978-0077861667 Chapter 12 Lecture Note Part 1

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1.1.1.1.1Chapter Twelve

Commercial Banks’ Financial Statements and

Analysis

1.1.1.2 I. Chapter Outline

1. Why Evaluate the Performance of Commercial Banks? Chapter Overview

2. Financial Statements of Commercial Banks

a. Balance Sheet Structure

b. Off-Balance-Sheet Assets and Liabilities

c. Other Fee-Generating Activities

d. Income Statement

e. Direct Relationship between the Income Statement and the Balance Sheet

3. Financial Statement Analysis Using a Return on Equity Framework

a. Return on Equity and Its Components

b. Return on Assets and Its Components

c. Other Ratios

4. Impact of Market Niche and Bank Size on Financial Statement Analysis

a. Impact of a Bank’s Market Niche

b. Impact of Size on Financial Statement Analysis

II. Learning Goals

1. Describe the four major categories of assets on a commercial bank’s balance sheet.

2. Distinguish between core deposits and purchased funds.

3. Identify off-balance-sheet activities that commercial banks undertake.

4. Describe the major categories on a commercial bank’s income statement.

5. Examine ratios that can be used to analyze a commercial bank’s performance.

1.1.1.3 III. Chapter in Perspective

This is the second of three chapters that cover commercial banks. This chapter develops the

tools necessary to analyze bank performance. The chapter reviews the major on and

off-balance-sheet assets and liabilities in greater detail than in Chapter 11 and then shows the

linkage between the income statement and the balance sheet. A detailed analysis of ROE and

ROA is presented. The chapter concludes by indicating how a bank’s competitive conditions

affect performance. If the instructor is focusing more on markets, risk management or financial

engineering this chapter can be skipped with little loss of continuity. If the instructor prefers to

delve into more detail about managing institutions, then this chapter will be useful to introduce

students to the tools necessary to analyze bank financial statements.

1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students

Report of condition Loan commitment

Report of income Up-front fee

Retail bank Back-end fee

Wholesale bank Letters of credit

Correspondent bank Standby letters of credit

Net write offs When-issued securities

Earning assets Loans sold

NOW account Recourse

MMDA Derivative securities

Other savings deposits Total operating income

Retail CDs Time series analysis

Wholesale CDs Cross-sectional analysis

Negotiable instrument Net interest margin

Brokered deposits Spread

Core deposits Overhead efficiency

Purchased funds

1.1.1.5 V. Teaching Notes

1. Why Evaluate Performance of Depository Institutions: Chapter Overview

The chapter uses a ROE framework to analyze the major aspects of performance of banks. The

analysis could also be applied to thrifts and credit unions.

2. Financial Statements of Commercial Banks

Financial statements of banks and other DIs must be submitted to regulatory authorities

quarterly. The statement of condition (balance sheet) and the report of income (income

statement) are required. The Federal Financial Institutions Examination Council (FFIEC)

prescribes uniform principals, standards and report forms for DIs. The results of off-balance

sheet activities are shown on the report of income. The chapter compares two bank holding

companies of different size and market placement: Heartland Bank and Trust (HBT) and Bank of

America (BOA). HBT is a privately owned bank operating in Illinois and Missouri with under

$3 billion in assets. HBT is primarily a retail bank but it offers business banking services,

particularly in general real estate and farmland. BOA is more of a wholesale bank. Wholesale

banks focus primarily on business banking relationships including correspondent banking

relationships. BOA also has extensive retail banking services however. While HBT is a $3

billion bank with under 70 offices, BOA is one of the nation’s largest banks with assets of

$1,666 billion in 2013 and over 5,500 offices in more than 40 countries. BOA has the nation’s

largest ATM network with 16,300 ATMs serving 30 million users. It is the largest debit card

issuer, a top small business lender and boasts of having one of the largest number of relationships

with mid-size companies. BOA has trust services, investment management and credit cards

businesses as well, and is the leading small business lender in the country. BOA is also a world

leader in fixed-income, currency and energy commodity products and their derivatives.

CAMELS Evaluations:

Banks and other depository institutions are evaluated by the appropriate regulators on six major

areas, depicted by the CAMELS acronym. Each component is discussed below:

C: Capital Adequacy – Risk based capital requirements are now used. The regulators

also evaluate the bank’s loss experience, amount of problem assets in relation to capital

and the institution’s access to capital.

A: Asset Quality – Banks are required to classify assets according to soundness and to

allocate loss reserves based on their evaluation of the quality of their assets. Regulators

can require bank managers to reassess the loan or other assets and may require the bank

to increase loss reserves. Adequacy of internal controls and the loan policy are also

evaluated. Over concentrations of credits in certain loan or investment types or

concentrations in geographic areas can lead to lower evaluations of asset quality.

