Commercial Banking
FIN 323
Dr. Mehdi MILI
Associate Professor
Department of Economics and Finance, CBA, University of Bahrain, Bahrain.
1
Academic year
2022-2023
Chapter Five
The Financial Statements of Banks and Their
Principle Competitors
2
Intro

Services that a financial institution offer and its
overall size of each financial service organization
are reflected in its financial statements.

Financial statements is a road map telling us
where a financial firm has been in the past, where
it is now, and where it is headed in the future.

It can signal success or disaster, if properly
structured.
3

Balance sheet, and Income statements.
An Overview of Balance Sheets and Income
Statements

Balance sheet: “Report of Condition” shows:
-The
-
amount and composition of funds sources
How much has been allocated to loans,
securities and other uses.
5
An Overview of Balance Sheets and Income
Statements

Income Statement: “Report of Income” shows:
-
the revenues generated by selling services to the
public.
-
Loans, leases and servicing customer deposits.
How much it has cost to acquire funds and to
generate revenues from the uses of the bank.
6
-
Interest paid to depositors and other creditors, expenses for hiring management and
staff, overhead, and taxes.
-
Net earnings after all costs are deducted from
the sum of revenues.
7
The Balance Sheet: ( Report of Condition)
Assets = Liabilities + Equity capital
Assets
Liabilities
Cash in the vault and deposits held at other
depository institutions ( C )
Deposits made by and owed to various customers
(D)
Government and private interest bearing securities
purchased in the open market (S)
Non-deposit borrowings of funds in the money and
capital markets (NDB)
Loans and lease financing made available to
customers (L)
Miscellaneous Assets (MA)
Equity Capital
Long term funds the owners contribute (EC)
C +S+L+MA = D+NBD+EC
8
The Balance Sheet: ( Report of Condition)
9
The Balance Sheet: ( Report of Condition)
Main Assets Components:
• Cash assets (C)  are designed to meet the financial firm’s need for
liquidity
• Security holdings (S)  are a backup source of liquidity and include
investments that provide a source of income
• Loans (L)  are made principally to supply income
• Miscellaneous assets (MA)  are usually dominated by fixed assets
(plant and equipment) and investments in subsidiaries (if any)
10
The Balance Sheet: ( Report of Condition)
Main Liabilities Components:
Deposits (D)  are typically the main source of funding for
banks
Non-deposit borrowings (NDB)  are carried out mainly to
supplement deposits and provide the additional liquidity that
cash assets and securities cannot provide
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The Balance Sheet: ( Report of Condition)
Equity Capital:
Equity capital (EC)  supplies the long-term, relatively stable
base of financial support upon which the financial firm will rely
to grow and to cover any extraordinary losses it incurs
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The Balance Sheet: ( Report of Condition)
 Liabilities and equity capital = accumulated sources of funds
Which provide the needed spending power to acquire assets
 A bank’s assets = accumulated uses of funds
Which are made to generate income for its stockholders, pay
interest to its depositors, and compensate its employees for
their labor and skill
13
The Balance Sheet: ( Report of Condition)
TABLE 5–2 Highlighted Bank Financial Data ($ million)
from the FDIC (December 31, 2009)
14
The Balance Sheet: ( Report of Condition)
TABLE 5–3 Report of Condition (Balance Sheet) for BB&T
(Year-End 2008 and 2009)
15
The Balance Sheet: ( Report of Condition)
Assets of the Banking Firm
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The Balance Sheet: ( Report of Condition)
1. Cash Assets
Account is called Cash and Deposits Due from Bank
▫ Includes:
▫
▫
▫
▫
Vault Cash
Deposits with Other Banks (Correspondent Deposits)
Cash Items in Process of Collection
Reserve Account with the Central Bank
▫ Sometimes called primary reserves
▫ First line of defense against customer loan requests
▫ Banks will strive to keep the size of this account as low as
possible. Why?
17
The Balance Sheet: ( Report of Condition)
2. Investment Securities - The Liquid Portion
▫
▫
▫
▫
Second line of defense to meet the demand for cash
Sometimes called available for sale
Short Term Government Securities
Privately Issued Money Market Securities
▫ Interest Bearing Time Deposits
▫ Commercial Paper
▫ Often called secondary reserves
▫ They earn some income, but mainly held for liquidity
purposes.
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The Balance Sheet: ( Report of Condition)
3. Investment Securities - The Income-Generating Portion
▫ Sometimes called “ held to maturity securities”
▫ Can be divided into:
▫ Taxable Securities
▫ Government Notes
▫ Government Agency Securities
▫ Corporate Bonds
▫ Tax-Exempt Securities
▫ Municipal Bonds
▫ Recorded in the books at their original cost or at market value
whichever is lower.
