BWBB2013

BANK MANAGEMENT

CHAPTER 3
ANALYZING BANK
FINANCIAL STATEMENTS
 INTRODUCTION
 2 most important financial statements for a
banking firm:
 Balance Sheet / Report of Condition
 Financialinformation comparing what a bank owns
with what it owes and the ownership interest of
stockholders
 Income Statement / Report of Income
 Show the revenues, expenses, and net earnings of
the financial firms.

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 The Balance Sheet

 Lists the assets, liabilities and equity capital

(owners’ funds) held by or invested in a bank or
other financial firm on any given date
 Basic balance sheet identity:

Assets = Liabilities + Equity capital

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Cont…
 Assets
 Cash in the vault and deposits held at the
other depository institutions (C)
 Government and private interest-bearing
securities purchased in the open market (S)
 Loans and lease financings made available to
customers (L)
 Miscellaneous assets (MA)

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Cont…
 Liabilities
 Deposits made by and owed to various
customers (D)
 Nondeposit borrowings of funds in the money
and capital markets (NDB)

 Equity Capital
 Represents long term funds the owners
contribute (EC)

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Cont…
 Therefore balance sheet identity can also be
pictured as:

C+S+L+MA = D+NDB+EC

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Cont…
 Cash Assets (C) – designed to meet a bank’s
need for liquidity
 Deposit
withdrawal, loans and unexpected or
immediate cash needs
 Security holdings (S) – backup source of
liquidity and provide another source of income
 Loans (L) – made principally to supply income
 Miscellaneous assets (MA) – dominated by fixed
assets and investments in subsidiaries

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Cont…
 Deposits (D) – main source of funding for banks
 Nondeposit borrowings (NDB) – mainly to
supplement deposits and provide the additional
liquidity that cash assets and securities cannot
provide
 Equity Capital (EC) – supplies the long term,
relatively stable base of financial support upon
which the financial firm will rely to grow and to
cover any extraordinary losses it incurs

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Cont…
 Assets (accumulated uses of funds)
 Made to generate income for its stockholders,
pay interest to its depositors and compensate
its employees for their labor and skill
 Liabilities and Equity capital (accumulated
sources of funds)
 Provide the needed spending power to
acquire assets

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Cont…

 The balance sheet identity can also be pictured

as:

Accumulated uses = Accumulated sources

of funds of funds

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 Assets of the Banking Firm
 Cash and Due from Depository Institutions
 Also referred as primary reserves
 The first line of defense against customer deposit
withdrawals and the most important funds to meet
customers loan request
 Cash balances earn little or no interest income
 Example: cash held in the bank’s vault, deposits
placed with other depository institutions, cash item
in the process of collection and the banking firm’s
reserve account held with the central bank
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 Cont…
 Investment Securities: The Liquid Portion
 Liquid Security Holdings - Second line of defense to
meet demands for cash
 Middle ground between cash assets and loans
 Earning some income
 Held mainly for the ease with which they can be
converted into cash on short notice
 Often called secondary reserves or referenced on
regulatory reports as “available for sale”
 Typically include holdings of short-term government
securities and privately issued money market securities,
including interest-bearing time deposits held with
other banking firms and commercial paper
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 Cont…
 Investment Securities: The Income-
Generating Portion
 Securities held primarily for their expected rate of
return or yield
 Example: Bonds, notes and other securities
 Investment securities can be divided into:
 Taxable securities

 Government bonds and notes

 Securities issued by various federal agencies

 Corporate bonds and notes

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Cont…
 Tax-exempt securities
 State and local government bonds
 Investment securities may be recorded on the
books of a banking firm at their original cost or
at market value, whichever is lower
 Recent trend in accounting rules for banking is
toward current market values (replacing
historical cost)

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Cont…

 Trading Account Assets

 Securities purchased to provide short-term profits
from short-term price movements
 Not included in the “Securities” item in the balance
sheet
 Reported as trading account assets

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Cont…
 Federal Funds Sold and Reverse
Repurchase Agreements
 Includes mainly temporary loans made to other
depository institutions, securities dealers, major
industrial corporations
 Funds come from the reserves a bank has on
deposit with the federal reserve bank (or central
bank)
 Repurchase agreements – banking firms acquire
temporary title to securities owned by the borrower
and holds those securities as collateral until the loan
is paid off (normally after only a few days)
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Cont…
 Loans and leases
 The largest asset item
 Loan types:
 Commercial and industrial loans
 Consumer loans / loans to individual
 Real estate loans
 Loans to other institutions
 Foreign loans
 Agricultural production loans
 Security loans
 Leases

