Problem:
On July 27, 1998, Pueblo Bank and Trust paid $1.1m for $47m of assets and $225 million of insured deposits of failed BestBank, headquartered in Boulder, Colorado. State bank regulators had closed BestBank on July 23 after they concluded that the bank had $135 million in categorized (problem) loans which were largely uncollectable and the bank’s $23 million in capital was inadequate to support the expected loan losses…. BestBank’s primary product was subprime credit card loans. The term ‘subprime’ refers to high level of risk which results from such cards being issued to high-risk individuals who would be anticipated to default in higher numbers compared to ‘prime’ or low-risk borrowers… Although banks fail for dissimilar reasons, BestBank is unusual since it had consistently reported profits which were well above averages for comparable-sized Colorado and national banks. How can a bank that is earning above average profits fail?... (Bank Management, T W Koch, S S MacDonald).
Required:
Question 1: Banks use Return on Assets (ROA) as a main tool to examine bank’s performance. Decompose the ROA showing clearly the various formulas employed to compute the expenditure ratio and asset utilization.
Question 2: What are the main sources of risk facing bank managers? Illustrate out how each potentially influence bank performance.