Commercial Bank Financial
Statements
Like other intermediaries, commercial banks facilitates the
flow of funds from savers to borrowers. The main
characteristics of commercial banks are as follows:
1-Most banks own few fixed assets, and thus low
operating leverage.
2- Many bank liabilities are payable on demand or carry
short-term maturities so depositors can negotiate
rates as market rates change. As a result interest
expenses changes coincidentally with short-run
changes in market interest rates.
3- Banks operates with less equity capital than nonfinancial companies.
Each characteristic presents special problems and risks to
the bank manager.
The Balance Sheet
It present financial information comparing
what a bank owns with what it owes and the
ownership interest of stockholders.
•Assets indicates what the bank owns
•Liabilities represent what the bank owes.
•Equity refers to the owners’ interest.
Assets = Liabilities + Equity
Bank Assets
It falls into one of four general categories as follows:
Loans, which are the major asset in most banks’
portfolios and generate the greatest amount of
income before expenses and taxes. Loans may
be group into several categories, such as:
–
–
–
Real estate loans. They are secured by real estate and
generally consist either of (1) property loans or (2)
interim construction loans.
Commercial Loans which consist of commercial and
industrial loans, loan to financial institutions, and
obligations(other than securities) to state and political
subdivisions.
Individual Loans include those negotiated directly with
individuals for household, family and other personal
expenditures.
Bank Assets-con.
– Agricultural Loans which are directed to finance
agricultural production and other loans of farmers.
– Loans in Domestic Offices include all other loans and
all lease-financing receivables in domestic offices.
– Loan and Lease in Foreign offices, are essentially
business loans and lease receivables made to foreign
companies or loans guaranted by foreign
governments.
– Net loans and leases can be calculated as follows:
Bank Assets-con.
Net Loans and Leases = Gross Loans and
Leases – Unearned Income – Loan and
Lease Loss Allowances.
2. Investment Securities. They are held to
earn interest, help to meet liquidity needs,
speculate on interest rate movement, and
serve as part of bank’s dealer functions.
Investment securities may be group into
several categories, such as:
•
•
•
•
•
•
Treasury and Agency Securities.
Municipal Securities
Foreign Debt Securities.
Other Securities.
Interest-Bearing Bank Balances.
Total Earning Assets = Net Loan and Leases +
Total Investment
• Other items included in the assets account are
Non-interest Cash and Due from Banks. They
consist of:
• Vault Cash: it is coin and currency that the bank holds to
meet customers withdrawals.
• Deposit held at Federal Reserve Banks: They are
demand balances used to meet legal reserve
requirements, assist in check clearing and wire transfers,
or effect the purchase and sale of Treasury Securities.
• Deposit held at other Financial Institutions, called
correspondent banks, primary to purchase services.
• Items in the process of collection.
• Other assets are residual assets of relatively small
magnitude, including customers’ liabilities to the bank
under acceptance, the depreciated value of bank
premises and equipment, other real estate owned
(OREO)., etc.
Bank Liabilities and Stock
Holders’ Equity
Bank funding sources are classified
according to the type of debt instrument
and equity component. They consist of the
following:
• Demand Deposit, they are transaction
accounts held by individuals, partnerships,
corporations, and government that pay no
interest.
Bank Liabilities and Stock
Holders’ Equity.cont.
• Negotiable Order of Withdrawal (NOW),
Automatic Transfer From Savings (ATS)
accounts, and Money Markets Deposits
Accounts (MMDAs), represent interestbearing transactions accounts. NOW and
ATS accounts pay interest set by each
bank without federal restrictions. NOW
are available only to non-commercial
customers.
Bank Liabilities and Stock
Holders’ Equity.cont.
• Saving and Time Deposits: They have in
the past, represented the bulk of interestbearing liabilities at banks. Now a days
MMDAs and time deposit under some
certain amount of money have become the
largest source of interest-bearing liabilities.
Bank Liabilities and Stock
Holders’ Equity. cont.
Deposits Held in Foreign Offices: They refer
to the same types of dollar-denominated
demand and time deposits discussed
above except that the balances are issued
by a bank subsidiary (owned by the bank
holding company) located outside the
country.
Bank Liabilities and Stock
Holders’ Equity .cont.
Subordinated Notes and Debentures: they
consist of notes and bonds with maturities
in excess of one year. Most meet
requirement as bank capital for regulatory
purposes. When bank fails, depositors are
paid before subordinated debt holders.
Bank Liabilities and Stock
Holders’ Equity. cont.