M: Management – The technical competence of management, their history of past

compliance, the adequacy of internal controls, management compensation and experience

level are all components of the evaluation of management.

E: Earnings – The stability and growth rate of earnings are important elements of this

evaluation. Peer group comparisons of profitability and interest rate risk exposure are

normally used to evaluate earnings, as is the adequacy of the loan loss reserve.

L: Liquidity – Estimating liquidity risk requires knowledge of the turnover rates of the

bank’s sources of funds, particularly deposit turnover. Measures for this category would

include the percentage of core deposits versus “hot money” sources, the amount of loan

commitments and the volume of liquid assets held by the bank.

S: Sensitivity to Market Risk – This category attempts to measure the bank’s exposure to

changes in interest rates, foreign exchange rates, and commodity or equity prices. Capital

adequacy, the extent of formal risk management plans and the stability of earnings are

considered.

CAMELS composites are constructed by regulators ranging from 1 to 5 with 1 being the safest.

Banks with a composite rating of 4 or 5 are considered ‘problem banks.’

Composite “1” – Institutions that are sound in all aspects of performance

Composite “2” – Institutions that are fundamentally sound but have modest weaknesses

correctable in the normal course of business

Composite “3” – Institutions that have financial operational or compliance weaknesses ranging

from moderately severe to unsatisfactory

Composite “4” – Institutions that have an immoderate volume of serious financial weaknesses or

a combination of other conditions that are unsatisfactory

Composite “5” – Institutions that have an extremely high immediate or near term probability of

failure

Teaching Tip: Asking the students whether CAMELS ratings should be made public can

generate an interesting class discussion.

3. Balance Sheet Structure (Typical percentage breakdowns are provided in Chapter 11)

Major Assets:

Cash and balances due from other DIs

Consist of vault cash, currency in the process of collection (CIPC), correspondent balances and

reserves at the Fed.

Teaching Tip: These are sometimes called primary reserves.

Investment Securities

Short term:

Interest bearing deposits at other FIs,

Fed funds sold

Reverse Repos

U.S. Treasury and agency securities

These securities are described in detail in Chapter 5 and the major features are reviewed in this

chapter of the text as well.

Long term:

Municipal bonds

Mortgage backed securities

Other securities (long and short term): These include corporate bonds, foreign bonds,

Brady bonds and short term securities held for sale (see Teaching Tip below)

Detailed descriptions of these securities can be found in the appropriate markets chapters.

Short term investments are safe liquid assets held to assist in liquidity management. Rates of

return are usually significantly lower than on loans. Long term securities are held for income

and are typically investment grade.

Teaching Tip: Banks designate their investment securities as held for income (to maturity) or

available for sale. Securities held for income are normally carried at book value; those available

for sale are carried at the lower of current market or book value. Securities held for sale and

other short term investments are sometimes called ‘secondary reserves.’

Teaching Tip: Not all municipal bonds/loans are independently evaluated or rated. State

chartered banks in particular may face some pressure to invest in munis of the state that regulates

their activities.

Loans and leases

Commercial and industrial (C&I) loans: C&I loans may be working capital loans, loans

for capital equipment, bridge loans, etc. They may be secured or unsecured.

Traditionally, banks only made well collateralized working capital loans, but now they

may finance start up businesses without tangible collateral. Analysis of C&I loans varies

by type of borrower. Today loans of more than one year maturity are likely to be floating

rate.

Loans secured by real estate: Primarily single family mortgage and home equity loans,

although banks engage in commercial real estate development and multifamily housing.

Consumer loans

Auto loans are a major component of consumer loans. Others include credit card loans,

signature loans and loans collateralized by consumer durables.

Other loans

Other loans include loans to domestic and foreign FIs, and loans to state, federal and

foreign government entities.

Loans are the largest category on the balance sheet and generate the majority of revenue; hence,

the quality and pricing of the loan portfolio are paramount determinants of a bank’s success.

Unearned income and the allowance for loan and lease losses are contra asset accounts that are

subtracted from total (gross) loans to calculate net loans. Unearned income is income that the

bank has received on a loan but has not yet earned nor recorded on the income statement. The

allowance account is management’s estimate of the total amount of loans that will not be repaid.

Other assets

Other assets include nonearning assets such as the physical structures and property owned,

collateral seized on defaulted items, intangible assets, such as goodwill and mortgage

servicing rights, deferred and prepaid items, etc.

Major liabilities:

Demand deposits

Until recently, corporate demand deposits could not pay interest. As of July 2011 the

Depression era restriction was removed.

NOW accounts

Negotiable Order of Withdrawals are checking accounts that pay interest if the owner

maintains the minimum balance required.

MMDAs

Money Market Deposit Accounts are accounts with limited checking privileges that pay

rates of interest comparable to money market mutual funds. MMDAs are not reservable

and they are insured. They typically require higher minimum balances than NOW

accounts.

