AF5358

Management of
Financial Institutions

The Financial Statements of Banks

&
Performance Evaluation
 Learning Objectives
• An Overview of the Balance Sheets and
Income Statements of Banks.
• Composition of major asset & liabilities Items
(note the differences between US and HK).
• Recent Expansion of Off-Balance Sheet Items
• Components of the Income Statement and
how banks derive the net income.
• Performance evaluation of banks using the
ROE (Du Pont) analytical framework.
 Readings
• This PowerPoint notes

• Saunders & Cornett (2018)

Chapter 2 - Appendix 2A & 2B

Supplementary
• Financial statements of the BOCHK (Holdings)
Limited from the annual reports.
 Financial Statements
Basic financial statements
• Balance sheet (report of condition)
• Income statement (report of income)
• Statement of stockholders’ equity
• Statement of cash flows
We focus on B/S and I/S which are sufficient for us to study the
nature of business and to evaluate the performance of
banks. We also need to refer to the ‘Notes to the financial
statements’ in order to know in detail individual accounting
items.
Balance Sheet (Report of Condition)
• The Balance Sheet of a Bank Showing its Assets,
Liabilities and Net Worth at a given point in time.

• May be viewed as a list of financial inputs (sources of

funds) and outputs (uses of funds).

• You may find differences in the balance sheet

between banks and commercial firms which reflect
the different nature of their business.
 Key Balance Sheet Items of Banks

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

C= Cash Assets D= Deposits

S= Security Holdings NDB = Nondeposit
L= Loans Borrowings
MA = Miscellaneous Assets EC = Equity Capital
 Cash Assets
• Account is Called “Cash and Deposits Due
from Banks”.
• Includes:
– Vault Cash
– Reserve Account with the Federal Reserve
– Deposits with Other Banks (Correspondent
Deposits)
– Cash Items in Process of Collection
• Sometimes Called ‘Primary Reserves’
 Security Holdings
• Security holdings for 3 major purposes:
– Liquidity
– Trading
– Investment
• Sometimes presented by different items in the
balance sheet.
• Need to refer to the ‘Notes to the financial
statements’.
 Securities: For Liquidity
• Often Called ‘Secondary Reserves’.

• Include:
– Short Term Government Securities
– Private sector Money Market Securities
• Federal Funds Sold
• Reverse Repurchase Agreements
• Interest Bearing Time Deposits
• Commercial Paper
 Federal Funds Sold &
Reverse Repurchase Agreements
• Loans between banks (the interbank market).
• Generally short-term with maturity as short as
one day (Overnight Loans).
• Federal Funds Sold-Uncollateralized loans
made by one bank to another through the
accounts in the Federal Reserve in US.
• Reverse Repurchase Agreements – Lending
bank takes temporary title to securities owned
by borrower.
 Securities: For Trading
• Securities purchased to provide short-term
profits from short-term price movements
(position taking)
• When the bank acts as a securities dealer
• Refer as ‘proprietary trading’
• Valued at Market (marked-to-market)
– FASB 115
 Securities: For Investment
• Securities held for longer-term (often held up
to maturity) for investment purpose
• Income generated from interest received and
price gain
• Securities differ by risk and tax status…etc.
• Examples of securities:
– U.S. Treasury Notes & Bonds
– US Agency Securities
– Municipal Securities
– Mortgage-backed Securities
– Corporate Bonds
 Loans
• Major assets of banks that generate the
largest flow of revenue income
• The least liquid asset items (most banking
loans are non-marketable contracts between
the banks and the borrowers)
• The major source of credit and liquidity risk
• Also the source of interest rate risk because
the maturity mismatch between loans and
deposits
 Types of Loans
• Commercial and Industrial Loans
• Consumer Loans (Loans to Individuals)
• Real Estate Loans
• Financial Institution Loans
• Foreign Loans
• Agriculture Production Loans
• Security Loans...etc.
• Leases (used as alternatives to loans when the bank,
as owner of a physical asset, allows a customer to
use the asset in return for periodic lease payments)
 Components of Loans Account
• Gross Loans – Sum of All Loans

• Allowance for Loan Losses (ALL)

– Contra Asset Account
– For Potential Future Loan Losses

• Net Loans = Gross Loans – ALL

• Unearned Discount Income

 Allowance for Loan Losses (ALL)
Beginning Allowance for Loan Losses
+ Provision for Loan Loss (Income Statement)
= Adjusted Allowance for Loan Losses
- Actual Charge-Offs
+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses
 Allowance for Loan Losses (ALL)
The allowance can also be divided into specific and
general reserves
• Specific Reserves
– Set Aside to Cover a Particular Loan
– Designate a Portion of ALL or
– Add More Reserves to ALL
• General Reserves
– Remaining ALL
• Determined by bank management BUT influenced by
taxes and government regulation
 Miscellaneous Assets

• Bank Premises and Fixed Assets

• Other Real Estate Owned (OREO)

• Goodwill and Other Intangibles

 Deposits
• Major liabilities item of banks
• Bank customers place deposits with banks either for
transaction or saving (investment) purpose
• Transaction (demand) deposits are the major means
that banks provide the payment and settlement
services
• Maturity of deposits are usually shorter than that of
loans that creates ‘maturity mismatch’ of banks’
assets and liabilities and gives rise to various kinds of
risks
 Deposit Accounts

