Bank Financial Statements & Operations Copyright 2014 Diane Scott Docking 1.
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Transcript of Bank Financial Statements & Operations Copyright 2014 Diane Scott Docking 1.
Bank Financial Statements & Operations
Copyright 2014 Diane Scott Docking1
2Copyright 2014 Diane Scott Docking
Learning Objectives
Examine how commercial banking is conducted to earn the highest profits possible. Topics include: The Bank Balance Sheet The Bank Income Statement Off-Balance Sheet Activities General Measuring Bank Performance
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Bank Financial Statements
Report of Condition – Balance Sheet
Report of Income – Income Statement
Copyright 2014 Diane Scott Docking
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The Bank Balance Sheet
Flow of funds (tab down to commercial banks) http://www.federalreserve.gov/releases/z1/current/z1r-4.pdf 4
Copyright 2014 Diane Scott Docking
C + S + L + MA = D + NDB + EC
C =Cash Assets
S =Security
Holdings
L = Loans
MA =Miscellaneous
Assets
D =Deposits
NDB =Non Deposit
Borrowings
EC = Equity Capital
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Copyright 2014 Diane Scott Docking6
To Increase a Bank’s Account:
Debit Credit
Asset
Liability
Income
Capital
Expense
Cash Assets
Account is called Cash and Due from Banks
Includes: Vault Cash Deposits with Other Banks Cash Items in Process of Collection Reserve Account with Fed
Sometimes Called Primary Reserves
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Securities Holdings
Money Market Securities (sometimes called Secondary Reserves)Investment Securities Taxable Securities Tax-Exempt Securities
Trading Account Securities Held for Resale Only Valued at Market Value
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Bank Investments and FASB 115
Following FASB 115 a bank, at purchase, must designate the objective behind buying investment securities as either:
Copyright 2014 Diane Scott Docking9
Security Classification
Security Classification
Recorded At
Balance Sheet Reporting
Income Statement Effect
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Trading Cost Unrealized gain/loss recognized in _____
HTM
AFS
Cost
CostUnrealized gain/loss recognized in _________________
Gain/loss recognized when _____________
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Federal Funds Sold and Reverse Repurchase Agreements
A Type of Loan Account
Generally Overnight Loans
Federal Funds Sold - Funds Come from the Deposits at the Federal Reserve
Reverse Repurchase Agreements – Bank Takes Temporary Title to Securities Owned by Borrower
Copyright 2014 Diane Scott Docking
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Loan Accounts
Gross Loans = Sum of All Loans
- Allowance for Possible Loan Losses Contra Asset Account
For Potential Future Loan Losses
- Unearned Discounts
= Net Loans
Nonperforming Loans
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Problem: Loan Loss ReservesPortland Bank made a provision for loan losses of $3.5 million, took loan charge-offs of $5 million, and had recoveries of $1,750,000 during the year 2XX2. At December 31, 2XX2, the bank’s balance sheet reserve for loan losses was $2 million. What was the bank’s apparent reserve for loan losses at the end of the prior year (December 31, 2XX1)?
Copyright 2014 Diane Scott Docking
Problem: Loan Loss Reserves (cont.)
LLR a/c (in millions)
Beginning Balance 12/31/2xx1
+ Provision
- Charge-offs
+ Recoveries
Ending Balance 12/31/2XX2
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BB = 2 – 1.75 + 5 – 3.5 = __________
The Expense
Problem: Loan Charge-offs
Sycamore Bank’s allowance for loan losses from its balance sheet for the years ending 2XX1 and 2XX2 is:
12/31/2XX112/31/2XX2
Allowance for loan losses $49,235,000 $55,335,000
During the year 2XX2, Sycamore Bank took a provision for loan losses charge of $15 million against its income. Determine the apparent amount of net loan charge-offs during 2XX2.
Copyright 2014 Diane Scott Docking
Problem: Loan Charge-offs (cont.)
LLR a/c
Beginning Balance 12/31/2xx1
+ Provision
- Net Charge-offs
Ending Balance 12/31/2XX2
Copyright 2014 Diane Scott Docking16
Net Charge-offs = 49.235 + 15.00 – 55.335 = ______
Miscellaneous Assets
Net Premises and Equipment
OREO
Goodwill and Other Intangibles
Other Miscellaneous Assets
Copyright 2014 Diane Scott Docking17
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Deposit Accounts
Non interest-Bearing Demand Deposits
Savings Deposits
Now Accounts
Money Market Deposit Accounts (MMDA)
Time Deposits
Core vs. Volatile Deposits
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Nondeposit Borrowings
Fed Funds Purchased/BorrowedSecurities Sold under Agreements to Repurchases (Repurchase Agreements)Acceptances OutstandingEurocurrency BorrowingsDue to Fed (Discount Loans)Long-term Debt Notes and Debentures
notes and bonds with maturities in excess of one year. Stock
Other Liabilities
Copyright 2014 Diane Scott Docking19
Equity Capital Accounts
____________________ Stock Listed at par
____________________ Stock Ownership interest in the bank. Listed at par
____________________ represents the amount of proceeds received by the bank in excess
of par when it issued the stock______________________ Retained Earnings
Treasury StockContingency ReserveReserves for .