Other savings accounts

These are primarily passbook savings accounts. Checks cannot be written on savings

accounts although they can be accessed by ATM.1

Retail CDs

These are time deposits with denominations under $100,000.

Wholesale CDs

Wholesale CDs are time deposits with denominations of $100,000 or more. These are

negotiable (saleable) instruments. Banks may obtain wholesale CDs by paying other

banks or investment banks a small finder’s fee to locate corporate or institutional

investors willing to deposit money in the bank for a set time. Deposits obtained in this

manner are called brokered deposits. Time deposits held in dollars outside the U.S. are

called Eurodollar deposits.

Most Eurodollar accounts are time deposits of 6 months or less; many carry a variable rate of

interest tied to Libor. Eurodollar accounts pay slightly higher rates than similar domestic

deposits because these accounts avoid some regulatory costs. They are not subject to reserve

requirements or deposit insurance (even though they have defacto been insured).

Purchased funds

Fed funds borrowings

Repurchases

Banker’s Acceptances sold

Commercial paper issued by the holding company parent (banks cannot issue commercial

paper)

Medium term subordinated notes and debentures

Discount window loans

Brokered deposits

Purchased funds can be more expensive sources of funds than deposits, particularly core

deposits. Core deposits are deposits that are at the bank for reasons other than earning interest.

Earning interest may still be important but convenience, a relationship with the bank, customer

satisfaction, etc. keep the customer at the bank even if the bank does not pay the highest rate of

interest available on similar accounts at other banks.

Noninterest bearing liabilities

Accrued interest owed

Deferred taxes

Dividends payable

Minority interest in consolidated subsidiaries, etc.

Equity capital

1Banks can impose a fourteen day wait before granting a request for a withdrawal on a savings

account. Most do not impose any wait although they typically limit the number of free

withdrawals in a given period.

Preferred stock (paid in capital and surplus if any)

Common stock (paid in capital and surplus)

Retained earnings

The minimum capital requirements are covered in Chapter 13.

a. Off-Balance-Sheet Assets and Liabilities

Off-balance-sheet (OBS) assets and liabilities are contingent assets and liabilities or accounts

that may end up on the balance sheet depending on what events transpire. They are disclosed in

footnotes to the financial statements.

Loan commitments

Most C&I loans are draw downs of prearranged lines of credit. The line of credit is a

commitment to make a loan, and it is a contingent liability of the bank. Once the loan is

made it becomes an asset. An up-front fee (or facility fee) is often charged, it may be 1/8 of

1% of the commitment amount. The borrower may also be charged a back-end fee at the

end of the period on the unused portion of the credit line.

Commercial letters of credit

Commercial letters of credit are a commitment by a bank to pay a seller of goods if the buyer

of the goods cannot pay. The creditworthiness of the bank is substituted for the

creditworthiness of the buyer. They are frequently used in international trade where sellers

would find credit investigation of buyers to be costly.

Teaching Tip: Letters of credit of this type are used less frequently in trade between

developed economies where information about firms is widely available and trade problems

have historically been low. Using letters of credit adds significantly to the cost of trade for

corporations and in the majority of cases the bank does not have to pay anything.

Standby letters of credit

Sometimes called performance letters of credit or financial letters of credit, these cover less

predictable risks, and are usually for higher amounts than commercial letters of credit.

Examples of financial letters include a bank’s promise to pay if a commercial paper borrower

fails to repay the amount owed, or if a municipal borrower cannot make scheduled interest

and principle payments. Financial letters are often used by commercial paper issuers to

obtain higher credit ratings on the paper. Commercial paper rating spreads may be 40 basis

points or more in normal markets; thus, if the bank’s fee is less than this amount, the issuer of

marginal quality paper can reduce their borrowing costs by procuring a standby letter of

credit. A loan commitment may be a less costly alternative to the standby letter.

Performance letters may be issued where banks agree to pay if a construction project is not

completed on time, or if goods do not meet certain specifications, etc. Both commercial and

standby letters are forms of insurance, and it should not be surprising that property and

casualty insurers (and also some foreign institutions) issue standby letters. One reason banks

have not issued more standby letters is their own lack of a high credit rating. This has left an

opening for higher rated non-bank FIs and foreign banks to issue more attractive standby

letters.

Loans sold

Loans may be sold in part or as a whole. Sales may be with or without recourse.2 Most are

without recourse.

Derivative contracts

Derivatives include futures, forwards, swaps and options positions. Their use is heavily

concentrated among the largest banks. These positions may create contingent risk to the

institution depending upon whether they are used for hedging other bank positions or

speculating. Forward contracts and other OTC contracts also expose the institution to credit

risk, but exchange traded options and futures do not.

b. Other Fee-Generating Activities

Correspondent banking and trust services

Trust services constitute the management of assets for individuals and corporations.

