FINANCIAL

STATEMENTS AND
BANK PERFORMANCE

Chapter 2

William Chittenden edited and updated the PowerPoint slides for this edition.

Key topics

1. 1. Financial statements of banks

2. 2. Bank performance analysis

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 1. Financial statements of banks
1. 1.1. Overview of the Balance sheets and Income
statements of banks
2. 1.2. Balance sheet or Report of condition
1. Asset items
2. Liability items
3. 1.3. Recent expansion of off-balance sheet items
4. 1. 4. Components of the Income statement:
Revenues and Expenses
5. 1.5. Financial statement manipulation 3

Bank financial statements

 Report of condition – Balance sheet

 Report of income – Income statement

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 Key items on a bank financial statement

 Table 5.1. – p.130

 Snapshot: What are the similar and
different items of banks compare to non-
financial firms?
- Balance sheet
- Income statement

5-6

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 Table 5.3 - page 133
 Questions 5.2 and 5.3
 Proportion of main items
 Characteristics of banks

Report of condition - Balance sheet

 The Balance sheet of a bank showing its

Assets, Liabilities and Net worth at a given
point in time

Assets = Liabilities + Equity

 May be viewed as a list of financial inputs

(sources of funds) and outputs (uses of funds)

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 5-9

Balance sheet

C + S + L + MA = D + NDB + EC
C = Cash assets D = Deposits
S = Security holdings NDB = Non-deposit
borrowings
L = Loans
EC = Equity capital
MA = Miscellaneous
assets

Balance Sheet (assets): PNC and Community National Bank

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 5-11

Key asset item: Loan accounts

 The major asset

 Gross loans – sum of all loans
 Allowance for possible loan losses
 Contra asset account
 For potential future loan losses
 Net loans
 Unearned discount income
 Nonperforming loans
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5-12

Types of loans

 Commercial and industrial loans

 Consumer loans (loans to individuals)
 Real estate loans
 Financial institution loans
 Foreign loans
 Agriculture production loans
 Security loans
 Leases
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 Adjustments to total loans
…three adjustments are made to obtain a net loan
figure.

1. Leases are included in gross loans.

2. Unearned income is deducted from gross
interest received.
3. Gross loans are reduced by the dollar
magnitude of a bank's loan-loss reserve,
which exists in recognition that some loans
will not be repaid.
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5-14

Specific and general reserves

 Specific reserves
 Set aside to cover a particular loan
 Designate a portion of ALL or
 Add more reserves to ALL
 General reserves
 Remaining ALL
 Determined by management but influenced by
taxes and government regulation
 Loans to lesser developed countries require
allocated transfer reserves
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ALL : Allowance for loan losses

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 5-15

Allowance for loan losses (ALL)

Beginning ALL
+ Provision for loan loss (Income statement)
= Adjusted allowance for loan losses
- Actual charge-offs

+ Recoveries from previous charge-offs

= Ending allowance for loan losses
VN: see Circular 02/2013/TT-NHNN

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Provisions for loan losses

Recoveries

Provisions for loan losses

Reserve for Loan Losses Charge offs

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 Average assets, capital and loan loss data: PNC and Community NB

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5-18

Miscellaneous assets

 Bank premises and fixed assets

 Other real estate owned (OREO)

 Goodwill and other intangibles

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 Bank liabilities
 Non interest-bearing demand deposits
 Transactions accounts that pay no interest
 Negotiable orders of withdrawal (NOWs) and
automatic transfers from savings (ATS)
accounts
 Pay interest set by each bank without federal
restrictions
 Money market deposit accounts (MMDAs)
 Pay market rates, but a customer is limited to no
more than six checks or automatic transfers each
month
 Savings and time deposits represent the bulk of
interest-bearing liabilities at banks. 19

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Bank liabilities (cont.)

 Two general time deposits categories exist:
 Time deposits in excess of $100,000, labeled
jumbo certificates of deposit (CDs).
 Small CDs, considered core deposits which tend
to be stable deposits that are typically not
withdrawn over short periods of time.
 Deposits held in foreign offices
 Balances issued by a bank subsidiary located
outside the U.S.

