The Financial

Statements of
Banks and Their
Principal
Competitors

Key Topics
An Overview of the Balance Sheets and Income
Statements of Banks and Other Financial Firms
The Balance Sheet or Report of Condition
Asset Items
Liability Items
Recent Expansion of Off-Balance Sheet Items
The Problem of Book-Value Accounting and "Window
Dressing"
Components of the Income Statement: Revenues
and Expenses

Bank Financial
Statements

Report of Condition Balance Sheet

Report of Income Income Statement

The balance sheet (Report of

Condition)
A balance sheet, or Report of Condition, lists the
assets, liabilities, and equity capital (owners
funds) held by or invested in a bank or other
financial firm on any given date.
Assets = Liabilities + Equity Capital

Assets

In banking, the assets on the balance sheet are

of four major types:
- Cash assets: Cash in the vault and deposits
held at
other depository institutions (C)
- Security holdings: Government and private
interest
bearing securities purchased in the open
market (S)
- Loans: Loans and lease financings made
available to
customers (L)
- Miscellaneous assets: usually dominated by
fixed
assets (plant and equipment) and investments

Liabilities and Equity Capital

Liabilities fall into two principal categories:
- Deposits: made by and owed to various
customers (D)
- Nondeposit borrowings: nondeposit
borrowings of fund in the money and capital
markets (NDB)
Equity Capital: represents long-term funds the
owners contribute (EC)
C + S + L + MA = D + NDB + EC

Assets of the Banking firm

- Cash and Due from Depository Institutions:

includes cash held in the banks vault, any
deposits placed with other depository institutions
(usually called correspondent deposits), cash
items in the process of collection (mainly
uncollected checks, is also referred to as primary
reserves.
- Investment Securities: The Liquid Portion A
second line
of defense to meet demands for cash in liquid
security holdings, often called secondary
reserves. These typically include holdings of
short-term government securities and privately
issued money market securities, including
interest-bearing time deposits held with other
banking firms and commercial paper.

Assets of the Banking firm

- Investment Securities: The incomeGenerating Portion

Bonds, notes, and other securities held primarily
for their expected rate of return or yield.
Frequently investments are divided into taxable
securities for example, U.S. government bonds
and notes, securities issued by various federal
agencies and corporate bonds and notes and
tax-exempt securities, which consist principally
of state and local government (municipal) bonds.
The latter generate interest income that is
exempt from federal income taxes.
- Trading Account Assets: Securities purchased
to provide short-term profits from short-term
price movements are not included in Securities
on the Report of Condition. They are reported as
trading account assets. If the banking firm serves

Assets of the Banking firm

- Federal Funds Sold and Reverse Repurchase

Agreements
A type of loan account listed as a separate item on
the Report of Condition. This item includes mainly
temporary loans (usually extended overnight, with
the funds returned the next day) made to other
depository institutions, securities dealers, or even
major industrial corporations. The funds for these
temporary loans often come from the reserves a
bank has on deposit with the Federal Reserve Bank
in its district hence the name federal funds.
Some of these temporary credits are extended in
the form of reverse repurchase (resale) agreements
(RPs) in which the banking firm acquires temporary
title to securities owned by the borrower and holds
those securities as collateral until the loan is paid

Assets of the Banking firm

-

loans and Leases : which generally account for

half to almost three-quarters of the total value of
all bank assets. A banks loan account one
commonly used breakdown is by the purpose for
borrowing money.
1. Commercial and industrial (or business)
loans.
2. Consumer (or household) loans; on
regulatory reports
these are referenced as Loans to individuals.
3. Real estate (or property-based) loans.
4. Financial institutions loans (such as loans
made to other
depository institutions as well as to nonbank
financial

Loans and Leases

6. Agriculture production loans (or farm loans,

extended
primarily to farmers and ranchers to harvest
crops and
raise livestock).
7. Security loans (to aid investors and dealers in
their
trading activities).
8. Leases (usually consisting of the bank buying
equipment
for business firms and making that equipment
available
for the firms use for a stipulated period of time
in return
for a series of rental payments the functional

Assets of the Banking firm

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- loan Losses However, loan losses, both current

and projected, are deducted from the amount of
this total (gross) loan figure. Under current tax law,
depository institutions are allowed to build up a
reserve for future loan losses, called the
allowance for loan losses (ALL), from their flow
of income based on their recent loan-loss
experience. The ALL, which is a contra-asset
account, represents an accumulated reserve
against which loans declared to be uncollectible
can be charged off. This means that bad loans
normally do not affect current income. Rather,
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.

