Chapter Twelve
Commercial Banks’
Financial Statements and
Analysis
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Chapter Outline
1. Financial Statements of Financial
Institutions
2. Financial Statement Analysis Using a ROE
Framework
1.1 Evaluate Performance of Commercial
Banks (CBs)
• CBs are unique in
– the special services they perform (e.g., assistance in
the implementation of monetary policy)
– the level of regulatory attention they receive
– the types of assets and liabilities they hold
• Managers, stockholder, depositors, regulators, and
other parties use performance, earnings, and other
measures obtained from financial statements to
evaluate which CB stocks they will purchase
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Financial Statements of Commercial Banks
• Report of condition - balance sheet of a commercial
bank reporting information at a single point in time
• Report of income - income statement of a commercial
bank reporting revenues, expenses, net profit or loss,
and cash dividends over a period of time
• Retail bank - focuses on consumer banking
relationships
• Wholesale bank - focuses on commercial banking
relationships
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1.2 Balance Sheet: Assets
• Four major subcategories
– cash and balances due from other depository institutions
• vault cash, deposits at the Federal Reserve, deposits at other FIs, and
cash items in the process of collection
– investment securities
• interest-bearing deposits at other FIs, fed funds sold, RPs, U.S.
Treasury and agency securities, securities issued by states and political
subdivisions, mortgage-backed securities, and other debt and equity
securities
– loans and leases
– other assets
• premises and fixed assets, real estate owned, investments in
unconsolidated subsidiaries, intangible assets, other fees receivable
Liabilities
• NOW account - negotiable order of withdrawal
account, similar to a demand deposit with minimum
balance
• MMDAs - money market deposit accounts with retail
savings accounts and limited checking account
• Other savings deposits - other than MMDAs
• Retail CDs - time deposits with face value below
$100,000
• Wholesale CDs - time deposits with face value above
$100,000
(continued)
Liabilities
• Negotiable instrument - an instrument whose
ownership can be transferred in the secondary market
• Brokered deposits - wholesale CDs obtained through a
brokerage house
• Core deposits - deposits of the bank that are stable over
short periods of time and thus provide a long-term
funding source to a bank
• Purchased funds - rate-sensitive funding sources of the
bank
Equity Capital
•
•
•
•
Preferred and common stock (listed at par value)
Surplus or additional paid-in capital
Retained earnings
Regulations require banks to hold a minimum
level of equity capital to act as a buffer against
losses from their on- and off-balance sheet assets
1.3 Off-Balance-Sheet Assets and Liabilities
• Contingent assets and liabilities that may affect the
future status of the FIs balance sheet
• OBS activities grouped into 5 major categories
– Loan commitments - contractual commitment to loan
to a firm a certain maximum amount at given interest
rate terms
• up-front fee - fee charged for making funds available through
a loan commitment
• back-end fee - fee charged on the unused component of a loan
commitment
(continued)
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– Commercial and Standby Letters of Credit
• letters of credit - contingent guarantees sold by an FI to underwrite the
trade or commercial performance of the buyer of the guarantee
• standby letter of credit - guarantees issued to cover contingencies that
are potentially more sever and less predictable than contingencies
covered under trade-related or commercial letters of credit
– Forward Purchases and Sales of When-Issued Securities
• when-issued securities - commitments to buy or sell securities before
they are issued
– Loans Sold
• loans that a bank originated and then sold to other investors that may
be returned (with recourse) to the originating institution in the future
• recourse - the ability to put an asset or loan back to the seller should the
credit quality of that asset deteriorate
– Derivative Contracts
• futures, forward, swap, and option positions taken by the FI for
hedging or other purposes
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1.4 Income Statement
•
•
•
•
•
•
•
•
•
•
Interest Income
Interest Expenses
Net Interest Income
Provision for Loan Losses
Noninterest Income
Noninterest Expense
Income before Taxes and Extraordinary Items
Income Taxes
Extraordinary Items
Net Income
The Direct Relationship between the
Income Statement and the Balance Sheet
N
NI =
M
 rnAn -  rmLm n=1
P + NII
-
NIE
-
T
m=1
where
NI = Bank’s 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 = 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
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2. Financial Statement Analysis Using a
Return on Equity Framework
• Time series analysis - analysis of financial statements
over a period of time
• Cross-sectional analysis - analysis of financial
statements comparing one firm with others
• Return on equity (ROE) - measures overall profitability of the FI per dollar of equity
ROE =
Net income
Total Assets

Total Assets
Total equity capital
= ROA  EM
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Return on Assets and Its Components
Return on Assets (ROA) - measures profit generated
relative to the FI’s assets
ROA =
Net Income
 Total operating income
Total operating income
Total assets
= PM
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 AU
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2.1 Profit Margin
Profit Margin (PM) - measures a bank’s ability to pay
expenses and generate net income from interest and
noninterest income
Interest expense ratio =
Interest expense
Total operating income
Provision for loan loss ration = Provision for loan losses
Total operating income
Noninterest expense ratio = Noninterest expense
Total operating income
Tax Ratio =
Income taxes
Total operating income
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2.2 Asset Utilization
Asset utilization (AU) - measures the amount of interest/
noninterest income generated per dollar of total assets
AU = Total operating income = Interest + Noninterest
Total assets
income
income
ratio
ratio
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2.3 Net Interest Margin
Net interest margin - interest income minus interest
expense divided by earning assets
Net
interest =
margin
=
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Net interest income
Earning assets
Interest income - Interest expense
Investment securities + Net loans and leases
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Spread
Spread - the difference between lending and deposit
rates
spread = Interest income Interest expense
Earning assets Interest-bearing liabilities
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Overhead Efficiency
Overhead efficiency - a bank’s ability to generate
noninterest income to cover noninterest expenses
Overhead efficiency = Noninterest income
Noninterest expense
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