job of maintaining earnings. Also, management’s decision to “look before they leap” into a new product shows they have considered the risk/return of the new strategy and have built in a contingency plan if it doesn’t work.

4 FDIC Statement of Policy, Uniform Financial Ratings System, January 1, 1997 https://www.fdic.gov/regulations/laws/rules/5000-900.html 5 Part 364 of the FDIC Rules and Regulations, Standards for Safety and Soundness. https://www.fdic.gov/regulations/laws/rules/2000-8600.html 6 Appendix A to Part 364 – Interagency Guidelines Establishing Standards for Safety and Soundness, https://www.fdic.gov/regulations/laws/rules/2000-8630. html#fdic2000appendixatopart364

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Supervisory Insights

Summer 2015