Allowance for loan losses (ALL)

Example : suppose a bank granted a $10 million loan
to a property development company to build a
shopping center and the company subsequently
went out of business. If the bank could reasonably
expect to collect only $1 million of the original $10
million owed, the unpaid $9 million would be
subtracted from total (gross) loans and from the
ALL account.

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Provision for loan losses (PLL)

The allowance for possible loan losses is built up
gradually over time by annual deductions from
current income. These deductions appear on the
banking firms income and expense statement (or
Report of Income) as a noncash expense item
called the provision for loan losses (PLL).
Example : suppose a banking firm anticipated loan
losses this year of $1 million and held $100 million
already in its ALL account. It would take a noncash
charge against its current revenues, entering $1
million in the provision for loan-loss account (PLL)
on its Report of Income.
Amount reported on the income and expense
statement

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Allowance for loan losses (ALL)

Amount reported on the income and expense
statement
Annual provision for loan-loss expense (PLL) = $1
million, a noncash expense item deducted from
current revenues
Then adjust the banking firms balance sheet, in its
ALL account
Allowance for loan losses (ALL) = $100 million + $1
million (from PLL on the current income and
expense statement)
= $101 million

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Net allowance for loan losses (ALL)

Now supposed the bank subsequently discovers that
its truly worthless loans, which must be written off,
total only $500,000.
Beginning balance in the allowance for
Loan loss account (ALL)
=
$100 million
+
This years provision for loan losses (PLL) = + $1
million
= Adjusted allowance for loan losses (ALL) =
$101
million
- Actual charge-offs of worthless loans
$500,000
= Net allowance for loan losses (ALL)
after all charge-offs
=

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$100.5 million

Ending balance in the allowance for loan loss

account (ALL)
At about the same time suppose that management
discovers it has been able to recover some of the
funds (say $1.5 million) that it had previously
charged off as losses on earlier loans. Often this
belated cash inflow arises because the banking
firm was able to take possession of and then sell
the collateral that a borrower had pledge behind
his or her defaulted loan. These so-called
recoveries, then, are added back to the allowance
for loan loss account (ALL)
Net allowance for loan losses (ALL)
after all charge-off
= $100.5 million
+ Recoveries from previously charged-off
loans
=+
$1.5 million
= Ending balance in the allowance for
loan loss account (ALL)
= $102.0 million

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Allowance for loan loss account (ALL)

Beginning balance in the allowance for Loan loss account
(ALL)
+ This years provision for loan losses (PLL)
= Adjusted allowance for loan losses (ALL)
- Actual charge-offs of worthless loans
+ Recoveries from previously charged-off loans
Ending balance in the allowance for loan loss account (ALL)

Net Loans = Gross Loans (Allowance for loan losses +

Unearned
income
on loans)

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17

- Specific and General Reserves Many financial firms

divide the ALL account into two parts:
+ Specific reserves: are set aside to cover a particular
loan or loans
expected to be a problem or that represent aboveaverage risk.
Management may simply designate a portion of the
reserves
already in the ALL account as specific reserves or add
more
reserves to cover specific loan problems.
+ General Reserves: the remaining reserves in the loanloss
account
- International Loan Reserves The largest U.S. banks that
make international loans to lesser-developed countries are
required to set aside allocated transfer-risk reserves
(ATRs).
- Unearned Discount Income This item consists of interest
income on loans received from customers, but not yet
earned under the accrual method of accounting banks use
today. For example, if a customer receives a loan and pays
all or some portion of the interest up front, the banking

