Bank Financial Statements & Operations Copyright 2014 Diane Scott Docking 1

Bank Financial Statements & Operations

Copyright 2014 Diane Scott Docking1

2Copyright 2014 Diane Scott Docking

Learning Objectives

Examine how commercial banking is conducted to earn the highest profits possible. Topics include: The Bank Balance Sheet The Bank Income Statement Off-Balance Sheet Activities General Measuring Bank Performance

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Bank Financial Statements

Report of Condition – Balance Sheet

Report of Income – Income Statement

Copyright 2014 Diane Scott Docking

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The Bank Balance Sheet

Flow of funds (tab down to commercial banks) http://www.federalreserve.gov/releases/z1/current/z1r-4.pdf 4


http://www.federalreserve.gov/releases/z1/%0Bcurrent/z1r-4.pdf

C + S + L + MA = D + NDB + EC

C =Cash Assets

S =Security

Holdings

L = Loans

MA =Miscellaneous

Assets

D =Deposits

NDB =Non Deposit

Borrowings

EC = Equity Capital

Copyright 2014 Diane Scott Docking 5


To Increase a Bank’s Account:

Debit Credit

Asset

Liability

Income

Capital

Expense

Cash Assets

Account is called Cash and Due from Banks

Includes: Vault Cash Deposits with Other Banks Cash Items in Process of Collection Reserve Account with Fed

Sometimes Called Primary Reserves


Securities Holdings

Money Market Securities (sometimes called Secondary Reserves)Investment Securities Taxable Securities Tax-Exempt Securities

Trading Account Securities Held for Resale Only Valued at Market Value


Bank Investments and FASB 115

Following FASB 115 a bank, at purchase, must designate the objective behind buying investment securities as either:


Security Classification

Security Classification

Recorded At

Balance Sheet Reporting

Income Statement Effect


Trading Cost Unrealized gain/loss recognized in _____

HTM

AFS

Cost

CostUnrealized gain/loss recognized in _________________

Gain/loss recognized when _____________

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Federal Funds Sold and Reverse Repurchase Agreements

A Type of Loan Account

Generally Overnight Loans

Federal Funds Sold - Funds Come from the Deposits at the Federal Reserve

Reverse Repurchase Agreements – Bank Takes Temporary Title to Securities Owned by Borrower


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Loan Accounts

Gross Loans = Sum of All Loans

- Allowance for Possible Loan Losses Contra Asset Account

For Potential Future Loan Losses

- Unearned Discounts

= Net Loans

Nonperforming Loans


Problem: Loan Loss ReservesPortland Bank made a provision for loan losses of $3.5 million, took loan charge-offs of $5 million, and had recoveries of $1,750,000 during the year 2XX2. At December 31, 2XX2, the bank’s balance sheet reserve for loan losses was $2 million. What was the bank’s apparent reserve for loan losses at the end of the prior year (December 31, 2XX1)?


Problem: Loan Loss Reserves (cont.)

LLR a/c (in millions)

Beginning Balance 12/31/2xx1

+ Provision

- Charge-offs

+ Recoveries

Ending Balance 12/31/2XX2


BB = 2 – 1.75 + 5 – 3.5 = __________

The Expense

Problem: Loan Charge-offs

Sycamore Bank’s allowance for loan losses from its balance sheet for the years ending 2XX1 and 2XX2 is:

12/31/2XX112/31/2XX2

Allowance for loan losses $49,235,000 $55,335,000

During the year 2XX2, Sycamore Bank took a provision for loan losses charge of $15 million against its income. Determine the apparent amount of net loan charge-offs during 2XX2.


Problem: Loan Charge-offs (cont.)

