Chapter 3

BANK
MANAGEMENT
CHAPTER 3
ANALYZING BANK
FINANCIAL STATEMENTS
INTRODUCTION
2 most important financial statements

for a banking firm:
Balance Sheet / Report of Condition
Financial
information comparing what a

bank owns with what it owes and the
ownership interest of stockholders
Income
Statement / Report of Income
Reflects
the financial nature of banking

as interest on loans and investments
represents the bulk of revenue
2
The Balance Sheet
Lists the assets, liabilities and equity

capital (owners funds) held by or
invested in a bank or other financial
firm on any given date
Basic balance sheet identity:
Assets = Liabilities + Equity
capital
3
Cont
Assets
Cash in the vault and deposits held
at the other depository institutions
(C)
Government and private interestbearing securities purchased in the
open market (S)
Loans and lease financings made
available to customers (L)
Miscellaneous assets (MA)
4
Cont
Liabilities
Deposits made by and owed to
various customers (D)
Nondeposit borrowings of funds in
the money and capital markets
(NDB)
Equity Capital
Represents long term funds the
owners contribute (EC)
5
Cont
Therefore balance sheet identity can

also be pictured as:
C+S+L+MA = D+NDB+EC
Cont
Cash Assets (C) designed to meet a

banks need for liquidity
Deposit
withdrawal, loans and unexpected or

immediate cash needs
Security holdings (S) backup source of

liquidity and provide another source of
income
Loans (L) made principally to supply
income
Miscellaneous assets (MA) dominated by
fixed assets and investments in subsidiaries
7
Cont
Deposits (D) main source of funding for

banks
Nondeposit borrowings (NDB) mainly
to supplement deposits and provide the
additional liquidity that cash assets and
securities cannot provide
Equity Capital (EC) supplies the long
term, relatively stable base of financial
support upon which the financial firm
will rely to grow and to cover any
extraordinary losses it incurs
8
Cont
Assets (accumulated uses of funds)

Made to generate income for its
stockholders, pay interest to its
depositors and compensate its
employees for their labor and skill
Liabilities and Equity capital
(accumulated sources of funds)
Provide the needed spending
power to acquire assets
9
Cont
The balance sheet identity can also

be pictured as:
Accumulated uses =
Accumulated sources
of funds
of funds
10
Assets of the Banking

Firm
Cash and Due from Depository

Institutions
Also referred as primary reserves

The first line of defense against customer
deposit withdrawals and the most important
funds to meet customers loan request
Cash balances earn little or no interest income
Example: cash held in the banks vault,
deposits placed with other depository
institutions, cash item in the process of
collection and the banking firms reserve
account held with the central bank
11
Cont
Investment Securities: The Liquid

Portion
Liquid Security Holdings - Second line of

defense to meet demands for cash
Middle ground between cash assets and loans
Earning some income
Held mainly for the ease with which they can
be converted into cash on short notice
Often called secondary reserves or referenced
on regulatory reports as available for sale
Typically include holdings of short-term
government securities and privately issued
money market securities, including interestbearing time deposits held with other banking
firms and commercial paper
12
Cont
Investment Securities: The IncomeGenerating Portion
Securities held primarily for their expected

rate of return or yield
Example: Bonds, notes and other securities
Investment securities can be divided into:
Taxable securities
Government bonds and notes
Securities issued by various federal
agencies
Corporate bonds and notes
13
Cont
Tax-exempt
State
securities
and local government bonds
Investment securities may be

recorded on the books of a banking
firm at their original cost or at
market value, whichever is lower
Recent trend in accounting rules for
banking is toward current market
values (replacing historical cost)
14
Cont
Trading Account Assets
Securities purchased to provide shortterm profits from short-term price

movements
Not included in the Securities item in
the balance sheet
Reported as trading account assets
15
Cont
Federal Funds Sold and Reverse
Repurchase Agreements
Includes mainly temporary loans made to

other depository institutions, securities
dealers, major industrial corporations
Funds come from the reserves a bank
has on deposit with the federal reserve
bank (or central bank)
Repurchase agreements banking firms
acquire temporary title to securities
owned by the borrower and holds those
securities as collateral until the loan is
paid off (normally after only a few days)
16
Cont
Loans and leases
The largest asset item

