Professional Documents
Culture Documents
[1] Introduction
The particular services that each financial firm chooses to offer and the overall size of each
financial-service organization are reflected in its financial statements.
They are invaluable guideposts that can, if properly constructed and interpreted, signal success or
signal disaster. (Enron Scandal & WorldCom Scandal)
The two main financial statements that managers, customers (particularly large depositors not
fully protected by deposit insurance), and the regulatory authorities rely upon are "The balance
sheet (Report of Condition)" and "The income statement (Report of Income)".
Finally, we explore some of the similarities and some of the differences between bank financial
statements and those of their closest financial competitors.
[2] An Overview of Balance Sheets and Income Statements
The two most important financial statements for a banking firm—its
(Balance sheet, or Report of Condition) and its (Income statement, or Report of Income)
May be viewed as a list of financial inputs and outputs.
-The Report of Condition (B.S): Shows the amount and composition of funds sources (financial
inputs) drawn upon to finance lending and investing activities and how much has been allocated
to loans, securities, and other funds uses (financial outputs) at any given point in time.
The Report of Income also shows the Revenues (cash flow) generated by selling services to the
public, including making loans and leases and servicing customer deposits.
Finally, The Report of Income shows net earnings after all costs are deducted from the sum of all
revenues, some of which will be reinvested in the business for future growth and some of which
will flow to stockholders as dividends.
[3] The Balance Sheet (Report of Condition)
The Principal Types of Accounts
A "Balance sheet = 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.
Because financial institutions are simply business firms selling a particular kind of product, the
basic balance sheet identity: Assets = Liabilities + Equity capital
must be valid for banks and other financial-service providers.
In banking: C + S + L + MA = D + NDB + EC
❖ The Assets on the balance sheet are of four major types:
1. Cash in the vault and deposits held at other depository institutions (C):
Cash Assets (C): are designed to meet a bank’s need for liquidity (immediately spendable
cash) in order to meet deposit withdrawals, customer demands for loans, and other
unexpected or immediate cash needs.
2. Government and Private interest-bearing Securities purchased in the open market (S):
Security holdings (S) are a backup source of liquidity and provide another source of income.
A bank’s 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.
Let’s take a closer look at the principal components of this banking firm’s Report of Condition.
This item includes cash held in the bank’s vault, any deposits placed with other depository
institutions (usually called correspondent deposits), cash items in the process of collection
(mainly uncollected checks), and the banking firm’s reserve account held with the Federal
Reserve bank (Central Bank) in the region.
The cash and due from depository institutions is also referred to as "Primary Reserves".
This means that these assets are the first line of defense against customer deposit
withdrawals and the first source of funds to look to when a customer comes in with a loan
request.
Normally, banks strive to keep the size of this account as low as possible, because cash
balances earn little or no interest income.
2- Investment Securities:
(A)"The Liquid Portion":
A second line of defense to meet demands for cash is liquid security holdings, often called
"Secondary Reserves" or referenced on regulatory reports as “Available for sale.”
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.
"Secondary Reserves" occupy the middle ground between cash assets and loans, earning
some income but held mainly for the ease with which they can be converted into cash on
short notice.
"In EGYPT all type in EG Exchange Market are Exempted from Tax according to EG law."
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 (Central Bank).
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 off (normally after
only a few days).
A bank’s loan account typically is broken down into several groups of similar type loans.
We may see listed on a banking firm’s balance sheet the following loan types:
6- Loan Losses:
Loan losses, both current and projected, are deducted from the amount of this total (gross)
loan figure.
Under current U.S. 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.
Total (Gross) Loans and Leases ( ـــــALL) = Net Loans and Leases
The Allowance for Possible Loan Losses (ALL) is built up gradually over time by annual
deductions from current income.
These deductions appear on the banking firm’s income and expense statement (or Report of
Income) as a non-cash expense item called "The Provision for Loan Losses" (PLL).
"The Allowance for Loan Losses" (ALL): affected by Recoveries (Increase) and Charging-off
/Writing off (Decrease).
-General Reserves.
This division of loan-loss reserves helps managers better understand their institutions
need for protection against current or future loan defaults.