All Common and Preferred Capital or Stock
Holders’ equity:
It is the ownership interest in the bank.
• Common an d preferred stock are listed at their par
values while the surplus account represents the amount
of proceeds received by the bank in excess of par when
it issued the stock.
• Bank Cumulative Net Income = Retained Earnings since
the Firm Started Operation – All Cash Dividends Paid to
Stock Holders.
• Other equity is small and usually reflects capital
reserves.
Income Statement
A Bank’s Income statement reflects the
financial nature of banking, as interest on
loan and investments comprises the bulk
of revenue.
• Income Statement Format starts with
interest income, and end with the net
income, which is divided between
dividends and retained earnings.
Income Statement. CON.
• Net Income is calculated as follows:
• NI = NII – Burden – PL - + SG – T
NII = Net Interest Income before provisions.
Burden = Represents Bank burden (noninterest expense > non-interest Income).
PL = Provision for Loan Losses.
SG = Securities Gains (losses).
T= Taxes including accounting adjustments
and extraordinary items.
Income Statement. CON.
NI can be calculated as follows:
NII= II – IE
II = Total Interest Income.
IE = Total interest expense.
Burden = OE – OI
OE = Noninterest Expense or overhead
expense.
OI = Noninterest Income.
Income Statement. CON.
Bank Efficiency Ratio (Eff) is calculated as follows:
Eff = OE/(NII + OI).
The contribution of each of the components is summarized
bellow:
NII
2,425.141
-Burden
-972,382
-PLL
-65,000
+ SG
40817
-T
527,690
--------------------------= NI
$900,886
Income Statement. CON.
Eff = 2343936/(2425141+1371554)= 0.617
This ratio is widely used in the practice. It measure
the banks’ ability to control non interest expense
relative to net operating income (NII – non
interest income). It indicate how much a bank
pays in no-interest expense for one dollar of
operating income. Bank analyst expect to keep
this ratio below 55% per dollar of operating
income.
The relationship between the Balance
Sheet and the Income Statement
-Both sheets are correlated. The net income
is determined by the composition of assets
and liabilities and the relationship different
interest rates.
-The Mix of deposits between consumer
commercial consumers affects the services
provided by and thus the magnitude of
noninterest income and noninterest
expense.
The relationship between the Balance
Sheet and the Income Statement
The ownership of nonbank subsidiaries
increases fee income but often raises
noninterest expense. The following analysis
emphasizes the above interrelationships. As
it is known:
Assets = liabilities + equity
This equation can be restated as:
The relationship between the Balance
Sheet and the Income Statement
A = L + NW
Where,
While net interest income can be
represented as:
n
m
i 1
j 1
NII   ri Ai   rj L j
The relationship between the Balance
Sheet and the Income Statement
Where:
Ai = dollar magnitude of the ith asset
L = dollar magnitude of the jth
j
liabilities.
NM = dollar magnitude of the stockholders’
equity.
r
th asset
i
i = average pretax yield on the
C = average interest cost of the jth liabilities
j
The relationship between the Balance
Sheet and the Income Statement
n
Interest Earned on asset =  r A  Total Interest Income
Interest Paid on each liability =  r L  Total Intesest Expense
-The new statement of NII indicates what factors
can cause net interest income to change over
time. These factors are:
1- Changes in the composition or volume of
assets and liabilities. As portfolio composition
change, the respective A’s and L’s change in
magnitude.
i 1
i
i
m
j 1
j
j
The relationship between the Balance
Sheet and the Income Statement
This alters net interest income because A or
L is multiplied by different interest rates.
2- A change in average asset yields and
interest costs may rise or fall due to
changing in interest rates and lengthening
or shortening of maturities on underlying
instruments.
The relationship between the Balance
Sheet and the Income Statement
We distinguish between two type of banks:
1- Retail Banks which focus on individual
consumers banking relationships.
Therefore, individual demand, saving, and
time deposits comprise most of liabilities
while consumers and small businesses
loans linked to key individuals are a higher
fraction of the loan portfolio.
The relationship between the Balance
Sheet and the Income Statement
2- Wholesale Banks deal primarily with
commercial consumers so that they
typically operate with fewer consumers
deposits, more purchased liabilities, and
hold proportionately more business loans
to large firms. This difference in portfolio
composition produces different yields on
earning assets (ri) and costs of liabilities
(cj).