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Cont…
Loan losses
- deducted from the amount of total (gross) loan figure.
- banks are allowed to build up a reserve for future loan
losses, called the allowance for loan losses (ALL) based
on their recent loan-loss experience.
- the ALL is a contra-asset account, which represents an
accumulated reserve against which loans declared to be
uncollectible can be charged off.

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Cont…
- This means that bad loans normally do not affect
current income.
- When a loan is considered uncollectible, the accounting
department will write (charge) it off the books by
reducing the ALL account by the amount of the
uncollectible loan while simultaneously decreasing the
asset account for gross loans.

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Cont…
 Specific and general reserves
 Allowance for loan losses (ALL) can be divided into:
 Specific reserves

 Set aside to cover a specific loan problems or

loans expected to be a problem or that represent
above-average risk
 General reserves

 The remaining reserves in the loan-loss account

after deducted specific reserves

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Cont…
 Nonperforming (noncurrent) loans (NPL)
 Credits that no longer accrue interest income or that
have had to be restructured to accommodate a
borrower’s changed circumstances
 NPL – scheduled loan repayment which past due for
more than 90 days
 Will be deducted from loan revenues

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Cont…
 Bank premises and fixed assets
 Goodwill and other intangible assets
 All other assets

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 Liabilities of the Banking Firm
 Deposits
 5 major types of deposit
 Noninterest-bearing demand deposits / checking
account
 Savings deposits

 NOW accounts

 Money market deposit accounts (MMDAs)

 Time deposits

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Cont…
 Borrowings from Nondeposit Sources
 borrowings in the money market such as REPOs,
BAs, Bills of Exchange, and issuing commercial
paper.
 The larger the depository institution, the greater
use it tends to make of nondeposit source of funds

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Cont…
 Equity capital
1. Share capital – common and preferred stocks
2. Retained earnings
3. Contingency reserve – protection against unforeseen
losses
4. Treasury stock – stock that has been retired.

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 BALANCE SHEET
ASSETS: LIABILITIES+EQUITY
Cash & due from financial institutions
Liabilities:
xxx
 Deposits xxx
Investment securities xxx
Borrowed funds xxx
Total (gross) loans xxx
Other liabilities xxx
Allowance for loan losses (xx)
Long-term debt xxx
Net loans xxx
Premises & Equipment xxx Equity:
Other assets xxx Capital
surplus xxx
Accumulated retained earnings

xxx
TOTAL ASSETS XXX TOTAL L + E XXX
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 STATEMENT OF LOAN LOSS
PROVISION

Beginning reserve for loan losses xxx

+ Provision for loan losses xxx
- Loan losses during the year (xxx)
+ Recoveries from previous loan losses xxx
Ending reserve for loan losses XXX

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 Income Statements
 indicates the amount of revenue received and
expenses incurred over a specific period of
time.
 Principal source of bank revenue:
 Interest income generated by the bank’s
earning assets, mainly its loans (L),
 Securities (S),
 Interest-bearing deposits that are part of cash
assets (C), held with other banks
 Any miscellaneous Assets (M) generating
revenue. 28
 INCOME STATEMENT
Major expenses incurred in generating bank revenue:
i) Interest paid out to depositors (D),
ii) Interest owed on non-deposit borrowings (NDB),
iii) Cost of equity capital (EC),
iv) Salaries, wages and benefits paid to bank employees
(SWB),
v) Overhead expenses associated with the bank’s physical
plant (O),
vi) Funds set aside for possible loan losses (PLL),
vii) Taxes owed (T), and
viii) Miscellaneous expenses (ME).
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Cont…
The difference between all revenues and expenses
is net income.

