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Certainly many financial institutions have their own unique objectives. Some wish to grow faster and achieve some long-range growth objective. Others seem to prefer the quiet life, minimizing risk and conveying the image of a sound institution, but with modest rewards for their shareholders.
Maximizing the Value of the Firm: If the stock fails to rise in value com- mensurate with stockholder expectations, current investors may seek to unload their shares and the financial institution will have difficulty raising new capital to support its future growth.
The value of the stream of future stockholder dividends is expected to increase, due per- haps to recent growth in some of the markets served or perhaps because of profitable acquisitions the organization has made. Expected dividend increases are combined with declining risk, as perceived by investors. Research evidence over the years has found the stock values of financial institutions to be especially sensitive to changes in market interest rates, currency exchange rates, and the strength or weakness of the economy that each serves.
Most capital-market investors have a limited time horizon, however, and plan to sell the stock at the end of their planned investment horizon. Why should banks and other corporate financial 6—4. Can you estimate the current 6—3.
Profitability Ratios: This fact forces the financial analyst to fall back on surro- gates for market-value indicators in the form of various profitability ratios. By out- nearly every service they offer.
As electronic data processing sourcing computer facilities and people, these leading financial- of financial information becomes more and more integral to the service firms hope to save money and time while improving functions of financial-service firms, their managers can realize overall accuracy. Often the vendors and staff are not being fully utilized. Factoid Key Profitability Ratios Contrary to popular Among the most important ratio measures of profitability used today are the following: Interpreting Profitability Ratios Each of the foregoing ratios looks at a slightly different aspect of profitability.
Thus, return on assets ROA is primarily an indicator of managerial efficiency; it indicates how capable management has been in converting assets into net earnings. Return on equity ROE , on the other hand, is a measure of the rate of return flowing to shareholders. It approximates the 2 Many authorities prefer to use total earning assets in the denominator of the net interest margin and noninterest margin. Earning assets are those generating interest or fee income, principally loans and security investments.
The reasoning is that net interest income as well as net noninterest income should be compared, not to all assets, but rather to those assets that account for the majority of all income. The net operating margin, net interest margin, and net noninterest margin are efficiency measures as well as profitability measures, indicating how well management and staff have been able to keep the growth of revenues which come primarily from loans, investments, and service fees ahead of rising costs principally the interest on deposits and other borrow- ings and employee salaries and benefits.
The net interest margin measures how large a spread between interest revenues and interest costs management has been able to achieve by close control over earning assets and pursuit of the cheapest sources of funding.
The net non- interest margin, in contrast, measures the amount of noninterest revenues stemming from service fees the financial firm has been able to collect relative to the amount of noninterest costs incurred including salaries and wages, repair and maintenance of facilities, and loan- loss expenses. Typically, the net noninterest margin is negative: Noninterest costs generally outstrip fee income, though fee income has been rising rapidly in recent years as a percent- age of all revenues.
Another traditional measure of earnings efficiency is the earnings spread, or simply the spread, calculated as follows: Greater competition tends to squeeze the difference between average asset yields and average liability costs. If other factors are held constant, the spread will decline as competition increases, forcing management to try to find other ways such as generating fee income from new services to make up for an eroding earnings spread.
Concept Check 6—5. Can Is this ROA high or low? How could you find out? Why do the managers of financial firms often pay useful to the managers of financial firms? Suppose a bank reports that its net income for the noninterest margin? To the earnings spread? Suppose further that assets important? Who usually sells break down some of these profitability ratios into their key components. For example, it is or liquidates the failed institution? A easy to see that ROE and ROA, two of the most popular profitability measures in use failure declaration must today, are closely related.
Both use the same numerator: Therefore, these two come from the agency profit indicators can be linked directly: Or, in other words: In fact, the ROE—ROA relationship illustrates quite clearly the fundamental trade-off the managers of financial-service firms face between risk and return.
