Part 2:
Bank Financial Statements, Risks, and
Valuation

Chapter 4: Sources and Uses of Bank Funds and
the Risks of Banking

Chapter 5: Accounting and Economic Models of
Bank Performance and Valuation

Chapter 6: Case Studies in Bank Valuation and
Performance
Chapter 4
1
CHAPTER 4
Sources and Uses of Bank Funds
and the Risks of Banking
Chapter 4
2
LEARNING OBJECTIVES
TO UNDERSTAND...




Three Views of a Bank: As a Portfolio or Balance
Sheet, as an Information Processor, and as a
Regulated Firm
A Bank’s Sources and Uses of Funds
The Components of a Bank’s Income-Expense
Statement
The Linkage Between Bank Financial Statements and
the Risks of Banking
Chapter 4
3
CHAPTER THEME

The traditional business of banking is funding
loans (use of funds) with deposits (source of
funds). This function generates the “breadand-butter cash flow” of a bank – net
interest income. Netting out the provision
for loan loss and net noninterest income gets
to a bank’s pre-tax net income. Measuring
and managing the risks associated with this
business represents the hear of bank financial
management, which is risk management.
Chapter 4
4
Bank’s Evolution from Money Changers to
Dealer-Makers, Information Processors, and
Regulated Firms

Functions that a Bank Performs
1. Chest: the safekeeping or
risk-control function
2. Bench: the transactions
function

Cash, Check, Credit/Debit Card
Chapter 4
5
Banks As Portfolios: Two-Way Funds
Rental and Risk Control
Risks

Credit Risk

Interest-Rate Risk

Liquidity Risk

Prepayment Risk

Foreign-Exchange Risk
Chapter 4
6
Bank Financial Statements

Balance Sheet: A = L + NW

Income-Expense Statement:
P=R-C-T

Book Values

Market Value of Equity
Chapter 4
7
Bank Balance Sheets
Sources of Funds: Core Deposits
CORE DEPOSITS
Gathered in Local Markets and
Typically have Lower Interest
Costs than Purchased Fund




Demand Deposit Accounts
Other Checkable Balances
Savings Accounts
Small Time Deposits
Chapter 4
8
Bank Balance Sheets
Sources of Funds: Managed Liabilities
Managed Liabilities


As the antithesis of core deposits, managed
liabilities are more volatile and more ratesensitive funds that are gathered in national
and international money markets rather than
local markets
Examples: Foreign deposits, large CDs, FF
purchases, repos, demand notes,
subordinated notes and debentures, and
other borrowed money
Chapter 4
9
Bank Balance Sheets
Uses of Funds

Interest-Earning Assets

Loans and leases


C&I, real estate, and consumer
Investment securities

Investment account





Held to Maturity (historical cost or book value)
Available for Sale (market value)
Trading account (recorded at market value under
“trading assets”)
Fee-Based Assets (e.g., trust services)
Nonearning Assets (e.g., cash and due and
premises)
Chapter 4
10
Bank Balance Sheets
Sources and Uses of Funds
Federal Funds
and
Repurchase Agreements
Chapter 4
11
CREDIT RISK, PLL, AND LLR
OR ALLL (see Box 4-1, p. 112)



Credit or default risk results in loan losses –
an accepted part of the business of lending
Banks set aside funds for such purpose,
called the provision for loan loss (PLL) – a
noncash outlay that runs through the incomeexpense statement to a contra-asset account
on the balance sheet called the loan-loss
reserve (LLR) or the allowance for loan and
lease loss (ALLL)
“Bathtub Analogy” in Box 4-1, p. 112
Chapter 4
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Bank Equity Capital



Equity Capital = Net Worth =
Book Value of Equity =
Assets - Liabilities
Regulatory capital
Market value of equity
Chapter 4
13
COMPONENTS OF BANK
EQUITY CAPITAL



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
Common stock ($32.4 billion, par value)
Surplus ($238 billion)
Undivided profits ($203.3 billion)
Book values for all insured commercial banks
at the beginning of 2000 are in parentheses
External equity: issue equity or hybrid
securities (e.g., trust preferred stock, TPS)
Internal equity: retained earnings or
undivided profits
Chapter 4
14
Sources of Bank Revenue
(“Sales” and “Cross-Selling”)

Total revenue or “sales” for a bank:

Interest Income
From Loans, Securities, Federal Funds Sold

Non-Interest Income
From Fees and Service Charges
Chapter 4
15
Bank Costs

Interest Expenses
On Deposits and other Interest-Bearing
Liabilities

Non-Interest Expenses
Administrative and Operating Expenses

PLL is so important that it is treated
separately
Chapter 4
16
A Bank’s Income-Expense
Statement

Net Interest Income =
Interest Income - Interest Expense

Net Interest Margin =

Net Interest Income / Total Assets
PLL = Provision for loan loss

Net Noninterest Income: “Burden”
Noninterest Income - Noninterest Expense


Taxes
Net income
Chapter 4
17
A BANK’S “BURDEN”



For almost all banks, net interest income is
negative (< 0) because noninterest expense
exceeds noninterest income
For this reason, it can be described as a
bank’s “burden”
Since NII has the tremendous job of having
to cover a bank’s PLL, its burden, and its
taxes, it is the “bread and butter” of the
business of traditional banking
Chapter 4
18
A Bank’s Income-Expense
Statement

Return on Assets (ROA)
Net Income / Total Assets

Return on Equity (ROE)
Net Income / Total Equity
or
ROA x Equity Multiplier (EM)
Chapter 4
19
A Bank’s Income-Expense
Statement

Dividends and Additions to
Retained Earnings

Internal Capital Generation Rate
Chapter 4
20
RECAP OF BANK INCOME AND
EXPENSES

Four key components:






1.
2.
3.
4.
Net interest income
PLL
Net noninterest income (”burden”)
Taxes
Net income is the bottom line
ROA is the key accounting measure of
bank performance
Chapter 4
21
CHAPTER SUMMARY

Three alternative ways of viewing a
bank are:




1. Portfolio or balance sheet
2. Information processor
3. Regulated firm
This chapter has focused on the first
view and the income and expenses that
flow from a bank’s portfolio or balance
sheet
Chapter 4
22