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Off-Balance-Sheet Items
Unused Commitments
Standby Credit Agreements
Derivative Contracts Futures Contracts Options Swaps
OBS Transactions Exposes a Firm to Counterparty Risks
Copyright 2014 Diane Scott Docking
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22Copyright 2014 Diane Scott Docking
Off-Balance-Sheet Activities
1. Loan sales (secondary loan participation)2. Fee income from
Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit
3. Trading Activities and Risk Management Techniques1. Financial futures and options 2. Foreign exchange trading3. Interest rate swaps
All these activities involve risk and potential conflicts
Banks' Income Statement
23Copyright 2014 Diane Scott Docking
Banks' Income Statement (cont.)
24Copyright 2014 Diane Scott Docking
Net Interest Income =Interest Income - Interest Expenses
Interest on: Loans Taxable Securities Tax-exempt Securities Deposits held at other
institutions, Other Interest Income
Interest on: Deposits Short Term Debt Long Term Debt
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Interest Income Interest Expenses
Net Noninterest Income =Noninterest Income - Noninterest Expenses
Fee income
Service Charge on Customer Deposits
Trust Department Income
Trading account gains and fees
Other Operating Income
Wages, Salaries, and benefits
Other Personnel Expenses
Net Occupancy Expenses rent and depreciation on
equipment and premises
Other Operating Expenses Utilities, advertising,
deposit insurance premiums, etc.
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Noninterest Income Noninterest Expenses
Problem: Bank Income Statements
You know the following figures:Total interest income $140 Provision for loan losses
$5
Total interest expense $100 Income taxes$5
Total noninterest income $ 15 Increases in bank’s undivided profits$6
Total noninterest expenses $ 35
Calculate the following items:a) Net interest income e) Total operating revenues
b) Net noninterest income f) Total operating expenses
c) Pretax net operating income g) Dividends paid to common stockholders
d) Net income after taxes Copyright 2014 Diane Scott Docking 27
Solution: Bank Income Statements
Calculate the following items:a) Net interest income
b) Net noninterest income
c) Pretax net operating income
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= Total Interest Income – Total Interest Expense= 140 – 100 = _____
= Total Noninterest Income – Total Noninterest Expense= 15 – 35 = _______
= Net Interest Income + Net Noninterest Income + PLL= 40 – 20 – 5 = _______
Solution: Bank Income Statements (cont.)
d) Net income after taxes
e) Total operating revenues
f) Total operating expenses
g) Dividends paid to common stockholders
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Pretax net operating income – Taxes= 15 – 5 = ______
Interest Income + Noninterest Income=140 + 15 = ______
Interest Expenses + Noninterest Expenses + PLL= 100 + 35 + 5 = _______
Net Income After Taxes – Increase in Undivided Profits= 10 – 6 = _____
Problem: Bank Balance Sheets
You know the following figures:Gross loans $275 Miscellaneous assets $ 38
Cash and due from banks $ 9 Nondeposit borrowings $ 20
Investment securities $ 36 Allowance for loan losses $ 5
Trading account securities $ 2 Preferred stock$ 3
Goodwill and other intangibles $ 3 Common stock $ 5
Other real estate owned $ 4 Surplus $ 19
Bank premises and equipment, gross $ 34 Total liabilities $375
Bank premises and equipment, net $ 29 Total equity capital $ 39
Calculate the following items:a) Total assets d) Accumulated Depreciation
b) Net loans e) Total deposits
c) Undivided profits f) Fed funds soldCopyright 2014 Diane Scott Docking 30
Solution: Bank Balance Sheets
Calculate the following items:a) Total assets
b) Net loans
c) Undivided profits
d) Accumulated Depreciation
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Total Liabilities + Total Equity Capital= 375 + 39 = ______
Gross Loans – ALL= 275 – 5 = _____
Total Equity Capital – Preferred Stock – Common Stock – Surplus= = 39 – 3 – 5 – 19 = ______
PPE, gross – PPE, net= 34 – 29 = ______
Solution: Bank Balance Sheets
Calculate the following items:e) Total deposits
f) Fed funds sold
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Total Liabilities – Nondeposit Borrowings= 375 – 20 = _______
Total Assets: Cash and Due from Banks $ 9 Federal Funds Sold ? Investments 36 Gross Loans 275 Less: Allowance for Loan Losses -5 Bank Premises and Equipment, Net 29 Miscellaneous Assets 38 Trading Account Securities 2 Other Real Estate Owned 4 Goodwill and other Intangibles 3 Subtotal 391 Less Total Assets 414 Difference = Fed Funds Sold** ____
33Copyright 2014 Diane Scott Docking
Measuring Bank Performance
As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows both calculations and historical averages for key bank performance measures.
