Analyzing Bank Financial Statements and Performance

Bank Analyst Training Charlottesville, VA

July 27, 2016

Erik Oja Emily Parker

Presenter Overview

Erik Oja Banking Industry Analyst S&P Global Market Intelligence Erik Oja has covered U.S. banks at S&P GMI (formerly S&P Equity Research), since 2006. He is a frequent contributor to CNBC, Wall Street Journal, Reuters, BNN, and American Banker. Erik also covers Canadian banks, consumer lenders, and asset managers. Previously, he worked as a buy side analyst at a pension plan for savings banks. Prior to that, he was a financial analyst at the same firm. He has an MA in Economics from New York University, and a BA in Economics from State University of New York at Buffalo.

Emily Parker Product Manager, Financial Institutions Group S&P Global Market Intelligence Emily Parker is a product manager at S&P GMI, with a focus on bank regulatory products, content, and services. Emily is focused on partnering with our banking customers to create new and useful tools that can help meet everyday challenges. Prior to joining S&P, Emily spent six years at JPMorgan Chase working in their Corporate Mergers & Acquisitions Group and Financial Planning & Analysis teams in New York City. Emily has a BS in Finance and International Business from Georgetown University in Washington DC, and is currently based in Richmond, VA.

2

Agenda

• Introduction & Session Goals • Risk

• Types of risk facing banks • Key risk ratios (CAMELS)

• Return • Types of returns available to bank investors • Key return ratios • Drivers of bank ROE/ROA performance

• Valuation and Peer Analysis • Key valuation ratios • Case Study

• Conclusion

3

Session Goals

● Learn the objectives, benefits and shortfalls of ratio analysis

● Examine bank risk using ratios within the CAMELS framework

● Evaluate bank performance and returns from an investor perspective using earnings metrics and multiples

● Perform peer analysis by identifying discrepancies in risk, return and valuation ratios across similar and dissimilar banking institutions

4

QUESTION 1: A bank in your investment portfolio has $40 million of non-performing energy loans. How much of a concern is this, and what else should you look at? QUESTION 2: A bank you are looking to invest in pays an 8% dividend, and has kept its payout steady for 12 years. Before buying this stock what questions should you ask? QUESTION 3: You are an investment banker advising a community bank on a potential sale. A similar bank recently sold for 2.0x tangible book value. What does tangible book value tell you, and what other factors should you consider?

Warm up

5

Bank Balance Sheet

Assets ● Cash ● Securities ● Fed Funds Sold & Reverse

Repos ● Loans & Leases ● Allowance for Loan & Lease

Losses ● Trading Assets ● Premises & Fixed Assets ● Other Real Estate Owned

(OREO) ● Intangible Assets

Liabilities ● Deposits ● Fed Funds & Repos ● Trading Liabilities ● Short Term Debt ● Long Term Debt

Equity ● Preferred Equity ● Common Equity ● Retained Earnings ● Minority Interest

6

Interest Income -Interest Expense Net Interest Income +Non Interest Income +Realized Gain / (Loss) on Securities - Non Interest Expense - Provision for Loan & Lease Losses Pre-tax Income -Income Tax Net Income

Bank Income Statement

7

PART II: RISK

8

Definition and Types

• What is Risk? “The chance that an investment (as a stock or commodity) will lose value” - Merriam Webster

• Types of risks facing banking institutions:

o Credit Risk - default on a debt o Market Risk - losses due to financial market performance o Operational Risk - system breakdown, procedure & people issues o Interest Rate Risk - loss in investment value due to change in interest rates o Liquidity Risk - asset cannot be traded quickly enough to prevent losses o Foreign Exchange Risk - loss in investment value due to change in currency

exchange rates o Sovereign Risk - risk that a government will not comply with terms of

contract o Reputational Risk - risk that perceptions of the brand of an institution will

result in financial losses o Systemic Risk - risk that a company activity could trigger collapse of an

entire industry

9

How do you evaluate bank risk?

C Capital Adequacy

A Asset Quality

M Management

E Earnings

L Liquidity

S Sensitivity

10

Key CAMELS Ratios Ratios So what?

