April 21, 2004

 

 

 

TO THE CHIEF EXECUTIVE OFFICER OF THE INSTITUTION ADDRESSED

 

 

The purpose of this letter is to discuss a revision of the Self-Examination Program that will become effective on May 1.  Please share this letter with others at your institution who review Self-Examination reports and, most importantly, with the personnel who prepare the Input Report.

 

Perhaps the most notable change to the program is the adjustment of net income reported by participating banks with a Subchapter S election.  Since these banks do not pay income taxes at the corporate level, their returns on assets and equity cannot be validly compared with banks that have not elected Subchapter S status.  The typically higher ROAs and ROEs calculated for Subchapter S banks can skew peer ratios, reducing the usefulness of these measures of comparability.

 

Beginning May 1, an assumed tax rate of 34.00 percent will be applied to net income reported by participating banks with a Subchapter S election.  This adjustment will affect two ratios – Return on Average Assets (“ROAA”) and Return on Average Equity.  The “adjusted” ratios of these banks will be used in peer calculations to improve comparability within peer groups.  However, ROAA will continue to be calculated without this adjustment for Subchapter S banks only.  This ratio, “Return on Average Assets (unadjusted)” will become an additional line item under the heading, Other Performance Indicators, on several output reports.  This ratio will not be used in the calculation of peer ratios.

 

Three new ratios are being added to the Self-Examination.  They are:

 

• Investment Securities Yield (Book).  This ratio will measure the yield on a bank’s investment securities portfolio.  The ratio will not be calculated on a tax-equivalent basis to reflect the benefit of tax-exempt securities.  A parameter will not be assigned to this ratio.  Calculation of the ratio requires a new line item on the Input Report – Interest and Dividend Income on Securities.
• Reserve for Loan Losses to Non-performing Loans (X).  This ratio will provide an indication of reserve coverage of a bank’s highest-risk credits.  It will be stated in terms of “number of times” and not as a percentage.  For example, assume the balance of a bank’s Allowance for Loan and Lease Losses is $100.  Assume, further, that the bank has $50 in loans that either are on nonaccrual or are 90 or more days overdue and still accruing.  The value of this ratio for the bank is 2.000 (X) – not 200 percent – indicating the balance of the loan-loss reserve is twice the balance of “non-performing” loans.  A parameter will not be assigned to this ratio.
• Net Loans to Total Deposits and All Other Funds.  Traditional measures of liquidity may be inadequate if a bank utilizes supplemental funding sources such as borrowings from the Federal Home Loan Bank (“FHLB”).  Reliance on such “wholesale” funds has increased to offset declining core deposit levels.  This ratio compares loan volume to virtually all funding sources, including deposits; federal funds purchased; securities sold under agreements to repurchase; FHLB borrowings; and subordinated notes and debentures.  The calculation does not reflect unused borrowing capacity.  The Self-Examination Program parameter is established at 80.000%.

 

As part of this revision, two ratios are being deleted from the Self-Examination Program.  These ratios are Loans Sold to Total Loans and Loans Purchased to Total Loans.  Accordingly, the numerators of these ratios will be eliminated as line items on the Input Report.  The line item, Commitments and Contingencies, also is being deleted from input and output reports.  The line item, Bankers Acceptances and Commercial Paper, also is being removed from the Input Report.

 

In addition to the new line item for income from securities, two other line items are being added to the Input Report.  They are Cash Surrender Value of Life Insurance, which should be included as a component of total earning assets, and Capital Injections-Current Month, which is being added to facilitate the reconciliation of total equity capital from month to month.

 

Other notable changes in the Self-Examination Program include:

 

§         The addition of a new output report showing the 13-month trend for all participating banks.  The ratios of every bank will be averaged for this report.

§         Modified asset peer group categories.  The smallest participating banks will be grouped in a category up to $74,999,999 in assets, while the largest banks will be those with total assets of more than $225,000,000.

§         A reconfiguration of geographic peer groups to reflect the most recent Group Map of the Arkansas Bankers Association.

§         Revised parameters for the following ratios:  Nonaccrual Loans to Total Loans, from 3.000 percent to 1.000 percent; Net Loans to Total Deposits, from 75.000 percent to 90.000 percent; and Other Borrowed Money to Total Assets, from 5.000 percent to 10.000 percent.

§         Updated Earnings Change Ratios (“ECRs”) used to calculate Income Statement Gap.  The ECRs are computed on data through March 31, 2004.

 

The new ECRs are included in a copy of the revised Self-Examination Program manual, which is scheduled to be mailed to all state-chartered banks and other participants on April 23.  The manual also contains a copy of the revised Input Report.  The revised manual will be put on the Bank Department Web site at:

http://www.arkansas.gov/bank/.

 

These changes are designed to keep the Self-Examination Program up to date and reflective of current trends in Arkansas banking.  At the same time, one of our primary objectives – to keep the program simple in format and “user friendly” – has not changed.  We genuinely hope these changes add value to the program and are consistent with this objective.  As always, we welcome your feedback.