Ch02-The Financial Statement of a Bank

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Chapter 02: The Financial

Statements of a Bank

Lectured by: Mr. Rithjayasedh PEOU, MFin (Melb)


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Content

! Balance Sheet or Report of Condition! Assets! Liabilities! Capital Account

! Income Statement or Report of Income! Debate

6 October 2013Mr. Rithjayasedh PEOU, MFin (Melb) 2


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Introduction

! The particular services each bank chooses to offer and theoverall size of a banking organization are reflected in its

financial statements.

! The two main financial statements that bank managers,customers and the regulatory authorities look at are the

balance sheet (Report of Condition) and the income

statement (Report of Income).

! The other two key financial statements are often used by creditanalysts and bank managers in assessing changes in the funds-using and funds-raising activities of a bank are the Sources and

Uses of Funds Statement (Funds-Flow Statement) and the

Statement of Stockholders Equity.



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Balance Sheet

! A banks balance sheet (Report of Condition) lists the assets,liabilities, and equity capital (owners funds) held by or invested in the

bank on any given date.

! Because bank are simply business firms selling a particular kind ofproduct, the basic balance sheet identity (A = L + E) must be valid.! In banking, the assets on the BS include four major kinds of assets:! C: Cash in the vault and the deposits held at other depository

institutions

! S: Govt and private interest-bearing securities purchased in theopen market.! L: Loans and lease financing made available to customers! MA: Miscellaneous assets



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Balance Sheet

! Liabilities fall into two principal categories:! D: Deposits made by and owed to various customers! NDB: Nondeposit borrowings of funds in themoney and capital markets

! Equity capital (EC) represents long-term funds that theowners contribute to the bank.

! Therefore, the banks BS identity can be written asfollows:

C + S + L + MA = D = NDB + EC



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Bank Assets

! The Cash Account (Cash and deposits due from banks)! Cash held in the banks vault,! Deposits the bank has placed with other banks

(correspondent deposits),

! Cash items in the process of collection (mainly uncollectedchecks), and

! The banks reserve account held with the Federal Reservebank in the region, is often labeledprimary reserve.

! Note: Banks strive to keep the size of this account as low aspossible because cash balances earn little or no interest income

for the bank.



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Bank Assets

! Investment Securities: The Liquid Portion! Holdings of shorter-term government securities

both U.S. government and municipal securities, and! Money market securities, including interest-bearing

time deposits held with other banks and commercial

paper.

! Note: Serving as secondary reserve, the liquid portionoccupy the middle ground between cash assets and loans,earnings some income but held mainly for the ease with

which they can be converted into cash on short notice.



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Bank Assets

! Investment Securities: The Income-Generating Portion! Taxable securitiesmainly U.S. government bonds and notes,

securities issued by various federal agencies and corporate bonds

and notes, and! Tax-exempt securitiesprincipally state and local government

(municipal) bonds.

! Note: Investment securities may be recorded on a banks books attheir original cost, at market value, or at the lower of cost or market

value.! Trading account securities implies that the bank serves as a security

dealer for certain kinds of securities. The amount recorded in theaccount represents those securities the bank intends to sell before they

reach maturity, valued at market.



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Bank Assets

! Loans! The larger, called gross loan, is the sum of all outstanding

IOUs owed to the bank in the form of consumer, real

estate, commercial, and agricultural loans plus any credit

extended by the bank to security dealers and other financial

institutions.

! Loan losses, both current and projected, are deducted fromthe amount of this total (gross) loan figure.

! Note: Loans account is by far the largest asset item of a bank,which generally account for half to almost three-quarters of the

total value of all bank assets.



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Bank Assets

! Allowance for possible loan losses (ALL),! ALL, which is a contra-asset account, represents an accumulated

reserve against which loans declared to be uncollectible can be

charged off.! When a loan is considered uncollectible, the banks accounting

department will write (charge) it off the books by reducing theALL account by the amount of the uncollectible loan while

simultaneously decreasing the asset account for gross loans.

! The allowance for possible loan losses is built up gradually overtime by annual deductions from current income.