LLR a/c

Beginning Balance 12/31/2xx1

+ Provision

- Net Charge-offs

Ending Balance 12/31/2XX2


Net Charge-offs = 49.235 + 15.00 – 55.335 = ______

Miscellaneous Assets

Net Premises and Equipment

OREO

Goodwill and Other Intangibles

Other Miscellaneous Assets


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Deposit Accounts

Non interest-Bearing Demand Deposits

Savings Deposits

Now Accounts

Money Market Deposit Accounts (MMDA)

Time Deposits

Core vs. Volatile Deposits


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Nondeposit Borrowings

Fed Funds Purchased/BorrowedSecurities Sold under Agreements to Repurchases (Repurchase Agreements)Acceptances OutstandingEurocurrency BorrowingsDue to Fed (Discount Loans)Long-term Debt Notes and Debentures

notes and bonds with maturities in excess of one year. Stock

Other Liabilities


Equity Capital Accounts

____________________ Stock Listed at par

____________________ Stock Ownership interest in the bank. Listed at par

____________________ represents the amount of proceeds received by the bank in excess

of par when it issued the stock______________________ Retained Earnings

Treasury StockContingency ReserveReserves for .


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Off-Balance-Sheet Items

Unused Commitments

Standby Credit Agreements

Derivative Contracts Futures Contracts Options Swaps

OBS Transactions Exposes a Firm to Counterparty Risks


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Off-Balance-Sheet Activities

1. Loan sales (secondary loan participation)2. Fee income from

Foreign exchange trades for customers Servicing mortgage-backed securities Guarantees of debt Backup lines of credit

3. Trading Activities and Risk Management Techniques1. Financial futures and options 2. Foreign exchange trading3. Interest rate swaps

All these activities involve risk and potential conflicts

Banks' Income Statement


Banks' Income Statement (cont.)


Net Interest Income =Interest Income - Interest Expenses

Interest on: Loans Taxable Securities Tax-exempt Securities Deposits held at other

institutions, Other Interest Income

Interest on: Deposits Short Term Debt Long Term Debt


Interest Income Interest Expenses

Net Noninterest Income =Noninterest Income - Noninterest Expenses

Fee income

Service Charge on Customer Deposits

Trust Department Income

Trading account gains and fees

Other Operating Income

Wages, Salaries, and benefits

Other Personnel Expenses

Net Occupancy Expenses rent and depreciation on

equipment and premises

Other Operating Expenses Utilities, advertising,

deposit insurance premiums, etc.


Noninterest Income Noninterest Expenses

Problem: Bank Income Statements

You know the following figures:Total interest income $140 Provision for loan losses

$5

Total interest expense $100 Income taxes$5

Total noninterest income $ 15 Increases in bank’s undivided profits$6

Total noninterest expenses $ 35

Calculate the following items:a) Net interest income e) Total operating revenues

b) Net noninterest income f) Total operating expenses

c) Pretax net operating income g) Dividends paid to common stockholders

d) Net income after taxes Copyright 2014 Diane Scott Docking 27

Solution: Bank Income Statements

Calculate the following items:a) Net interest income

b) Net noninterest income

c) Pretax net operating income


= Total Interest Income – Total Interest Expense= 140 – 100 = _____

= Total Noninterest Income – Total Noninterest Expense= 15 – 35 = _______

= Net Interest Income + Net Noninterest Income + PLL= 40 – 20 – 5 = _______

Solution: Bank Income Statements (cont.)