ROE can be misleading
If ROE is high - may mean there is not enough capital and this is not good
If ROE is low - May mean a lot of capital. This is okay, but bank may be inefficient.
Copyright 2014 Diane Scott Docking34
Copyright 2014 by Diane S. Docking36
Example: Bank Accounting
Jason opens a savings account at First National Bank with $100 cash. What are the accounting entries made by the bank to record this transaction?
Copyright 2014 by Diane S. Docking37
Solution to Example: Bank Accounting
T-account Analysis: Deposit of $100 cash into First National Bank
First National BankAssets Liabilities
Vault cash +$100 Checkabledeposits
+$100
Dr) Vault Cash $100 Cr) DDA $100
Copyright 2014 by Diane S. Docking38
Example 2: Bank Accounting
Ruthie has a checking account at First National Bank. She deposits a $100 check from her mom. Her mom’s checking account is at the Second National Bank. What are the accounting entries made by First National Bank and Second National Bank to record this transaction?
Copyright 2014 by Diane S. Docking39
First National Bank Assets Liabilities
CIPC +$100 Checkable deposits
+$100
Solution to Example 2: Bank Accounting
First National Bank Assets Liabilities
Reserves at Fed CIPC
+$100
-$100
Second National BankAssets Liabilities
Reserves -$100 Deposits -$100
Deposit of $100 check
When check clears:
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Example 3: Bank Accounting
Ruthie has a checking account at First National Bank. She deposits a $100 check from her mom. Her mom’s checking account is at the Second National Bank.
What are the accounting entries made by First National Bank to record this transaction assuming the bank must keep 10% of every deposit as Required Reserves?
Copyright 2014 by Diane S. Docking41
Solution to Example 3: Bank Accounting
T-account Analysis: Deposit of $100 cash into First National Bank
First National Bank Assets Liabilities
Required reserves Excess reserves
+$10 +$90
Checkable deposits
+$100
Copyright 2014 by Diane S. Docking42
Example 4: Bank Accounting
Assume, after the transactions in Example 3, that First National Bank makes a $90 loan to Mary Smith.
What are the accounting entries made by First National Bank to record this transaction.
Copyright 2014 by Diane S. Docking43
Solution to Example 4: Bank Accounting
T-account Analysis: Loan of $90 to Mary Smith
First National Bank Assets Liabilities
Excess reserves Loans
- $90 +$90
Copyright 2014 by Diane S. Docking44
General Principles of Bank Management
The bank has four primary concerns when managing assets:
1. Liquidity management
2. Asset management Managing credit risk Managing interest-rate risk
3. Liability management
4. Managing capital adequacy
Copyright 2014 by Diane S. Docking45
Example: Bank Liquidity Management –Excess Reserves
Assets Liabilities
Reserves $20 million Deposits $100 million
Loans $80 million Bank Capital $10 million
Securities $10 million
FNB Bank is required to keep 10% of deposits as Required Reserve.Below is their beginning Balance Sheet:
NOTE: The Bank has $10 million required reserves and $10 million in excess reserves.
Copyright 2014 by Diane S. Docking46
Example: Bank Liquidity Management – Excess Reserves (cont.)
Assume $10 million is withdrawn from various deposit accounts.The Bank Balance Sheet is now:
Deposit outflow of $10 millionAssets Liabilities
Reserves $10 million Deposits $90 million
Loans $80 million Bank Capital $10 million
Securities $10 million
Now, Bank has $9 million in required reserves and $1 million in excess reserves.
Copyright 2014 by Diane S. Docking17-47
Example: Bank Liquidity Management – No Excess Reserves
The Bank has No excess reserves.
Assets Liabilities
Reserves $10 million Deposits $100 million
Loans $90 million Bank Capital $10 million
Securities $10 million
FNB Bank is required to keep 10% of deposits as Required Reserve.Below is their beginning Balance Sheet:
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Example: Bank Liquidity Management – No Excess Reserves (cont.)
