FINC 3321 Part 6 Integrative Problem - Forecasting Bank Performance

FINC 3321

Part 6 Integrative Problem

Forecasting Bank Performance

As an analyst of a medium-sized commercial bank, you have been asked to forecast next year’s performance. In June you were provided with information about the sources and uses of funds for the upcoming year. The bank’s sources of funds for the upcoming year are as follows:

The bank also has $1 billion in capital.

The bank’s uses of funds for the upcoming year are as follows:

The bank also has $900 million in fixed assets. The interest rates on loans to small and large businesses are tied to the T-bill rate and will change at the beginning of each new year. The forecasted Treasury bond rate is tied to the future T-bill rate, based on the expectation that an upward-sloping yield curve will exist at the beginning of next year. The corporate bond rate is tied to the Treasury bond rate, allowing for a risk premium of 2 percent. Consumer loans will be provided at the beginning of next year, and interest rates will be fixed over the lifetime of the loan. The remaining time to maturity on all assets except T-bills exceeds three years. As the one-year T-bills mature, the funds are to be reinvested in new one-year T-bills (all T-bills are to be purchased at the beginning of the year). The bank’s loan loss percentage reflects the percentage of bad loans. Assume that no interest will be received on these loans. In addition, assume that this percentage of loans will be accounted for as loan loss reserves (assume that they should be subtracted when determining before-tax income). The bank has forecasted its noninterest revenues to be $200 million and its noninterest expenses to be $740 million. A tax rate of 34 percent can be applied to the before-tax income in order to estimate after-tax income. The bank has developed the following probability distribution for the one-year T-bill rate that will exist as of the beginning of next year:

Questions

1. Using the information provided, determine the probability distribution of return on assets (ROA) for next year by completing the following table:

2. Will the bank’s ROA next year be higher or lower if market interest rates are higher? (Use the T-bill rate as a proxy for market interest rates.) Why? The information provided did not assume any required reserves. Explain how including required reserves would affect the forecasted interest revenue, ROA, and ROE.

3. The bank is considering a strategy of attempting to attract an extra $1 billion as one year negotiable certificates of deposit (NCDs) to replace $1 billion of five-year NCDs. Develop the probability distribution of ROA based on this strategy:

4. Is the bank’s ROA likely to be higher next year if it uses the strategy of attracting more one-year NCDs?

5. What would be an obvious concern about a strategy of using more one-year NCDs and fewer five-year NCDs beyond the next year?

6. The bank is considering a strategy of using $1 billion to offer additional loans to small businesses instead of purchasing T-bills. Using all the original assumptions provided, determine the probability distribution of ROA (assume that noninterest expenses would not be affected by this change in strategy).

7. Would the bank’s ROA likely be higher or lower over the next year if it allocates the extra funds to small business loans?

8. What is the obvious risk of such a strategy beyond the next year?

9. The strategy of attracting more one-year NCDs could affect noninterest expenses and revenues. How would noninterest expenses be affected by the strategy? How would noninterest revenues be affected by the strategy?

10. Now assume that the bank is considering a strategy of increasing its consumer loans by $1 billion instead of using the funds for loans to small businesses. Using this information along with all the original assumptions provided, determine the probability distribution of ROA.

11. Other than possible changes in the economy that may affect credit risk, what key factor will determine whether this strategy is beneficial beyond one year?

12. Now assume that the bank wants to determine how its forecasted return on equity (ROE) next year would be affected if it boosts its capital from $1 billion to $1.2 billion. (The extra capital would not be used to increase interest or noninterest revenues.) Using all the original assumptions provided, complete the following table:

Briefly state how the ROE will be affected if the capital level is increased.