That is, following Equation 6— In other words: For example, the trade-off table on page indicates that a financial firm with a 5-to-1 assets-to-capital ratio can expect a a 2. In contrast, with a 20 to 1 assets-to-capital ratio a financial firm can achieve a 10 percent ROE simply by earning a modest 0. Clearly, as earnings efficiency represented by ROA declines, the firm must take on more risk in the form of higher leverage to have any chance of achieving its desired rate of return to its shareholders ROE.
See Exhibit 6—1. For example: The equity multiplier reflects leverage or financing policies: If any of these ratios begins to decline, management needs to pay close attention and assess the reasons behind that change. For example, of these three financial ratios the equity multi- plier EM , or assets to equity ratio, is normally the largest, averaging about 15X or larger for most banks.
Bigger banks often operate with multipliers of 20X or more. Equity multiplier EM or the employment of What sources of financial leverage to funding should raise net earnings be used? Because equity must absorb losses on assets, the larger the multiplier, the U. However, the larger the multiplier, the less than 1 or 2 percent greater the potential for high returns for the stockholders. It reminds us that financial- service corporations can increase their earnings and the returns to their stockholders by successfully controlling expenses and maximizing revenues.
Similarly, by carefully allo- cating assets to the highest-yielding loans and investments while avoiding excessive risk, management can raise the average yield on assets AU, or asset utilization. An interesting case in point is the recent track record of average ROE for all FDIC- insured depository institutions between and , shown in Table 6—1. Careful perusal of the figures in this table reveals very attractive ROEs for FDIC-insured deposi- tory institutions covering more than a decade.
The lowest earnings over this period for depository institutions, as measured by ROE, were a very acceptable The average ROE for the industry gradually increased over the years, reaching What created such healthy ROEs between and ? Operating revenues expanded significantly faster than operating expenses. Federal Deposit Why did these latter two ratios AU and EM decline? The equity multiplier EM fell because equity capital increased due to record profits and encouragement from government regulators that depository institutions use more equity and less debt to finance their downloads of assets.
At the same time banks managed to slow their asset growth by making much heavier use of off-balance-sheet transactions as we saw in Chapter 5 and by increasing revenues from the sale of fee-based services rather than booking so many new assets.
A slight variation on this simple ROE model produces an efficiency equation useful for diagnosing problems in four different areas in the management of financial-service firms: Ernst and Young allegedly had both an auditor—client and a Source: Federal Deposit Insurance Corporation.
The FDIC charged revenue survive after operating expenses are removed—a measure of operating efficiency and expense control. In the banking example shown above, if the ratio of net income to pretax net operating income falls from 0. If pretax net operating income to operating revenue drops from 0. And if the ratio of operating revenues to assets plummets from 0. Actually, ROA is based on three simple component ratios: Why did ROA for — keep getting better and better?
Federal Deposit — Provision for loan and Insurance Corporation. Figures may not add exactly to totals due to rounding and the exclusion of extraordinary items.
Concept Check 6— What are the principal components of ROE and Expense control efficiency indicator? Asset man- what does each of these components measure? Funds management 6— Suppose a bank has an ROA of 0. What is its ROE? Suppose 6— If a bank has a net interest margin of 2.
What is the dinary items of —0. Tax-management efficiency indicator? The foregoing analysis reminds us that Which banks in the achieving superior profitability for a financial institution depends upon several crucial factors: Careful use of financial leverage or the proportion of assets financed by debt as margins between their opposed to equity capital.
Careful use of operating leverage from fixed assets or the proportion of fixed-cost the interest cost of inputs used to boost operating earnings as output grows. Careful control of operating expenses so that more dollars of sales revenue become net Answer: The smallest income. Careful management of the asset portfolio to meet liquidity needs while seeking the highest returns from any assets acquired.
Measuring Risk in Banking and Financial Services3 Risk to the manager of a financial institution or to a regulator supervising a financial institu- tion means the perceived uncertainty associated with a particular event. For example, will the customer renew his or her loan? Will deposits and other sources of funds grow next month? Are interest rates going to rise or fall next week, and will a financial institution lose income or value if they do?
