[Home] [Papers] [Courses] [Contact]

Jamal Munshi, Sonoma State Univesity
All rights reserved

A Simple Banking Model

In its simplest form, a bank is a business that borrows short term at low interest rates and lends long term at a higher interest rate and profits from the spread. The extent to which this spread can enhance the wealth of the bank's shareholders depends on how well managers can control costs and loan losses and optimize risks in carrying out the operations necessary to make the spread. The gross margin is reduced by the cost of running the operation that generates the spread and also by losses such as defaults, fraud, and theft. What remains is a fraction of the gross spread which we can refer to as the net spread. The net spread is the wealth managers deliver to stakeholders and it is divided up between owners and the tax man. The actual return on equity earned by owners is leveraged by the ratio of total assets to equity. The managers also take advantage of fractional reserve banking by holding only a small portion of their demand deposits in reserves. Increasing the fraction in reserves enhances the bank's liquidity but decreases the bank's profitability by limiting the loans it can make at any given level of reserves.

Bank management styles

Bank managers juggle a complex nexus of tradeoffs to reach their particular level of risk, return, diversification, and liquidity within regulatory constraints. In addition to capitalization and liquidity decisions, tradeoffs include the levels of loan default risk, marketing and origination costs, customer services and fees, loan servicing and collection, loan sales and securitization, and FDIC insurance. The intertwined tradeoff nature of the bank management variables allow bank managers to operate within a range of values of these variables. The choices that each management team makes may be used to identify its particular set of priorities, objectives, and management style.

In this study we compare the management styles of ten FDIC insured community banks in the North Coast region of California using 1997 data from the FDIC. We examine patterns in these data to infer management style and performance against the average California bank in the same asset class. We find that North Coast community banks are a mixed bag with a variety of management performance and styles. The banks in the sample span four asset classes and these are described in Table 1. The ten banks in the study are listed in Table 2. (LINK TO TABLES). The banks are compared according to asset and liability management used to generate the spread, operational efficiency to conserve the spread, and the level of risk. The data are summarized in a SET OF BAR CHARTS. In these charts, the ten banks in the study are identified by acronyms. The letters A thru D identify the averages for FDIC insured commercial banks in California in each of four asset classes. The acronym for North Coast Bank has been assigned as "NCNB".

Size of the banks in the study

The sample consists of ten community banks in Sonoma, Lake, and Mendocino counties of California. The total assets of the banks in the sample range from less than $40 million to over $700 million and span four FDIC defined asset classes. The asset classes are identified as A (less than $100 million), B ($100 million to $300 million), C ($300 million to $500 million), and D ($500 million to $1 billion). There are six banks in class A (North Coast bank, Bank of Willits, Clear Lake National Bank, Lake Community Bank, Bank of Lake County, and Sonoma Valley Bank), two in class B (Bank of Petaluma and Sonoma National Bank), one in class C (National Bank of the Redwoods), and one in class D (Exchange Bank). Sonoma Valley Bank, Bank of Willits, Lake Community Bank, Clear Lake National Bank, Bank of Lake County, Sonoma National Bank, and National Bank of the Redwoods are larger than the average bank in their class while Bank of Petaluma and Exchange Bank are somewhat smaller and North Coast Bank is tiny by comparison. The size data are shown in TA.GIF. The three largest banks in the sample, Exchange Bank, National Bank of the Redwoods, and Sonoma National Bank account for more than half of the $2 billion in total assets in the sample.