Loan types:
Commercial and industrial loans

Consumer loans / loans to individual
Real estate loans
Loans to other institutions
Foreign loans
Agricultural production loans
Security loans
Leases
17
Cont
Loan losses
- deducted from the amount of total (gross) loan
figure.
- banks are allowed to build up a reserve for
future loan losses, called the allowance for loan
losses (ALL) based on their recent loan-loss
experience.
- the ALL is a contra-asset account, which
represents an accumulated reserve against
which loans declared to be uncollectible can be
charged off.
18
Cont
-
This means that bad loans normally do not affect

current income.
When a loan is considered uncollectible, the
accounting department will write (charge) it off
the books by reducing the ALL account by the
amount of the uncollectible loan while
simultaneously decreasing the asset account for
gross loans.
19
Cont
Specific and general reserves

Allowance for loan losses (ALL) can be
divided into:
Specific reserves
Set aside to cover a specific loan
problems or loans expected to be a
problem or that represent aboveaverage risk
General reserves
The remaining reserves in the loan-loss
account after deducted specific reserves
20
Cont
Nonperforming (noncurrent)
loans (NPL)
Credits that no longer accrue interest
income or that have had to be
restructured to accommodate a
borrowers changed circumstances
NPL scheduled loan repayment which
past due for more than 90 days
Will be deducted from loan revenues
21
Cont
Bank premises and fixed assets

Goodwill and other intangible assets
All other assets
22
Liabilities of the Banking

Firm
Deposits
5 major types of deposit

Noninterest-bearing demand
deposits / checking account
Savings deposits
NOW accounts
Money market deposit accounts
(MMDAs)
Time deposits
23
Cont
Borrowings from Nondeposit
Sources
borrowings in the money market such as

REPOs, BAs, Bills of Exchange, and issuing
commercial paper.
The larger the depository institution, the
greater use it tends to make of nondeposit
source of funds
24
Cont
Equity capital
1.
2.
3.
4.
Share capital common and preferred

stocks
Retained earnings
Contingency reserve protection against
unforeseen losses
Treasury stock stock that has been retired.
25
BALANCE SHEET
ASSETS:
Cash & due from financial
institutions
xxx
Investment securities
xxx
Total (gross) loans
xxx
Allowance for loan losses
(xx)
Net loans
xxx
Premises & Equipment
xxx
LIABILITIES+EQUI
TY
Liabilities:
Deposits
Borrowed funds
Other liabilities
Long-term debt
xxx
xxx
xxx
xxx
Equity:
Capital
surplus
xxx
Accumulated retained
earnings
26
STATEMENT OF LOAN LOSS

PROVISION
Beginning reserve for loan losses
xxx
+ Provision for loan losses
xxx
- Loan losses during the year
(xxx)
+ Recoveries from previous loan losses
xxx
Ending reserve for loan losses
XXX
27
Income Statements
indicates the amount of revenue

received and expenses incurred over a
specific period of time.
Principal source of bank revenue:
Interest income generated by the
banks earning assets, mainly its
loans (L),
Securities (S),
Interest-bearing deposits that are
part of cash assets (C), held with
other banks
28
INCOME STATEMENT
Major expenses incurred in generating
bank revenue:
i)
ii)
iii)
iv)
v)
vi)
vii)
Interest paid out to depositors (D),

Interest owed on non-deposit borrowings
(NDB),
Cost of equity capital (EC),
Salaries, wages and benefits paid to bank
employees (SWB),
Overhead expenses associated with the
banks physical plant (O),
Funds set aside for possible loan losses
(PLL),
29
Taxes owed (T), and
Cont
The difference between all revenues
and expenses is net income.
Net Income:
Total revenue Total expense

items
items
30
Cont
Interest Income
Interest and fees generated from loans
account for most bank revenues (normally
two-thirds or more of the total)
Followed in importance by:
investment earnings from taxable and
tax exempt securities
Interest earned on federal funds loans
and repurchase agreements
Interest received on time deposits
placed with other banks
31
Cont
Interest expenses
the number one expense item for a
bank is interest on its deposits
Net Interest Income
many banks subtract total interest
expenses from total interest income to
yield net interest income or often
referred to as the interest margin, the
gap between the interest income and
the interest cost.
A key determinant of profitability
32
Cont
Loan-Loss Expense
Another expense item that banks can
deduct from current income is known as
the provision for possible loan losses
This provision account is really a noncash
expense
Its purpose is to shelter a portion of the
banks current earnings from taxes in
order to help prepare for bad loans
33
Cont
Noninterest Income
Sources of income other than earnings
from loans and securities
Normally include fees earned from
offering trust services, service charges on
deposit accounts and miscellaneous fees
and charges for other bank services
Recently, noninterest income (fee income)
have been targeted by bankers as a key
source of future revenues
34
Cont
Noninterest Expenses
Key noninterest expense items for banks are
wages, salaries, and other personnel expenses
Others are costs of maintaining bank properties
and rental fees on office space, bank furniture
and equipment, legal fees, paper and office
supplies and repair costs
Net Income
Net income is equal to the income that a firm has
after subtracting costs and expenses from the
total revenue.
Net income can be distributed among holders of
common stock as a dividend or held by the firm
as retained earnings.
35
INCOME STATEMENT
Interest income
- Interest expense
xxx
(xxx)
NET INTEREST INCOME