! The se deductions appear on the bank's income statement as anoncash expense item called theprovision for loan losses

(PLL)



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Bank Assets

! Unearned discount! It is also deducted from gross loans to derive net loans.! These discounts consist of interest income from loans that has

been received from customers but not yet earned under theaccrual method of accounting used by banks today.

! Over the life of discounted loan, the income will gradually beearned by the bank and the necessary amounts will be transferred

from unearned discount to the banks interest income account.

! Nonperforming loans! A loan is placed in the nonperforming category when any

scheduled loan repayment is past due for more than 90 days.

! The bank is forbidden to record any interest income from theloan until a cash payment actually comes in.



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Bank Assets

! Federal funds sold and securities purchased under resaleagreements

! This item includes mainly temporary loans (usuallyextended overnight, with the funs returned the next day)made to other banks, securities dealers, or even major

corporations.

! The funds for these temporary loans often come from hereserves bank ahs on deposit with the Federal Reserve

Bank in its district.

! Some of the these temporary credits are extended in theform of repurchase (resale) agreements (RPs) .



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Bank Assets

! Customers Liability on Acceptances! Larger banks often provide a form of credit for their

customers known as acceptance financing.

! The reader will note that this term coincides exactly withan item listed under bank liabilities, acceptanceoutstanding.

! The dual pair of accounts increase each time a bank agreesto stand behind a customers credit, usually to help thatcustomer pay for goods imported from overseas.

! Bankers acceptance are widely used today for financinginternational trade, for purchasing foreign currencies andeven to support the shipment and storage of goods andagricultural commodities in the domestic economy.



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Bank Assets

! Miscellaneous assets! Bank assets also include building and equipment, the net

(adjusted for depreciation) value of bank buildings and

equipment, investments in subsidiary firms, prepaid

insurance, and other relatively insignificant asset items.

! Note: Fixed assets typically generate fixed operating costs in theform of deprecation expense, property taxes, and so on, which

provide operating leverage, enabling the bank to boost itsoperating earnings if it can increase its sales volume to high

enough level and earn more form using its fixed assets than

those assets cost.



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Bank Liabilities

! Deposits! Non-interest bearing demand deposit, or regular

checking accounts, generally permit unlimited check

writing.

! Savings depositsbear the lowest rate of interest offeredto depositors by a bank but may be of any denomination

and permit the customer to withdraw at will.

! NOW accounts, which can be held by individuals andnonprofit institutions, bear interest and permit drafts

(checks) to be written against each account in order to pay

third parties.



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Bank Liabilities

! Deposits (Contd)! Money market depots accounts (MMDAs) can pay

whatever interest rate the offering bank feels competitive

and have limited check-writing privileges attached.

! Time deposits (mainly certificates of deposit, or CDs)usually carry a fixed maturity (term) and a stipulated

interest rate but may be of any denomination, maturity, and

yield agreed upon by the bank and its depositor. Includedare large ($100,000-plus) negotiable CDsinterest-bearing

deposits that banks use to raise money from their most

well-to-do customers.



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Bank Liabilities

! Borrowings from nondeposit sources! Federal funds purchased and securities sold under

agreements to repurchase tracks the banks temporary

borrowings in the money market, mainly from reserves loaned toit by other banks or from repurchase agreements where the bank

has borrowed funds collateralized by some of its own securitiesfrom another bank or a large corporate customer.

! Other short-term borrowings include borrowing reserves fromthe discount windows of the Federal Reserve banks and

Eurodollar borrowings from multinational banks abroad or fromthe borrowing banks own overseas branches.

! Other liabilities account include a deferred tax liability andobligations to pay off investors who hold bankers acceptances.



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Bank Capital Accounts

! Common stock is the total par (face) value of common stockoutstanding.

! Capital surplus account is the excess market value of the stock.! Preferred stock guarantees its holders an annual dividend before

common stockholders receive any dividend payments.

! Retained earnings represents accumulated net income left over eachyear after payment of stockholder dividends.

! Contingency reserve held a s protection against unforeseen losses.! Treasury stock is stocks that have been retired.! Subordinated notes and debentures are debt securities that are long-

term and carry a claim on the banks assets and income that comesafter (is subordinated to) the claims of its depositors.