Common Equity Tier 1 Capital Ratio Tier 1 Risk Based Capital Ratio Leverage Ratio

-Ability of bank to cover losses in times of stress -Measures risk of balance sheet (RWA) -Strips away less stable sources of equity to better measure financial stability and health

Non-Performing Loans / Loans Net Chargeoffs / Avg Loans Texas Ratios

-Quality of loans and health of portfolio -Highlights percentage of loans in default (or expected to be) -Ability of bank to underwrite and fund operations

Compensation growth Enforcement actions Legal settlements

-Qualitative assessments of how the bank is being run -Identifies if CEO is overcompensated, operational issues -Legal issues can result in bank failure or FDIC conservatorship

ROE ROAA Efficiency Ratio Net Interest Margin

-Ability of bank to generate net income using its balance sheet -How well a bank is able to turn its expenses into revenue -Bank’s focus on returning earnings back to its shareholders

Liquidity Coverage Ratio Net Stable Funding Ratio Liquidity Ratio Liquid Assets / Assets

-Measures bank’s ability to pay its own short term debt obligations with funding on hand -”Run on the bank” - Asset allocation - treasuries (liquid) vs. private equity (illiquid)

Long-Term Assets / Assets Rate-Sensitive Liabilities / Total Liabilities Assets Repricing within 1 year / Assets

-Sensitivity of a bank’s balance sheet to changes in interest rates -Leads to liquidity risk and drains on earnings if duration is mismatched

11

Capital Adequacy

CAMELS Ratio Calculation

Quarter Ended

Minimum 2008Q2 2016Q1

Common Equity Tier 1 Capital Ratio

Common Equity Tier 1 Capital Total Risk Weighted Assets

9.27% 12.45% 4.5%

Tier 1 Risk Based Capital Ratio

Tier 1 Capital Total Risk Weighted Assets

9.46% 12.54% 6.0%

Leverage Ratio Tier 1 Capital Average Total Assets

7.57% 9.54% 4.0%

• Common Equity Tier 1 Capital: “Core” capital to protect against losses. Common stock, retained earnings, AOCI, deductions, qualifying minority interest.

• Tier 1 Capital: Next phase of capital to protect against losses. Common equity tier 1 capital, noncumulative perpetual preferred stock, qualifying minority interest.

• Risk Weighted Assets: Bank assets weighted according to their risk (e.g., cash = 0%, high volatility commercial real estate loans = 150%)

• Main focus of regulation post 2008 • Evolution of Basel rules - Basel I vs. II vs. III

Based on U.S. Commercial Banking Aggregated data from Call Reports (FFIEC 031 / 041) Source: SNL Financial

12

Is meeting the regulatory minimums enough?

Source: FDIC

13

Stress Testing

• Comprehensive Capital Analysis and Review (CCAR) Capital Plans and Stress Tests • 2009 was the first year of post-crisis stress tests (SCAP) • CCAR is mandated by Dodd-Frank Act of 2010 • March 2011 marked the first CCAR stress test results and capital plans

• Large and regional banks increased their dividends and repurchases • A few banks did not get their capital plans approved right away

• March 2012 - June 2016 • Additional CCAR requirements each year • Expansion of CCAR to mid-sized regional banks and to foreign banks • Further increases of dividends and repurchases • Some banks did not get their capital plans approved

14

Stress Testing

• 2011 CCAR: • 19 U.S. banks with assets over $100 billion

• “Severely adverse” scenario assumed: • 1% GDP decline • 10% housing price fall • 11% unemployment

• 2016 CCAR: • 33 bank holding companies with assets over $50 billion

• Severely adverse scenario assumes: • 10% unemployment • Negative yields for short-term Treasuries • Mild deflation and moderate recession

15

CCAR Results

16

Capital Adequacy in the News

17

Asset Quality

CAMELS Ratio Calculation

Quarter Ended

2008Q2 2016Q1

Non-Performing Loans / Loans

(Nonaccrual Loans + Restructured Loans) Total Loans

1.59% 1.77%

Net Chargeoffs / Avg Loans

(Loan Chargeoffs - Loan Recoveries) Avg Loans

1.25% 0.45%

Texas Ratio (Nonperforming Assets + Loans 90D Past Due) (Tangible Equity + Loan Loss Reserve)

17.21% 13.96%

• Nonaccrual Loan: No longer generating interest due to financial difficulties of the borrower. More likely to default than a performing loan.