XXX
Non interest income

- Non interest expense
NET NON INTEREST INCOME
XXX
OPERATING PROFIT
XXX
- PROVISION FOR LOAN LOSSES
(XXX)
PROFIT BEFORE TAX
xxx
(xxx)
36
Off-Balance Sheet in
Banking
Fee-based activities offered by

banking institutions that normally do
not show up on the balance sheet
Recently, banks have converted many
of their customer services into feegenerating transactions that are not
recorded on their balance sheets
Prominent examples of these offbalance sheet items include:
37
Cont
Standby
credit agreements
Bank pledges to guarantee
repayment of a customers loan
received from a third party
Interest rate swaps
A bank promises to exchange
interest payments on debt
securities with another party
38
Cont
Financial
futures and option interestrate contracts

A bank agrees to deliver or to take
delivery of securities from another
party at a guaranteed price
Loan commitments
A bank pledges to lend up to a
certain amount of funds until the
commitment matures
Foreign exchange rate contracts
A bank agrees to deliver or accept
delivery of foreign currencies
39
Cont
The problems with these offbalance-sheet transactions is that

they often expose a bank to added
risk even though they may not show
up in conventional bank condition
reports.
40
Other Useful Bank

Financial Statements
Two useful sources of financial

information to supplement the
information provided on the balance
sheet and the income statement:
Funds flow or sources and uses of
funds statement
Capital account statement or
stockholders equity
41
Sources and Uses of Funds

Statement
Answer two questions:

Where did the funds a bank used over a
certain period of time come from?
How were those funds utilized?
It is based upon the following

relationships:
42
Funds provided to the

bank =
over a specific period of
time
Fund used by the bank

=
during a specific period
of
time
Fund provided from

operations +
Decreases in
bank assets +
Increases in
bank liabilities
Dividends paid out to
Stockholders +
Increases in
bank assets +
Decreases in
bank liabilities
43
And, of course
Funds provided to the = Funds used
by the
bank over a specific
bank during
the
time period
same time
period
44
The Capital Account

Statement / Statement of
Stockholders Equity
The financial report reveal changes in

the all-important capital account,
showing how the owners investment of
funds in the bank has changed over time
Stockholders equity represents a
cushion of financial strength for the bank
that can be used to absorb losses and
protect the depositors and other
creditors, changes in the banks capital
account are closely followed by
regulators and large depositors
45
Cont
Bank analysts look closely at these
statements to make sure that the banks
capital account is still growing fast
enough to keep up with the growth of its
assets (especially loans).
If the capital account is declining,
analysts try to determine if the amount of
owners capital remaining is sufficient to
absorb all expected losses with an added
cushion to deal with unexpected losses.
46

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BANK

2 most important financial statements

information comparing what a

Statement / Report of Income

the financial nature of banking

The Balance Sheet

Lists the assets, liabilities and equity

Therefore balance sheet identity can

Cash Assets (C) designed to meet a

withdrawal, loans and unexpected or

Security holdings (S) backup source of

Deposits (D) main source of funding for

Assets (accumulated uses of funds)

The balance sheet identity can also

Assets of the Banking

Cash and Due from Depository

Also referred as primary reserves

Investment Securities: The Liquid

Liquid Security Holdings - Second line of

Investment Securities: The IncomeGenerating Portion

Securities held primarily for their expected

and local government bonds

Investment securities may be

Trading Account Assets

Securities purchased to provide shortterm profits from short-term price

Includes mainly temporary loans made to

Loans and leases

The largest asset item

Commercial and industrial loans

This means that bad loans normally do not affect

Specific and general reserves

Bank premises and fixed assets

Liabilities of the Banking

5 major types of deposit

borrowings in the money market such as

Share capital common and preferred

STATEMENT OF LOAN LOSS

indicates the amount of revenue

Interest paid out to depositors (D),

Total revenue Total expense

NET INTEREST INCOME

Non interest income

Fee-based activities offered by

futures and option interestrate contracts

The problems with these offbalance-sheet transactions is that

Other Useful Bank

Two useful sources of financial

Sources and Uses of Funds

Answer two questions:

It is based upon the following

Funds provided to the

Fund used by the bank

Fund provided from

The Capital Account

The financial report reveal changes in

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