Individual trusts and pension funds comprise the bulk of this activity and it is dominated by

large banks. Large banks also provide correspondent services for smaller banks including

services such as check clearing, foreign exchange, hedging and loan participations.

Processing Services

Many banks provide data processing services for business customers. They may help

manage a firm’s accounts receivables and payables, assist in cash management and in

information technology services for customers.

c. Income Statement

Interest income

Interest income is the largest component of income. It is comprised of interest and fee

income on loans and securities. For the year 2013 interest income comprised 65% of total

income (down from 74% in 2007). (All the data in this segment are from the FDIC Banking

Statistics: FDIC insured banks, average for all banks.)

Interest expense

Interest expense is composed of interest on deposits, interest on purchased funds and interest

on other borrowings. For the year 2013 interest expense comprised about 10.8% of total

expense, much lower than the 49.5% level at the start of the crisis in 2007.

Net interest income is interest income less interest expense. Net interest income was 89%

of interest income in 2013.

Provision for loan losses (PLL)

2A loan sale made without recourse means that if the borrower defaults the seller of the loan is not liable for repayment to the loan buyer.

The PLL is a deduction from current earnings made by management to offset loans that

management believes will go bad in the upcoming quarter. The PLL in 2013 was 19.8% of

net income (down dramatically from 58% in 2007 and 20% in 2006). Recall that actual write

offs are called net charge offs (NCOs). NCOs were 34.6% of net income in 2013. These

decreases reflect improvements in real estate and credit card loans losses. It is possible that

requirements for PLL charges may change as early as 2015. Regulators want banks to

recognize potential losses earlier and moving from a model of expensing near term incurred

losses to expensing longer term expected loan losses. The change may result in increases to

PLL charges and may lead to greater swings in earnings. From an economics standpoint

these changes are desirable as earnings will incorporate more information about prospective

long term cash flows of the bank.

Noninterest income

Noninterest income includes income from service charges on deposits, income from fiduciary

activities, gains and losses and fees from trading activities and fees from commitments and

letters of credit, etc. Noninterest income comprised 34.9% of total income for 2013.

Interest income plus noninterest income equals total operating income. This is equivalent to

the sales revenue figure for a nonfinancial firm.

Noninterest expense

This component consists of salaries and benefits, expenses for the premises and equipment

and other expenses and was 89.2% of total expenses in 2013.

Income before taxes and extraordinary items

Operating profit before taxes and extraordinary items: Operating profit before tax was 30.8%

of total income (interest and noninterest income) in 2013.

Extraordinary items

One off events, including changes in accounting rules, major asset liquidations, lawsuit

damages, etc. These were about 0.02% of total income in 2013.

Net income

The bottom line: Net income was 21.6% of total revenue for 2013. This represents an

improvement from the much poorer levels of the crisis years.

d. The Direct Relationship Between the Income Statement and the Balance Sheet

NI = Interest revenue – Interest expense – P + (NII – NIE) – T or













TNIENIIPLr

ArNI mmnn

NI = Net Income

An = Value of the bank’s nth asset ($)

Lm = Value of the bank’s mth liability ($)

rn = rate earned on the bank’s nth asset

rm = rate earned on the bank’s mth liability

P = Provision for loan losses

NII = Noninterest income

NIE = Noninterest expense

T = bank taxes

N = number of assets and M = number of liabilities

This equation states that the bank’s net income is the product of the interest rate of return on

an asset times the number of dollars invested in that asset less the interest cost on a fund’s

source times the dollars raised in that category less the provision for loan loss, plus the net

noninterest income minus taxes.

Teaching Tip: One can use the above equation to find the required dollar interest spread in order

to hit a given ROE target. Suppose that a bank has equity of $200, interest expense of $90, P =

$20, net noninterest income of -$15 and a tax rate of 34%. What is the minimum total interest

revenue required to give a ROE of 15%? (Numbers in millions)

Required NI = NI/$200 = 0.15 or NI = $30

NI = [Interest revenue– Interest expense – P + (NII – NIE)]  (1 – Tax rate) or

$30 = [Interest revenue – $90 – $20 + –$15]  (1 – 0.34)

Required interest revenue = $170.45

This example could be taken one step further to illustrate loan pricing. If securities are $500 and

are earning an average rate of return of 5% and the bank has $1500 in loans, what must be the

average loan rate to generate interest revenue of $170.45?

$170.45 = ($500  0.05) + ($1500  Avg. Loan Rate)

Avg. Loan Rate required = 9.7%

The instructor can now lead the students in a discussion of the factors that would determine

whether the required average loan rate is feasible (the mix, competitive conditions, loan demand

and the elasticity of loan demand with respect to interest rates) and how changing interest rates

would affect this number. Examples of this nature can be found in Gardiner, Mills and

Cooperman, Managing Financial Assets: An Asset/Liability Approach, 4th ed, Dryden Press,

2000.