Bankers, for example are usually interested in achieving high stock values and high profitability, but none can fail to pay attention to the risks they are accepting to achieve these goals. Earnings may decline unexpectedly due to factors inside or outside the finan- cial firm, such as changes in economic conditions, competition, or laws and regulations.
For example, recent increases in competition have tended to narrow the spread between earnings on assets and the cost of raising funds. Among the more popular measures of overall risk for a financial firm are the following: The higher the standard deviation or variance of the above measures, the greater the overall risk.
Risk can be broken down into a number of components and even referenced using different terms as illustrated by the different risk matrices used currently by U. Risk Matrices Used by Selected U. A number of research studies have examined top-earning firms in For example, banks with the best profits seem to generate and the banking industry in an effort to answer a simple question: How did top-earning Leverage lower equity capital and greater use of debt also banks get that way?
Top-earning banks, for example, Bank size is clearly one factor. Government deregula- Expense control stands out as the most important discrimina- tion has put added pressure on financial institutions to charge fees tor between top performers and the also-rans.
Their ratios of operating expenses because top-earning banks seem to grow faster than average, pos- to operating revenues tend to be significantly below the expense- sibly reflecting the presence of more aggressive management or to-revenue ratios of low-profit institutions.
However, growth The deposit structure also appears to influence profit perfor- should not become a substitute for profits. Top-earning banks seem mance. Top-earning banks often hold more demand deposits than to recognize that growth can be overdone, resulting in uncontrolled other banks; these checkable deposits pay little or no interest and expansion that increases operating expenses faster than revenues. Relat- Moderate growth is usually a better route to high profits.
Klee and Fabio M. Commercial the bank than larger deposit accounts. The following are four of the most widely used indicators of credit risk: Nonperforming assets are income-generating assets, including loans, that are past due for 90 days or more. If some of these loans ultimately generate income, the amounts recovered are deducted from gross charge-offs to yield net charge-offs. The final two credit risk indicator ratios reveal the extent to which a lender is preparing for loan losses by building up its loan-loss reserves the allowance for loan losses through annual charges against current income the provision for loan losses.
Another popular and long-standing credit risk measure is: As this ratio grows, examiners representing the regulatory community may become more concerned because loans are usually among the riskiest of all assets for depository institu- tions, and, therefore, deposits must be carefully protected. A rise in bad loans or declining market values of otherwise good loans relative to the amount of deposits creates greater depositor risk.
Liquidity Risk Financial-service managers are also concerned about the danger of not having sufficient cash and borrowing capacity to meet customer withdrawals, loan demand, and other cash needs. Faced with liquidity risk a financial institution may be forced to borrow emergency funds at excessive cost to cover its immediate cash needs, reducing its earnings. Very few financial firms ever actually run out of cash because of the ease with which liquid funds can be borrowed from other institutions.
Somewhat more common is a shortage of liquidity due to unexpectedly heavy deposit withdrawals, which forces a depository institution to borrow funds at an elevated interest rate, higher than the interest rates other institutions are paying for similar borrowings.
For example, significant decline in its liquidity position often forces a bank to pay higher inter- est rates to attract negotiable money market CDs, which are sold in million-dollar units and therefore are largely unprotected by deposit insurance.
Heavier use of downloadd funds increases the chances of a liquidity crunch in the event deposit withdrawals rise or loan quality declines. Market risk is composed of both price risk and interest rate risk. Interest Rate Risk Movements in market interest rates can also have potent effects on the margin of revenues over costs for both banks and their competitors.
Among the most widely used measures of interest-rate risk expo- sure are these: In contrast, when rate-sensitive liabilities exceed rate-sensitive assets, losses are likely to be incurred if market interest rates rise. With more volatile market interest rates in recent years, bankers and their competitors have developed several new ways to defend their earnings margins against interest-rate changes, including interest-rate swaps, options, and financial futures contracts.