Assets of the Banking firm

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- Nonperforming (noncurrent) Loans which are credits

that no longer accrue interest income or that have had to
be restructured to accommodate a borrowers changed
circumstances. A loan is placed in the nonperforming
category when any scheduled loan repayment is past due
for more than 90 days. Once a loan is classified as
nonperforming, any accrued interest recorded on the
books, but not actually received, must be deducted from
loan revenues. The bank is then forbidden to record any
additional interest income from the loan until a cash
payment actually comes in.
- Bank Premises and Fixed Assets Bank assets also
include the net (adjusted for depreciation) value of
buildings and equipment. The fixed assets represented by
buildings and equipment needed to carry on daily
operations. However, fixed assets typically generate fixed
operating costs in the form of depreciation expenses,
property taxes, and so on.
- Other Real Estate Owned (OREO) This asset category
includes direct and indirect investments in real estate. The

Assets of the Banking firm

- Goodwill and Other Intangible Assets Most banking
firms have some purchased assets lacking physical
substance. Goodwill occurs when a firm acquires another
firm and pays more than the market value of its net assets
(assets less liabilities). Other intangible assets include
mortgage servicing rights and purchased credit card
relationships.
- All Other Assets This account includes investments in
subsidiary firms, customers liability on acceptances
outstanding, income earned but not collected on loans,
net deferred tax assets, excess residential mortgage
servicing fees receivable, and all other assets.

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Liabilities of the Banking Firm

-

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Deposit representing financial claims held by businesses,

households, and governments against the banking firm. In
the event a bank is liquidated, the proceeds from the sale
of its assets must first be used to pay off the claims of its
depositors. Other creditors and the stockholders receive
whatever funds remain. There are five major types of
deposits:
1. Noninterest-bearing demand deposits, or regular
checking
accounts, generally permit unlimited check writing.
But, under
federal regulations, they cannot pay any explicit
interest rate
(though many banks offer to pay postage costs and
offer other
free services that yield the demand deposit customer
an
implicit rate of return.
2. Savings deposits generally bear the lowest rate of
interest
offered to depositors but may be of any denomination

Deposit

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4. Money market deposit accounts (MMDAs) can pay

whatever
interest rate the offering institution feels is
competitive and have
limited check-writing privileges attached. No minimum
denomination or maturity is required by law, though
depository
institutions must reserve the right to require seven
days notice
before any withdrawals are made.
5. 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 offering institution and its depositor. Included
are large

Liabilities of the Banking Firm

22

- Borrowings from Nondeposit Sources One reason

borrowings from nodeposit funds sources have grown
rapidly in recent years is that there are no reserve
requirements or insurance fees on most of these funds,
which lowers the cost of nondeposit funding. Also,
borrowings in the money market usually can be arranged
in a few minutes and the funds wired immediately to the
depository institution that needs them. One drawback,
however, is that interest rates on nondeposit funds are
highly volatile. If there is even a hint of financial problems
at an institution trying to borrow from these sources, its
borrowing costs can rise rapidly, or money market lenders
may simply refuse to extend it any more credit.
+ Federal funds purchased and repurchase agreements
This account tracks temporary borrowings in the money
market,
mainly from reserves loaned by other institutions
(federal funds
purchased) or from repurchase agreements in which the

Borrowings from Nondeposit Sources

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- Negotiable certificate of deposit (CD) Short-term (2 to

52 weeks) large denomination ($100,000 minimum) CD
that is issued at a discount on its par value, or at a fixed
interest rate payable at maturity. Negotiable CDs issued
by large banks are freely traded in secondary markets.
- Commercial paper is an unsecured, short-term debt
instrument issued by a corporation, typically for the
financing of accounts receivable, inventories and meeting
short-term liabilities. Maturities on commercial paper
rarely range any longer than 270 days. Commercial paper
is usually issued at a discount from face value and reflects
prevailing market interest rates.
- Eurocurrency Market is the money market in which
currency held in banks outside of the country where it is
legal tender is borrowed and lent by banks. The
eurocurrency market is utilized by banks, multinational
corporations, mutual funds and hedge funds that wish to
circumvent regulatory requirements, tax laws and interest
rate caps often present in domestic banking, particularly
in the United States. The term eurocurrency has nothing to

Borrowings from Nondeposit Sources

- Long-term debt including real estate mortgages, for the
purpose of constructing new office facilities or
modernizing plant and equipment.
- Subordinated debt (notes and debentures) includes
limited-life preferred stock (that is, preferred stock that
eventually matures) and any noncollateralized borrowings.
- Other liabilities account serves as a catch-all of
miscellaneous amounts owed, such as a deferred tax
liability and obligations to pay off investors who hold
bankers acceptances.

