BANK

MANAGEMENT
CHAPTER 3
ANALYZING BANK
FINANCIAL STATEMENTS

INTRODUCTION

2 most important financial statements for a banking

firm:
Balance Sheet / Report of Condition
Financial information comparing what a bank
owns with what it owes and the ownership interest
of stockholders
Income Statement / Report of Income
Reflects the financial nature of banking as interest
on loans and investments represents the bulk of
revenue
2

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

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)
4

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)
5

Cont

Therefore balance sheet identity can

also be pictured as:
C+S+L+MA = D+NDB+EC

Cont

Cash Assets (C) designed to meet a banks 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

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

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
9

Cont

The balance sheet identity can also be pictured

as:
Accumulated uses = Accumulated sources
of funds
of funds

10

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 banks vault, deposits
placed with other depository institutions, cash item
in the process of collection and the banking firms
reserve account held with the central bank
11

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

12

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
13

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)

14

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

15

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)

16

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
17

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.
18

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.

19

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

20

Cont

Nonperforming (noncurrent) loans (NPL)

Credits that no longer accrue interest income or
that have had to be restructured to accommodate a
borrowers changed circumstances
NPL scheduled loan repayment which past due
for more than 90 days
Will be deducted from loan revenues

21

Cont

Bank premises and fixed assets

Goodwill and other intangible assets
All other assets

22

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
23

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

24

Cont

Equity capital
1.

2.
3.

4.

Share capital common and preferred

stocks
Retained earnings
Contingency reserve protection against
unforeseen losses
Treasury stock stock that has been retired.

25

BALANCE SHEET
ASSETS:
Cash & due from financial institutions
xxx
Investment securities
Total (gross) loans
xxx
Allowance for loan losses (xx)
Net loans
xxx
Premises & Equipment
xxx
Other assets
xxx

TOTAL ASSETS

XXX

LIABILITIES+EQUITY
Liabilities:
Deposits
xxx
xxx
Borrowed funds
xxx
Other liabilities
xxx
Long-term debt
xxx
Equity:
Capital surplus
xxx
Accumulated retained earnings
xxx
TOTAL L + E
XXX

26

STATEMENT OF LOAN LOSS

PROVISION
Beginning reserve for loan losses
+ Provision for loan losses
- Loan losses during the year
+ Recoveries from previous loan losses
Ending reserve for loan losses

xxx
xxx
(xxx)
xxx
XXX

27

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 banks 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)
ii)
iii)
iv)
v)
vi)
vii)
viii)

Interest paid out to depositors (D),

Interest owed on non-deposit borrowings (NDB),
Cost of equity capital (EC),
Salaries, wages and benefits paid to bank employees
(SWB),
Overhead expenses associated with the banks physical
plant (O),
Funds set aside for possible loan losses (PLL),
Taxes owed (T), and
Miscellaneous expenses (ME).
29

Cont
The difference between all revenues
and expenses is net income.
Net Income:

Total revenue Total expense

items

items
30

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
31

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

32

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 banks current
earnings from taxes in order to help prepare for bad
loans

33

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

34

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.
35

INCOME STATEMENT
-

Interest income
xxx
Interest expense
(xxx)
NET INTEREST INCOME
Non interest income
xxx
Non interest expense
(xxx)
NET NON INTEREST INCOME
OPERATING PROFIT
PROVISION FOR LOAN LOSSES
PROFIT BEFORE TAX
TAX
NET INCOME

XXX

XXX
XXX
(XXX)
XXX
(XXX)
XXXXX
36

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:

37

Cont
Standby

credit agreements
Bank pledges to guarantee repayment of
a customers loan received from a third
party
Interest rate swaps
A bank promises to exchange interest
payments on debt securities with another
party
38

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.

40

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

41

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:
42

Funds provided to the bank = Fund provided from

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

Dividends paid out to

Stockholders + Increases
in
bank assets + Decreases in
bank liabilities

43

And, of course
Funds provided to the = Funds used
by the
bank over a specific
bank during
the
time period
same time
period

44

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 banks capital account are closely followed by
regulators and large depositors

45

Cont

Bank analysts look closely at these statements to make

sure that the banks 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.

46