Headquartered in Charlotte (NC), stands as the single-largest wealth management company worldwide under the acquisition of Merrill Lynch in 2008. BAC also has an outstanding retail banking presence as it is the only one of the Big 4 major money center banks with retail branches in all 50 states. The firm’s size can be attributed to the mergers and acquisitions through its history: Fleet Boston Financial, Countrywide Financial and NationsBank to name a few. The main competitors of Bank of America are the other three major money center banks in the United States: JPMorgan Chase, Wells Fargo and Citigroup. Consequently, the peer group used in this paper will refer to the Big 4. Based on both total assets and total deposits, Bank of America is ranked the second largest amongst the Big 4 as of 2018. The bank’s EPS of 1.91 is substantially below the peer group average of 5.02; however, its forecasted earnings growth by the end of this year is 39.28% over last year—which marks the highest against the other three banks.
Bank of America’s market capitalization is $270 billion and its net operating income is slightly over $8.5 billion. This report will analyze risks associated with Bank of America and compare the performance, level of risk exposure and risk management of the bank to its pre-determined peers. The analysis comprises of data throughout the years 2014-2018; all statistics is sourced from the FDIC website unless stated otherwise. To further analyze the bank’s profitability, this section will examine the following metrics over the past 5 years: ROA, ROE, Efficiency Ratios, Net Interest Margin. Bank of America has been realizing return well above the group average on its assets while in line with the increasing industry trend and has succeeded in delivering return to its shareholders above the peer group average since last year. This improvement in ROE especially can be accredited to the bank’s recent capital management strategy in repurchasing approximately $12.8 billion of common stock at the end of 2017.
Given that the efficiency ratio indicates the cost incurred per dollar of revenue the bank generates, it is in all organization’s interest to achieve a lower ratio. Since 2015, efficiency ratio of Bank of America has been superior to its peers. Specifically, in the third quarter of 2018, the bank was able to decrease noninterest expense by $327 million which improved the efficiency ratio to 57%. The decrease in expense was due to lower operating costs, reduction from the sale of the non-U.S. consumer credit card business and lower mitigation expense. In the same quarter, BAC was able to gain both increased net interest and noninterest income. The increase of net interest income was primarily due to the benefits from higher interest rates and loan and deposit growth: deposits specifically, have grown year-over-year by more than $40 billion on average for 12 consecutive quarters. The most significant changes that affected the increase in noninterest income were mostly an impact of pricing strategies: service charges increased $180 million, investment & brokerage services income increased $536 million, investment banking income increased $770 million and so on.
Overall, Bank of America is an example of a mature bank with stable earnings. At today’s standing, the bank is outperforming the peer group in all four aspects. While its ROE is slightly above average, its ROA is outstandingly high. The bank is also able to realize higher than average net interest margin by maintaining a low efficiency ratio. On top of the comparative analysis and firm specific phenomenon/activities, it is important to keep in mind the macroeconomic trend that impacts the well-being of the economy as a whole. Most notable changes and trends are as follows: On December 22, 2017, the Tax Cuts and Jobs Act was enacted which involved lower U.S. corporate tax rate effective in 2018 Economy is gaining momentum for the 9th consecutive year The Federal Open Market Committee (FOMC) raised its target range for the Federal funds rate three times in 2017: ultimately to a rise in 125 bps.
INTEREST RATE RISK
BAC states “Interest rate risk represents the most significant market risk exposure to our banking book balance sheet” and specifies that “client-facing activities, primarily lending and deposit-taking, create interest rate sensitive positions on our balance sheet.”Interest rate risk is the risk to bank’s earnings from movement of interest rates and it arises from various operative aspects of the bank: from interest-rate-related options rooted in bank products (option risk), timing differences of rate changes and cash flows (repricing risk), transformation of rate relationships across the spectrum of maturities (yield curve risk). In this paper, we will analyze the repricing risk examining the bank’s repricing gap and income sensitivity. Throughout its operation, the BAC seems to have had higher GAP ratios for the two extreme GAP buckets in terms of maturity—the 3 months or less and over 15 years—compared to its peer group until 2015.
Since 2016, Bank of America has remained to have higher 3 months or less GAP and lower over 15 years GAP than the peer average. Thus, demonstrating a strategy that puts a heavier emphasis on short-term maturities than its competitors. The sensitivity analysis—on the left, provided by Bank of America’s 2017 Annual Report—assumes that the bank will not take any action in responses to rate shocks and that there will be no change in deposits portfolio in terms of size or mix from the baseline forecast. The analysis demonstrates how the bank’s asset sensitivity to rising rates remain fairly unchanged. BAC states “we continue to be asset sensitive to a parallel move in interest rates with the majority of that benefit coming from the short end of the yield curve.”
The graph on the left depicts the ratio between total interest income and total noninterest income of BAC, of the peer group average, and of peer banks individually. One can notice the steadily increasing weight of interest income for Bank of America, which is consistent to the peer group trend. However, overall, BAC’s ratio seems to be lower than the peer group average; meaning, BAC’s interest income weighs less than that of its peer banks’ in terms of the percentage of total income (interest + non-interest income). In conclusion, Bank of America is fairly hedged against negative interest rate shocks and its dominant strategy seems to be a heavier emphasis on short-term assets. Furthermore, BAC seems to be in the process of positioning itself take advantage of today’s rising interest rate by increasing the weight of its interest rate income at faster rate than all of its peer banks.
CREDIT RISK
“Credit risk is the risk of loss arising from the inability or failure of a borrower or counterparty to meet its obligations.” This particular type of risk is critical and can be extremely detrimental to the financial health of commercial banks especially. The objective of credit risk management in financial institutions is to maximize their risk-adjusted rate of return by preserving credit risk exposure within adequate parameter. Although there are numerous methods to measure credit risk, this paper will focus on BAC’s loan portfolio composition and the following ratios as points of evaluation: long-term assets/total assets, non-current loans/total loans, net charge-offs/total loans, loss allowance/non-current loans, loans for sale/net loans. Portfolio diversification is one of the most commonly used methods to mitigate risk. Bank of America is on the right track in becoming well-diversified. One can detect the evolution of the bank’s portfolio composition from 2014 to 2018 by analyzing the histogram below.
Most notably, real estate loans used to account for almost half (48%) of the portfolio in 2014 but has decreased 35% by 2018. As seen by subprime mortgages in the last financial crisis, real estate loans can be tremendously risky. BAC’s effort to diversify its loan portfolio by reducing real estate loans seems to be a logical risk management strategy that is line with its peer banks. The ratio between a bank’s Long-Term Asset (5+ years) to Totals Assets is a critical metric because loans with longer maturities are inherently more exposed to credit risk than those with shorter maturities: probability of default and loan maturity is positively correlated. As displayed on the graph above on the right, BAC has historically had greater percentage of Long-Term Asset to Total asset compared to its peer group. This conflicts with the conclusion formed from the GAP analysis under the interest rate risk section that the bank allocated greater weight on short-term maturities than its peers. Thus, the following is the refined conclusion: even if long-term assets are greater, Bank of America holds comparatively a less rate-sensitive long-term asset on average.