Reserves for loan losses are determined by management; however, they are influenced
by tax laws and government regulations.
For example, if a customer receives a loan and pays all or some portion of the interest up
front, the banking firm cannot record that interest payment as earned income because the
customer involved has not yet had use of the loan for any length of time.
Over the life of the loan, the bank will gradually earn the interest income and will transfer the
necessary amounts from unearned discount to the interest income account.
Once a loan is classified as “non-performing,” 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.
A banking firm usually devotes only a small percentage (less than 2 percent) of its assets to
the institution’s physical plant—that is, the fixed assets represented by buildings and
equipment needed to carry on daily operations.
Assets are financial claims (loans and investment securities) rather than fixed assets.
إلتام او حمل عىل البنك زي كإنك واخد قرض بالظبط وده يقصد إن أصول البنك ُتعد من الناحية المالية ر ز،أكت
النقطة متعلقة بالفينانس ر
ز
والخدمات الموجودة،المبن ز
المبن فأنا هدفع ثمن ّ ،ألن األصول الثابتة زف البنك مش بتكون مصدر إيراد لكن مصدر تكاليف
كو ز ين أملك ي
ز
.المبن واإلستهاللك ز،فيه
والضائب العقارية عىل
However, fixed assets typically generate fixed operating costs in the form of depreciation
expenses, property taxes, and so on, which provide "Operating leverage" enabling the
institution to boost its operating earnings if it can increase its sales volume high enough and
earn more from using its fixed assets than those assets cost.
ز
المبن الىل بضفها عىل ز
الىل البنك بيقدمها ريتهن عىل أهمية التكاليف ي
هيدخىل إيراد من خالل الخدمات ي ي المبن وجوده هنا بيكلم لو
.يعتت حمل عىل البنك وده ،لزمة ملهوش ز
المبن ر
يبق منها ر
أكت او التكاليف يعادل اد
ر إي بسببه بيج مش ز
المبن لو
ر ي ر
But with so few fixed assets relative to other assets, banks cannot rely heavily on operating
leverage to increase their earnings; they must instead rely mainly upon
"Financial leverage": The use of borrowed funds—to boost their earnings and remain
competitive with other industries in attracting capital.
على قد ما يبص على ناحية التمويل وازاي الفلوس اللي عنده يجيب بها أرباح ألنها،عشان كدا البنك مش لزم يبص على الناحية التشغيلة
. فلزم يشوف هيدفع كام ومتوقع يجي كام وإال ّ هيتحمل تكاليف وخالص،فلوس نّاس
بدل ما ر،أتني
يشتوا ماكينة خاصة بهم أغلب البنوك ممكن تستخدم ماكينة بنك واحد أو زATM فكرة،أبسط مثال عىل الجزئية دي
يشتوا ماكينة ز
تان وبيدفعوا تكاليف الخدمة أقل من إنهم ر ز
من خالل بنك يATM هما بتودا للعميل بتاعهم خدمة ،ويتحملوا تكاليف
.ني ز يف منطقة واحدة
لعميل واحد أو أت ز
While “kids” may want as many Oreos as possible, bankers like to keep the OREO account
small by lending funds to borrowers who will make payments in a timely fashion (a timely
manner).
12- 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.
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 = "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. (though most depository institutions impose a minimum size requirement)
and permit the customer to withdraw at will.
3. NOW accounts:
Which can be held by individuals and nonprofit institutions, bear interest and permit drafts
(checks) to be written against each account to pay third parties.
One reason borrowing from non-deposit funds sources have grown rapidly in recent years
is that there are:
1- No reserve requirements 2- insurance fees on most of these funds
3- which lowers the cost of non-deposit 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 non-deposit 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.
The most important non-deposit funding source for most depository institutions, typically,
is represented by 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 financial firm has borrowed funds collateralized by some of its own securities
from another institution.
Other borrowed funds that may be drawn upon include short-term borrowings such as
borrowing reserves from the discount windows of the Federal Reserve banks, issuing
commercial paper, or borrowing in the Eurocurrency market from multinational banks.
Every new financial firm begins with a minimum amount of owners’ capital and then borrows
funds from the public to “lever up” its operations.