d) Net income after taxes

e) Total operating revenues

f) Total operating expenses

g) Dividends paid to common stockholders


Pretax net operating income – Taxes= 15 – 5 = ______

Interest Income + Noninterest Income=140 + 15 = ______

Interest Expenses + Noninterest Expenses + PLL= 100 + 35 + 5 = _______

Net Income After Taxes – Increase in Undivided Profits= 10 – 6 = _____

Problem: Bank Balance Sheets

You know the following figures:Gross loans $275 Miscellaneous assets $ 38

Cash and due from banks $ 9 Nondeposit borrowings $ 20

Investment securities $ 36 Allowance for loan losses $ 5

Trading account securities $ 2 Preferred stock$ 3

Goodwill and other intangibles $ 3 Common stock $ 5

Other real estate owned $ 4 Surplus $ 19

Bank premises and equipment, gross $ 34 Total liabilities $375

Bank premises and equipment, net $ 29 Total equity capital $ 39

Calculate the following items:a) Total assets d) Accumulated Depreciation

b) Net loans e) Total deposits

c) Undivided profits f) Fed funds soldCopyright 2014 Diane Scott Docking 30

Solution: Bank Balance Sheets

Calculate the following items:a) Total assets

b) Net loans

c) Undivided profits

d) Accumulated Depreciation


Total Liabilities + Total Equity Capital= 375 + 39 = ______

Gross Loans – ALL= 275 – 5 = _____

Total Equity Capital – Preferred Stock – Common Stock – Surplus= = 39 – 3 – 5 – 19 = ______

PPE, gross – PPE, net= 34 – 29 = ______

Solution: Bank Balance Sheets

Calculate the following items:e) Total deposits

f) Fed funds sold


Total Liabilities – Nondeposit Borrowings= 375 – 20 = _______

Total Assets: Cash and Due from Banks $ 9 Federal Funds Sold ? Investments 36 Gross Loans 275 Less: Allowance for Loan Losses -5 Bank Premises and Equipment, Net 29 Miscellaneous Assets 38 Trading Account Securities 2 Other Real Estate Owned 4 Goodwill and other Intangibles 3 Subtotal 391 Less Total Assets 414 Difference = Fed Funds Sold** ____


Measuring Bank Performance

As, much like any firm, ratio analysis is useful to measure performance and compare performance among banks. The following slide shows both calculations and historical averages for key bank performance measures.

ROE can be misleading

If ROE is high - may mean there is not enough capital and this is not good

If ROE is low - May mean a lot of capital. This is okay, but bank may be inefficient.


Copyright 2014 by Diane S. Docking36

Example: Bank Accounting

Jason opens a savings account at First National Bank with $100 cash. What are the accounting entries made by the bank to record this transaction?


Solution to Example: Bank Accounting

T-account Analysis: Deposit of $100 cash into First National Bank

First National BankAssets Liabilities

Vault cash +$100 Checkabledeposits

+$100

Dr) Vault Cash $100 Cr) DDA $100


Example 2: Bank Accounting

Ruthie has a checking account at First National Bank. She deposits a $100 check from her mom. Her mom’s checking account is at the Second National Bank. What are the accounting entries made by First National Bank and Second National Bank to record this transaction?


First National Bank Assets Liabilities

CIPC +$100 Checkable deposits

+$100

Solution to Example 2: Bank Accounting


Reserves at Fed CIPC

+$100

-$100

Second National BankAssets Liabilities

Reserves -$100 Deposits -$100

Deposit of $100 check

When check clears:



Ruthie has a checking account at First National Bank. She deposits a $100 check from her mom. Her mom’s checking account is at the Second National Bank.

What are the accounting entries made by First National Bank to record this transaction assuming the bank must keep 10% of every deposit as Required Reserves?



T-account Analysis: Deposit of $100 cash into First National Bank


Required reserves Excess reserves

+$10 +$90

Checkable deposits

+$100



Assume, after the transactions in Example 3, that First National Bank makes a $90 loan to Mary Smith.

What are the accounting entries made by First National Bank to record this transaction.



T-account Analysis: Loan of $90 to Mary Smith


Excess reserves Loans

- $90 +$90


General Principles of Bank Management

The bank has four primary concerns when managing assets:

1. Liquidity management

2. Asset management Managing credit risk Managing interest-rate risk

3. Liability management

4. Managing capital adequacy


Example: Bank Liquidity Management –Excess Reserves

Assets Liabilities

Reserves $20 million Deposits $100 million

Loans $80 million Bank Capital $10 million

Securities $10 million

FNB Bank is required to keep 10% of deposits as Required Reserve.Below is their beginning Balance Sheet:

NOTE: The Bank has $10 million required reserves and $10 million in excess reserves.