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Non-deposit borrowings

 Fed funds purchased

 Securities sold under agreement to
repurchase (repurchase agreements)
 Acceptances outstanding
 Eurocurrency borrowings
 Subordinated debt (Notes and bonds with
maturities in excess of one year)
 Limited life preferred stock
 Other liabilities 21

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Balance Sheet (liabilities): PNC and Community National Bank

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 Minor liability item – but very
important: Stockholders equity

 Stockholders' equity
 Ownership interest in the bank
 Common and preferred stock are listed at par
 Surplus account (= purchase value - par value of
issued stocks)
 Retained earnings (accumulated net income not paid
out as cash dividends)
 Treasury stock (retired stock)
 Contingency reserve (protection against unforeseen
losses)
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5-24

Comparative
Balance
Sheet
Ratios for
Different Size
Banks (FDIC,
2006)

- What are the differences among banks according to their size? 24

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 Quick quiz

 Question 5.6 – p. 145

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5-26

Off-balance-sheet items
 Unused commitments: committed amount to lend
over a defined period of time
 Standby credit agreements: guarantee repayment
of a loan that borrower received from another lender
 Derivative contracts: potential to earn profit or incur
loss on an asset that the bank presently does not own
 Futures contracts
 Options
 Swaps
 Off-balance-sheet transactions exposure a firm
to counterparty risks 26

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Off-balance-sheet items
 Often expose the bank to considerable risk that
conventional financial statements do not
capture
 Unauthorized trading in derivatives caused
notorious losses for financial institutions
around the world
E.g. see the collapse of 234-year-old Barings
Bank in 1995 by Nicholas Leeson
http://www.time.com/time/2007/crimes/18.html
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Table 5.5 - p. 143

 Comment on off-balance sheet items
of banks.

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 5-29

Report of income
 The statement of revenues, expenses and
profits for a bank over a period of time
 Shows how much it has cost to acquire funds
and to generate revenues from the uses of
funds in Report of conditions
 Shows the revenues (cash flow) generated by
selling services to the public
 Shows net earnings after all costs are deducted
from the sum of all revenues
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5-30

Report of Income for BB&T Corporation – (p 147)

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 Questions

 What are total incomes/total expenses?

 What are the proportion of each income item in

2 years? Comment.

 What are the proportion of each expense item

in 2 years? Comment.

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5-32

Net interest income =

Interest income – Interest expenses
Interest income Interest expenses
 Interest and fees on  Deposit interest costs
loans and leases  Interest on short-term
 Deposits held at other debt
institutions  Interest on long-term
 Taxable securities debt
revenue
 Tax-exempt securities
revenue
 Other interest income 32

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 5-33
Net noninterest income =
Noninterest income – Noninterest expenses

Noninterest income Noninterest expenses

 Fees earned from  Wages, salaries, and

fiduciary activities employee benefits
 Service charges on  Premises and
deposit accounts equipment expense
 Trading account gains  Other operating
and fees
expenses
 Additional noninterest
income

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5-34

Income statement
Net interest income
- Provision for loan loss
Net income after PLL
+/- Net noninterest income
Net income before taxes
Taxes
Net income
- Dividends
Undivided profits

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 5-35
Comparative Income Statement Ratios for Different Size Banks
(FDIC, 2006)

What are the most important revenue and expense items on the income statement
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of a bank?

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Game: 45 min
 6 groups
 Internal discussion among team in 10 minutes
 All group members line up on the board.
 List down the items of assets, liabilities &
equity, income statements correctly.
 The winner get prize basing on the
time/correctness of completion.
 Payment for the losers: 10-8-6-4-2
 Winner: no payment.

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 Quick check

 Questions 5.10 and 5.11 – page 149.

 What are the relationships among items in

Report of Conditions and Report of Income?

- Drawing the BS and IS in your notebook

- Making the lines among related items

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5-38

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 Financial statement manipulation
 The problem with book-value accounting
 Original (historical, book-value) cost
 Amortized cost
 Market-value
 Held-to-maturity and available-for-sale securities

 Off-balance sheet activities

 Enron and “Special-purpose vehicles”
(http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articl
es/specpurpentity.htm)
 Window dressing
 Eliminate Fed borrowing prior to financial statement
reporting date 39

 Increase asset size prior to year-end

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Food for thoughts

 Ethics in banking and financial services:
The cosmetics of “window dressing” and
“creative accounting” – p. 151.
 Do you think it will apply to Vietnamese
banks?
 How to deal with this problem?

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 Financial statement manipulation (cont.)

 Non-performing loans
 Banks may lend borrower funds to make payments on
past due loans, understating non-performance status
 Allowance for loan losses
 Management discretion and IRS* regulations may be
in conflict
 Preferred stock
 Meets capital requirements but causes NIM (net
interest margin), NI (net interest), ROE, and ROA to be
overstated
*IRS (Internal Revenue Service): the US federal government agency
that collects taxes and enforces the internal revenue laws.
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Financial statement manipulation (cont.)

 Securities gains and losses

 Banks often classify all investment securities
as “available for sale,” overstating any true
“gains or losses”
 Non-recurring sales of assets
 This type of transaction is not part of the
bank’s daily activities and typically cannot be
repeated; thus it overstates earnings

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 6-43

2. Bank Performance analysis

2.1. Stock values and profitability ratios

2.2. Measuring credit, liquidity, and other risks

2.3. Measuring operating efficiency

2.4. Performance of competing financial firms

2.5. Size and location effects

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Banks’ key objectives

1. Maximizing the bank value

2. Controlling wide-range risks

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 6-45

Key profitability ratios in banking

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6-46

Key profitability ratios in banking (cont.)