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Equity Capital for the Banking Firm

25

The equity capital accounts on a depository institutions

Report of Condition represent the owners (stockholders)
share of the business. Every new financial firm begins with
a minimum amount of owners capital and then borrows
funds from the public to lever up its operations. If fact,
financial institutions are among the most heavily
leveraged (debt-financed) of all businesses. Their capital
accounts normally represent less than 10 percent of the
value of their total assets. Bank capital accounts typically
include many of the same items that other business
corporations display on their balance sheets. They list the
total par (face) value of common stock outstanding.
When that stock is sold for more than its par value, the
excess market value of the stock flows into a surplus
account. Few banking firms issue preferred stock, which
guarantees its holders an annual dividend before common
stockholders receive any dividend payments. Usually, the
largest item in the capital account is retained earnings
(undivided profits), which represent accumulated net
income left over each year after payment of stockholder
dividends. There may also be a contingency reserve

Report of Condition (Balance Sheet)

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Report of Condition (Balance Sheet)

One useful way to view the balance sheet identity is to note
that liabilities and equity capital represent accumulated
sources of funds, which provide the needed spending
power to acquire assets. A banks assets, on the other
hand, are its accumulated uses of funds, which are made
to generate income for its stockholders, pay interest to its
depositors, and compensate its employees for their labor
and skill. Thus, the balance sheet identity can be pictured
simply as:
Accumulated uses
of funds
(assets)
capital)

Accumulated sources
=
of funds
(liabilities and equity

Clearly, each use of funds must be backed by a source of

funds, so that accumulated uses of funds must equal
accumulated sources of funds.

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Recent Expansion of Off-Balance-Sheet Items in

Banking
The balance sheet, although a good place to start, does not
tell the whole story about a financial firm. Financial firms
offer their customers a number of fee-based services that
normally do not show up on the balance sheet. Prominent
examples of these off-balance-sheet items include:
1. Unused commitments, in which a lender receives a fee
to lend up to a certain amount of money over a defined
period of time; however, these funds have not yet been
transferred from lender to borrower.
2. Standby credit agreements, in which a financial firm
receives a fee to guarantee repayment of a loan that a
customer has received from another lender.
3. Derivative contracts, in which a financial institution has
the potential to make a profit or incur a loss on an asset
that it presently does not own. This category includes
futures contracts, options, and swaps that can be used to
hedge credit risk, interest rate risk, or foreign exchange
risk.

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Recent Expansion of Off-Balance-Sheet Items in

Banking

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Components of the Income

Statement (Report of Income)
An income statement, or Report of Income, Indicates the
amount of revenue received and expenses incurred over a
specific period of time. There is usually a close correlation
between the size of the principal items on a banks
balance sheet (Report of Condition) and its income
statement. After all, assets on the balance sheet usually
account for the majority of operating revenues, while
liabilities generate many of a banks operating expenses.
The principal source of bank revenue generally is the interest
income generated by earning assetsmainly loans and
investments. Additional revenue is provided by the fees
charged for specific services (such as ATM usage). The
major expense incurred in generating this revenue include
interest paid out to depositors; interest owed on
nondeposit borrowings; the cost of equity capital; salaries,
wage, and benefits paid to employees; overhead expenses
associated with the physical plant; funds se aside for
possible loan losses; and taxes owed.

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Components of the Income

Statement (Report of Income)
The difference between all revenues and expenses is net
income.
Net income = Total revenue items Total expense items
- Interest Income Not surprisingly, interest earned from
loans and security investments accounts for the majority
of revenues for most depository institutions and for many
other lenders as well. It must be noted, however, that the
relative importance of interest revenues versus
noninterest revenues (fee income) is changing rapidly,
with fee income today growing faster than interest income
on loans and investments as financial-service managers
work hard to develop more fee-based services.

