Commercial Banks’

Financial Statements and

Analysis

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline

1.
1. Financial
Financial Statements
Statements of
of Financial
Financial
Institutions
Institutions
2.
2. Financial
Financial Statement
Statement Analysis
Analysis Using
Using aa ROE
ROE
Framework
Framework
 1.1 Evaluate Performance of Commercial
Banks (CBs)
•• CBs
CBs are
are unique
unique in
in
–– the
thespecial
specialservices
servicesthey
theyperform
perform(e.g.,
(e.g.,assistance
assistancein
in
the
theimplementation
implementationof ofmonetary
monetarypolicy)
policy)
–– the
thelevel
levelof
ofregulatory
regulatoryattention
attentionthey
theyreceive
receive
–– the
thetypes
typesof
ofassets
assetsand
andliabilities
liabilitiesthey
theyhold
hold
•• Managers,
Managers, stockholder,
stockholder, depositors,
depositors, regulators,
regulators, and
and
other
other parties
parties use
use performance,
performance, earnings,
earnings, and
and other
other
measures
measures obtained
obtained from
from financial
financial statements
statements to
to
evaluate
evaluate which
which CB
CB stocks
stocks they
they will
will purchase
purchase

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Financial Statements of Commercial Banks

•• Report
Report ofof condition
condition -- balance
balance sheet
sheet of of aa commercial
commercial
bank
bank reporting
reporting information
information at at aa single
single point
point inin time
time
•• Report
Report ofof income
income -- income
income statement
statement of of aa commercial
commercial
bank
bank reporting
reporting revenues,
revenues, expenses,
expenses, net net profit
profit or
or loss,
loss,
and
and cash
cash dividends
dividends over
over aa period
period of of time
time
•• Retail
Retail bank
bank -- focuses
focuses onon consumer
consumer bankingbanking
relationships
relationships
•• Wholesale
Wholesale bank bank -- focuses
focuses onon commercial
commercial banking
banking
relationships
relationships

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1.2 Balance Sheet: Assets
•• Four
Four major
major subcategories
subcategories
–– cash
cashand
andbalances
balancesdue
duefrom
fromother
otherdepository
depositoryinstitutions
institutions
•• vault
vaultcash,
cash,deposits
depositsatatthe
theFederal
FederalReserve,
Reserve,deposits
depositsatatother
otherFIs,
FIs,and
and
cash
cashitems
itemsininthe
theprocess
processofofcollection
collection
–– investment
investmentsecurities
securities
•• interest-bearing
interest-bearingdeposits
depositsatatother
otherFIs,
FIs,fed
fedfunds
fundssold,
sold,RPs,
RPs,U.S.
U.S.
Treasury
Treasuryandandagency
agencysecurities,
securities,securities
securitiesissued
issuedby
bystates
statesand
andpolitical
political
subdivisions,
subdivisions,mortgage-backed
mortgage-backedsecurities,
securities,and
andother
otherdebt
debtand
andequity
equity
securities
securities
–– loans
loansand
andleases
leases
–– other
otherassets
assets
•• premises
premisesand
andfixed
fixedassets,
assets,real
realestate
estateowned,
owned,investments
investmentsinin
unconsolidated
unconsolidatedsubsidiaries,
subsidiaries,intangible
intangibleassets,
assets,other
otherfees
feesreceivable
receivable
Liabilities

•• NOW
NOW account
account -- negotiable
negotiable order
order ofof withdrawal
withdrawal
account,
account, similar
similar to
to aa demand
demand deposit
deposit with
with minimum
minimum
balance
balance
•• MMDAs
MMDAs -- money
money market
market deposit
deposit accounts
accounts with
with retail
retail
savings
savings accounts
accounts andand limited
limited checking
checking account
account
•• Other
Othersavings
savings deposits
deposits -- other
other than
than MMDAs
MMDAs
•• Retail
Retail CDs
CDs -- time
time deposits
deposits with
with face
face value
value below
below
$100,000
$100,000
•• Wholesale
Wholesale CDs
CDs --time
timedeposits
deposits with
with face
face value
value above
above
$100,000
$100,000 (continued)
(continued)
Liabilities

•• Negotiable
Negotiable instrument
instrument -- an an instrument
instrument whose
whose
ownership
ownership can
can be
be transferred
transferred inin the
the secondary
secondary market
market
•• Brokered
Brokered deposits
deposits -- wholesale
wholesale CDs CDs obtained
obtained through
through aa
brokerage
brokerage house
house
•• Core
Core deposits
deposits -- deposits
deposits ofof the
the bank
bank that
that are
are stable
stable over
over
short
short periods
periods of
of time
time and
and thus
thus provide
provide aalong-term
long-term
funding
funding source
source toto aa bank
bank
•• Purchased
Purchased funds
funds -- rate-sensitive
rate-sensitive funding
funding sources
sources of
of the
the
bank
bank
Equity Capital