19
The Balance Sheet: ( Report of Condition)
4. Trading Account Assets
 Securities purchased to provide short-term profits from
short-term price movements
 Occurs when the bank acts as a securities dealer. How?
 Valued at Market – FASB 115
20
The Balance Sheet: ( Report of Condition)
5. Central Bank Sold and Reverse Repurchase Agreements
- Temporary loans (usually extended overnight, with the funds
returned the next day) made to other depository institutions,
securities dealers, or major industrial corporations
- Often come from the reserves a bank has on deposit with
the Federal Reserve Bank in its district
▫ “Fed funds”
21
Some of these temporary credits are extended in the form of
reverse repurchase (resale) agreements (RPs) in which the
banking firm acquires temporary title to securities owned by the
borrower and holds those securities as collateral until the loan
is paid off
22
The Balance Sheet: ( Report of Condition)
6. Loans and leases
The Major Asset – half to three quarters of the total assets
Broken down to several groups of similar type
Commonly grouped by the purpose of borrowing
Gross loans and leases
Net loans and leases
23
The Balance Sheet: ( Report of Condition)
6. Loans and leases
• Types of Loans
▫
▫
▫
▫
▫
▫
▫
▫
Commercial and industrial (or business) loans
Consumer (or household) loans
Real estate (or property-based) loans
Financial institutions loans
Foreign (or international) loans
Agricultural production loans
Security loans
Leases
24
The Balance Sheet: ( Report of Condition)
7. Loans losses
Current and projected loan losses are deducted from the gross loans
figure
A reserve for future loan losses = allowance for loan losses (ALL)
It is a contra-asset account
That would mean that bad loans do not affect current income
The bad loan is going to be subtracted from gross loans and ALL
account
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The Balance Sheet: ( Report of Condition)
7. Loans losses
Allowance is built gradually over time by annual deduction from
current income.
The deduction appears in the income statement as a non-cash
expense called “ provision for loan losses”
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The Balance Sheet: ( Report of Condition)
7. Loans losses
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Beginning Allowance for Loan Losses
+ This Year’s Provision for Loan Loss
= Adjusted Allowance for Loan Losses
- Actual Charge-Offs of Worthless Loans
+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses
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The Balance Sheet: ( Report of Condition)
7. Loans losses
Example:
existing Allowance for loan losses
Anticipated loan losses (current)
$ 100m
$ 1m
Income Statement
* A noncash expense deducted from current
revenues (PLL)
Revenues
(less) Provisions for loan losses
$xx
($1m)
Balance Sheet
* Adjusting the ALL account
Existing ALL
(add) amount deducted as PLL
Adjusted ALL
$ 100m
$ 1m
$ 101m
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The Balance Sheet: ( Report of Condition)
6. Loans losses
Example: Cont’d
-existing Allowance for loan losses
-Anticipated loan losses (current)
-worthless loan (must be written off )
$ 100m
$ 1m
$ 500, 000
Beginning Allowance for Loan Losses
$100m
+ This Year’s Provision for Loan Loss
+$1m
= Adjusted Allowance for Loan Losses
$101m
- Actual Charge-Offs of Worthless Loans
= Net Allowanace for loan losses (ALL)
-$500,000
$100.5m
after all charge offs
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The Balance Sheet: ( Report of Condition)
6. Loans losses
Example: Cont’d
-existing Allowance for loan losses
-Anticipated loan losses (current)
-worthless loan (must be written off )
-Recoveries from previously charged-off loans
$ 100m
$ 1m
$ 500, 000
$ 1.5m
Beginning Allowance for Loan Losses
$100m
+ This Year’s Provision for Loan Loss
+$1m
= Adjusted Allowance for Loan Losses
$101m
- Actual Charge-Offs of Worthless Loans
-$500,000
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+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses
+$1.5m
$102m
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The Balance Sheet: ( Report of Condition)
6. Loans losses
-As the loan portfolio increase in size, additions to ALL are needed.
-Accounting entries: increase:
a.
Contra asset ALL
b.
