BANKING

Summer Term (I), 2015

Instructor: Sumaira Hamid

Chapter 4:
The Financial Statements of a Bank
Balance Sheet

Balance Sheet Report of Condition

TA = TL + EQ
Balance Sheet Report of Condition
Balance Sheet is also known as the report of condition because it
shows the amount and composition of funds sources (Financial
Inputs i.e. OE and Liab) the bank has drawn upon to finance to its
lending & investing activities i-e how much has been allocated to
loans, securities & other funds uses ( Financial Outputs i.e.
Assets) at any given time.
Users of Funds: (Assets) - Financial Outputs - Spending cash on
Sources of Funds: (Liab + OE) Financial Inputs - Raising funds
from

TA

= TL +

EQ

Investing Decision = Financing Decision

Uses of Funds = Sources of Funds
Financial Output = Financial Input

Assets
= Liabilities+ Equity
C+S+L+MA = D+NDB+EC
ASSETS
(C) = CASH ASSETS -> Designed to meet banks immediate need for
liquidity
(S) = SECURITY HOLDINGS -> Backup source of liquidity & another
source of Income
(L) = LOANS -> Are made principally to supply Income
(MA) = Miscellaneous Assets -> Dominated by fixed Assets or
Investment in subsidiaries if any.

LIABILITIES
(D) = Deposit Borrowings -> Main source of Funding [Customers
deposits]
(NDB) = Non Deposit Borrowings ->To supplement deposits,
provide additional source of funding & liquidity

EQUITY
(EC) Equity Capital ->Providing long-term, relatively stable base of
financial support

Balance Sheet Report of Condition

TA = TL + EQ

ASSETS
1. The Cash Account - Primary Reserves
Account
Designed to meet banks immediate need for
liquidity Most Liquid Asset
Cash held in the banks vault
Any deposits the bank has placed with other banks
(correspondent deposits)
The banks reserve account held with the Federal
Reserve Bank
Cash items in the process of collection (mainly
uncollected check)

All above four categories are Non-Earning Assets

(non- interest earning assets)

ASSETS
2. Investment Securities (The Liquid Portion) Secondary Reserves Account
Designed as a backup source of liquidity and to
earn low rate interest income
Interest bearing time & saving deposits held with other
banks
Money Market Instruments Short term debt instruments
with a maturity of maximum one year or less
for e.g short term government (Treasury Bills T-bills) municipal
(state and local) securities, privately issued money market
securities, commercial papers.

Earning Assets (Interest is earned on Investments)

ASSETS
3. Investment Securities (The Income generating Portion) Capital Market Instrument ( Long term Investments)
i) Equity Investments Investment in Shares ( Non- Earning
but generates dividend income) Income generating asset but
not an earning asset

Note: Definition of earning is on the basis of interest earned on

any asset
ii) Investments in Long term Debt Instruments
Maturity more than 1 year
Earning Asset
For Example: Notes, bonds and other security held by the bank
primarily for their expected rate of return or yield.
like Investments in Treasury Bonds, corporate bondsetc

ASSETS
Other Classification of Investment Securities
Taxable and Tax-Exempt Securities
HTM, AFS, Trading Account Securities
HTM ( Held Till Maturity) Intend and ability to hold
till maturity for capital gains
AFS( Available for Sale) Those securities which
bank may choose to sell for any need of liquidity
Trading Account Securities Held for resale in
short-term with intend to make profit out of short term
price movement ( to be sold within 90 days)

Concept Check 4-6 , page 127

Suppose that a bank holds cash in its vault

of $1.4 mill, short-term government
security of $12.4 mill, privately issued
money market instrument of $5.2 mill,
deposits at Federal Reserve Bank (noninterest) 20.1 mill, cash items in the
process of collection of $0.6 mill, and
non-interest deposits placed with the
other banks of $16.4 mill. How much
does this bank hold in its Primary
and Secondary Reserves?

