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THE AUSTRALIAN NATIONAL UNIVERSITY School of Finance, Actuarial Studies and Applied Statistics College of Business and Economics Financial Intermediation and Debt Markets Tutorial 2 - Answers Question 1 Go to the FDIC website https://www.fdic.gov/bank/statistical/ and download the December 2009 and the December 2010 call reports for Bank of America (National Association, Charlotte NC) and Citibank (N.A., Las Vegas NV) to answer the following questions. [From the page click on Central Data Repository (CDR), then select “call report”. In the search box type in the names of the bank and required dates, press enter and then download the files] a. Calculate the return on equity (ROE) for each of the banks in December 2009. Answer: ROE = net income/total equity = RIAD4340/ RCFD3210 BoA = 5,643,593/166,163,746=3.40% Citi = -2,794,000/116,599,000=-2.40% b. For each of the banks in December 2009, perform DuPont analysis and break up ROE into its component parts (i.e. return on assets, equity multiplier, net profit margin, asset utilization.) Answer: ROA = net income/total assets = RIAD4340/ RCFD2170 BoA = 5,643,593/ 1,465,221,449=0.39% Citi = -2,794,000/ 1,161,361,000=-0.24% EM = total assets/total equity = RCFD2170/ RCFD3210 BoA = 1,465,221,449/166,163,746=8.82 Citi = 1,161,361,000/116,599,000=9.96 Operating revenue = RIAD4107 + RIAD4079 BoA = 47,911,887+33,339,138 Citi = 45,788,000+12,090,000 PM = net income/operating revenue = RIAD4340/(RIAD4107 + RIAD4079) BoA = 5,643,593/(47,911,887+33,339,138)= 6.95% Citi = -2,794,000/(45,788,000+12,090,000)=-4.83%

AU = operating revenue/total assets =(RIAD4107+RIAD4079)/ RCFD2170 BoA = (47,911,887+33,339,138)/1,465,221,449=5.55% Citi = (45,788,000+12,090,000)/1,161,361,000=4.98% c. Which bank is more profitable according to these measures? Answer: BoA looks to be more profitable and is also less levered. d. Calculate the return on equity (ROE) for each of the banks in December 2010. Answer: ROE = net income/total equity = RIAD4340/ RCFD3210 BoA = 9,054,794/ 171,325,208=5.29% Citi = 7,904,000/ 127,090,000= 6.22% e. For each of the banks in December 2010, perform DuPont analysis and break up ROE into its component parts (i.e. return on assets, equity multiplier, net profit margin, asset utilization.) Answer: ROA = net income/total assets = RIAD4340/ RCFD2170 BoA = 9,054,794/ 1,482,278,257=0.61% Citi = 7,904,000/ 1,154,293,000= 0.68% EM = total assets/total equity = RCFD2170/ RCFD3210 BoA = 1,482,278,257/171,325,208=8.65 Citi = 1,154,293,000/127,090,000=9.08 Operating revenue = RIAD4107 + RIAD4079 BoA = 43,173,074+ 26,665,559=69838633 Citi = 40,820,000+ 15,545,000=56365000 PM = net income/operating revenue = RIAD4340/(RIAD4107 + RIAD4079) BoA = 9,054,794/(43,173,074+ 26,665,559)= 12.97% Citi =7,904,000/(40,820,000+ 15,545,000)= 14.02% AU = operating revenue/total assets =(RIAD4107+RIAD4079)/ RCFD2170 BoA = (43,173,074+ 26,665,559)/1,482,278,257=4.71% Citi = (40,820,000+ 15,545,000)/1,154,293,000=4.88% f. Which bank is more profitable according to these measures? Answer: Citi looks to be more profitable and is also more levered.

