Page 81 - FINAL CFA II SLIDES JUNE 2019 DAY 5.2

Management Capabilities
The quality of a bank’s management influences the success READING 17: ANALYSIS OF FINANCIAL INSTITUTIONS
with which the bank is able to exploit profitable opportunities
while also controlling the level of risks taken.
MODULE 17.3: MANAGEMENT CAPABILITIES AND EARNINGS QUALITY

Risk management and control is critical for banks. This includes identification and control of different types of risk (e.g., credit, market, operating, legal, and
other). A bank’s internal control and governance systems (including an independent board) ensure that managers do not take undue risks or engage in self-
serving behavior. The board also sets appropriate levels of maximum allowable risk for the managers. Internal control systems should continuously
measure and monitor the myriad risks that the bank may be exposed to.

Earnings

Considered high quality if they are adequate (providing a rate of return above the cost of capital) as well as sustainable. Ideally, the trend in
earnings should be positive and the underlying accounting estimates (used to arrive at reported earnings) should be unbiased. Finally, earnings
should ideally be derived from recurring sources.

A major source of earnings of a bank is from investment in securities. Estimates used in the valuation of these securities may lead to biased
earnings. Both IFRS and U.S. GAAP use the concept of a fair value hierarchy based on types of inputs used in determining the fair value of
financial assets.
• Level 1 inputs are quoted market prices of identical assets.
• Level 2 inputs are observable but not quoted prices of identical assets. Examples of Level 2 inputs include quoted prices of similar assets,
quoted prices of identical assets in non- active markets, observable interest rates, spreads, and implied volatility. Level 3 inputs are non-
observable and hence subjective. For example, fair value may be derived from models or based on estimated future cash flows discounted at
an estimated discount rate.

In practice, banks often use the fair value hierarchy to label their assets (e.g., Level 2 securities are those whose value was determined using Level 2
inputs) or to label their valuation methodology (e.g., Level 2 methodology is defined as one that uses Level 2 inputs).
Similar to other companies, other subjective estimates (e.g., goodwill impairment, recognition of deferred tax assets, and recognition of contingent
liabilities) affects the quality of a bank’s earnings.

For a typical bank, major sources of earnings are (1) net interest income, (2) service income, and (3) trading income. Of these, trading income is the
most volatile year-to-year, and, hence, on a relative basis, banks with proportionally higher net interest income and service income would have more
sustainable earnings.