Total Interest Income __ Total Interest Expense

Earnings Spread = Total Earning Assets Total Interest Bearing Liability

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 6-47

Breaking down ROE

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Return on equity (ROE = NI / TE)

… the basic measure of stockholders’ returns

 ROE is composed of two parts:

 Return on Assets (ROA = NI / TA),
 represents the returns to the assets the bank has
invested in

 Equity Multiplier (EM = TA / TE),

 the degree of financial leverage employed by the
bank

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 Return on assets (ROA = NI / TA)
…can be decomposed into two parts:
 Asset Utilization (AU) → income generation
 Expense Ratio (ER) → expense control

 ROA = AU - ER
= (TR / TA) - (TE / TA)
Where:
TR = total revenue or total operating income
= Int. inc. + Non-int. inc. + SG and
TE = total expenses
= Int. exp. + Non-int. exp. + PLL + Taxes

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ROA is driven by the bank’s ability to:

…generate income (AU) and control expenses (ER)
 Income generation (AU) can be found on the UBPR
(page 1) as:

 Expense control (ER) can be found on the UBPR

(page 1) as:

Note, ER* does not include taxes.

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 6-51

ROE depends on:

 Equity multiplier=Total assets/Total equity capital
 Leverage or financing policies: the choice of sources of
funds (debt or equity)

 Net profit margin=Net income/Total operating revenue

 Effectiveness of expense management (cost control)

 Asset utilization=Total operating revenue/Total assets

 Portfolio management policies (the mix and yield on assets)

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Bank Performance Model Rate

Composition (mix)
Interest
Returns to
Shareholders Volume
ROE = NI / TE INCOME
Fees and Serv Charge
Non Interest Trust
Other
Return to the Bank
ROA = NI / TA
Rate
Interest
Composition (mix)
Volume
EXPENSES
Salaries and Benefits
Overhead
Occupancy
Degree of Leverage
Prov. for LL Other
EM =1 / (TE / TA)
Taxes

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Determinants
of ROE in a
financial firm

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6-54
Components of ROE for all insured U.S.
Banks (1992-2007)

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 6-55

A variation on ROE

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6-56

Breakdown of ROA

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 6-57

Quick quiz
1. What individuals or groups are likely to be interested
in the banks’ level of profitability and exposure to risk?
2. What are the principal components of ROE, and what
does each of the these components measure?
3. Suppose a bank has an ROA of 0.80% and an equity
multiplier of 12x. What is its ROE? Suppose this
bank’s ROA falls to 0.60%. What size equity multiplier
must it have to hold its ROE unchanged?
4. What are the most important components of ROA and
what aspects of a financial institution’s performance
do they reflect?
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Bank risk
…Popular measures of overall risk

1. Standard deviation (σ) or variance (σ2) of

stock price

2. Standard deviation or variance of net income

3. Standard deviation or variance of ROE & ROA

The higher σ and σ2, the greater the overall risk

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 6-59

Bank risks
… most important types of risk

1. Credit risk 6. Legal and compliance

2. Liquidity risk risk

3. Market risk 7. Reputation risk

4. Interest rate risk 8. Strategic risk

5. Operational risk 9. Capital risk

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6-60

Credit risk

The probability that some of the financial firm’s

assets will decline in value and perhaps become

worthless resulting from nonpayment or delayed

payment on loans and securities.

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 6-61

Credit risk measures

1. Nonperforming loans/Total loans

2. Net charge-offs/Total loan

3. Provision for loan losses/Total loan

4. Provision for loan losses/Equity capital

5. Allowance for loan losses/Total loan

6. Allowance for loan losses/Equity capital

7. Nonperforming loans/Equity capital

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Credit risk: more ratios to consider

 Three Questions need to be addressed:

1. What has been the loss experience?

2. What amount of losses do we expect?

3. How prepared is the bank?

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 Credit ratios to consider

 What has been the loss experience?

1. Net loss to average total Loan & Lease (LN&LS)
2. Gross losses to average total LN&LS
3. Recoveries to avg. total LN&LS
4. Recoveries to prior period losses
5. Net losses by type of LN&LS
 What amount of losses do we expect?
1. Non-current LN&LS to total loans
2. Total Past/Due LN&LS - including nonaccrual
3. Non-current & restruc LN&LS / Gross LN&LS
4. Current - Non-current & restruc/ Gr LN&LS
5. Past due loans by loan type

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Credit ratios to consider (cont.)

 How prepared are we?