The relationship between the Balance
Sheet and the Income Statement
Again we refer to NI equation:
NI =  r A   r L – Burden – PL - + SG – T
Net income in excess of dividends payments
to shareholders increase retained earnings
and thus total equity.
n
i 1
m
i
i
j 1
j
j
The Return on Equity Model
The return on equity model is adopted her to
analyze bank profitability and identifies
specific measures of credit risk, interest
rate risk, operation risk, and capital risk.
This means the adoption of ratio analysis,
the Dupont system of financial analysis.
The Return on Equity Model-Con.
The Uniform Bank Performance Report.
The UBPR is a comprehensive analytical tool
adopted for supervisory purposes. The UBPR
contains a wealth of profitability and risk
information.
Profitability Analysis
Aggregate bank profitability is generally measured
and compared in terms of Return on Equity
(ROE) and Return on Assets (ROA). The ROE
model relates ROE to ROA and financial
leverage, and then composes ROA into its
contributing elements.
The Return on Equity Model-Con.
By definition:
ROE = Net Income/Total Equity
-It measures the percentage return on each
dollar of stockholder’ equity.
- The higher the return the better, as banks
can add more to retained earnings and
pay more in cash dividends when profits
are higher.
The Return on Equity Model-Con.
ROE cab rewritten as follows:
Net Income
AverageTotal Assets
ROE 
*
AverageTotal Assets AverageTotal Equity
ROE  ROA * EM
Where EM is the equity multiplier. EM measures
financial leverage and represents both profit and
risk measure.
The Return on Equity Model-Con.
Example of two banks A and B
Bank
Total Assets (Million)
Equity
Debt
A
100
10
90
B
100
5
95
ME of Bank A = 100/10 = 10x
ME of Bank B = 100/5 =20x
The Return on Equity Model-Con.
In the above example if both banks earned
1% on assets, Bank A would report a ROE
of 10% while the ROE of Bank B would
equal 20%. This means Bank B provide
shareholders a return that is twice that of
Bank A.
If each bank reported a negative of 1% of
ROA, the ROE of Bank B would equal (–
20%) or twice a loss of Bank A.
The Return on Equity Model-Con.
EM represents a risk measure because it
reflects how many assets can go into
default before a bank become s insolvent.
Consider the ratio of total equity to total
assets or 1/EM, the ratio for bank A equals
10% while the ratio for bank B is 5%. Both
hold the identical assets, but bank A is
less risky Bank than B.
The Return on Equity Model-Con.
Expense Ratio and Asset utilization
The UBPR provides a wealth of data to assist in
the analysis of a bank’ performance. The ROA
is composed of two principle parts:
1. Income generation
2. Expense control (including taxes)
Recall that net income NI is:
NI = Total Return (TR) – Total Operating Expenses (TXP) – Taxes
Dividing both sides of the above equation by the average total assets
(TA) will get:
The Return on Equity Model-Con.
NI TR EXP Taxes



TA TA
TA
TA
( ROA )  AU  ER  TAX
The Return on Equity Model-Con.
Where:
AU = Assets Utilization
ER = Expense Ratio
Tax = Tax Ratio
Expense Decomposition: ER Components.
It provides intuitive interpretation. For example if
ER = 5%, it means that bank’ gross operating
expenses equal 5% of total asset. The lower ER
the more efficient a bank will be in controlling
expenses and vise versa.
The Return on Equity Model-Con.
There are three isolated types of specific
ratios of operating expenses:
Interest Expense ( IE )
Interest expense ratio = AverageTotalAssets (TA)
Noninterest Expense Ratio =
Provision for loan Loss Ratio =
No int erest Expens (OE )
AverageTotal Assets (TA)
Pr ovision for loan losses ( PLL)
AverageTotal Assets(TA)
The Return on Equity Model-Con.
The sum of these three ratios equals ER:
ER =
IE OE PLL


TA TA
TA
The ER can be calculated directly from UBPR
report or to sum all the three ratios.
The fist way is:
ER = (Total interest expense + Total Non-interest
Expense + Provision for Loan & lease
Losses)/Average Total Assets.
The Return on Equity Model-Con.
The second way is to sum all three ratios to
get the ER.
All other factor being equal, the lower each ratio,
the more profitable the bank.
-Interest expense and noninterest expenses
required to be examined by source.
-Interest expense may vary between banks for
three reasons:
1-rate effects 2- Composition effects. 3- Volume
effects.
The Return on Equity Model-Con.
Noninterest expense can decomposed into:
• Personnel expense (salaries and benefit payments)
• Occupancy expense.
• Other operating expenses.
Income Decomposition: Asset Utilization
Components (AU).
