economics_of_money_banking__financial_markets

Some Problems with Income and Duration Gap Analysis

Duration Gap Analysis 6

$50 million of consumer loans with maturities of less than one year, for a total of $55 million of rate-sensitive assets. The manager then calculates the rate-sensitive liabilities to be equal to the $40 million of commercial paper, all of which has a maturity of less than one year, plus the $3 million of bank loans maturing in less than a year, for a total of $43 million. The calculation of the income gap is then:

GAP RSA RSL $55 million $43 million $12 million

To calculate the effect on income if interest rates rise by 1%, the manager multiplies the GAP of $12 million times the change in the interest rate to get the following:

I GAP i $12 million 1% $120,000

Thus the manager finds that the finance companyÕs income will rise by $120,000 when interest rates rise by 1%. The reason that the company has benefited from the interest-rate rise, in contrast to the First National Bank, whose profits suffer from the rise in interest rates, is that the Friendly Finance Company has a positive income gap because it has more rate-sensitive assets than liabilities.

Like the bank manager, the manager of the Friendly Finance Company is also interested in what happens to the market value of the net worth of the company when interest rates rise by 1%. So the manager calculates the weighted duration of each item in the balance sheet, adds them up as in Table 2, and obtains a duration for the assets of 1.16 years and for the liabilities, 2.77 years. The duration gap is then calculated to be:

DURgap DURa AL DURl 1.16 10090 2.77 1.33 years

Since the Friendly Finance Company has a negative duration gap, the manager realizes that a rise in interest rates by 1 percentage point from 10% to 11% will increase the market value of net worth of the firm. The manager checks this by calculating the change in the market value of net worth as a percentage of assets:

With assets of $100 million, this calculation indicates that net worth will rise in market value by $1.2 million.

Even though the income and duration gap analysis indicates that the Friendly Finance Company gains from a rise in interest rates, the manager realizes that if interest rates go in the other direction, the company will suffer a fall in income and market value of net worth. Thus the finance company manager, like the bank manager, realizes that the institution is subject to substantial interest-rate risk.

Although you might think that income and duration gap analysis is complicated enough, further complications make a financial institution managerÕs job even harder.

One assumption that we have been using in our discussion of income and duration gap analysis is that when the level of interest rates changes, interest rates on all maturities change by exactly the same amount. That is the same as saying that we conducted our analysis under the assumption that the slope of the yield curve remains unchanged. Indeed, the situation is even worse for duration gap analysis, because the

Bank’s Income

Statement

To understand how well a bank is doing, we need to start by looking at a bankÕs income statement, the description of the sources of income and expenses that affect the bankÕs profitability.

The end-of-year 2002 income statement for all federally insured commercial banks appears in Table 1.

Operating Income. Operating income is the income that comes from a bankÕs ongoing operations. Most of a bankÕs operating income is generated by interest on its assets, particularly loans. As we see in Table 1, in 2002 interest income represented 67.6% of commercial banksÕ operating income. Interest income fluctuates with the level of interest rates, and so its percentage of operating income is highest when interest rates are at peak levels. That is exactly what happened in 1981, when interest rates rose above 15% and interest income rose to 93% of total bank operating income.

Noninterest income is generated partly by service charges on deposit accounts, but the bulk of it comes from the off-balance-sheet activities, which generate fees or trading profits for the bank. The importance of these off-balance-sheet activities to bank profits has been growing in recent years. Whereas in 1980 other noninterest income from off-balance-sheet activities represented only 5% of operating income, it reached 26.8% in 2002.

Operating Expenses. Operating expenses are the expenses incurred in conducting the bankÕs ongoing operations. An important component of a bankÕs operating expenses is the interest payments that it must make on its liabilities, particularly on its deposits. Just as interest income varies with the level of interest rates, so do interest expenses. Interest expenses as a percentage of total operating expenses reached a peak of 74% in 1981, when interest rates were at their highest, and fell to 30.1% in 2002 as interest rates moved lower. Noninterest expenses include the costs of running a banking business: salaries for tellers and officers, rent on bank buildings, purchases of equipment such as desks and vaults, and servicing costs of equipment such as computers.

The final item listed under operating expenses is provisions for loan losses. When a bank has a bad debt or anticipates that a loan might become a bad debt in the future, it can write up the loss as a current expense in its income statement under the Òprovision for loan lossesÓ heading. Provisions for loan losses are directly related to loan loss reserves. When a bank wants to increase its loan loss reserves account by, say, $1 million, it does this by adding $1 million to its provisions for loan losses. Loan loss

Measures of Bank

Performance

1987. Since then, losses on loans have begun to subside, and in 2002, provisions for loan losses dropped to 12% of operating expenses.