Net Income:

Total revenue – Total expense

items items

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 Cont…
 Interest Income
 Interest and fees generated from loans account for most
bank revenues (normally two-thirds or more of the total)
 Followed in importance by:

 investment earnings from taxable and tax exempt

securities
 Interest earned on federal funds loans and repurchase
agreements
 Interest received on time deposits placed with other
banks

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 Cont…
 Interest expenses
 the number one expense item for a bank is
interest on its deposits
 Net Interest Income
 many banks subtract total interest expenses from
total interest income to yield net interest income or
often referred to as the interest margin, the gap
between the interest income and the interest
cost.
 A key determinant of profitability
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 Cont…

 Loan-Loss Expense
 Another expense item that banks can deduct from
current income is known as the provision for possible
loan losses
 This provision account is really a noncash expense
 Its purpose is to shelter a portion of the bank’s current
earnings from taxes in order to help prepare for bad
loans

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 Cont…
 Noninterest Income
 Sources of income other than earnings from loans and
securities
 Normally include fees earned from offering trust
services, service charges on deposit accounts and
miscellaneous fees and charges for other bank services
 Recently, noninterest income (fee income) have been
targeted by bankers as a key source of future revenues

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 Cont…
 Noninterest Expenses
 Key noninterest expense items for banks are wages,
salaries, and other personnel expenses
 Others are costs of maintaining bank properties and
rental fees on office space, bank furniture and equipment,
legal fees, paper and office supplies and repair costs
 Net Income
 Net income is equal to the income that a firm has after
subtracting costs and expenses from the total revenue.
 Net income can be distributed among holders of
common stock as a dividend or held by the firm as
retained earnings.
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 INCOME STATEMENT
Interest income xxx
- Interest expense (xxx)
NET INTEREST INCOME XXX
Non interest income xxx
- Non interest expense (xxx)
NET NON INTEREST INCOME XXX
OPERATING PROFIT XXX
- PROVISION FOR LOAN LOSSES (XXX)
PROFIT BEFORE TAX XXX
- TAX (XXX)
NET INCOME XXXXX
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 Off-Balance Sheet in Banking

 Fee-based activities offered by banking

institutions that normally do not show up on the
balance sheet
 Recently, banks have converted many of their
customer services into fee-generating transactions
that are not recorded on their balance sheets
 Prominent examples of these off-balance sheet
items include:

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Cont…
 Standby credit agreements
 Bank pledges to guarantee repayment of a
customer’s loan received from a third
party
 Interest rate swaps

 A bank promises to exchange interest

payments on debt securities with another
party

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Cont…
 Financial futures and option interest-rate
contracts
 A bank agrees to deliver or to take delivery of
securities from another party at a guaranteed
price
 Loan commitments

 A bank pledges to lend up to a certain amount

of funds until the commitment matures
 Foreign exchange rate contracts

 A bank agrees to deliver or accept delivery of

foreign currencies 39
Cont…

 The problems with these off-balance-sheet

transactions is that they often expose a bank to
added risk even though they may not show up
in conventional bank condition reports.

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 Other Useful Bank Financial
Statements
 Two useful sources of financial information to
supplement the information provided on the
balance sheet and the income statement:
 Funds flow or sources and uses of funds
statement
 Capital account statement or stockholders’
equity

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 Sources and Uses of Funds
Statement
 Answer two questions:
 Where did the funds a bank used over a certain
period of time come from?
 How were those funds utilized?

 It is based upon the following relationships:

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Funds provided to the bank = Fund provided from
over a specific period of time operations + Decreases in
bank assets + Increases in
bank liabilities

Dividends paid out to

Fund used by the bank
during a specific period of
time
=
Stockholders + Increases in
bank assets + Decreases in
bank liabilities

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And, of course

Funds provided to the = Funds used by the

bank over a specific bank during the
time period same time period

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 The Capital Account Statement /
Statement of Stockholders’ Equity
 The financial report reveal changes in the all-
important capital account, showing how the
owners’ investment of funds in the bank has
changed over time
 Stockholders’ equity represents a cushion of
financial strength for the bank that can be used to
absorb losses and protect the depositors and
other creditors, changes in the bank’s capital
account are closely followed by regulators and
large depositors
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Cont…
 Bank analysts look closely at these statements
to make sure that the bank’s capital account is
still growing fast enough to keep up with the
growth of its assets (especially loans).
 If the capital account is declining, analysts try
to determine if the amount of owners’ capital
remaining is sufficient to absorb all expected
losses with an added cushion to deal with
unexpected losses.
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