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Off-Balance-Sheet Items

! Standby credit agreement, in which a bank pledges toguarantee repayment of a customer's loan received from a third

party.

! Interest rate swaps, in which a bank promises to exchangeinterest payments on debt securities with another party.

! Financial futures and option interest-rate contracts, inwhich a bank agrees to deliver or to take delivery of securities

from another party at a guaranteed price.

! Loan commitments, in which a bank pledges to lend up to acertain amount of funds until the commitment matures.

! Foreign exchange rate contracts, in which a bank agrees todeliver or accept delivery of foreign currencies.



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Income Statement

! A banks income statement, or Report of Income, indicates theamount of revenue received and expenses incurred over a specific

period of time.

!The principal source of bank revenue is the interest income generatedby the banks earnings assets, mainly:

! Loans (L),! Securities (S),! Any interest-bearing deposits that are part of cash assets (C) held

with other banks, and! Any miscellaneous asses (M) generating revenue (including any

income earned by subsidiaries of the bank or rental income formproperty that it owns.



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Income Statement

! The major expenses incurred in generating this revenue include:! Interest paid out to depositors (D),! Interest owed on nondeposit borrowings (NDB),! The cost of equity capital (EC),! Salaries, wages, and benefits paid to bank employees (SWB),! Overhead expense associated with the banks physical plant

(O),

!Funds set aside for possible loan losses (PLL),

! Taxes owed (T), and! Miscellaneous expenses (ME).



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Income StatementKey Items on a Banks Income Statement

Revenues (revenues from the banks service outputs)

Loan income

Investment income

Noninterest sources of income

Expenses (cost of the banks inputs of resources needed to produce its services)

Interest paid on deposits

Interest paid on nondeposit borrowings

Salaries and wages (employee compensation)

Provision for loan losses (allocations to the reserve for possible olosses on any loans made)

Other expenses

Gains or losses from trading in securities

Taxes

Income before taxes and securities transactions

Net income after taxes and securities gains or losses


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Income Statement

! Interest income! Not surprisingly, interest and fees generated form loans

account for most bank revenues (normally two-thirds or

more of the total).

! It must be noted, however, that the relative importance ofloan revenue versus noninterest revenue sources (so-called

fee income) is changing rapidly, with fee income today

growing much faster than interest income on loans asbankers work to develop fee-based services.

! Interest expenses is the number 1 expense item for a bank.6 October 2013Mr. Rithjayasedh PEOU, MFin (Melb) 24


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Income Statement

! Net interest income (interest margin) is the gap between theinterest income the bank receives on loans and securities and the

interest cost of its borrowed funds.

! Noninterest Expense! It includes wages, salaries, and other personnel expense.! The costs of maintaining bank properties and rental fees on

office space show in net occupancy and equipment expense.

! The cost of bank furniture and equipment also appears underthe noninterest expense category, along with numerous small

expense items including legal fees, paper and office supplies,and repair costs.



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Income Statement


! Noninterest income! It includes fees earned from offering trust services, service

charges on deposit accounts, and miscellaneous fees and

charges for other bank services.

! Recently, bankers have targeted noninterest incomeknownas fee incomeas a key source of future revenues.

! By more aggressively selling services other than loans (such assecurity brokerage, insurance, and trust services), bankers havefound a promising channel for boosting the bottom line on

their IS, for diversifying their income sources, and for insulting

their banks more adequately from fluctuations in interest rates.


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Income Statement


! Loan-loss expense (provision for possible loan losses) is really anoncash expense and to shelter a portion of the banks current

earnings from taxes in order to help prepare for bad loans.

!Securities gains or losses: Most banks purchase, sell or redeemsecurities during the year, and this trading activity often results in gains

or losses above or below the original cost (BV) of the securities.

! Net income! Bank accounting practices call for the deduction of both

noninterest expenses and interest expenses from the sum of

interest and noninterest incomes to yield income (or loss) before

taxes.

! Applicable federal and state income tax rates are applied to thisincome figure to derive the banks net after-tax income (or loss).


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Debate



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End of Chapter 02

Lectured by: Mr. Rithjayasedh PEOU, MFin (Melb)

Ch02-The Financial Statement of a Bank

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