In fact, financial institutions are among the most heavily leveraged (debt-financed) of all
businesses.
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.
Perpetual preferred stock is part of equity capital, while limited-life preferred stock is usually
listed as debt capital.
Preferred stock is generally viewed in the banking community as expensive to issue,
principally because the annual dividend is not tax deductible, and a drain on the earnings
that normally would flow to stockholders, though the largest bank holding companies have
issued substantial amounts of preferred shares in recent years.
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 held as protection against unforeseen losses and
treasury stock that has been retired.
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.
The problem with these off-balance-sheet transactions is that they often expose a financial
firm to considerable risk that conventional financial reports simply won’t pick up.
After all, assets on the balance sheet usually account for the majority of operating revenues,
while liabilities generate many of a bank’s operating expenses.
-The principal source of bank revenue generally is the interest income generated by earning
assets—mainly (loans and investments).
Additional revenue is provided by the fees charged for specific services (such as ATM
usage).
-The major expenses incurred in generating this revenue include:
-Interest paid out to depositors
-Interest owed on non-deposit borrowings.
-The cost of equity capital
-Salaries, wages, and benefits paid to employees.
-Overhead expenses associated with the physical plant.
-Funds set aside for possible loan losses.
-Taxes owed.
The previous chart on revenue and expense items reminds us that financial firms interested in
Increasing their net earnings (income) have a number of options available to achieve this goal:
Management does not have full control of all of these items that affect net income.
The yields earned on various assets, the revenues generated by sales of services, and the
interest rates that must be paid to attract deposits and non-deposit borrowings are
determined by demand and supply forces in the marketplace.
Over the long run, the public will be the principal factor shaping what types of loans the
financial-service provider will be able to make and what services it will be able to sell in its
market area.
Within the broad boundaries allowed by competition, regulation, and the pressures exerted
by public demand, however, management decisions are still a major factor in determining
the particular mix of loans, securities, cash, and liabilities each financial firm holds and the
size and composition of its revenues and expenses.
1) Interest Income.
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.
Another important interest expense item is the interest owed on short-term borrowings in
the money market—mainly borrowings of federal funds (reserves) from other depository
institutions and borrowings backstopped by security repurchase agreements—plus any
long-term borrowings that have taken place (including mortgages on the financial firm’s
property and subordinated notes and debentures outstanding).
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 line— net after-
tax earnings—and the dividends their stockholders receive on each share of stock held
may decrease as well."
B. 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.
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
3) Non-interest income.
Sources of income other than interest revenues from loans and investments are called
noninterest income (fee 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 (such as trust services).
(2) service charges on deposit accounts.
(3) trading account gains and fees.
(4) additional noninterest income (including revenues from investment banking,
security brokerage, and insurance services).
4) Non-interest Expenses.
The key noninterest expense item for most financial institutions is wages, 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 institution’s properties and rental fees on office space
show up in "The premises and equipment expense".
The cost of furniture and equipment also appears under the non-interest expense
category, along with numerous small expense items such as (legal fees, office supplies,
and repair costs).
Applicable income tax rates are applied to Pre-tax net operating income plus securities
gains or losses to derive income before extraordinary items.
-Securities gains (losses): are usually small, but can be substantial for some financial
firms. For example, banks purchase, sell, or redeem securities during the year, and this
activity often results in gains or losses above or below the original cost (book value) of
the securities.
Regulators require that banks report securities gains or losses as a separate item;
however, other income statements may record these gains or losses as a component of
non-interest income.
A bank can use these gains or losses to help smooth out its net income from year to year.
If earnings from loans decline, securities gains may offset all or part of the decline.
In contrast, when loan revenues (which are fully taxable) are high, securities losses can be
used to reduce taxable income. Another method for stabilizing the earnings of financial
institutions consist of nonrecurring sales of assets.
These one-time-only (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 lender’s books at minimal market value, but its sale price may turn out to be
substantially higher.
The key bottom-line item on any financial firm’s income statement is net income, which
the firm’s board of directors usually divides into two categories.
-Some portion of net income may flow to the stockholders in the form of cash dividends.
-Another portion (usually the larger part) will go into retained earnings (also called
undivided profits) in order to provide a larger capital base to support future growth.