We will examine these and other risk-management tools in Chapters 7, 8, and 9. The broad group of actions included in this risk definition often decrease earnings due to unexpected operating expenses. Some analysts say that operational risk is the risk of loss due to anything other than credit or market risk. Others say it includes legal and com- pliance risk, but not reputation or strategic risk. As technology has improved, computer hardware and software systems have become essential to the daily operations of most financial firms.
These natural and not- risk discussed in this so-natural disasters may close financial institutions for extended periods and interrupt section have been developed and refined their service to customers. Foregone income from such disasters is unpredictable, resulting by the Bank for in unexpected operating expenses and greater variability in earnings. Legal risk creates variability in earnings resulting from actions taken by our legal system.
Lawyers are never cheap and fines can be expensive! In a broader sense compliance risk reaches beyond violations of the legal system and includes violations of rules and regulations. For example, if a depository institution fails to hold adequate capital, costly corrective actions must be taken to avoid its closure.
These cor- rective actions are laid out in capital adequacy regulations and are examined in more detail in Chapter Reputation risk is the uncertainty associ- ated with public opinion. Strategic Risk Variations in earnings due to adverse business decisions, improper implementation of deci- sions, or lack of responsiveness to industry changes are parts of what is called strategic risk.
This risk category can be characterized as the human element in making bad long- range management decisions that reflect poor timing, lack of foresight, lack of persistence, and lack of determination to be successful.
Because variability in capital stems from other types of risk it is often not considered separately by government regulatory agencies. However, risks to the capital that underlies every financial firm captures the all-important risk of insol- vency or ultimate failure. For example, if a bank takes on an excessive number of bad loans or if a large portion of its security portfolio declines in market value, generating serious capital losses when sold, then its equity capital account, which is designed to absorb such losses, may be over- whelmed.
If investors and depositors become aware of the problem and begin to withdraw their funds, regulators may have no choice but to declare the institution insolvent and close its doors. Moreover, in the case of depository institu- Paul Newman as an tions, depositors not covered by insurance also risk losing a substantial portion of their incarcerated bank robber who had stolen funds.
For this reason, the prices and yields on capital stock and on large uninsured millions from the banks deposits can serve as an early warning sign of solvency problems. When investors believe to which he sold and that a financial firm has an increased chance of failing, the market value of its capital stock installed security usually begins to fall and it must post higher interest rates on its borrowings in order to systems and then attract needed funds.
Economists call this phenomenon market discipline: Where the security prices in the financial marketplace move against the troubled firm, forcing it to Money Is.
This ratio often falls if investors come to believe that a financial firm is undercapitalized relative to the risks it has taken on. downloadd funds usually include unin- sured deposits and borrowings in the money market from banks, nonbank corporations, and governmental units that fall due within one year. Risk assets consist mainly of loans and securities and exclude cash, plant and equipment, and miscellaneous assets.
Some authorities also exclude holdings of short-term government securities from risk assets because the market values of these securities tend to be stable and there is always a ready resale market for them. Concern in the regulatory community over the risk exposure of depository institutions has resulted in heavy pressure on their management to increase capital. This usually means reducing operating expenses and increasing the productivity of their institutions—can most employees through the use of automated equipment and improved employee training.
The easily be found at such Web sites as government deregulation movement has forced depository institutions, for example, to pay www. Among the most revealing mea- www.
Usually medium-size face less risk of losing earnings or market share. Several recent studies have found, for exam- and larger institutions ple, that some banks in this situation display expense preference behavior: Unfortunately for the stockholders of these institutions, a preference for expenses sacrifices profits and limits potential gains in stock values. This is espe- cially true of those nonbank financial institutions that are private, profit-making corpora- Factoid In recent years FDIC- tions, including stockholder-owned thrift institutions, insurance companies, finance and insured savings credit-card companies, security broker and dealer firms, and mutual funds.
