ACFI330 - Lecture 3 - Commercial Banks financial statement analysis

What are the four main categories of assets on a bank's balance sheet?

1. Cash and due from depository institutions

2. Investment securities

3. Loans and leases

4. Other assets

What does "Cash and due from depository institutions" include?

Vault cash, deposits at the Federal Reserve, deposits at other financial institutions, and cash items in the process of collection. These generate little to no income for the bank.

What are investment securities and what is their primary purpose?

Investment securities include federal funds sold, repurchase agreements, U.S. Treasury and agency securities, municipal securities, and mortgage-backed securities. They are highly liquid, low default risk, tradeable in secondary markets, and used primarily for liquidity risk management.

What are the characteristics of loans and leases on a bank's balance sheet?

• Major asset items generating the largest flow of revenue income

• Categorized as C&I loans, real estate loans, consumer loans, and other loans

• Least liquid assets

• Major source of credit and liquidity risk

What are "earning assets"?

Earning assets = Investment securities + Net loans and leases

What are the four main categories of liabilities on a bank's balance sheet?

1. Deposits

2. Borrowed funds

3. Other liabilities

4. Equity capital

What are the main types of deposit accounts?

• Demand deposits (no explicit interest)

• NOW accounts (interest-bearing with minimum balance)

• Money market deposit accounts (MMDAs)

• Other savings deposits

• Retail CDs (under $100,000)

• Wholesale CDs ($100,000+)

• Deposits in foreign offices

What is the difference between retail and wholesale CDs?

• Retail CDs: time deposits with face value below $100,000

• Wholesale CDs: time deposits with face value of $100,000 or more; they are negotiable instruments that can be resold in secondary markets

What are brokered deposits?

Wholesale CDs obtained through a brokerage or investment house rather than directly from a customer.

What are the main types of borrowed funds?

• Federal funds

• Repurchase agreements (repos)

• Other borrowing: banker's acceptances, commercial paper, medium-term notes, discount window loans

What is the difference between core deposits and purchased funds?

• Core deposits: demand deposits, NOW accounts, MMDAs, other savings accounts, and retail CDs; cheapest and most stable funds

• Purchased funds: brokered deposits, wholesale CDs, foreign deposits, fed funds purchased, repos, and subordinated notes; more expensive and volatile

Why are core deposits valuable to banks?

Core deposits are the cheapest and most stable funds. They remain at the bank for reasons beyond just earning interest (convenience, relationships, customer satisfaction), even if the bank doesn't pay the highest rates.

What components make up equity capital?

• Preferred and common stock (at par value)

• Surplus and additional paid-in capital (capital raised above par value)

• Retained earnings

What are off-balance-sheet (OBS) items?

Contingent assets and liabilities that may affect the future status of a financial institution's balance sheet.

What are loan commitments?

Contractual commitments to loan a firm a certain maximum amount at given interest rate terms. Banks may charge an up-front fee and/or commitment fee. Loans only appear on the balance sheet when the borrower draws on the commitment.

What is a commitment fee?

The fee charged on the unused component of a loan commitment.

What are the two types of letters of credit?

• Commercial LCs: guarantees to underwrite trade/commercial performance; commitment to pay seller if buyer cannot pay

• Standby LCs: cover more severe, less predictable risks for higher amounts (e.g., commercial paper defaults, municipal payment failures, construction delays)

What are loans sold with recourse?

Loans originated by the bank and sold to other investors that can be returned to the originating institution if credit quality deteriorates. Recourse is the ability to put an asset back to the seller.

What derivative securities do banks use as OBS items?

Futures, forwards, swaps, and option positions taken for hedging or other purposes. Banks can be either users or dealers of derivatives, which creates counterparty (contingent credit) risk.

What is the risk of providing both liquidity to depositors and credit lines to borrowers?

Banks can be exposed to "double-runs" on both assets and liabilities simultaneously.

What are the two basic financial documents banks must submit quarterly?

1. Report of condition (balance sheet): presents assets, liabilities, and equity capital

2. Report of income (income statement): presents revenues, expenses, and net profit/loss

What is the formula for net interest income?

: Net interest income = Interest income − Interest expense

What is the provision for loan losses?

A noncash, tax-deductible expense representing the current period's allocation to the allowance for loan losses on the balance sheet.