The purpose of bank capital is to absorb loan losses. Increasing bank capital is "good" because it decreases the probability of insolvency at any given charge-off rate; but it is also "bad" because it decreases the leverage multiplier which in turn decreases return on equity (ROE) at any given level of return on assets (ROA). The capitalization level chosen will depend on the manager's conservatism, the anticipated charge-off rate, and extent of diversification in the loan portfolio. Core capital data shown in EQUITYLLA.GIF range from 5 times loan loss allowance (National Bank of the Redwoods) to almost 14 times (Exchange bank) and show how managers differ in balancing safety against leverage. We see from these figures that seven out of ten banks in the sample are more aggressive than average. They set their capitalization at a reduced solvency spread in order to gain ROE by leverage. But three of the banks, Exchange Bank, Bank of Willits, and Bank of Petaluma, are more conservative than average, holding excess capital for safety and sacrificing some ROE to do so. In the figure EQUITY.GIF we express equity as a percent of total assets. It shows that Bank of Willits and Exchange Bank are capitalized well above average. The figures range from about 7% for Clear Lake National Bank to to over 15% for Bank of Willits. Clearly Bank of Willits and Exchange Bank managers have chosen safety over ROE leverage in making their capitalization decision.

An important way for bank managers to narrow the solvency spread and squeeze out more ROE for shareholders is to diversify their loan portfolio. In general, the more diversified the portfolio, the lower the solvency risk for a given spread and likewise it is possible to operate a lower solvency spread, and therefore lower capitalization, at the same level of loan risk. In this respect community banks are at a disadvantage when compared with national and regional banks for two reasons. First, they face the "big customer" problem. A single large business in the community may form a large part of their loan portfolio, and if that single customer defaults it may drive the bank into insolvency. A second diversification disadvantage borne by community banks by virtue of the nature of community banking is that their loan portfolio is tied to the local economy. For example, if the local economy is based on wine, the solvency of the bank may be controlled by the demand for wine or by agricultural pests and climactic events that threaten profitable wine production. For these reasons, large diversified banks can operate at a thinner solvency margin than small community banks by setting either higher charge-off rates or lower capitalization or both. Community bank capitalization and tolerable levels of loan losses may not be directly compared with those of regional banks and they typically must carry a higher capitalization rate.

Asset and Liability Management

Asset management decisions include asset utilization, asset allocation, and risk/returns characteristic of loans. Asset utilization refers to minimizing the level of non-producing assets within regulatory and risk tolerance constraints. In this sample, between 75% and 90% of bank assets are earning assets which was computed as (securities + loans) divided by total assets. Sonoma National Bank and Bank of Lake County show very high asset utilization and North Coast Bank and Lake Community Bank have the lowest utilization ratios. The utilization data are displayed in EA.GIF.

In addition to securities banks are also active in the fed funds market in which banks lend excess liquidity to each other. In FEDFUNDS.GIF we see that banks vary a great deal with respect to how much excess liquidity they hold. Bank of Lake County and Bank of Petaluma hold almost none while North Coast Bank and Bank of Willits hold more than 12% of their total assets in fed funds or reverse repos. This compares with an average of 6% held by the larger community banks and about 10% held by smaller banks.

If fed funds is considered an earning asset, then the asset utilization of the banks is seen to be significantly higher ranging from 82% for Lake Community Bank to over 95% for Bank of Willits. These figures are displayed in TEA.GIF. Except for Bank of Petaluma (about average) and lake Community Bank (below average) we find that most community banks in the North Coast have a total asset utilization ratio that is higher than California averages.

But, like capitalization, utilization also involves a trade-off that becomes evident when we examine the cash to deposits ratios shown in CASH.GIF and cash to transaction assets in LIQUIDITY.GIF. We see that Bank of Willits and Sonoma National Bank face the highest liquidity risk in the sample because they hold less than 4% of deposits or 15% of transaction assets in cash; and Lake Community Bank with a low utilization ratio maintains a safe liquidity level with over 12% of deposits or approximately 45% of transaction assets held in cash.

Safety from the depositor's point of view is not as important a function of liquidity as it has been historically because of the emergence of active and liquid fed funds, repo, and loan sales markets. However, an optimal liquidity level is still important to shareholders because activity in these markets is costly. Optimality in this case consists of balancing the cost of holding non-productive assets to enhance liquidity against the expense the bank may incur in repeatedly acquiring liquidity in the repo market.