Answer - Check 4-6 , page 127

Primary Reserve:
Cash $1.4 m
Dep at Fed $20.1m
Cash Item $0.6m
Non. Interest Dep with other banks $16.4m Total
$38.5 m
Secondary Reserves:
Sh.Term govt sec $12.4m
Privately issued money mkt invest $5.2m
Total $17.6m

ASSETS
4. Loans Largest Asset item and source of
income
Classification By Purpose of Borrowing Money
Commercial and Industrial Loans
Consumer Loans
Real Estate Loans
Financial Institutions Loans
Foreign Loans
Agricultural Loans
Security Loans
Leases

ASSETS
Other Classifications of Loans
1. Loan, by Origin and Source
By Origin
. Domestic Loan: Denominated in the local currency on terms and
conditions prevailing in the local market regardless of the source of loan,
that is local banks or branches of foreign banks operating locally.
. Foreign Loans: Denominated in a foreign currency such as US Dollars,
Pounds, Japanese Yen or any other currency and is extended on the interest
rates, terms and conditions prevailing in the market or country of currency
of the loan, by any lender or bank located in any country.
By Source
. Bank Loan: A formal Loan, a loan extended by a banking institution.
. Informal Loan: A loan obtained from informal sources such as money
lenders, unregistered cooperatives, personal credit sources etc.

ASSETS
2. Loan, by Terms and Conditions:
Soft Loans: Extended on concessional rates of interest, generous grace
period and maturity suited to the needs of the borrower.
Hard Loans: Reflect Full market costs of the loan plus a spread or
premium depending on the borrowers credit worthiness and competitive
terms and conditions prevailing in the market.
Term loans: of medium to long-term maturity at variableinterest rates
Fixed or variable rate loans: where interest is either fixed or
isvariable
Guaranteed Loans: issued with a third party guarantee besidesthe
collateral e.g a government guarantee, foreign currency deposit
guarantee etc.
Secured or unsecured loan: depending on the creditworthiness of the
borrower

ASSETS
3. Loan,by Type of Borrower:
Government or sovereign loans: borrowed by government or
agovernment department or agency
Cooperation, a company, or a business, borrowing from the
banking system to finance their routine business needs
Individual or personal loans borrowed by households
4. ByType of Maturity:
Short term loan: usually up to 90 days for a maximum of 180days, in
established business up to 1 yr
Medium term Loan: usually for a period of one to two years
andmaximum three years
Long term Loan: typically for a period of 3 to 5 years or more.

ASSETS
NetLoans = Gross Loans - Allowance for Loan Loss - Unearned Discounts

Unearned Discounts: Interest Income from loans that has beenreceived but not yet earned
Gross Loans = Sum of all standing lOUs (sum of loans or total loans)
Allowance for Loan Loss (ALL) - balance sheet item
Reserve for possible (future) loan losses
Estimated Provision for doubtful loans
Accumulated Account
Contra Asset Account (to write off uncollectable loans oradd recoveries)
Two components of ALL (Allowance for Loan loss)
Specific Reserves: for specific loan problems, are set aside to cover;particular loan or loans
expected to be a problem or that present anabove average risk
General Reserves: remaining reserves in the loan loss account, thishelps banks better
understand their needs for protection againstcurrent or future loan defaults.
Provision for Loan Loss (PLL) - Income statement item
Non-cash expense item
Annual deductions for loan losses

ASSETS
Additions to ALL are usually made
1) when a banks loan portfolio grows in size,
2) when any sizable loan is judged to be
completely or partially uncollectible, or
3) when an unexpected loan default occurs
that has not already been reserved
The required accounting entries simply increase
the contra asset ALL account and the
expense account PLL

ASSETS
Formula to Calculate ending ALL balance
End ALL = Beginning ALL + PLL Write offs +
Recoveries
And
Net Loans = Gross Loan Ending ALL
Unearned Discounts

ASSETS
Suppose a bank anticipated loan losses this
year of $1 mill and held $ 100 mill already in
its ALL account. It would take non cash
charge against its current revenues, entering
$1 mill in the PLL account in its I/S.
Thus the Amount recorded on banks I/S would be
Annual loan loss expense ( PLL ) = $ 1 mill
Then adjust banks B/S in its ALL account
ALL = $100 mill + $ 1mill (PLL)
=$101 mill

ASSETS
Now suppose bank discovers that its truly worthless loans
which must be written of is $500,000 then
Beginning balance for ALL = $100 mill
Plus
PLL = $1 mill
Adjusted ALL
= $101 mill
LessActual charge offs of worthless loans
= ($ 500,000)
Net Allowance for loan loss(ALL) after all charge offs =$100.5 mill
$100.5 mill is the ending balance after adjusting PLL and Charge offs