For Net interest margin Equity multiplier example, for all of Asset utilization ratio Cash accounts to total assets commercial banks Nonperforming assets to equity capital ratio Interest-sensitive assets to interest- reported an average ROA of 1.
For savings associations. Insurers also pay close attention to an efficiency measure—the combined ratio of claims paid out plus operating expenses relative to premi- ums earned from policyholders. Among mutual funds, key performance markers include the growth of net sales i.
In contrast, finance and credit-card companies often pay close attention to the growth of their outstanding debt and their gross receivables a measure of total loans extended to customers.
Finally, among com- peting depository institutions, such as credit unions and mutual savings associations, key performance measures include total loans to members relative to capital reserves a measure of risk , home mortgage loans to total assets a rapidly growing credit ser- vice , and the number of actual members customers relative to potential members customers.
No financial institution can safely ignore its level of performance today relative to its past performance and relative to its competitors. Most of the performance ratios presented in this chapter are highly sensi- tive to the size group in which a financial institution finds itself. Similarly, the largest banks generally report the highest least negative nonin- terest margins because they charge fees for so many of their services.
Smaller and medium-size banks frequently display larger net interest margins and, therefore, greater spreads between interest revenue and interest costs because most of their deposits are small-denomination accounts with lower average interest costs.
In terms of balance-sheet ratios, many of which reflect the various kinds of risk expo- sure banks face, the smallest banks usually report higher ratios of equity capital to assets. Some bank analysts argue that larger banks can get by with lower capital-to-asset cushions because they are more diversified across many different markets and have more risk-hedg- ing tools at their disposal.
The biggest banks also appear to carry greater credit risk as revealed by their higher loan-loss net charge-offs to total loans and leases ratios. Data for all U. Size, Location, and Regulatory Bias in Analyzing the Performance of Banks and Competing Financial Institutions As we saw in the preceding section, the size of a financial institution often measured by its assets, deposits, or equity capital can have a highly significant impact on profitability and other performance measures.
For example, when we compare the performance of one financial firm with another, it is best to compare institutions of similar size. One reason is that similar-size financial firms tend to offer the same or similar services, so you can be a bit more confident that your performance comparisons have some validity.
To conduct even more valid performance comparisons, we should also compare finan- cial firms serving the same or similar market areas. Performance is usually greatly influ- enced by whether a financial-service provider operates in a major financial center, smaller city, or rural area. The best performance comparison of all is to choose institutions of sim- ilar size serving the same market area.
Unfortunately, in some smaller communities it may be difficult, if not impossible, to find another financial firm comparable in size. For example, in the banking community each regulator has a somewhat different set of rules banks must follow, and these government-imposed rules can have a profound impact on performance.
This is why comparison of financial firms in different countries is often so difficult and must be done with great caution. Even in the United States, with so many different regulatory agencies, analysts often stress the importance of comparing member banks of the Federal Reserve System against other member banks of the Federal Reserve System.
Very high likelihood of timely repayment of principal AAA: Extremely high capacity to repay. Strong ability to repay. Strong likelihood of timely repayment of principal A: Relatively strong ability to repay. Lowest investment grade rating with an acceptable capacity TBW Adequate capacity to service principal to repay.
Likelihood of default just above investment grade with some TBW Noninvestment grade and speculative in nature. Higher degree of uncertainty and greater likelihood of default than for higher-rated issues CCC: High likelihood of default. Subordinated to CCC obligations with less risk protection. Defaulted obligation. Key URLs banks, where possible, should be compared against that of other national banks, and state- If you wanted to chartered institutions should be compared against other state-licensed institutions.
If a compare the overall financial firm is an affiliate of a holding company, it can be revealing to compare its per- profitability of the insurance industry to formance with other holding company affiliates rather than with independently owned that of the banking institutions.
There is an old saying about avoiding comparing apples and oranges because of industry, where would their obvious differences; the same is true in the financial-services field. No two financial you look? The data firms are ever exactly alike in size, location, service menu, or customer base. The perfor- supplied by the mance analyst must make his or her best effort to find the most comparable institutions— American Council of Life Insurance at and then proceed with caution.