Expense account PLL
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The Balance Sheet: ( Report of Condition)
8. Specific and General Reserves
ALL is usually divided into two parts: 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 management but influenced by taxes and government
regulation
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The Balance Sheet: ( Report of Condition)
9. International Loan Reserves
 Loans to lesser developed countries require allocated transfer
reserves (ATRs)
 Deducted from gross loans, similar to ALL
35
The Balance Sheet: ( Report of Condition)
10. Unearned Discount Income
 Interest income on loans received from customers, but
not yet earned under the accrual method of accounting
i.e interest received, but customer has not used the loan
36
The Balance Sheet: ( Report of Condition)
11. Nonperforming loans
 loans which are credit that no longer accrue interest
income or that had to be restructured to accommodate
a borrower changed circumstances.
When a scheduled loan payment is past due for more
than 90 days.
Must be deducted from loan revenues
37
The Balance Sheet: ( Report of Condition)
12. Bank Premises and Fixed Assets
 Plant and equipment
Less than 2% of total assets
Generate fixed operating costs in the form of
depreciation expenses and property taxes  operating
leverage
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The Balance Sheet: ( Report of Condition)
13. Other Real Estate Owned (OREO)
 Direct and indirect investments in real estate
Commercial and residential properties obtained to
compensate for nonperforming loans.
Banks tend to keep this account as small as possible.
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The Balance Sheet: ( Report of Condition)
14. Goodwill and Other Intangible Assets
 Goodwill: acquiring a firm and paying more than the
market value of its net assets.
Mortgage servicing rights and purchased credit card
relationships
40
The Balance Sheet: ( Report of Condition)
15. All other Assets
 investment in subsidiary firms
Customer’s liability on acceptance outstanding
Net deferred tax assets
41
The Balance Sheet: ( Report of Condition)
Liabilities of the Banking Firm
42
The Balance Sheet: ( Report of Condition)
1.
-
Deposits
The principle liability of any bank
Mainly financial claims by businesses, households, and
governments against the banking firm
-
If the bank is liquidated, sale of assets proceeds
will first pay these claims, and then any other
creditors and stockholders
43
The Balance Sheet: ( Report of Condition)
1.
-
Deposits
There are five major types of deposits:
▫ Non interest-Bearing Demand Deposits
▫ Savings Deposits
▫ NOW Accounts
▫ Money Market Deposit Accounts (MMDA)
▫ Time Deposits
44
The Balance Sheet: ( Report of Condition)
1.
-
Deposits
There are five major types of deposits:
▫ Non interest-Bearing Demand Deposits
- Regular checking accounts
- Unlimited check writing
- Do not pay interest
45
The Balance Sheet: ( Report of Condition)
1.
-
Deposits
There are five major types of deposits:
▫ Savings Deposits
- Bear the lowest rate of interest
- May be of any denomination
- Permit withdrawal
46
The Balance Sheet: ( Report of Condition)
1.
-
Deposits
There are five major types of deposits:
▫ NOW (Negotiable Order of Withdrawal) Accounts
- Held by individuals and nonprofit institutions
- Bear interest
- Permit check writing
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The Balance Sheet: ( Report of Condition)
1.
-
Deposits
There are five major types of deposits:
▫ Money Market Deposit Accounts (MMDA)
Pays a competitive interest rate
Limited check writing
No minimum denomination or maturity
Seven days notice before withdrawal
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The Balance Sheet: ( Report of Condition)
1.
-
Deposits
There are five major types of deposits:
▫
-
Time Deposits
Fixed maturity
A specified interest rate
Of any denomination
Can be of $100,000-plus denomination
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The Balance Sheet: ( Report of Condition)
1.
-
Deposits
Most of deposits are held by individuals and businesses
-
Government deposits are called “Public funds deposits”
-
Deposits at foreign branches.
-
Banks face the pressure of risk and liquidity. How?
50
The Balance Sheet: ( Report of Condition)
2. Borrowings from Non-deposit Sources
-
Large depository institutions make greater use of nondeposit sources of funds
- Advantages:
-
Low cost (no reserves requirements, or insurance fees)
A prompt transaction (MM)
- Disadvantages:
-
Interest rates of NDB are highly volatile
51
The Balance Sheet: ( Report of Condition)
2. Borrowings from Non-deposit Sources
-
-
Federal Funds purchased and repurchase agreements:
- Temporary borrowings in the money market
- Repurchase agreements
Borrowing reserves from the discount windows of Fed
Reserves
Commercial papers
Eurocurrency Borrowings
Long term debt
Subordinated debt
Limited life preferred stock
Other liabilities
52
The Balance Sheet: ( Report of Condition)
Equity of the Banking Firm
53
The Balance Sheet: ( Report of Condition)
Equity:
-
Represents’ owners share of the business
-
Capital accounts usually represents less than 10% of total
assets. (because financial institutions are heavily leveraged)
it includes:
- Common stock, (sometimes surplus account)
- Preferred stocks (not usual, why?)