• Nonperforming Loan: Principal or interest has been overdue for over 90 days.

• Texas Ratio: Banks tended to fail when >100% Based on U.S. Commercial Banking Aggregated data from Call Reports (FFIEC 031 / 041) Source: SNL Financial

18

Asset Quality Impact on Bank Failure

19

Asset Quality Today - Oil Prices

20

Case Study: Cullen/Frost

• Disclosures vary by bank in their SEC documents, but some disclose their exposure by type of loan

• Cullen/Frost has 14% of its loan book in the energy sector

21

Case Study: Cullen/Frost

22

Management: Compensation

• Key Themes: • Shift in compensation from bonus

to salary to discourage risk taking • Size differences in compensation

structure • Clawbacks • % of cash vs. stock

23

Management: Enforcement Actions

24

Management: Legal Settlements

25

Earnings

CAMELS Ratio Calculation

Quarter Ended

2008Q2 2016Q1

Return on Average Equity (ROAE)

Net Income Average Equity

3.45% 8.42%

Return on Average Assets (ROAA)

Net Income Average Assets

0.35% 0.96%

Efficiency Ratio Operating Expense Operating Revenue

58% 60%

Net Interest Margin NII (Interest Income - Interest Expense) Average Earning Assets

3.27% 3.00%

Based on U.S. Commercial Banking Aggregated data from Call Reports (FFIEC 031 / 041) Source: SNL Financial

26

Earnings in the News

27

Liquidity

• What types of assets are liquid vs. illiquid? • Cash • Securities • Repos • OREO • Pledged Securities

CAMELS Ratio Calculation

Quarter Ended

Minimum 2008Q2 2016Q1

Liquidity Coverage Ratio (LCR)

High Quality Liquid Assets (HQLA) Net Cash Outflows

N/A 122%1 100%

Liquidity Ratio Liquid Assets Total Liabilities

27.56% 35.25%

Liquid Assets / Assets

Liquid Assets Total Assets

24.74% 31.26%

Based on U.S. Commercial Banking Aggregated data from Call Reports (FFIEC 031 / 041) 1Based on those financial institutions reporting LCR as of 2015 year end in their SEC filings Source: SNL Financial

28

Resolution Planning

29

Sensitivity

CAMELS Ratio Calculation

Quarter Ended

2008Q2 2016Q1

Long-Term Assets / Assets Securities & Loans that mature in >5 years Total Assets

21.62% 25.21%

Rate-Sensitive Liabilities / Total Liabilities

Deposits & Other Borrowings that mature < 1 year Total Liabilities

30.55% 13.13%

Assets Repricing within 1 year / Assets

Securities & Loans that mature in <1 year Total Assets

42.44% 45.31%

Based on U.S. Commercial Banking Aggregated data from Call Reports (FFIEC 031 / 041) Source: SNL Financial

30

Interest Rate Sensitive Banks

• Larger banks will disclose the impact to their NII based on changes in interest rates, either using an immediate or gradual 12-month scale

• To compare on an apples-to-apple basis, can screen for companies with the same methodology in their financial statements

31

Interest Rate Pricing Decisions

32

Yield Curve

33

Question

• A bank has $40 million of nonperforming energy loans. What tools do we have to analyze this? • Percent of lending portfolio • Net charge-offs • Worsening trends? • Contagion • Specific and general reserves • Capital ratios

34

PART III: RETURN

35

Definition and Types

● What is Return? ● Return as a measure of bank performance

o Return on Equity (ROE) o Return on Average Assets (ROAA)

● Returns available to bank investors: o Bond interest capital gains o Common equity capital gains o Common stock dividends, and preferred dividends o Takeovers o Private Equity Sales

● Return vs. Risk

36

Return Ratio Calculation

Quarter Ended

2008Q2 2016Q1

Return on Average Equity (ROAE)

Net Income Average Equity

0.1% 6.9%

Return on Average Tangible Equity (ROATE)

Net Income Average Tangible Equity

2.6% 7.5%

Return on Average Tangible Common Equity (ROATCE)

Net Income Average Tangible Common Equity

2.6% 7.8%

Return on Average Assets (ROAA)

Net Income Average Assets

-0.1% 0.7%

Dividend Yield Dividends Per Share Stock Price

2.3% 1.6%

Earnings Per Share (EPS)

Net Income Shares Outstanding

$1.55 $1.40

Key Return Ratios

Based on the average of GAAP financials of Listed banks in the US Source: SNL Financial, a product of S&P Global Market Intelligence

37

Financial Sector ROEs Are Currently Low

The S&P 500 currently has a 12% ROE, down from 18% a decade ago. The financial sector’s ROE is currently 9%, down from 17%.

