Chapter Twelve
Commercial Banks’
Financial Statements and
Analysis
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Regulators
• The Federal Deposit Insurance Corporation (FDIC)
insures the deposits of commercial banks
• The U.S. has a dual banking system—banks can be
either nationally or state chartered
– the Office of the Comptroller of the Currency (OCC) charters
and regulates national banks
– state agencies charter and regulate state banks
• The Federal Reserve System (FRS) has regulatory
power over nationally chartered banks and their holding
companies and state banks that opt in to the Federal
Reserve System
– a holding company is a parent company that owns a controlling
interest in a subsidiary bank or other FI
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Financial Statements
• The Federal Financial Institutions Examination Council
(FFIEC) prescribes uniform principles, standards, and report
forms for depository institutions
– balance sheets are reported on report of condition forms
– income statements are reported on report of income forms
– commercial banks report contingent assets and liabilities on offbalance-sheet reports
• Retail banks focus business activities on consumer banking
relationships
• Wholesale banks focus business activities on commercial
banking relationships
– most wholesale banks also engage in retail banking
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Financial Statements
• Comparative analysis of BOA and Webster
• Retail banks focus business activities on consumer
banking relationships - WBS
• Wholesale banks focus business activities on commercial
banking relationships
– most wholesale banks also engage in retail banking
– BOA has trust services, investment management and credit cards
businesses as well and is the leading small business lender in the
counry
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CAMELS Ratings
• Regulators use CAMELS ratings to evaluate the safety
and soundness of banks
• CAMELS ratings rely heavily on financial statement data
• Components
–
–
–
–
–
–
Capital adequacy
Asset quality
Management quality
Earnings quality
Liquidity
Sensitivity to market risk
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CAMELS Ratings
• CAMELS ratings range from 1 to 5
– Composite “1”—banks are basically sound in every respect
– Composite “2”—banks are fundamentally sound, but may have
modest weaknesses correctable in the normal course of business
– Composite “3”—banks exhibit financial, operational, or
compliance weaknesses ranging from moderately severe to
unsatisfactory
– Composite “4”—banks have an immoderate volume of serious
financial weaknesses or a combination of other conditions that are
unsatisfactory
– Composite “5”—banks have an extremely high immediate or near
term probability of failure
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Commercial Bank Assets
•
Cash and balances due from other depository institutions
–
•
Investment securities
–
–
•
short-term securities (e.g, Treasury bills and fed funds sold, Interest bearing deposits at
other FIs, Fed funds sold, Reverse Repos, U.S. Treasury and agency securities
long-term securities (e.g., Treasury bonds, munis, MBSs)
Loans
–
–
–
–
•
•
Consist of vault cash, currency in the process of collection (CIPC), correspondent
balances and reserves at the Fed. Also called primary reserves.
commercial and industrial
real estate
consumer
other loans
Unearned income and allowance for loan and lease losses
Other assets (e.g., fixed assets, goodwill, etc.)
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Commercial Bank Liabilities
• Core deposits
–
–
–
–
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demand deposits
negotiable order of withdrawal (NOW) accounts
money market deposit accounts (MMDAs)
other savings deposits
retail certificates of deposits
• Other deposits
– wholesale certificates of deposits (> $100,000)
• negotiable instruments traded in secondary markets
• brokered deposits
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Commercial Bank
Liabilities and Equity
• Non-deposit liabilities
– borrowed (purchased) funds
• fed funds purchased and repos
• other borrowed funds (e.g., banker’s acceptances, commercial
paper, discount window loans)
– subordinated notes and debentures
– other liabilities - non-interest bearing
• accrued interest, deferred taxes, dividends payable, etc.
• Equity
– preferred and common stock
– surplus or additional paid in capital
– retained earnings
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Off-Balance-Sheet Items
• Off-balance-sheet items are contingent assets and liabilities that
may affect a commercial bank’s balance sheet and/or income
statement
• Loan commitments
– up-front fees are charged for making funds available
– commitments fees are charged on unused portion of commitments
• Letters of credit
– commercial letters of credit
– standby letters of credit
• Loans sold
– loans can be sold with or without recourse
• Derivative contracts
– futures, forwards, swaps, and options
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Other Fee Generating Activities
• Correspondent banking and trust services
• Processing Services
•
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Income Statement
• Interest income – interest expense = net interest
income
• Noninterest income – noninterest expense = net
noninterest income
• Net interest income – provision for loan losses + net
noninterest income = income before taxes and
extraordinary items (EBTEI)
• EBTEI – income taxes – extraordinary items = net
income
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Income Statement
• There is a direct relationship between the income
statement and the balance sheet of commercial banks
N
M
n 1
m
NI   rn An  rm Lm  P  NII  NIE  T
NI = net income
An = dollar value of the bank’s nth asset
Lm = dollar value of the bank’s mth liability
rn = rate earned on the bank’s nth asset
rm = rate paid on the bank’s mth liability
P = provision for loan losses
NII = non-interest income earned, including income from OBS activities
NIE = non-interest expenses
T = taxes and extraordinary items
N = number of assets the bank holds
M = number of liabilities the bank holds
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Finding the required dollar interest
spread
• Suppose that a bank has equity of $200, interest expense of
$90, P = $20, net noninterest income of -$15 and a tax rate
of 34%. What is the minimum total interest revenue
required to give a ROE of 15%?
• Required NI = NI/$200 = 0.15 or NI = $30
• NI = [Interest revenue– Interest expense – P + (NII – NIE)]
X (1 – Tax rate) or
• $30 = [Interest revenue – $90 – $20 + –$15] (1 – 0.34)
• Required interest revenue = $170.45
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Illustrative loan pricing
• If securities are $500 and are earning an average
rate of return of 5% and the bank has $1500 in
loans, what must be the average loan rate to
generate interest revenue of $170.45?
• $170.45 = ($500 x 0.05) + ($1500 x Avg. Loan
Rate)
• Avg. Loan Rate required = 9.7%
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Financial Statement Analysis
• Financial statement analysis is based on accounting
ratios
• Time series analysis is the analysis of financial
statements over a period of time
• Cross-sectional analysis is the analysis of financial
statements comparing one firm with others
– the Uniform Bank Performance Report (UBPR) maintained by the
FFIEC allows banks to observe competitor financial statements
• Most financial statement analyses is a combination of time
series analysis and cross-sectional analysis
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RETURN ON EQUITY AND ITS COMPONENTS
2007 Full Year
Data
Interest Expense
Operating Income
Profit Margin
Net Income
Operating
Income
11.89%
ROA
Net Income
Total Assets
0.93%
ROE
Net Income
Total Equity
Capital
9.13%
Equity Multiplier
McGraw-Hill/Irwin
Total Assets
Total Equity Capital
9.65x
Asset Utilization
Operating
Income
Total Assets
7.15%
9-17
37.46%
PLL
6.95%
Operating Income
Noninterest
expense
Operating Income
38.20%
Income Taxes
Operating Income
5.21%
Interest Income
Total Assets
Noninterest
income
Total Assets
5.47%
1.89%
©2009 The McGraw-Hill Companies, All Rights Reserved
Return on Equity (ROE) Framework
• Return on Equity (ROE) analysis begins with ROE and
then breaks it down into its components
• ROE measures the overall profitability of the bank per
dollar of equity
net income
ROE 
totalequity capital
• ROE can be broken down into its components
ROE 
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net income
totalassets

