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Analysis of earnings

Role of the Central Bank in Interbank Settlement | XVII. Study the Bank’s following tables, add the data on the Bank of England, and the NBU and state what is different and what is not in their performance. | Organization of Effective Bank Supervision | Introduction to the Legal Framework | I. Key terms | V. Study the following text and make up a plan, covering all crucial points | Introduction to the Camel Rating System | IX. Write a memorandum. | X. Read the passage below and explain the meanings of the words which have been highlighted. | VI. Study the following notes and prepare an oral presentation |


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Earnings are to be rated based upon their level (quantity) and their composition (quality). Both aspects of earnings must be appraised to derive the final rating. The quantitative aspect is to be evaluated by analyzing the bank's return on assets relative to its peer group mean or average. The peer group approach is utilized in appraising the quantitative aspect of earnings because income and expense items vary greatly depending upon the size and nature of a bank's operations. The preliminary assessment derived from peer group analysis is then modified, if necessary, to reflect the qualityorcomposition of the bank's net income. This step is essential. No rating is to be assigned to earnings without a careful consideration of the quality of earnings.

The quantitative aspect of earnings is evaluated through an analysis of the bank's return on assets (defined as net income divided by the average total assets) relative to the three-year mean for its particular peer group. The following total asset level cutoffs define the nationwide peer groups to be used for the earnings analysis:

under $50 million

$50 million to $100 million

$100 million to $300 million

$300 million to $1 billion

$1 billion to $5 billion

over $5 billion

 

A three-year mean return on assets is derived for each peer group and a three-year average return on assets is calculated for each peer group bank. This permits the determination of cutoffs, or benchmark ratios, based upon the three-year peer group array against which an individual bank's return for any given year can be compared. Cutoffs that divide the three-year peer group array into the highest 1 5 percent, the top 50 percent, the next 35 percent, and the bottom 15 percent will be used to set the ratio benchmarks. These benchmarks will then be used as standards against which an individual bank's return on assets for any given year will be evaluated. The use of three-year data to set standards diminishes the immediate effect of an industry-wide decline in earnings on the standards of performance, thus making the earnings criteria more stable and less subject to cyclical changes.

In practice, the examiner will compare a bank's most recent full year's return on assets with the benchmarks to determine a bank's preliminary earnings rating. Interim year-to-date earnings, especially for examinations conducted later in the year, must also be considered in assigning a final rating. As discussed below, the quality or composition of earnings is also a factor to be weighed in arriving at a final earnings rating.

Since the return on assets ratio alone does not always present a wholly reliable picture of a bank's earnings performance, the quantitative evaluation must be modified, if appropriate, to reflect the quality or composition of net income. Judgment must be brought to bear in determining the adequacy of transfers to valuation reserves and the extent to which securities transactions, tax effects, or any other unusual items contribute to net income. The quantitative evaluation may be modified upward or downward in a manner consistent with the definitions below in the event that an analysis of the composition of net income supports such an adjustment. Other things equal, net income that reflects, to an overly large degree, inadequate loan loss provisions, substantial tax credits, outsized securities gains, or significant non­recurring income items, is generally of lower quality than net income of similar magnitude that derives basically from operations and has not been materially influenced in any of the foregoing ways. Thus, earnings that are judged to be of inferior quality may be downgraded from the rating suggested in the preliminary assessment, since an inability to generate sufficient income from operations constitutes a serious deficiency and must be properly reflected in the final earnings rating.


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Component ratings| Analysis of liquidity

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