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Components of the Income Statement (Report of

Income)

32

- Interest Expenses The number one expense item for a

depository institution normally is interest on deposits.
For the banking company we have been following interest
on deposits accounted for almost 60 percent of this banks
total interest costs. Another important interest expense
item is the interest owed on short-term borrowings in the
money marketmainly borrowings of federal funds
(reserves) from other depository institutions and
borrowings back-stopped by security repurchase
agreementsplus any long-term borrowings that have
taken place (including mortgages on the financial firms
property and subordinated notes and debentures
outstanding).
- Net Interest Income
Net Interest Income = Interest Income Interest Expense
This important item is often referred to as the interest
margin, the gap between the interest income the financial
firm receives on loans and securities and the interest cost
of its borrowed funds. It is usually a key determinant of
profitability. When the interest margin falls, the
stockholders of financial firms will usually see a decline in
their bottom linenet after-tax earningsand the

Components of the Income Statement (Report of

Income)

- Loan-Loss Expense another expense item that banks and

selected other financial institutions can deduct from
current income is known as the provision for loan and
lease losses. This provision account is really a noncash
expense, created by simple book-keeping entry. Its
purpose is to shelter a portion of current earnings from
taxes to help prepare for bad loans. The annual loan-loss
provision is deducted from current revenues before taxes
are applied to earnings.
- Noninterest Income The financial reports that banks are
required to submit to regulatory authorities apportion this
income source into four broad categories:
1. Fees earned from fiduciary activities
2. Service charges on deposit accounts
3. Trading account gains and fees
4. Additional noninterest income

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Noninterest Income
1. Fiduciary Activities Income from services rendered by
the financial firms trust department or by any of its
consolidated subsidiaries acting in any fiduciary capacity,
such as:
- Fees for managing and protecting a customers property.
- Fees for recordkeeping for corporate security
transactions and
dispensing interest and dividend payments.
- Fees for managing corporate and individual pension and
retirement plans.
2. Service charges on deposit accounts held in domestic
offices, such as:
- Checking account maintenance fees.
- Checking account overdraft fees.
- Fees for writing excessive checks.
- Savings account overdraft fees.
- Fees for stopping payment of checks.

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Noninterest Income
3. Trading account gains and fees
Net gains and losses from trading cash instruments and
off-balance-sheet derivative contracts (including
commodity contracts) that have been recognized during
the accounting period.
4. Additional noninterest income includes the following
noninterest income sources:
- Investment banking, advisory, brokerage, and
underwriting.
- Venture capital revenue.
- Net servicing fees.
- Net securitization income.
- Insurance commission fees and income.
- Net gains (losses) on sales of loans.
- Net gains (losses) on sales of real estate owned.
- Net gains (losses) on sales of other assets (excluding
securities).

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Components of the Income Statement (Report of

Income)
- Noninterest Expenses The key noninterest expense item
for most financial institutions is wage, salaries, and
employee benefits, which has been a rising expense
item in recent years as leading financial firms have
pursued top-quality college graduates to head their
management teams and lured experienced senior
management away from competitors. The costs of
maintaining a financial institutions properties and rental
fees on office space show up in he premises and
equipment expense. The cost of furniture and
equipment also appears under the noninterest expense
category, along with numerous small expense items such
as legal fees, office supplies, and repair costs.
Total Noninterest Income = Noninterest Income Noninterest
Expenses

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Components of the Income Statement (Report of

Income)
Net Operating Income and Net Income
Net Operating Income = Net Interest Income Provision for
Loan
Losses + Net Noninterest Income
Net Income = Net Operating Income Tax Paid +/Extraordinary
Income/Losses

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Extraordinary income or loss transactions often involve the

sale of financial assets, such as common stock, or real
property pledged as collateral behind a loan upon which
the lender has foreclosed. A financial firm may also sell
real estate or subsidiary firms that it owns. Such
transactions frequently have a substantial effect on
current earnings, particularly if a lender sells property it
acquired in a loan foreclosure. Such property is usually
carried on the lenders books at minimal market value, but

Components of the Income Statement (Report of

Income)

Net Interest Income

Provision for Loan Loss

Net Income after PLL

+/- Net Noninterest Income
Net Income before Tax
- Taxes
Net Income
- Dividends
Undivided Profits

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Components of the Income Statement (Report of

Income)

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