•• Preferred
Preferred and
and common
common stock
stock (listed
(listed at
at par
par value)
value)
•• Surplus
Surplus oror additional
additional paid-in
paid-in capital
capital
•• Retained
Retained earnings
earnings
•• Regulations
Regulations require
require banks
banks toto hold
hold aa minimum
minimum
level
level of
of equity
equity capital
capital to
to act
act as
as aa buffer
buffer against
against
losses
losses from
from their
their on-
on- and
and off-balance
off-balance sheet
sheet assets
assets
 1.3 Off-Balance-Sheet Assets and Liabilities

•• Contingent
Contingent assets
assets and
and liabilities
liabilities that
that may
may affect
affect the
the
future
future status
status of
of the
the FIs
FIs balance
balance sheet
sheet
•• OBS
OBS activities
activities grouped
grouped into
into 55 major
major categories
categories
–– Loan
Loancommitments
commitments--contractual
contractualcommitment
commitmenttotoloan
loan
to
toaafirm
firmaacertain
certainmaximum
maximumamount
amountatatgiven
giveninterest
interest
rate
rateterms
terms
•• up-front
up-frontfee
fee--fee
feecharged
chargedfor
formaking
makingfunds
fundsavailable
availablethrough
through
aaloan
loancommitment
commitment
•• back-end
back-endfee
fee--fee
feecharged
chargedon
onthe
theunused
unusedcomponent
componentof ofaaloan
loan
commitment
commitment (continued)
(continued)

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 –– Commercial
Commercialand
andStandby
StandbyLetters
Lettersof
ofCredit
Credit
•• letters
lettersof
ofcredit
credit--contingent
contingentguarantees
guaranteessold
soldby byananFIFItotounderwrite
underwritethe
the
trade
tradeororcommercial
commercialperformance
performanceof ofthe
thebuyer
buyerof ofthe
theguarantee
guarantee
•• standby
standbyletter
letterof
ofcredit
credit--guarantees
guaranteesissued
issuedtotocover
covercontingencies
contingenciesthat
that
are
arepotentially
potentiallymore
moresever
severand
andless
lesspredictable
predictablethanthancontingencies
contingencies
covered
coveredunder
undertrade-related
trade-relatedor
orcommercial
commercialletters
lettersofofcredit
credit
–– Forward
ForwardPurchases
Purchasesand
andSales
Salesof
ofWhen-Issued
When-IssuedSecurities
Securities
•• when-issued
when-issuedsecurities
securities--commitments
commitmentstotobuy
buyor
orsell
sellsecurities
securitiesbefore
before
they
theyare
areissued
issued
–– Loans
LoansSold
Sold
•• loans
loansthat
thataabank
bankoriginated
originatedandandthen
thensold
soldtotoother
otherinvestors
investorsthat
thatmay
may
be
bereturned
returned(with
(withrecourse)
recourse)totothe
theoriginating
originatinginstitution
institutionininthe
thefuture
future
•• recourse
recourse--the
theability
abilitytotoput
putan
anasset
assetor
orloan
loanback
backtotothe
theseller
sellershould
should
the
thecredit
creditquality
qualityof
ofthat
thatasset
assetdeteriorate
deteriorate
–– Derivative
DerivativeContracts
Contracts
•• futures,
futures,forward,
forward,swap,
swap,and
andoption
optionpositions
positionstaken
takenby
bythe
theFI
FIfor
for
hedging
hedgingor orother
otherpurposes
purposes
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
1.4 Income Statement
•• Interest
Interest Income
Income
•• Interest
Interest Expenses
Expenses
•• Net
Net Interest
Interest Income
Income
•• Provision
Provision for
for Loan
Loan Losses
Losses
•• Noninterest
Noninterest Income
Income
•• Noninterest
Noninterest Expense
Expense
•• Income
Income before
before Taxes
Taxes and
and Extraordinary
Extraordinary Items
Items
•• Income
Income Taxes
Taxes
•• Extraordinary
Extraordinary Items
Items
•• Net
Net Income
Income
 The Direct Relationship between the
Income Statement and the Balance Sheet
NN M
M