Example: Bank Liquidity Management – Excess Reserves (cont.)

Assume $10 million is withdrawn from various deposit accounts.The Bank Balance Sheet is now:

Deposit outflow of $10 millionAssets Liabilities




Now, Bank has $9 million in required reserves and $1 million in excess reserves.

Copyright 2014 by Diane S. Docking17-47

Example: Bank Liquidity Management – No Excess Reserves

The Bank has No excess reserves.

Assets Liabilities




FNB Bank is required to keep 10% of deposits as Required Reserve.Below is their beginning Balance Sheet:


Example: Bank Liquidity Management – No Excess Reserves (cont.)

With 10% reserve requirement, bank has $9 million reserve shortfallWhat must it do??????

Deposit outflow of $10 millionAssets Liabilities




Assume $10 million is withdrawn from various deposit accounts.The Bank Balance Sheet is now:



Assets Liabilities

Reserves +$9 million Deposits $90 million

Loans $90 million Fed Funds Borrowed

+$9 million

Securities $10 million Bank Capital $10 million

1. Borrow $9 million from other banks either directly or in the Fed Funds market.



Assets Liabilities




2. Sell $9 million in Securities (AFS)



Assets Liabilities


Loans $90 million Discount Loans +$9 million

Securities $10 million Bank Capital $10 million

3. Borrow $9 million from the Fed Discount Window



Assets Liabilities




4. Call in or sell off loans.


Asset Management

Asset Management: the attempt to earn the highest possible return on assets while minimizing the risk.

1. Get borrowers with low default risk, paying high interest rates

2. Buy securities with high return, low risk

3. Diversify

4. Manage liquidity


Liability Management

Liability Management: managing the source of funds, from deposits, to CDs, to other debt.

1. Important since 1960s

2. No longer primarily depend on deposits

3. When see loan opportunities, borrow or issue CDs to acquire funds


Funds Management

It’s important to understand that banks now manage both sides of the balance sheet together, whereas it was more separate in the past. Indeed, most banks now manage this via the asset-liability management (ALM) committee.

This explains the increased use of CDs and loans over checkable deposits in recent decades.


Example: Capital Adequacy Management

1. Bank capital is a cushion that prevents bank failure. For example, consider these two banks:

High Capital Bank Assets Liabilities



Low Capital Bank Assets Liabilities



Capital/TA=10%

Capital/TA=4%


Example: Capital Adequacy Management (cont.)

What happens if these banks make loans or invest in securities (say, subprime mortgage loans, for example) that end up losing money? Let’s assume both banks lose $5 million from bad loans.


Example: Capital Adequacy Management (cont.)

Impact of $5 million loan loss.

High Capital Bank Assets Liabilities



Low Capital Bank Assets Liabilities


Loans $85 million Bank Capital -$1 million

Capital/TA=5.26%

Capital/TA= -1.05%


Capital Adequacy Management

So, why don’t banks hold want to hold a lot of capital??

2. Higher is bank capital, lower is return on equity ROA = Net Profits/Assets ROE = Net Profits/Equity Capital EM = Assets/Equity Capital ROE = ROA EM Capital , EM , ROE


Capital Adequacy Management

3. Tradeoff between safety (high capital) and ROE

4. Banks also hold capital to meet capital requirements (more on this in Chapter 13).


Managing Capital

Strategies for Managing Capital: what should a bank manager do if she feels the bank is holding too much capital?

• Sell or retire stock

• Increase dividends to reduce retained earnings

• Increase asset growth via debt (like CDs)


Managing Capital

Reversing these strategies will help a manager if she feels the bank is holding too little capital?

• Issue stock

• Decrease dividends to increase retained earnings

• Slow asset growth (retire debt)

Documents

Bank Financial Statements & Operations Copyright 2014 Diane Scott Docking 1