- Retained earnings (undivided profits)
- Contingency reserves
- Treasury stocks
-
54
Comparative Balance Sheet Ratios for Different
Size Banks
-
Larger banks trade securities for short-term profits, while
small banks don’t.
-
Small banks hold more investment securities and loans
compared to large banks
-
Small banks rely on deposits
-
Large banks make heavier use of money market borrowing
55
Recent Expansion of Off-Balance Sheet Items in
Banking
-
The Balance sheet do not give the whole story.
-
It is very important to look at the “off-balance sheet items”
-
They usually include a number of fee-based services that
do not show up at the balance sheet.
-
for example:
a.
b.
c.
Unused Loan Commitments
Standby Credit Agreement
Derivative Contracts
56
Recent Expansion of Off-Balance Sheet Items in
Banking
-
Off balance sheet items:
a.
Unused Loan Commitments : lender receives the fee, but the fund has
not been transferred to the borrower
a.
Standby Credit Agreement: the bank receives fee to guarantee the
repayment of a loan granted to the customer by another lender.
a. Derivative Contracts:
- Derivatives: futures contracts, options, swaps, etc.
- They bank might lose or gain from assets that it presently does not own.
57
Recent Expansion of Off-Balance Sheet Items in
Banking
-
Off balance sheet items:
-
They expose the financial firm to considerable risk.
-
The off-balance sheet items value has exceeded the value
of the banking assets.
-
Regulators, such as FASB, passed rules to make sure
accurate information about hedging instruments are
publicly available to users and reflect the over all position
of a financial firm.
58
Recent Expansion of Off-Balance Sheet Items in
Banking
59
The Problem of Book-Value Accounting
- Accounting method: book value, historical, or original cost
recording method.
-
it assumes that all balance-sheet items will be held to
maturity.
-
It does not take into consideration the affect of interest
rate change or possible default risk. ( affecting value and
cash flow of loans, securities and debt)
-
it should really be called, amortization cost method.
60
The Problem of Book-Value Accounting
- Not interpreting the market conditions and never altering
costs will deceive investors. ΔNW = ΔA - Δ L
- Ideal scenario:
Change in
interest rates
Change
assets and
liabilities
value
Change
Capital
value
- However, only realized income is recognized.
-
Example: selling asset that has risen in value, while ignoring impact
of losses in value of other assets still on the book.
At t0 Pa = $100
At t1 Pa= $120
- Pb = $100
Pb = $80
61
The Problem of Book-Value Accounting
- FASB Rule 115 and SEC:
- Separate securities into two groups:
Securities
Recording method
Held to
maturity
- Cost or market value whichever is lower.
Possible to be recorded at cost.
Available for
sale
Fair market value.
- To eliminate “gain selling”: when managers sell securities that
have risen in prices, and keep those whose price have
declined and continue to value them at their higher original
price.
62
Auditing: Assuring Reliability of Financial
Statements
-
Financial statements should audited by an independent public accountant
and filed with the FDIC within 90 days
-
A statement concerning the effectiveness of its internal controls and its
compliance with safety and soundness laws should be submitted.
-
An audit committee consisting of outside directors must review
statements with the management.
-
CEO and CFO should certify the accuracy of the financial reports. They
might be punished with heavy fines and even jail sentences.
63
Income Statement (Report of Income)
- It indicates the amount of revenue received and expenses
incurred over a specific period of time
- A close correlation between major balance sheet items and
major income statements items. How?
Sources of Revenue
Expenses
- Mainly, income from loans and
investments.
Mainly, interest paid to deposits and
NDB
- Fees from other services
Cost of equity capital
Salaries and wages, benefits paid to
employees, overhead expenses
Funds set aside for possible loan, and
taxes owed
64
Income Statement (Report of Income)
65
Income Statement (Report of Income)
- From the previous chart, a firm that is interested in
increasing their net income can:
1.
2.
3.
4.
5.
6.
7.
Increased net yield on held assets
Redistribute earning assets, with high proportion of those of high yield
Increase volume of services that provide fee income
Increase service fee
Use less costly borrowings
Reduce employees
Tax management
However, management do not have full control of these items.
Public, demand and supply, regulation and competition, all have
effects as well.