NI ==
NI 
rrnnAAnn -- 
 rrmmLLmm -- PP++NII
NII -- NIE
NIE -- TT
n=1
n=1 m=1
m=1
where
where
NI
NI == Bank’s
Bank’snet
netincome
income
AAn == Dollar
Dollarvalue
valueof ofthe
thebank’s
bank’snth
nthasset
asset
n
LLm ==Dollar
Dollarvalue
valueofofthe
thebank’s
bank’smth
mthliability
liability
m
rrn ==Rate
Rateearned
earnedon onthethebank’s
bank’snth
nthasset
asset
n
rrm ==Rate
Ratepaid
paidon
onthethebank’s
bank’smth
mthliability
liability
m
PP == Provision
Provisionfor
forloan
loanlosses
losses
NII
NII == noninterest
noninterestincome
incomeearned,
earned,including
includingOBS OBS
NIE
NIE == noninterest
noninterestexpenses
expensesincurred
incurred
TT == Bank’s
Bank’staxes
taxes
NN == number
numberofofassets
assetsthethebank
bankholds
holds
MM =/Irwin
McGraw-Hill = number
numberofofliabilities
liabilitiesthe
thebank
bankholds
holds
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 2. Financial Statement Analysis Using a
Return on Equity Framework
•• Time
Time series
series analysis
analysis -- analysis
analysis ofof financial
financial statements
statements
over
over aa period
period ofof time
time
•• Cross-sectional
Cross-sectional analysis
analysis -- analysis
analysis of of financial
financial
statements
statements comparing
comparing one one firm
firm with
with others
others
•• Return
Return onon equity
equity (ROE)
(ROE) -- measures
measures overall
overall profit-
profit-
ability
ability of
of the
the FI
FI per
per dollar
dollar of
of equity
equity

ROE
ROE == Net
Net income
income  Total
Total Assets
Assets
Total
Total Assets
Assets Total
Total equity
equity capital
capital

ROA  EM
== ROA EM
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Return on Assets and Its Components

Return
Return on on Assets
Assets (ROA)
(ROA) -- measures
measures profit
profit generated
generated
relative
relative to
to the
the FI’s
FI’s assets
assets

ROA
ROA == Net
NetIncome
Income  Total
Totaloperating
operatingincome
income
Total
Totaloperating
operatingincome
income Total
Totalassets
assets

PM  AU
== PM AU

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 2.1 Profit Margin
Profit
Profit Margin
Margin (PM)
(PM) -- measures
measures aa bank’s
bank’s ability
ability to
to pay
pay
expenses
expenses and
and generate
generatenet
net income
incomefrom
from interest
interest and
and
noninterest
noninterest income
income

Interest
Interest expense
expense ratio
ratio == Interest
Interest expense
expense
Total
Total operating
operating income
income
Provision
Provision for
for loan
loan loss
loss ration
ration == Provision
Provision for
for loan
loan losses
losses
Total
Total operating
operating income
income
Noninterest
Noninterest expense
expense ratio
ratio == Noninterest
Noninterest expense
expense
Total
Total operating
operating income
income
Tax
Tax Ratio
Ratio == Income
Income taxes
taxes
Total
Total operating
operating income
income
McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 2.2 Asset Utilization

Asset
Assetutilization
utilization(AU)
(AU)-- measures
measuresthe
theamount
amountof ofinterest/
interest/
noninterest
noninterest income generated per
incomegenerated per dollar
dollar of
of total
total assets
assets

AU
AU ==Total
Totaloperating
operatingincome
income ==Interest
Interest ++ Noninterest
Noninterest
Total
Totalassets
assets income
income income
income
ratio
ratio ratio
ratio

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 2.3 Net Interest Margin

Net
Net interest
interest margin
margin -- interest
interest income
income minus
minus interest
interest
expense
expense divided
divided by
by earning
earning assets
assets

Net
Net
interest
interest == Net
Net interest
interest income
income
margin
margin Earning
Earning assets
assets

== Interest
Interest income
income -- Interest
Interest expense
expense
Investment
Investment securities
securities ++ Net
Net loans
loans and
and leases
leases

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Spread

Spread
Spread -- the
the difference
difference between
between lending
lending and
and deposit
deposit
rates
rates

spread
spread == Interest
Interest income
income -- Interest
Interest expense
expense
Earning
Earning assets
assets Interest-bearing
Interest-bearing liabilities
liabilities

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Overhead Efficiency

Overhead
Overhead efficiency
efficiency -- aa bank’s
bank’s ability
ability to
to generate
generate
noninterest
noninterest income
income to
to cover
cover noninterest
noninterest expenses
expenses

Overhead
Overhead efficiency
efficiency == Noninterest
Noninterest income
income
Noninterest
Noninterest expense
expense

McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.