What are the main components of noninterest income?

All other income received from on- and off-balance sheet activities beyond interest income.

What are the main components of noninterest expense?

Personnel expenses (salaries and employee benefits), expenses of premises and fixed assets, and other operating expenses. Generally larger than noninterest income for most banks.

What is the formula for income before taxes and extraordinary items (operating profit)?

Operating profit = Net interest income − Provision for loan losses + Noninterest income − Noninterest expense

What is the formula for net income?

Net income = Income before taxes and extraordinary items − Income taxes ± Extraordinary items

What is the general relationship between income statement and balance sheet?

NI = Σ(rₙAₙ) − Σ(rₘLₘ) − P + NII − NIE − T

Where returns on assets minus costs of liabilities, adjusted for provisions, noninterest items, and taxes, equals net income.

How does changing the asset mix affect net income?

A: The effect equals the rate difference times the dollar value of the change.

Replacing $500,000 of 4.6% assets with 6% assets increases NI by (6% − 4.6%) × $500,000 = $7,000

What is Return on Equity (ROE)? A: ROE = Net income / Total equity capital

Measures the net income earned for each dollar of equity capital contributed by stockholders.

How can ROE be decomposed? A: ROE = ROA × EM

Where:

• ROA = Return on Assets

• EM = Equity Multiplier

Or: ROE = (Net income / Total assets) × (Total assets / Total equity capital)

What is Return on Assets (ROA)?

ROA = Net income / Total assets

Determines the net income produced per dollar of assets.

What is the Equity Multiplier (EM)?

EM = Total assets / Total equity capital

Measures the dollar value of assets funded with each dollar of equity. Higher ratios indicate more leverage/debt.

How can ROA be further decomposed?

ROA = PM × AU

Where:

• PM = Profit Margin

• AU = Asset Utilization

Or: ROA = (Net income / Total operating income) × (Total operating income / Total assets)

What is Profit Margin (PM)?

PM = Net income / Total operating income

Measures the bank's ability to control expenses and produce net income from operating income.

What are the main expense ratios that affect profit margin?

• Interest expense ratio

• Provision for loan loss ratio

• Noninterest expense ratio

• Tax ratio

All measured as a ratio of total operating income.

What is Asset Utilization (AU)?

AU = Total operating income / Total assets = Interest income ratio + Noninterest income ratio

Measures the extent to which assets generate revenue.

What is Net Interest Margin (NIM)?

NIM = Net interest income / Earning assets = (Interest income − Interest expense) / (Investment securities + Net loans and leases)

Measures the net return on earning assets.

What is the spread?

Spread = (Interest income / Earning assets) − (Interest expense / Interest-bearing liabilities)

Measures the difference between average yield on earning assets and average cost of interest-bearing liabilities.

What is overhead efficiency?

Overhead efficiency = Noninterest income / Noninterest expense

Measures the bank's ability to generate noninterest income to cover noninterest expenses. Usually barely larger than one due to high personnel and technology costs.

What three evaluations does ratio analysis allow?

• Current performance

• Change in performance over time (time series analysis)

• Performance relative to competitor banks (cross-sectional analysis)

What is the Uniform Bank Performance Report (UBPR)?

A tool that summarizes bank performance for various peer groups, size groups, and by state to assist in cross-sectional analysis.

What are the main differences between large and small banks?

Large banks typically:

• Have greater access to purchased funds and capital markets

• Operate with lower equity capital

• Use more purchased funds and fewer core deposits

• Invest more in salaries, premises, and expenses

• Diversify operations and services more

• Generate more noninterest income

What are the three main market niches for banks?

Retail banks, wholesale banks, and community banks - each operates differently and should be analyzed with their niche in mind.

What regulatory body prescribes uniform reporting standards for U.S. banks?

The Federal Financial Institutions Examination Council (FFIEC), which requires banks to submit Call Reports quarterly.

What is the complete ROE decomposition framework?

ROE = (Net income / Total equity capital) = (Net income / Total assets) × (Total assets / Total equity capital) = ROA × EM = (Net income / Total operating income) × (Total operating income / Total assets) × (Total assets / Total equity capital) = PM × AU × EM

This breaks down into profit margin, asset utilization, and leverage components.