Real estate 11.3%. Diversified Financials 10.0%. Banks 8.6%. Insurance 7.6%.

Source: S&P Indices.

38

Why are Financial Sector ROEs Low? • Financial companies are interest rate sensitive, in a low-rate environment

• Higher regulatory costs

• Greater liquidity requirements

• Higher loan loss provisions

• Larger legal settlements

• Basel III Capital requirements - higher risk weightings

• and so on...

Source: SNL Survey 39

Return on Equity (ROE)

ROE measures how well a company uses assets to generate earnings. The Dupont Analysis:

Net Income x Sales x Assets Sales Assets Equity

40

ROEs Vary Greatly

Source: S&P Indices

41

ROE Varies Widely Within Banks, by Business Line JPMorgan Chase’s ROE at March 31: 10.4%.

• Asset Management: 25% • Consumer & Community Banking:

19% • Corporate & Investment Bank: 11% • Commercial Banking: 11%

Look at “Pure Play” companies to compare ROE:

• Asset Management: • TROW: 23.0% • BLK: 11.2% • IVZ: 9.6%

• Credit card lenders: • AXP: 23.8% • DFS: 20.3% • COF: 8.3%

• Investment banks: • MS: 6.5% • GS: 5.1%

• Regional banks: • USB: 12.8% • HBAN 10.3% • BBT 8.1%

Why is Investment Banking a low ROE business? 42

One Way of Using ROE to Value Stocks

Are there any valuation discrepancies here? What could explain them?

43

Bank ROA

U.S. Bancorp 1.43%

Wells Fargo 1.32%

Fifth Third Bancorp 1.22%

PNC Financial Services Group 1.17%

BB&T Corp. 1.05%

Suntrust Banks 1.01%

JPMorgan Chase 0.99%

Citigroup 0.97%

Regions Financial 0.86%

Bank of America 0.75%

People’s United Bancorp 0.69%

ROAs

Source: S&P Indices.

• Like ROEs, ROA also varies by business segment.

• Citigroup’s ROA at March 31: 0.79%. • Citi Holdings ROA: 1.78%. • Global Consumer Banking ROA: 1.31%. • Institutional Clients Group ROA: 0.62%.

44

Using ROA to Spot Pricing Anomalies

Again, PBCT is an outlier. So is FITB. Why?

45

Dividends and Buybacks

• How should we look at dividend yields? • Comparison to banking peers • Comparison to the stock market • Historical payout ratios and yields • What is now allowed by regulators • Sustainability

46

Share Buybacks

Source: S&P Indices, SNL Financial.

Banks now spend more on buybacks than on dividends. Why?

47

Dividend Yield 2016 2006

Wells Fargo 3.1% 3.0%

BB&T Corp 3.0% 3.6%

Fifth Third Bancorp 2.9% 3.9%

JPMorgan Chase 2.8% 2.8%

Huntington Bancshares 2.5% 4.2%

Suntrust Banks 2.3% 2.9%

Bank of America 1.4% 3.9%

Citigroup 0.4% 3.5%

S&P 500 Banks 2.2% 3.2%

S&P 500 Financials 2.3% 2.3%

S&P 500 2.2% 1.8%

Dividend Yields

Source: S&P Indices, SNL Financial.

Bank dividend yields, for the stronger banks, are returning to pre-crisis levels.

48

Dividend Yields

Bank dividend yields historically were above-market, but are equal to the market now.

49

Dividend Payouts and Dividend Yields

Why is FITB is an outlier?