 ROA  EM
totalassets totalequity capital
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Return on Equity (ROE) Framework
• Return on Assets (ROA) measures profit generated
relative the banks assets
• Equity Multiplier (EM) measures the extent to which
assets are funded with equity relative to debt (i.e., it is a
measure of leverage)
• ROA can also be broken down into its components
net income
totaloperatingincome

totaloperatingincome
totalassets
 PM AU
ROA 
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Return on Equity (ROE) Framework
• Profit Margin (PM) measures the ability to pay expenses and
generate net income from interest and noninterest income and is
composed of
–
–
–
–
interest expense ratio
provision for loan loss ratio
noninterest expense ratio
tax ratio
• Asset Utilization (AU) measures the amount of interest and
noninterest income generated per dollar of total assets and is
composed of
– interest income ratio
– noninterest income ratio
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Other Ratios
• The net interest margin (NIM) measures the net return
on a bank’s earning assets
NIM 
net interestincome
interestincome interestexpense

earningassets
investmentsecurities net loansand leases
• The spread measures the difference between the
average yield on earning assets and average cost on
interest-bearing liabilities
Spread 
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interestincome
interestexpense

earningassets interest- bearing liabilities
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Other Ratios
• Overhead efficiency measures a bank’s ability to
generate noninterest income to cover noninterest expenses
Overheadefficiency
noninterest income
noninterest expense
• Many additional ratios are commonly used to analyze
commercial banks by breaking down the components
of ROE even further (see Tables 12-6 and 12-7)
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Comparison of WFS and BOA
ROA
Net Income
ROE
Net Income
Total Equity Capital
Equity Multiplier
Total Assets
Total Equity Capital
WFS = 8.51
BOA = 9.33
WFS = 38.40%
BOA = 37.16%
PLL
Operating Income
WFS = 1.14%
BOA = 5.33%
Noninterest expense WFS = 38.50%
Total Assets
WFS = 0.99%
BOA = 1.43%
WFS = 8.45%
BOA = 13.36%
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Profit Margin
Net Income
Operating Income
WFS = 14.02%
BOA = 18.18%
Interest Expense
Operating Income
Asset Utilization
Operating Income
Total Assets
WFS = 7.08%
BOA = 7.91%
9-23
Operating Income
BOA = 30.25%
Income Taxes
Operating Income
WFS = 6.94%
BOA = 9.15%
Interest Income
Total Assets
WFS = 5.95%
BOA = 5.57%
Noninterest income
Total Assets
WFS = 1.13%
BOA = 2.34%
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The Impact of Market Niche and Size
• Retail and wholesale commercial banks operate in
different market niches that should be noted when
performing financial statement analysis
• Webster Financial Bancorp (WBS)
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–
–
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WBS is a profitable and efficient retail bank
invests mainly in real estate loans
uses low cost retail deposits to fund its assets
holds relatively more equity capital than Bank of
America
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The Impact of Market Niche and Size
• Bank of America (BOA)
– BOA is both a retail and a wholesale bank
– has a relatively more diversified portfolio than WBS
– uses a broader array of deposits and more purchased
funds (i.e., fewer core deposits) than WBS
– offers a broad spectrum of financial services
• BOA is the more profitable bank
– uses less equity, which contributes to a higher ROE
– generates much more noninterest income
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