Activity in the fed funds and repo markets is depicted in FEDFUNDS.GIF and FEDPURCHASED.GIF. We see from these figures that North Coast banks in general are net providers of cash in the interbank market for liquidity. The notable exceptions are Bank of Lake County and Bank of Petaluma which obtain upwards of 5% of their liquidity needs in this market in what may be termed an aggressive liquidity policy. North Coast Bank and Bank of Willits are exceptionally large liquidity providers. Small banks tend to have more of their assets in fed funds (fed funds sold and reverse repurchase agreements) than larger banks.

An alternate measure of liquidity that includes the use of fed funds is a ratio of total short term assets including fed funds sold to total short term obligations including fed funds purchased. These ratios are shown in LIQ2.GIF and LIQ3.GIF. They show that North Coast Bank, Lake Community Bank, Bank of Willits, and Sonoma Valley Bank maintain exceptionally high liquidity holding more than 15% of their short term liabilities in short liquid assets while Bank of Lake County, Sonoma National Bank, Bank of Petaluma, and Exchange Bank have a more aggressive liquidity policy and hold less than 10% of their short term obligations in liquid assets. These ratios are significantly higher (20% to 60%) when term deposits are removed from the liability side.

In principle, the fed fund market provides banks a vehicle to diversify their liquidity wherein temporary and unpredictable shortfalls in some banks are made up by borrowing from equally temporary and unpredictable excesses in others. In such a case the fed fund holdings for each bank will cancel and average long term holdings will be close to zero. But this is not the case for all the banks in this study. Some banks such as North Coast Bank and Bank of Willits show large positive sustained average fed funds balances. These banks appear to be using fed funds as earning assets. Others such as Bank of Petaluma and Bank of Lake County that show a net fed funds liability appear to be using the fed funds market to fund earning assets. The strategy appears on the surface to be suboptimal in either case since 5% is a relatively low yield for assets and a high cost of funding earning assets.

Earning assets consist of loans, which earn higher interest but are subject to default, and Treasury and Agency securities, which may be thought to be free of default risk. We show this allocation as the percent of earning assets held as loans in LOANS.GIF. Here we see a large of range of values with Sonoma National Bank, once again as the most agressive bank, holding almost 95% of its earning assets as loans. This figure is extremely high relative to state-wide averages which are well below 75%. The most conservative asset allocator is Bank of Willits which holds more securities than loans in its portfolio. Bank of Lake County, Exchange Bank, and Bank of Petaluma are also conservative with less than 65% of earning assets as loans. The asset allocation decision is used by managers to set their level of risk and returns.

The interest rate earned on loans depends both on managers' marketing and sales ability and on the level of risk taken. Good asset management results in high interest on loans with relatively low risk. But it is also possible to increase the overall returns on loans by making high risk loans at very high interest rates. These dynamics and tradeoffs are apparent when we compare the yield on earning assets shown in YIELD.GIF as well as the loan loss allowance figures in LLA.GIF. Once again, we see a very wide spectrum of performance and managerial choices in the sample. Sonoma National Bank earned the highest returns, an astonishing 9.6% on earning assets in 1997, and it did so with a loan loss allowance of slightly over 1%, the lowest in the sample. Bank of Lake County, at less than 8%, earned the lowest yield, and with the highest loan loss allowance ratio of almost 3%. Clearly there is a variety of asset quality management and marketing and sales ability among these banks; and they provide an excellent opportunity for comparative analysis to students of bank management.

Marketing is also important in liability management. Bank managers must fund their earning assets at as low a cost as possible to deliver a large and profitable margin. Exchange Bank, which seems conservative and unspectacular on the asset side, is the clear leader in liability side management as we can see when we we compare the cost of funding earning assets shown in COST.GIF and the gross interest rate spread shown in SPREAD.GIF. Exchange Bank managers have access to funds at less than 2.5% while cost of funds at Sonoma National Bank is well over 4%. High cost of funds at Sonoma National Bank negates its yield advantage and leaves the bank with a gross interest rate spread of less than 5.4%. At the same time low cost of funds at Exchange Bank allows managers to overcome weaknesses in other areas to post a spread of over 6%, second only to North Coast Bank's 6.5% and significantly higher than the California average 5.2% in the same asset class. In contrast, North Coast Bank achieves a spectacular spread by combining less than spectacular cost of funding with good yield on earning assets.