50

Question

• A bank has paid a $1.00 dividend, yielding up to 8%, for 12 years. What questions should we ask before buying this stock? • Bank performance • Bank asset size and key regulatory milestones • Capital needs • Takeovers • Management • Shareholder base

51

PART IV: VALUATION &

PEER ANALYSIS

52

Key Valuation Ratios

Return Ratio Calculation

Quarter Ended

2008Q2 2016Q1

Price / Earnings (P/E) Stock Price Earnings Per Share

18.5x 16.6x

Price to Book Value (P/B)

Stock Price Book Value Per Share

1.1x 1.1x

Price to Tangible Book Value (P/TBV)

Stock Price Tangible Book Value Per Share

1.2x 1.2x

Based on the average of GAAP financials of Listed banks in the US Source: SNL Financial, a product of S&P Global Market Intelligence

53

Question

• You are analyzing a bank that may be interested in putting itself for sale. A neighboring bank recently sold for 2.0X tangible book value. What are all the tools we can use to value a bank? • Deposit base • Economic growth of its service territory • Price to assets • Price to deposits and loans • Price to earnings

54

Wrap Up

Key takeaways: Important to compare across institutions with ratios & multiples Benchmark against institutions of similar size, complexity & operating model Financials don’t tell the whole story...and they’re late

QUESTIONS?

55

Appendix: List of Key Ratios

56

Ratio Calculation

Common Equity Tier 1 Capital Ratio Common Equity Tier 1 Capital Total Risk Weighted Assets

Tier 1 Risk Based Capital Ratio Tier 1 Capital Total Risk Weighted Assets

Leverage Ratio Tier 1 Capital Average Total Assets

Non-Performing Loans / Loans (Nonaccrual Loans + Restructured Loans) Total Loans

Net Chargeoffs / Avg Loans (Loan Chargeoffs - Loan Recoveries) Avg Loans

Texas Ratio (Nonperforming Assets + Loans 90D Past Due) (Tangible Equity + Loan Loss Reserve)

Efficiency Ratio Operating Expense Operating Revenue

Net Interest Margin NII (Interest Income - Interest Expense) Average Earning Assets

Appendix: List of Key Ratios

57

Ratio Calculation

Liquidity Coverage Ratio (LCR) High Quality Liquid Assets (HQLA) Net Cash Outflows

Liquidity Ratio Liquid Assets Total Liabilities

Liquid Assets / Assets Liquid Assets Total Assets

Long-Term Assets / Assets Securities & Loans that mature in >5 years Total Assets

Rate-Sensitive Liabilities / Total Liabilities Deposits & Other Borrowings that mature < 1 year Total Liabilities

Assets Repricing within 1 year / Assets Securities & Loans that mature in <1 year Total Assets

Return on Average Tangible Equity (ROATE) Net Income Average Tangible Equity

Return on Average Tangible Common Equity (ROATCE)

Net Income Average Tangible Common Equity

Appendix: List of Key Ratios

58

Ratio Calculation

Return on Average Assets (ROAA) Net Income Average Assets

Dividend Yield Dividends Per Share Stock Price

Earnings Per Share (EPS) Net Income Shares Outstanding

Price / Earnings (P/E) Stock Price Earnings Per Share

Price to Book Value (P/B) Stock Price Book Value Per Share

Price to Tangible Book Value (P/TBV) Stock Price Tangible Book Value Per Share

Copyright © 2016 S&P Global. Knowledge Center, a part of S&P Gl b l M k t I t lli di i i f S&P Gl b l I

59

Disclosure Copyright © 2016 by S&P Global Market Intelligence, a division of S&P Global Inc. All rights reserved. No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of S&P Global Market Intelligence or its affiliates (collectively, S&P Global). The Content shall not be used for any unlawful or unauthorized purposes. S&P Global and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Global Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Global Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P GLOBAL PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Global Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages. Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P Global Market Intelligence’s opinions, analyses and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P Global Market Intelligence assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P Global Market Intelligence does not act as a fiduciary or an investment advisor except where registered as such. While S&P Global Market Intelligence has obtained information from sources it believes to be reliable, S&P Global Market Intelligence does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. S&P Global keeps certain activities of its divisions separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain divisions of S&P Global may have information that is not available to other S&P Global divisions. S&P Global has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process. S&P Global may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P Global reserves the right to disseminate its opinions and analyses. S&P Global's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P Global publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.

60