g. Can you explain any changes that occur over the year? Do these calculations highlight any problems with simple ratio analysis at any given point in time? Answer: In the year between December 2009 and December 2010, Citibank not only went from negative to positive profitability but it is also now more profitable than BoA. The main reasons for this significant change is that Citibank was more exposed to subprime risk (through positions in asset backed securities such as CDOs and CMOs) than BoA - which lead to massive losses on its balance sheet. As the financial system slowly recovered from the crisis, business returned to 'normal'. The analysis here shows that it is important not only to look at ratios between firms at any given point in time (cross-sectional analysis) but that it is also very important to consider changes in ratios over time (time-series analysis). h. Is this information enough to conclude that one bank is ‘better performing’ than the other? What other factors may you look at? From the call reports, can you come up with some ratios that measure these other factors that an analyst should consider? Answer: This analysis only considers the profit/return to investing in the bank. It ignores that riskiness of the bank. An important consideration is how risky the banks are relative to each other. I higher return that is generated by taking higher risks does not necessarily translate to ‘better performance’. Ideally, we would like a risk-adjusted return. Other ratios that one might look at include proxies for the riskiness of the bank including: loan charge-offs/loans; non-performing loans/loans; loan loss provisions/loans; liquid assets/liquid liabilities; interest sensitive assets/interest sensitive liabilities and so on. Question 2 Use the Quarterly Authorised Deposit-taking Institution Performance Statistics file you downloaded last week to answer the following: a. Produce a graph to compare the profit margins of the “Big 4” banks and smaller domestic banks for the 2004-2021 period. b. Produce a graph to compare the ROE of the “Big 4” banks and smaller domestic banks for the 2004-2021 period. c. Produce a graph to compare the deposits-to-assets ratio of the “Big 4” banks and smaller domestic banks for the 2004-2021 period. d. Produce a graph to compare the capital ratio of the “Big 4” banks and smaller domestic banks for the 2004-2021 period. e. Briefly comment on each of these graphs. Answer: See Excel Worksheet

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Question 3 a. Suppose the National Australia Bank (NAB) expects the net drain (i.e. outflow) on its cash position over the two days will be $100 million. The actual net drain after two days turns out to be $150 million. Is the NAB in a cash deficit or surplus? Explain the process through which the NAB would manage this unexpected cash position under normal circumstances. Answer: The NAB will be in deficit by $50 million. If this is the case, then the NAB will enter the interbank market to borrow funds on a short term basis from other banks. If it enters the Australian interbank market, it can borrow on an unsecured basis from other banks with surplus cash at the Bank Bill Swap rate (BBSW). Recall the level of the cash rate is determined by the RBA board on a monthly basis at the monthly board meeting. In some cases, it may borrow funds internationally at LIBOR. b. Suppose the NAB cannot manage its liquidity position using the process described in (a), describe the operation of one regulatory structure put in place by the Reserve Bank of Australia to minimize liquidity risk for Australian banks? Be detailed in describing the transactions that take place. Draw a diagram if it will help. Answer: If the NAB cannot raise funds from the interbank market then it must go to the lender of last resort to borrow (i.e. the RBA). The NAB can borrow from the RBA on a secured basis via a repurchase agreement (Repo transaction). In a Repo, the borrower (NAB) hands over collateral to the lender (RBA) in exchange for funding. The collateral is usually short-term, high quality and liquid (e.g. Treasury bill). This is known as the open leg. The two-parties also simultaneously enter into an agreement such that at maturity (e.g. in a day or two, or week) the borrower will repurchase the securities back from the lender for an amount greater than the amount lent in the open leg, the difference in the selling and repurchase price of the securities generates the return to the lender known as the repo rate. The RBA set the repo rate > BBSW so that banks are incentivized to use the interbank market before using the lender of last resort function. This is known as the close leg. If the borrower defaults, the lender keeps the collateral and sell it. The quality/value of the collateral is therefore very important in repo transactions. If the quality of collateral is low, the lender will apply a haircut to the collateral value to protect themselves. For example, if instead of handing over Treasury bills the NAB hands over BBB-rates corporate bonds, the RBA may apply a haircut of 20% meaning that for every $100 worth of bonds the NAB hands over, it will only receive $80 of funding. All countries provide this lender of last resort function for their banks. In the US it is referred to as discount window borrowing. A diagram is below.

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