Compared to other financial institutions, more information is available about banks than any other type of financial firm. Bankers can also obtain peer group reports, which allow them to com- pare their bank with other institutions of comparable size; average reports, which provide mean ratio values for each peer group; and state reports, which permit comparisons between an individual bank and the combined financial statements of all banks in a given state.
Uniform Bank Performance Reports www. Commercial loans 9,, 8,, , 6. Individual loans 7,, 7,, —60, —0. Agricultural loans 25, 6, 18, Other loans and leases in domestic offices , , —64, — Loans and leases in foreign offices , , 37, Gross loans and leases 42,, 38,, 3,, Unearned Income 27, 25, 1, 5.
Loan and lease loss allowance , , —78, — Net loans and leases 41,, 37,, 4,, Treasury and agency securities 1,, 1,, —, — Municipal securities 86, 20, 66, Foreign debt securities 85 78 7 8. All other securities , 1,, —, — Interest-bearing bank balances 2,, 12, 2,, Federal funds sold and resale agreements 1,, , , Trading account assets , , —16, —8.
Total investments 6,, 3,, 3,, Total earning assets 47,, 40,, 7,, Noninterest-bearing cash and deposits due from other banks 1,, 1,, , 8. Premises, fixed assets, capital leases , , 46, 9. Other real estate owned 5, 6, —1, — Investments in unconsolidated subsidiaries 0 0 0 Acceptances and Other assets 2,, 3,, —, — Noninvestment other real estate owned 5, 6, —1, — Loans held for sale 23, , —, — Held-to-maturity securities 0 0 0 Available-for-sale securities 2,, 2,, —, — The financial statements we see in this analysis, however, are focused on a single bank.
The format of the UBPR is more detailed and extensive, but similar to the financial statements presented in Chapter 5. How well or how poorly has NCB performed in recent years? To put this analysis in context, we should recall that the U.
The year Treasury bond yield dropped to a year low in June of The lowered interest rates and disappointing stock returns inspired consumers to invest in real estate, which increased the prices of homes and other properties while increasing the demand for real estate loans.
In a period characterized by low, but volatile interest rates, investors and lenders talked about whether a real estate bubble was about to burst! Tables 6—5 and 6—6 indicate the principal assets, liabilities, and capital items held by this bank and show how these items and their components have increased or decreased in volume since the same time a year earlier.
In NCB increased its real estate loans item 1 by Essentially, NCB provided what customers wanted—financing for housing at a time when prices in the stock market were declining and securities i.
In Table 6—6 we see that deposits in foreign offices item 8 increased significantly, up more than 53 percent, while core deposits item 6 increased a mere 2. Core deposits are the sum of items 1—5 in Table 6—6, representing sta- ble funds that are less likely to be removed from the bank. Money market deposit accounts 9,, 8,, , Other savings deposits 4,, 4,, —40, —0.
Core deposits 20,, 20,, , 2. Deposits in foreign offices 5,, 3,, 1,, Total deposits 27,, 24,, 3,, Federal funds downloadd and REPOs 2,, 4,, —1,, — FHL borrowing with maturities less than 1 year , 22 , FHL borrowing with maturities greater than 1 year 1,, 1,, , Other borrowings with maturities less than 1 year 6,, 6,, —, —8.
Other borrowings with maturities greater than 1 year 7,, 2,, 4,, Acceptances and other liabilities 1,, 2,, —, — Total liabilities including mortgages 47,, 41,, 5,, Subordinated notes and debentures 1,, 1,, —20, —1. All common and preferred capital 3,, 2,, , Total liabilities and capital 52,, 46,, 6,, Overall, total deposits item 9 increased by As market interest rates increased the growth in core deposits subsided and NCB appar- ently worked to lock in longer-term nondeposit borrowings.
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