• Non interest-Bearing Demand Deposits

(Checking deposits)
• Savings Deposits
• Negotiable Order of Withdrawal (NOW)
Accounts
• Money Market Deposit Accounts (MMDA)
• Time Deposits
 Nondeposit Borrowings
Short-term
• Fed Funds Purchased
• Securities Sold Under Agreement to Repurchase
(Repurchase Agreements)
• Acceptances Outstanding
• Eurocurrency Borrowings
Long-term
• Subordinated Debt
• Limited Life Preferred Stock
• Other Liabilities
 Equity Capital

• Preferred Stock
• Common Stock
– Common Stock Outstanding
– Capital Surplus
– Retained Earnings (Undivided Profits)
– Treasury Stock
– Contingency Reserve
 Off-Balance-Sheet (OBS) Items
OBS items
• Contingent assets and liabilities that may affect the future
status of a bank’s balance sheet.
Common OBS items of banks
• Unused Commitments
• Standby Credit Agreements
• Derivative Contracts
– Futures Contracts
– Options
– Swaps
• OBS transactions expose a bank to counterparty and
market risks
 Common Size Balance Sheet
• Obtained by dividing all balance sheet items
(assets, liabilities, equities) by the value of
Total Assets.
• Expressed as % alongside the $ value of all
balance sheet items (Total assets as 100%).
• The % reflects the relative importance of
individual balance sheet items.
Comparative
Balance
Sheet
Ratios for
Different Size
Banks (FDIC,
2006)

Which accounts are most important on the asset side of a Call Report? Liability side?
 Income Statement (Report of Income)

• The Statement of Revenues, Expenses and Profits for a

Bank Over a Period of Time

• Shows how much it has cost to acquire funds and to

generate revenues from the uses of funds in Report of
Conditions

• Shows the revenues (cash flow) generated by selling

services to the public

• Shows net earnings after all costs are deducted from the
sum of all revenues
Report of
Income for
BB&T
Corporation
 Income Statement
Net Interest Income
- Provision for Loan Loss (PLL)
Net Income After PLL
+/- Net Noninterest Income
Net Income Before Taxes & Extraordinary Items
- Income Taxes
+ / - Extraordinary Items
Net Income
- Dividends
Undivided Profits
 Net Interest Income =
Interest Income – Interest Expenses
Interest Income Interest Expenses
• Interest on Loans • Deposit Interest Costs
• Taxable Securities Revenue • Interest on Short-Term Debt
• Tax-Exempt Securities • Interest on Long-Term Debt
Revenue
• Other Interest Income
 Net Noninterest Income =
Noninterest Income – Noninterest Expenses
Noninterest Income Noninterest Expenses
• Fees Earned from Fiduciary • Wages, Salaries, and
Activities Employee Benefits
• Service Charges on Deposit • Premises and Equipment
Accounts Expense
• Trading Account Gains and
• Other Operating Expenses
Fees
• Other Noninterest Income
from OBS activities
Fees Earned from Fiduciary Activities

• Fees for Managing Protecting a Customer’s

Property
• Fees for Record Keeping for Corporate Security
Transactions and Dispensing Interest and
Dividend Payments
• Fees for Managing Corporate and Individual
Pension and Retirement Plans
Service Charges on Deposit Accounts

• Checking Account Maintenance Fees

• Checking Account Overdraft Fees
• Fees for Writing Excessive Checks
• Savings Account Overdraft Fees
• Fees for Stopping Payment of Checks
 Trading Account Gains and Fees

• Net Gains and Fees from Trading Marketable

Instruments and Off Balance Sheet Derivative
Contracts That Have Been Recognized During
the Accounting Period
 Other Noninterest Income
• 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
• Net Gains (Losses) on the Sales of Other Assets
 Common Size Income Statement
• Obtained by dividing all income statement items by
the value of Total Revenue or (Total Operating
Income).
(What is the total revenue of a bank as similar to
that of ‘Sales Revenue” of a commercial firm ?)
• Expressed as % alongside the $ value of all income
statement items (Total revenue as 100%).
• The % reflects the relative importance of individual
income statement items.
The Direct Relationship between the Income Statement and the
Balance Sheet

N M
NI =  rnAn -  rmIm - P + NII - NIE - T
n=1 m=1
where
NI = Bank’s net income
An = Dollar value of the bank’s nth asset
Lm = Dollar value of the bank’s nth liability
rn = Rate earned on the bank’s nth asset
rm = Rate paid on the bank’s nth liability
P = Provision for loan losses
NII = noninterest income earned, including OBS
NIE = noninterest expenses incurred
T = Bank’s taxes
N = number of assets the bank holds
M = number of liabilities the bank holds
 Performance Evaluation of Banks
Regulators’ focus:
• Overall safety and soundness of banks
• CAMELS rating (Capital adequacy, Asset quality,
Management, Earnings, Liquidity and Sensitivity to
market risk.)
Bank Shareholders’ focus:
• Sustainable return on equity (ROE)
• ROE framework (also known as DuPont analysis) is
used to identify factors affecting the ROE.