66
Income Statement (Report of Income)
- Balance sheet is a statement of financial stocks. (stocks of assets,
liabilities and equity)
- Income statement record the financial flow over time.
a. Financial outflow  expenses
b. Financial inflow  Revenues
- It is mainly divided into;
1. Interest income
2. Interest expenses
3. Non interest income
4. Non interest expenses
67
Income Statement (Report of Income)
1. Interest income
- Loans and security investment accounts ( almost 70%)
- Relative importance is changing, as the noninterest revenues (fee
income) is growing faster.
2. Interest Expenses
- interest on deposits (almost 60%)
- Interest on short-term borrowings in the money market
(borrowing from reserves)
- Borrowing by security repurchase agreements
- Long term borrowings
68
Income Statement (Report of Income)
3. Net Interest Income
- Total interest Expenses are subtracted from total interest income
- It is usually called “interest margin”
- It is the gap between interest income from loans and interest paid
on borrowed funds.
- Key profitability determinant
- If the gap declines, net income declines, dividends per share
decrease as well.
69
Income Statement (Report of Income)
4. Loan Loss Expense
-
Provisions for loan losses
-
A noncash expense, created by a book entry
-
A shelter a portion of current earnings from taxes to help prepare for
bad loans.
-
Two methods to calculate loan loss deduction:
a.
b.
Experience method: average (net loan charge offs/Total loans) * Current
total outstanding loans
Specific method: deduct amount each year no more than the amount
actually considered uncollectable.
- Large banks use specific charge-off method
70
Income Statement (Report of Income)
5. Noninterest Income
- Fee income
- Financial institutions are required to report such noninterest
revenues in four categories:
1. Fees earned from fiduciary activities
• Trust Services: the management of property owned by customers (
cash, securities, land and buildings)
• One of the oldest income generating services
• New channel for boosting the net income
71
Income Statement (Report of Income)
5. Noninterest Income
2. Service charges on deposit accounts
3.Trading account gains and fees
4. Traditional non-interest income
i.e investment baking, security brokerage, and insurance services
72
Income Statement (Report of Income)
6. Noninterest Expenses
- Key non-interest expense: “Personal Expenses” wages, salaries
and employee benefits
top-quality collage graduates and experienced senior management
- “Premises and equipment expenses”: cost of maintaining financial
institutions properties and rental fees
73
Income Statement (Report of Income)
7. Net Operating Income and Net Income
Income Statement
(1)Interest Income
-(2)(Interest Expenses)
(3)=(1)-(2): Net Interest Income
(4)Non-Interest Income
-(5) (Non-Interest Expenses)
(6)=(4)-(5): Net Non-Interest Income
(7)= (3)+(6): Pretax Net Operating Income
-(8)(Applicable Income Tax)
+/- (9) Securities gains or losses
A 2018
A 2019
10= (7)-(8)+/-(9): Income before extraordinary items
20
80
+/-(11)Extraordinary items
70
5
(12) = 10+/-(11) Net Income
90
85
74
Income Statement (Report of Income)
7. Net Operating Income and Net Income
- Securities gain (losses) are usually small, but can be
substantial
-
Can be used to smooth the income.
If earning from loan decline, securities gains offset part of the decline
When loan revenues are high, securities losses can be used to
reduce taxable income.
- Nonrecurring sales of assets (extraordinary income or loss )
-
One time only transaction often involve the sale of financial or real
asset.
It has a substantial effect on current earnings
75
The Financial Statements of Leading Nonbank Financial
Firms: A Comparative to Bank Statements
Comparative Income Statements Ratios for Different Size
Financial Firms
- Thrift institutions, credit unions, and saving associations have financial
statements similar to those of banks.
Finance
Companies
Insurance
Companies
Mutual Funds
Brokers and
Dealers
Assets
Loans(account
receivables )
Bonds, stocks,
mortgages, etc.
Bonds, stocks,
asset backed
securities
Bonds, stocks,
asset backed
securities
Liabilities
Borrowings from MM
Premiums and
Borrowings
Funds from sale of Borrowings,
share to the public capital
contributions
Income
Interest
Investment
returns
Investment
returns
Investment
returns,
commissions
76
Quick Quiz
• What are the principal accounts that appear on a bank’s balance sheet
(Report of Condition)?
• Which accounts are most important and which are least important on
the asset side of a bank’s balance sheet? What accounts are most
important on the liability side of a balance sheet?
• What are primary reserves and secondary reserves, and what are they
supposed to do?
• What accounts make up the Report of Income (income statement of a
bank)?
77
• What is the relationship between the provision for loan losses on a
bank’s Report of Income and the allowance for loan losses on its
Report of Condition?
• What are the key features or characteristics of the financial statements
of banks and similar financial firms?
78
END OF
CHAPTER 5
79