Chapter Twelve Commercial Banks Financial Statements and Analysis

Chapter Outline 1. Financial Statements of Financial Institutions 2. Financial Statement Analysis Using a ROE Framework

1. 1 Evaluate Performance of Commercial Banks (CBs) • CBs are unique in – the special services they perform (e. g. , assistance in the implementation of monetary policy) – the level of regulatory attention they receive – the types of assets and liabilities they hold • Managers, stockholder, depositors, regulators, and other parties use performance, earnings, and other measures obtained from financial statements to evaluate which CB stocks they will purchase Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Financial Statements of Commercial Banks • Report of condition - balance sheet of a commercial bank reporting information at a single point in time • Report of income - income statement of a commercial bank reporting revenues, expenses, net profit or loss, and cash dividends over a period of time • Retail bank - focuses on consumer banking relationships • Wholesale bank - focuses on commercial banking relationships Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

1. 2 Balance Sheet: Assets • Four major subcategories – cash and balances due from other depository institutions • vault cash, deposits at the Federal Reserve, deposits at other FIs, and cash items in the process of collection – investment securities • interest-bearing deposits at other FIs, fed funds sold, RPs, U. S. Treasury and agency securities, securities issued by states and political subdivisions, mortgage-backed securities, and other debt and equity securities – loans and leases – other assets • premises and fixed assets, real estate owned, investments in unconsolidated subsidiaries, intangible assets, other fees receivable

Liabilities • NOW account - negotiable order of withdrawal account, similar to a demand deposit with minimum balance • MMDAs - money market deposit accounts with retail savings accounts and limited checking account • Other savings deposits - other than MMDAs • Retail CDs - time deposits with face value below $100, 000 • Wholesale CDs - time deposits with face value above $100, 000 (continued)

Liabilities • Negotiable instrument - an instrument whose ownership can be transferred in the secondary market • Brokered deposits - wholesale CDs obtained through a brokerage house • Core deposits - deposits of the bank that are stable over short periods of time and thus provide a long-term funding source to a bank • Purchased funds - rate-sensitive funding sources of the bank

Equity Capital • • Preferred and common stock (listed at par value) Surplus or additional paid-in capital Retained earnings Regulations require banks to hold a minimum level of equity capital to act as a buffer against losses from their on- and off-balance sheet assets

1. 3 Off-Balance-Sheet Assets and Liabilities • Contingent assets and liabilities that may affect the future status of the FIs balance sheet • OBS activities grouped into 5 major categories – Loan commitments - contractual commitment to loan to a firm a certain maximum amount at given interest rate terms • up-front fee - fee charged for making funds available through a loan commitment • back-end fee - fee charged on the unused component of a loan commitment (continued) Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

– Commercial and Standby Letters of Credit • letters of credit - contingent guarantees sold by an FI to underwrite the trade or commercial performance of the buyer of the guarantee • standby letter of credit - guarantees issued to cover contingencies that are potentially more sever and less predictable than contingencies covered under trade-related or commercial letters of credit – Forward Purchases and Sales of When-Issued Securities • when-issued securities - commitments to buy or sell securities before they are issued – Loans Sold • loans that a bank originated and then sold to other investors that may be returned (with recourse) to the originating institution in the future • recourse - the ability to put an asset or loan back to the seller should the credit quality of that asset deteriorate – Derivative Contracts • futures, forward, swap, and option positions taken by the FI for hedging or other purposes Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

1. 4 Income Statement • • • Interest Income Interest Expenses Net Interest Income Provision for Loan Losses Noninterest Income Noninterest Expense Income before Taxes and Extraordinary Items Income Taxes Extraordinary Items Net Income

The Direct Relationship between the Income Statement and the Balance Sheet N NI = M r n A n - r m. L m - n=1 P + NII - NIE - T m=1 where NI = Bank’s net income An = Dollar value of the bank’s nth asset Lm = Dollar value of the bank’s mth liability rn = Rate earned on the bank’s nth asset rm = Rate paid on the bank’s mth liability P = Provision for loan losses NII = noninterest income earned, including OBS NIE = noninterest expenses incurred T = Bank’s taxes N = number of assets the bank holds M = number of liabilities the bank holds Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

2. Financial Statement Analysis Using a Return on Equity Framework • Time series analysis - analysis of financial statements over a period of time • Cross-sectional analysis - analysis of financial statements comparing one firm with others • Return on equity (ROE) - measures overall profitability of the FI per dollar of equity ROE = Net income Total Assets Total equity capital = ROA EM Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Return on Assets and Its Components Return on Assets (ROA) - measures profit generated relative to the FI’s assets ROA = Net Income Total operating income = PM Mc. Graw-Hill /Irwin Total operating income Total assets AU Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

2. 1 Profit Margin (PM) - measures a bank’s ability to pay expenses and generate net income from interest and noninterest income Interest expense ratio = Interest expense Total operating income Provision for loan loss ration = Provision for loan losses Total operating income Noninterest expense ratio = Noninterest expense Total operating income Tax Ratio = Income taxes Total operating income Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

2. 2 Asset Utilization Asset utilization (AU) - measures the amount of interest/ noninterest income generated per dollar of total assets AU = Total operating income = Interest + Noninterest Total assets income ratio Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

2. 3 Net Interest Margin Net interest margin - interest income minus interest expense divided by earning assets Net interest = margin = Mc. Graw-Hill /Irwin Net interest income Earning assets Interest income - Interest expense Investment securities + Net loans and leases Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Spread - the difference between lending and deposit rates spread = Interest income Interest expense Earning assets Interest-bearing liabilities Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Overhead Efficiency Overhead efficiency - a bank’s ability to generate noninterest income to cover noninterest expenses Overhead efficiency = Noninterest income Noninterest expense Mc. Graw-Hill /Irwin Copyright © 2007 by The Mc. Graw-Hill Companies, Inc. All rights reserved.