With 10% reserve requirement, bank has $9 million reserve shortfallWhat must it do??????
Deposit outflow of $10 millionAssets Liabilities
Reserves $0 million Deposits $90 million
Loans $80 million Bank Capital $10 million
Securities $10 million
Assume $10 million is withdrawn from various deposit accounts.The Bank Balance Sheet is now:
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Example: Bank Liquidity Management – No Excess Reserves (cont.)
Assets Liabilities
Reserves +$9 million Deposits $90 million
Loans $90 million Fed Funds Borrowed
+$9 million
Securities $10 million Bank Capital $10 million
1. Borrow $9 million from other banks either directly or in the Fed Funds market.
Copyright 2014 by Diane S. Docking50
Example: Bank Liquidity Management – No Excess Reserves (cont.)
Assets Liabilities
Reserves +$9 million Deposits $90 million
Loans $90 million Bank Capital $10 million
Securities $1 million
2. Sell $9 million in Securities (AFS)
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Example: Bank Liquidity Management – No Excess Reserves (cont.)
Assets Liabilities
Reserves +$9 million Deposits $90 million
Loans $90 million Discount Loans +$9 million
Securities $10 million Bank Capital $10 million
3. Borrow $9 million from the Fed Discount Window
Copyright 2014 by Diane S. Docking52
Example: Bank Liquidity Management – No Excess Reserves (cont.)
Assets Liabilities
Reserves +$9 million Deposits $90 million
Loans $81 million Bank Capital $10 million
Securities $10 million
4. Call in or sell off loans.
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Asset Management
Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk.
1. Get borrowers with low default risk, paying high interest rates
2. Buy securities with high return, low risk
3. Diversify
4. Manage liquidity
Copyright 2014 by Diane S. Docking54
Liability Management
Liability Management: managing the source of funds, from deposits, to CDs, to other debt.
1. Important since 1960s
2. No longer primarily depend on deposits
3. When see loan opportunities, borrow or issue CDs to acquire funds
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Funds Management
It’s important to understand that banks now manage both sides of the balance sheet together, whereas it was more separate in the past. Indeed, most banks now manage this via the asset-liability management (ALM) committee.
This explains the increased use of CDs and loans over checkable deposits in recent decades.
Copyright 2014 by Diane S. Docking56
Example: Capital Adequacy Management
1. Bank capital is a cushion that prevents bank failure. For example, consider these two banks:
High Capital Bank Assets Liabilities
Reserves $10 million Deposits $90 million
Loans $90 million Bank Capital $10 million
Low Capital Bank Assets Liabilities
Reserves $10 million Deposits $96 million
Loans $90 million Bank Capital $4 million
Capital/TA=10%
Capital/TA=4%
Copyright 2014 by Diane S. Docking57
Example: Capital Adequacy Management (cont.)
What happens if these banks make loans or invest in securities (say, subprime mortgage loans, for example) that end up losing money? Let’s assume both banks lose $5 million from bad loans.
Copyright 2014 by Diane S. Docking58
Example: Capital Adequacy Management (cont.)
Impact of $5 million loan loss.
High Capital Bank Assets Liabilities
Reserves $10 million Deposits $90 million
Loans $85 million Bank Capital $5 million
Low Capital Bank Assets Liabilities
Reserves $10 million Deposits $96 million
Loans $85 million Bank Capital -$1 million
Capital/TA=5.26%
Capital/TA= -1.05%
Copyright 2014 by Diane S. Docking59
Capital Adequacy Management
So, why don’t banks hold want to hold a lot of capital??
2. Higher is bank capital, lower is return on equity ROA = Net Profits/Assets ROE = Net Profits/Equity Capital EM = Assets/Equity Capital ROE = ROA EM Capital , EM , ROE
Copyright 2014 by Diane S. Docking60
Capital Adequacy Management
3. Tradeoff between safety (high capital) and ROE
4. Banks also hold capital to meet capital requirements (more on this in Chapter 13).
Copyright 2014 by Diane S. Docking61
Managing Capital
Strategies for Managing Capital: what should a bank manager do if she feels the bank is holding too much capital?
• Sell or retire stock
• Increase dividends to reduce retained earnings
• Increase asset growth via debt (like CDs)
Copyright 2014 by Diane S. Docking62
Managing Capital
Reversing these strategies will help a manager if she feels the bank is holding too little capital?
• Issue stock
• Decrease dividends to increase retained earnings
• Slow asset growth (retire debt)