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In bank analysis, does size really matter?

Regulators and analysts look at a half dozen key measures when they assess a bank’s health, said Boise-based John Hale, managing partner with KPMG, LLP. Banks are among the international audit and tax advisory firm’s clients.
“Everybody analyzes a bank the same way, no matter its charter or size,” he said.
Hale said a bank must look at its loan portfolio and figure how many of those borrowers likely will stop paying in the next 12 months. The bank also must figure how much of a loss it will take if a loan or loans stop performing and collateral must be sold. The bank has to fund the allowance for loan losses and leases out of current earnings — it’s an expense that reduces earnings. Analysts look at Allowance for Loan and Lease Losses (ALLL) divided by total loans.
“If that ratio is consistent, when a bank is growing they are adding good loans. They are not adding bad or more risky loans,” he said. “If you see that ratio going up, it means the bank’s view of future losses is increasing; the numerator is increasing faster than the denominator.”
The “A-triple-L” says something about the banking industry and the economy now.
“Most banks aren’t growing their loan portfolio, so the denominator is staying fixed,” Hale said. “The number of bad loans at most banks is going up, so you would expect ALLL to total loans to increase.”
Banks are identifying more problem loans, and as the recession continues, more borrowers are having difficulty paying on their loans, he said.
As non-performing assets increase as a percentage of total assets, “that means earning assets are going down, and that means interest income and net income are going down,” Hale said.
If the coverage ratio of ALLL to non-performing loans is going up, that’s typically a good sign, Hale said. That means the allowance, set aside for future losses, is growing faster than non-performing loans.
For example, if a bank starts with a 1-to-1 ratio of a dollar of allowance to a dollar of non-performing loans and then sees the ratio increase to 1.25-to-1, it means problem loans are holding steady as the allowance increases. “It’s typically an indicator that things are better,” he said. But worsening conditions can be indicated if the ratio in this example falls below 1-to-1, meaning problem loans are increasing faster than the allowance for losses.
Analysts look at the balance between impaired loans and non-accrual loans. “There are rules that cause a bank to stop accruing interest,” Hale said.
Non-accrual and non-performing loans reduce the bank’s recognized interest income. As non-performers go up, interest income goes down, which drags down net income, he said.
Banks’ periodic reports to federal regulators indicate how much banks have on their books in construction loans, and how the totals compare to banking industry averages. These are short-term loans that the borrower plans to pay off with long-term financing later. The reports include construction-loan entries on single-family housing, multi-family housing and commercial property.
Analysts are paying close attention to retail commercial real estate loan totals now, Hale said.
Analysts also use what is known as Tier 1 and Tier 2 capital to measure a banks’ health.
Tier 1 is equity capital minus intangibles plus perpetual preferred stock (trust-preferred securities can be included), he said. Tier 2 adds the loan-loss reserve, and subordinated debt.
Analysts have become wary of using Tier 1 capital as a measure of a bank’s health, Hale said. There is not a lot of confidence in the transparency into Tier 1 capital, he said.
Tier 1 is a more reliable measure for analyzing smaller community banks than for big money-center banks, Hale said. Most community banks “did not engage in a lot of the exotic (securities) instruments, in general.” The market for those instruments isn’t very transparent, he added.
“I’m not saying Tier 1 capital is reliable in a smaller bank. I’m saying it’s more reliable,” he said. “I’m also not saying it’s not reliable — it’s just more reliable as an indicator of health in a small community bank than in a money-center bank.”
As for the big picture, Hale said the issue facing banks is effectively trading defaulting borrowers for good loans. 
“For American banks, the challenge will be how to loan money in a low-interest-rate environment for the next few years when a lot of their higher-priced assets, meaning loans, are not paying,” Hale said. Banks would continue to pay interest for deposits, but would receive less interest on loans — particularly if the number of interest-earning loans drops.
If a bank asks troubled borrowers to leave the bank or forecloses, it has fewer total loans on its books unless it makes new loans.
“The problem they have now is that they can run off the troubled borrowers … but it’s harder than it used to be to replace those earning assets with good loans,” Hale said.

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