D. Asset Quality The assessment of asset quality involves much more than simply calculating past due and adverse classification ratios. In addition to assessing trends in classified assets, delinquent loans, and credit concentrations, the asset quality component takes into account management's ability to underwrite and administer credits in a prudent and sound manner. In that respect, the regulators will examine a banks loan policies, loan portfolios and the adequacy of the allowance for loan and lease losses The UBPR is a good starting point to begin extracting asset quality information. It is a very useful tool for identifying trends or outlying performance issues relative to a group of similar banks. Examiners use the UBPR to plan for examinations by identifying areas with potential credit exposure. Nonetheless, the UPBR will only take you so far in painting a picture of asset quality. Several financial ratios relating to asset quality are available in the UBPR. These ratios provide detail on balance sheet composition, off-balance sheet commitments, delinquencies, charge-offs, and portfolio mix. Four ratios to focus on when assessing asset quality include: 1. Asset Growth Rate - This ratio details the change in total assets over the past 12 months. 2. Non-current Loans and Leases to Gross Loans and Leases - This ratio reflects the percentage of loans that are 90 days or more past due, or are no longer accruing interest. 3. Net Losses to Average Total Loans and Leases - This ratio presents the level of net losses, on an annualized basis, as a percentage of the total portfolio. It takes into consideration any recoveries on prior period losses. 4. Loan and Lease Allowance to Total Loans - This ratio measures the allowance available to absorb loan losses relative to total loans outstanding. In relation to these ratios, answer the following questions: - Asset Growth Rate - What is the rate of asset growth and how would you characterize this growth? - What category dominated asset growth? - Non-current Loans to Gross Loans - How would you characterize the level of delinquencies? - Net Losses to Average Total Loans - What has the trend been? - Loan and Lease Allowance to Total Loans and Leases - What conclusions can you draw about the adequacy of the allowance? Of course, UBPR analysis is a starting point. You should also review your textbook which discusses the various bank assets in more detail. E. Capital After reviewing the previous four components, you should have developed a good idea as to what this bank's risk profile looks like. You will know whether they have weak or strong earnings record, any asset quality or liquidity problems and what the exposures are. The level of capital that would be considered satisfactory will vary according to the level of risk in a bank. Of course, the higher the risk, the greater the level of support required. Keep this in mind when you look at your bank's Uniform Bank Performance Report (UBPR). Even though a given bank's capital ratios are higher than peer, it does not mean that the bank has satisfactory capital. Peer ratio comparisons don't consider your bank's risk profile and don't provide a conscious assessment of a bank's capital position. It is not unusual that a bank with greater than peer capital levels might receive a lower capital rating. Basically, capital adequacy is examined relative to a given bank's risk profile and when you assess capital you need to consider any factor that impacts the bank. A short list of things that may impact the need for more or less capital include: 1. The quality, type, and diversification of assets - If your bank has high levels of classifications, sub-prime loans, high or unmonitored concentrations, aggressive underwriting, etc., you'll need higher levels of capital. 2. The quality of management - If the institution operates with bare minimum staffing levels or lower quality management, the risk profile is higher, requiring higher levels of capital. 3. The quantity and quality of earnings available for capital augmentation - When we talk about the quality of earnings, we consider whether earnings are from core banking operations or from anomalies such as gains on the sale of assets. The quantity of earnings is important because we are concerned with the bank's ability to augment capital via retained earnings. 4. Exposure to changing interest rates - Higher/lower interest rate risk impacts the risk profile and thus the need for more or less capital. 5. Anticipated growth (strategic plan/budget) - Regulators are concerned with what the capital needs will be going forward. This is assessed relative to earnings available for augmentation, as well as existing levels of capital. 6. Local economic conditions - If the bank's market is limited to one economic area or one industry, the risk profile is greater. The greater the diversification, the lower the risk. 7. Dividend requirements to shareholders or a holding company - Again, regulators are interested in what's available for capital augmentation to support growth and the risk profile. The above items are all qualitative factors. You should also use quantitative factors to assess capital. Some key ratios are provided in your UBPR, and include the following: 1. Tier 1 Leverage Capital Ratio (Tier 1 Capital/Average Assets) 2. Tier 1 Risk-Based Capital Ratio (Tier 1 Capital/Risk Weighted Assets) 3. Total Risk-Based Capital Ratio (Total Capital/Risk Weighted Assets) Your textbook provides definitions of the various capital categories in chapter 15. As you are reviewing your banks capital ratios, you should pay particular attention to the following: - The level of the capital ratios - How do they compare to peer? - What are the trends? - Which of these ratios showed the most significant change? - Why would one capital ratio show a greater change than another? Additionally, look to the growth rate section. - Can you explain any significant changes in the capital ratios? - What asset category dominated the growth or drop in total assets in recent times? - If its loan growth or decline does this loan change affect your bank's risk profile? You should also take a look at your textbooks continuing case assignment for chapter 15 which covers bank capital.