1. Provision for loan loss to: average assets
and average total LN&LS

2. LN&LS Allowance to: net losses and total

LN&LS

3. Earnings coverage of net loss

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 Credit risk ratios :
PNC and Community National

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6-66

Liquidity risk

Probability the financial firm will not have

sufficient cash and borrowing capacity to meet

deposit withdrawals and other cash needs.

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 6-67

Liquidity risk measures

1. Purchased funds/Total assets

2. Net loans/Total assets

3. Cash and due from banks/Total assets

4. Cash and government securities/Total sssets

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Liquidity risk ratios :

PNC and Community National

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 6-69

Market risk: comprises price risk and

interest rate risk

Probability of the market value of the financial

firm’s investment portfolio declining in value

due to a change in interest rates.

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6-70

Market risk measures

1. Book-value of assets/ Market value of assets

2. Book-value of equity/ Market value of equity

3. Book-value of bonds/Market value of bonds

4. Market value of preferred stock and common

stock

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 6-71

Interest rate risk

The danger that shifting interest rates may

adversely affect a bank’s net income, the value

of its assets or equity.

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6-72

Interest rate risk measures

1. Interest sensitive assets/Interest sensitive

liabilities

2. Uninsured deposits/Total deposits

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 Foreign exchange risk
… the risk to a financial institution’s condition resulting
from adverse movements in foreign exchange rates

 Foreign exchange risk arises from changes in foreign

exchange rates that affect the values of assets,
liabilities, and off-balance sheet activities denominated
in currencies different from the bank’s domestic
(home) currency.
 This risk is also often found in off-balance sheet loan
commitments and guarantees denominated in foreign
currencies; foreign currency translation risk

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6-74

Off-balance-sheet risk

The volatility in income and market value of bank

equity that may arise from unanticipated losses

due to OBS activities (activities that do not have

a balance sheet reporting impact until a

transaction is affected).

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 6-75

Operational risk

Uncertainty regarding a financial firm’s earnings

due to failures in computer systems, errors,

misconduct by employees, floods, lightening

strikes and similar events or risk of loss due to

unexpected operating expenses.

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6-76

Legal and compliance risk

Risk of earnings resulting from actions taken by

the legal system. This can include unenforceable

contracts, lawsuits or adverse judgments.

Compliance risk includes violations of rules and

regulations.

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 6-77

Reputation risk

This is risk due to negative publicity that can

dissuade customers from using the services of

the financial firm. It is the risk associated with

public opinion.

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6-78

Strategic risk

The variations in earnings due to adverse

business decisions, improper implementation of

decisions, or lack of responsiveness to industry

changes.

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 6-79

Capital risk

Probability of the value of the bank’s assets

declining below the level of its total liabilities.

The probability of the bank’s long run survival.

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6-80

Capital risk measures

1. Stock price/Earnings per share

2. Equity capital/Total assets

3. Purchased funds/Total liabilities

4. Equity capital/Risk assets

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Other goals in banking

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Average performance characteristics of

banks by business concentration and size
 ROE and ROA (up to $10 billion in assets)
increases with bank size
 Employees per dollar of assets decreases with
bank size
 Larger banks have lower efficiency ratios than
smaller banks
 Smaller banks:
 have proportionately more core deposits and
fewer volatile liabilities than larger banks
 have a proportionately larger earnings base
than larger banks
 have proportionately lower charge-offs than
larger banks
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 Bank performance measure by size

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Bank risk measures by size

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 Average performance characteristics of
banks by business concentration and size
 Wholesale Banks

 Focus on loans for the largest commercial

customers and purchase substantial funds from
corporate and government depositors

 Retail Banks

 Focus on consumer, small business, mortgage,

and agriculture loans and obtain deposits form
individuals and small businesses
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Profitability measures of banks by

business concentration

86

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 Risk measures of banks by business
concentration

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Questions & Problems – part 1

1. What are the essential differences among demand deposits,
savings deposits, and time deposits?
2. What are primary reserves, and secondary reserves and what
are they supposed to do?
3. How do the financial statements of major nonbank financial
firms resemble or differ from bank financial statements? Why
do these differences or similarities exist?
4. What major trends are changing the content of the financial
statements prepared by financial firms?
5. Problem 5 and 6 (page 157) and 11 (page 159)
NB. Problem 11: Pretax net operating income = $252 88

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 Questions & Problems – part 2
6. Why should banks and other corporate financial firms be
concerned about their level of profitability and exposure to
risk?
7. Why do the managers of financial firms often pay close
attention today to the net interest margin and noninterest
margin? To the earnings spread?
8. What items on a bank's balance sheet and income
statement can be used to measure its risk exposure? To what
other financial institutions do these risk measures seem to
apply?
9. Problem 4, 10 and 11 (page 194-6)

89

FINANCIAL
STATEMENTS AND
BANK PERFORMANCE

Chapter 2

William Chittenden edited and updated the PowerPoint slides for this edition.

90

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