Question

Bank Balance Sheet (Note: Use this information for all three problems)

Item                             Amount            Duration       Interest Rate       

Cash-type Securities       $50m                1.2 year             2.25%

Commercial Loans          $100m             2.4 years           4.50%

Mortgages                     $350m             8.0 years           6.50%

Core Deposits                $270m             1.0 year             2.00%

Notes Payable                $180m             2.0 years           4.50%

1. Deposit Outflow Analysis (6 points)

a. Calculate the bank’s assets (A), liabilities (L) and its current value, or equity (E).

b. Calculate the bank’s Net Income (Interest Income – Interest Expense) for the current year (ignore taxes here and below, and ignore any maturity values), and the bank’s ROA% and ROE%. (Return on Assets = Net Income / Assets).

Assume an unexpected $70m outflow of core deposits. The bank considers 2 options:

Option A: Issue $70m of new subordinated debt for 5.50%.

Option B: Sell $70m of its mortgage portfolio at full book value.

c. Under Option A, calculate the bank’s Net Interest Income, ROA (express as a percent), and ROE (express as a percent).

d. Under Option B, calculate the bank’s Net Interest Income, ROA and ROE (express ROA and ROE as a percent).

e. If maximizing ROA is the bank’s goal, which option should it use (report and compare the ROAs)? What if ROE is the goal (report and compare the two ROEs)?

Answer 1

(a) Assets:

Cash Type Securities, Commercial Loans and Mortgages will be counted as the bank's assets.

Total Asset Value = Cash Type Securities + Commercial Loans + Mortgages = 50 + 100 + 350 = $ 500 million

Liabilities:

Notes Payable and Core Deposits will be considered as the bank's liabilities

Total Liability Value = Notes Payable + Core Deposits = 180 + 270 = $ 450 million

Current Value(Equity) = 500 - 450 = $ 50 million

(b) Interest generated on cash type securities, mortgages and commercial loans will be interest incomes whereas interest generated on notes payable and core deposits will be treated as interest expenses.

Interest Income:

Cash Type Securities = 50 x 0.0225 = $ 1.125 million

Commercial Loans = 100 x 0.045 = $ 4.5 million

Mortgage = 350 x 0.065 = $ 22.75 million

Total Interest Income = 1.125 + 4.5 + 22.75 = $ 28.375 million

Interest Expense:

Core Deposits = 270 x 0.02 = $ 5.4 million

Notes Payable = 180 x 0.045 = $ 8.1 million

Total Interest Expense = 5.4 + 8.1 = $ 13.5 million

Net Income = 28.375 - 13.5 = $ 14.875 million

(c) Option A: Issuance of subordinated debt of $ 70 million will count as a liability. A reduction in liability of $ 70 million owing to loss of cash deposits is compensated for by this new liability of subordinated debt. Hence, the asset value, liability value and equity value remain unchanged. However, the interest expense part changes(as composition of liability changes) and the interest income part remains constant (as composition of assets is unchanged)

Interest Expense:

Notes Payable = 180 x 0.045 = $ 8.1 million

Core Deposits = (270 - 70) x 0.02 = $ 4 million

Subordinated Debt = 70 x 0.055 = $ 3.85 million

Total Interest Expense = 8.1 + 4 + 3.85 = $ 15.95 million

Net Income = 28.375 - 15.95 = $ 12.425 million

Total Assets = $ 500 million and Total Equity = 500 - 450 = $ 50 million

ROE = 12.425 / 50 = 0.2485 or 24.85 % and ROA = 12.425 / 500 = 0.02485 or 2.485 %

(d) Option B: Selling $ 70 million worth of mortgages at full book value.

This option would lead to a reduction in both assets and liabilities of the firm in the form of reduced mortgages (owing to sell off) and reduced core deposits(owing to outflow). This, in turn, would lead to a change in both total interest income and total interest expense, thereby impacting the firm's net income.

Interest Income:

Cash Type Securities = 50 x 0.0225 = $ 1.125 million

Commercial Loans = 100 x 0.045 = $ 4.5 million

Mortgage = (350 - 70) x 0.065 = $ 18.2 million

Total Interest Income = 1.125 + 4.5 + 18.2 = $ 23.825 million

Interest Expense:

Core Deposits = (270 -70) x 0.02 = $ 4 million

Notes Payable = 180 x 0.045 = $ 8.1 million

Total Interest Expense = 5.4 + 8.1 = $ 13.5 million

Net Income = 23.825 - 13.5 = $ 10.325 million

The firm's assets and liabilties will both reduce by $ 70 million, thereby keeping the equity constant at $ 50 million.

New Asset Value = 500 - 70 = $ 430 million, New Liability = 450 - 70 = $ 380 million

ROE = 10.325 / 50 = 0.2065 or 20.65 % and ROA = 10.325 / 430 = 0.02401 or 2.401 %

NOTE: Please raise a separate query for the solution to the remaining sub-part.