Income. Subtracting the $401.4 billion in operating expenses from the $529.1 billion of operating income in 2002 yields net operating income of $127.7 billion. Net operating income is closely watched by bank managers, bank shareholders, and bank regulators because it indicates how well the bank is doing on an ongoing basis.

Two items, gains (or losses) on securities sold by banks ( $6.5 billion) and net extraordinary items, which are events or transactions that are both unusual and infrequent (insignificant), are added to the $127.7 billion net operating income figure to get the $134.2 billion figure for net income before taxes. Net income before taxes is more commonly referred to as profits before taxes. Subtracting the $44.1 billion of income taxes then results in $90.1 billion of net income. Net income, more commonly referred to as profits after taxes, is the figure that tells us most directly how well the bank is doing because it is the amount that the bank has available to keep as retained earnings or to pay out to stockholders as dividends.

Although net income gives us an idea of how well a bank is doing, it suffers from one major drawback: It does not adjust for the bankÕs size, thus making it hard to compare how well one bank is doing relative to another. A basic measure of bank profitability that corrects for the size of the bank is the return on assets (ROA), mentioned earlier in the chapter, which divides the net income of the bank by the amount of its assets. ROA is a useful measure of how well a bank manager is doing on the job because it indicates how well a bankÕs assets are being used to generate profits. At the beginning of 2003, the assets of all federally insured commercial banks amounted to $7,075 billion, so using the $90.1 billion net income figure from Table 1 gives us a return on assets of:

Although ROA provides useful information about bank profitability, we have already seen that it is not what the bankÕs owners (equity holders) care about most. They are more concerned about how much the bank is earning on their equity investment, an amount that is measured by the return on equity (ROE), the net income per dollar of equity capital. At the beginning of 2003, equity capital for all federally insured commercial banks was $647.9 billion, so the ROE was therefore:

Another commonly watched measure of bank performance is called the net interest margin (NIM), the difference between interest income and interest expenses as a percentage of total assets:

NIM interest income interest expenses assets

As we have seen earlier in the chapter, one of a bankÕs primary intermediation functions is to issue liabilities and use the proceeds to purchase income-earning assets. If a bank manager has done a good job of asset and liability management such that the bank earns substantial income on its assets and has low costs on its liabilities,

Recent Trends in

Bank Performance

Measures

profits will be high. How well a bank manages its assets and liabilities is affected by the spread between the interest earned on the bankÕs assets and the interest costs on its liabilities. This spread is exactly what the net interest margin measures. If the bank is able to raise funds with liabilities that have low interest costs and is able to acquire assets with high interest income, the net interest margin will be high, and the bank is likely to be highly profitable. If the interest cost of its liabilities rises relative to the interest earned on its assets, the net interest margin will fall, and bank profitability will suffer.

Table 2 provides measures of return on assets (ROA), return on equity (ROE), and the net interest margin (NIM) for all federally insured commercial banks from 1980 to 2002. Because the relationship between bank equity capital and total assets for all commercial banks remained fairly stable in the 1980s, both the ROA and ROE meas-

PREVIEW

The operations of individual banks (how they acquire, use, and manage funds to make a profit) are roughly similar throughout the world. In all countries, banks are financial intermediaries in the business of earning profits. When you consider the structure and operation of the banking industry as a whole, however, the United States is in a class by itself. In most countries, four or five large banks typically dominate the banking industry, but in the United States there are on the order of 8,000 commercial banks, 1,500 savings and loan associations, 400 mutual savings banks, and 10,000 credit unions.

Is more better? Does this diversity mean that the American banking system is more competitive and therefore more economically efficient and sound than banking systems in other countries? What in the American economic and political system explains this large number of banking institutions? In this chapter, we try to answer these questions by examining the historical trends in the banking industry and its overall structure.

We start by examining the historical development of the banking system and how financial innovation has increased the competitive environment for the banking industry and is causing fundamental changes in it. We then go on to look at the commercial banking industry in detail and then discuss the thrift industry, which includes savings and loan associations, mutual savings banks, and credit unions. We spend more time on commercial banks because they are by far the largest depository institutions, accounting for over two-thirds of the deposits in the banking system. In addition to looking at our domestic banking system, we also examine the forces behind the growth in international banking to see how it has affected us in the United States.