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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
M
1m
TNIENIIPLr
N
1n
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.