The greater is AU, the greater the bank’s ability to generate
income from the assets that the own. When a bank’s AU
is 10%, means its gross return on total assets equal
10%. A higher figure indicates higher profit. If a bank ER
is 7%, then bank net return on investment (assets)
before tax is 3%.
The Return on Equity Model-Con.
Total revenue TR can be divided into three
components:
TR = Interest Income (II) + Noninterest Income
(OI) + Realized Security Gains or Losses (SG)
Divide both side of the above equation by TA:
TR II OI SG



TA TA TA TA
The Return on Equity Model-Con.
This equation indicates the sources of
income. Yield on asset can be calculated
as follows:
Interest Income on Asseti
Yield on Asseti 
Average balanceof Asseti
Interest income would be decomposed into
its components to examine the percentage
of each asset relative to total assets.
The Return on Equity Model-Con.
The Bank’s Earning Base (EB) ratio is used
to examine whether one bank has more or
less assets earning interest than peers.
EB can be calculated as follows:
Earning Assets
ER 
Average Total Assets
Earning assets include all assets that
generate explicit interest income or lease
receipts.
The Return on Equity Model-Con.
Noninterest Income can be decomposed
into its contributing sources, in order to
examine the contribution of each source to
assets utilization (AU).
Earning Base
-The bank earning base can be used to
compare the proportionate investment in
earning assets to total assets.
-It indicates whether one bank has more or
less assets earning interest than peers.
The Return on Equity Model-Con.
Earning base can be calculated as follows:
Earnings Base 
Earning Assets
AverageTotal Assets
Earning Assets includes all assets that
generate explicit interest income or lease
receipt.
The Return on Equity Model-Con.
Tax payment is the other factor which affect the
ROA, accordingly, ROE can be calculated as
follows:
ROE = ROA*EM,therefore,
ROE = [AU – ER – TAX]*EM
Several profitability measures are used in the
practice such as Net Interest Margin (NIM),
Spread, Burden Ratio, and Efficiency Ratio. The
can calculated as follows:
The Return on Equity Model-Con.
Net Interest Income
NIM 
Earning Assets
Interest Income
Interest Expense
Spread 

Earning Assets Interest Bearing Kiabilitie s
Non int erest Expense  Non int erest Income
Burden Ratio 
AverageTotal Assets
Non int erest Expense
Efficiency Ratio 
Net Interest Income  Non int erest Income
The Return on Equity Model-Con.
*NIM is a summary measure of net interest return
on income producing assets.
*Spread is a measure of the rate spread or funding
differential. It is the difference between the
average yield on earning assets and the
average cost of interest-bearing liabilities.
*Both NIM and Spread are extremely important in
evaluating a bank’s ability to manage interest
rate risk. For example if interest rate increase,
both interest income and interest expense will
increase because some assets and liabilities will
re-price at higher at higher rates.
The Return on Equity Model-Con.
The Burden Ratio measures the amount of
non-interest expense covered by fees,
service charges, securities gains and other
incomes, as a fraction of total average
assets.
The Efficiency Ratio measures a bank’s
ability to control non-interest expense
relative to net operating income.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
-Wealth maximization of the shareholders is the main goal
of bank management.
-This means to evaluate the present value of the cash flows
under risk and uncertainty conditions.
Bank’s profitability will vary directly with riskiness of its
portfolio and operations. Therefore management act in
order to reduce effect the anticipated risk.
Risk management is the process by which managers
identify, asses, monitor, and control risk associated with
financial institution’s activities.
It is stated that there are six types of risk. They are:
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
1.
2.
3.
4.
5.
6.
Credit Risk.
Liquidity Risk.
Market Risk.
Operating Risk.
Reputation Risk.
Legal Risk.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Credit Risk
It is associated with quality of individual
assets and the likelihood of default.
It is difficult to assess individual asset quality
because of information shortage .
Credit risk is the potential variation in net
income and market value of equity
resulting from nonpayment or delay of
borrowers of the principal and interest.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
-Different types of assets and activities have
different default probabilities. Loans are
associated with greatest risk.
-Many other kind of loans are associated
with risk according to many conditions
such as general economic conditions and
firm’s operating environment.
-Bank investment securities are assciated
with less credit risk.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Credit risk is evaluated basically by asking
three basic questions:
1. What is the historical loss rate and
investments?
2. What are expected losses in the future?
3. How is the bank prepared to weather the
losses?
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
So, the concern here about the expected
losses. Some standards are used here.