Now suppose bank recovers $1.5 Mill that it had previously

charged off as losses as earlier loans then

Net allowance for the loan loss (ALL) after all charge offs = $ 100.5 mill
Plus Recoveries from previously charged off loans
= $1.5 mill
Ending Balance in ALL account = $ 1.2 mill

ASSETS

Conceptcheck 4.12 (pp 134)

Supposea bank has an allowance for loan
losses of $1.25 million atthe beginning of
the year and charges current income for a
$250,000 provisions for loan losses, charges
off worthless loans of $150,000 and recovers
$ 50,000 on loans previously charged
off.What will be the balance in the bank's
allowance for loan losses atyear end?

ASSETS

Answer - Conceptcheck 4.12 (pp 135)

Beg ALL = $ 1.25
Plus PLL = 0.25 m
LessWorthless loans = (0.15 m)
Plus Recoveries = 0.05 m
Ending ALL = $ 1.4
End ALL = Beginning ALL + PLL Write offs +
Recoveries

ASSETS
5.

Federal Funds Sold and Securities Purchased under

Resale Agreement (Earning Asset) Lending to Financial
Institutions
This item includes mainly temporary loans (Usually extended
overnight, with the funds returned next day) made to the other
banks or financial institutions

Federal Funds:
Are unsecured loans of reserve balances at Federal Reserve Bank that
depository institutions lend to one another at Federal Reserve Rate

Important: These are excess amount of reserve balances

maintained with Federal Reserve Bank
Federal Funds Sold is an ASSET and Federal Funds Purchased
is LIABILITY.

ASSETS
Resale Agreement (asset) / Repurchase
Agreement (liab):
Loan backed by investment security
Repurchase Agreement: Sale of investment
securities by one party to another with an agreement to
purchase the securities at a specified date and price.

IMPORTANT
Securities purchased with Resale Agreement
ASSET
Securities sold with Repurchase Agreement
LIABILITY

ASSETS
6. Customers Liabilities on Acceptances
( Earning Asset only if Interest related)
Large banks often provide a form of credit to their
customers known as acceptance financing ( e.g.
Bankers Acceptance or Letter of Credit ( LCs))
Signed letter of credit to help customers pay their
goods etc.

7. Miscellaneous Assets (Non-Earning Asset)

Buildings, Equipment, Investment in subsidiary etc.

LIABILITIES
DEPOSITS
Non-interest-bearing demand deposit or regular checking accounts,
generally permits unlimited check writing.
Saving Deposits generally bear the lowest rates of interest offered to
depositors by a bank but may be of any denomination and permit the customer
to withdraw at will- No Maturity
NOW Accounts Negotiable Order of Withdrawals : which can be held only by
individuals and nonprofit institutions bear interest and permit drafts to be written
against each account to pay third parties.
Money Market Deposit Accounts can pay whatever interest rates the offering
bank feels is competitive and have limited check writing privileges attached. No
minimum denomination or maturity is required by law, though depository
institutions must reserve right to require seven days notice before any
withdrawals are made.
Time Deposits usually carry fixed maturity and a stipulated interest rate but
may be of any denomination, maturity and yield agreed upon by the bank and its
depositor. Included are large negotiable CDs, interest bearing deposits that banks
use to raise money from their most well-to-do customers.

LIABILITIES
NON-DEPOSIT BORROWING
Borrowings from Financial Institutions
Fed Funds Purchased
Securities Sold Under Agreement To Repurchase

Acceptances Outstanding
Eurocurrency Borrowings
Short Term Debt
Mortgage Indebtedness
Subordinated Loans and Debentures
A subordinated loan, subordinated bond, subordinated debt that ranks below other
debt or security with regard to claim on assets or earnings
In case of bankruptcy, these debt holders would not get paid until senior debt
holders are paid in full

EQUITY-CAPITAL ACCOUNT
Common stock outstanding : Total Par or stated value of
outstanding shares
Preferred Stock: Guarantees annual dividends before
common stock holders
Capital Surplus: Share premium or additional paid up capital
Retained Earnings: Undivided profits
Treasury Stock: Reacquired Stock- Stock which is bought
back by the issuing company to avoid a takeover threat, to
reissue later at a higher price, to retire or reduce number of
outstanding shares to increase EPS etc
Contingency Reserve: Reserve for unforeseen losses.