Efficiency of Operations

Generating the spread is costly because it takes office rent, marketing costs, customer services, loan processing, and loan losses to maintain the spread. These costs reduce the spread so that the net spread delivered by managers to stakeholders is significantly smaller than the gross spread. In very efficient operations these costs are low and more of the spread is preserved but inefficient operations are unable to conserve as much of the margin.

The FDIC publishes a measure of inefficiency computed as non-interest expense over total expense. These values are shown in FDIC.GIF. The values for the asset class averages, A, B, C, and D, show that there are economies of scale in banking efficiency. Class A has the highest FDIC inefficiency (75%) and class D the lowest (60%). Among the banks in the sample, we find that North Coast Bank and National Bank of the Redwoods are the least efficient with FDIC inefficiencies exceeding 75. Sonoma National Bank and Bank of Willits are the most efficientwith FDIC inefficiencies approaching 50. Bank of Petaluma and the all the class A banks except for North Coast Bank are more efficient than average.

We may also compare efficiency as the percent of gross spread that survives as net spread. This measure, shown in EFFICIENCY.GIF, is somewhat more discriminating than the FDIC measure because it does not penalize managers who overcome higher non-interest expense by using that expense well to generate higher spreads. Once again Sonoma National Bank and Bank of Willits are the most efficient banks in the sample but the Bank of Willits appears more efficient than Sonoma National Bank by this measure of efficiency. North Coast Bank retains its position in the efficiency cellar by either measure; but the other five small banks in class A are more efficient than the average class A bank possibly because of size. The average class A bank has $56 million in assets and is significantly smaller than the small banks in the study except for North Coast Bank. Exchange Bank and Bank of Petaluma are of average efficiency and National Bank of the Redwoods appears to be less efficient than average bank in its asset class.

Efficiency may also be indicated using a salary productivity measure defined as the dollars of pre-tax operating earnings generated per dollar of salary expense. The results are shown in PRODUCTIVITY.GIF. Once again we find that Bank of Lake County, Sonoma National Bank, and Bank of Willitsk are the efficiency leaders with Bank of Lake County managers producing over $2 of operating income per dollar of salary expense. The other 5 banks produce less than a dollar of operating earnings per dollar of salary. North Coast Bank and National Bank of the Redwoods generate less than 50 cents of operating earnings per dollar of salary and come out as the least efficient by this measure.


Exchange Bank, the largest bank in the sample, enjoys a very low cost of funds and this advantage allows the bank to overcome otherwise conservative and sluggish performance. On the other hand, the much smaller Sonoma National Bank with very efficient and aggressive management overcomes a very high cost of funds to deliver a better net interest rate spread than Exchange Bank by earning a very high yield on its portfolio and controlling office costs. These banks pose an interesting contrast to Bank of Willits which combines all aspects of good management to generate a high net spread.

The National Bank of the Redwoods, the second largest bank in the sample, is surprisingly inefficient with a very large salary expense. The Bank of Petaluma that may be described as average with good management and an efficient operation and somewhat conservative but safe portfolio. All of of the small banks in the sample except for Bank of Willits show evidence of efficient well managed banks but with specific drawbacks. Lake Community Bank and Clear Lake National Bank suffer from a high cost of funds. Sonoma Valley Bank and Bank of Lake County face higher than average loan risk but both offer excellent efficiency and spread management; and North Coast Bank suffers from operational inefficiency possibly because of its small size.

The ten banks in the study offer a good case study of small bank management because of their varied strengths, weaknesses, and management styles. The findings are summarized according to the MEASURE OF PERFORMANCE used and FOR EACH BANK in the study. The measures of efficiency used assume that managers are agents of external owners and may be misleading in cases where the banks are run by owner-managers who may choose salary rather than dividends as a method of recovery.

[report] [summary by bank] [summary by measure] [figures] [tables]
[Home] [working papers] [webcam] [email]