These are:
Gross loan losses (charge-offs) is the
dollar value of loans actually written off as
uncollectable during a period.
Recoveries refer to dollar amount of loans
that were previously charged-off but now
collected.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Net charge-off is the difference between gross
charge-offs and recoveries.
Some ratios are used to examine the expected
future losses. These ratios include:
1. Loans past due to total asset ratio.
2. Non-accrual to total asset ratio.
3. Total non-current loans to total asset ratio.
4. Classified loans to total asset ratio.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Loans past due loans represent loans for which contracted
interest and principal payments have not been made
within 90 days after the due date but still accruing
interest.
Non- Accrual Loans are those with past due payments
which are not currently accruing interest.
Total non-current loan is the sum of these two types of
loans.
Classified loans are a general category of loans in which
regulators have forced management to set aside
reserves for clearly recognized losses.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Another ratio used to measure a bank ability
to cover current period losses is:
Earning coverage ratio: It is a measure of
net operating income before taxes,
securities gains (losses), extraordinary
items, and the provision for loan losses
divided by net loan and lease losses.
A higher ratio indicates greater coverage
and thus greater protection.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
There are two other sources of credit risk:
High growth of loan create greater risk.
Country risk, which refer to the potential loss
of interest and principal on international
loans due to borrowers in a country
refusing to make timely payments.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Liquidity Risk
it is the current and potential risk to earnings
and the market value of stockholders’
equity that a bank cannot meet payment or
clearing obligations in timely and costeffective manner.
This risk is a result of either funding
problems or market liquidity risk.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Funding liquidity risk is the inability to
liquidate assets or obtain adequate
funding from new borrowing.
Market liquidity risk is the inability of the
bank to easily unwind or offset specific
exposures with out significant losses from
inadequate market depth or market
disturbances.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Risk measures indicate both the bank’s ability to borrow
funds and its liquid assets near maturity or available-forsale.
The equity asset ratio and volatile (net non-core) liability
asset ratio represent the bank’s equity base and
borrowing capacity in the money market.
Core deposits are stable deposits that are not highly
interest rate-sensitive, but more sensitive to fees
charges services rendered, and location of the bank.
It includes demand deposits, NOW account, MMDAs, and
small time deposit that the bank expects to remain on
deposit over the business cycle.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Pledging Requirements stipulate that banks
pledge either Treasury or Municipal securities as
collateral against deposit liabilities such as
Treasury deposits, municipal deposits,
borrowing from federal reserve banks.
Cash Assets are held to meet customer
withdrawals and legal reserve requirements or to
purchase services from other financial
institutions.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Market Risk
It is a current and anticipated risk earnings
and stockholders’ equity resulting from
undesirable movements in the market
rates or prices. These risks are in terms
of:
1. Interest rate or reinvestment rate risk.
2. Security price risk.
3. Foreign exchange risk.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Interest risk analysis compares the
sensitivity of interest income to change in
asset yield with sensitivity of interest
expense to change in interest costs of
liabilities.
This analysis will determine how much net
interest income will vary with movements
in the market interest rates.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Duration gap analysis is used to compare the
duration of assets with the duration of liabilities.
It assess the impact of rate changes on net
interest income and the market value of
stockholders’ equity.
Foreign exchange risk arise from changes in
foreign exchange rates that effect the value of
assets, liabilities, and off-balance sheet activities
denominated in currencies different from the
bank’s domestic currency.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Operating Risk
It refers to the possibility that operating expenses
might vary sharply from what is anticipated,
which cause a decline in the net income.
The cause of fluctuations are:
1.
Inefficiency in controlling direct cost and employee
processing errors.
2. Theft and fraud of both employee and costumer.
It is difficult to be measured. But some measures are
adopted such as ratios of total assets per employee
and total personnel expense per employee.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Legal and Reputation Risk
It is the risk that unenforceable contracts,
lawsuits, or adverse judgments could
disrupt or negatively effect the operations,
profitability, condition or solvency of the
institution.
It is difficult to measure.
Bank Risks and Returns: The Profitability,
Liquidity, and Solvency Trade-off.
Capital or Solvency Risk
It is not separated from all previous risks. All above risk
affect the bank’s capital.
Capital risk refers to the potential decrease in the market value of
assets below the market value of liabilities indicating economic net
worth is zero or less.
One indicator of capital risk is a comparison of stockholders’ equity with
the bank’s assets.
The greater equity is to asset, the greater the amount of assets that can
default without the bank becoming insolvent. A bank with equity to
assets equal 10% can withstand the risk with a bank with 5%.