Chapter Five
The Financial Statements of Banks and
Their Principal Competitors
McGraw-Hill/Irwin
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
Key Topics
• An Overview of the Balance Sheets and Income Statements of
Banks and Other Financial Firms
• The Balance Sheet or Report of Condition
• Asset Items
• Liability Items
• Recent Expansion of Off-Balance-Sheet Items
• The Problem of Book-Value Accounting and “Window
Dressing”
• Components of the Income Statement: Revenues and Expenses
• Appendix: Sources of Information on the Financial-Services
Industry
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-2
Introduction
• The particular services each financial firm chooses to offer
and the overall size of each financial-service organization
are reflected in its financial statements
• Financial statements can be viewed as a “road map”
▫ Tell us where a financial firm has been in the past, where it is
now, and possibly where it is headed in the future
• The two main financial statements that managers,
customers, and the regulatory authorities rely upon are
▫ The balance sheet (Report of Condition)
▫ The income statement (Report of Income)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-3
An Overview of Balance Sheets and Income
Statements
• The Report of Condition shows the amount and composition of funds
sources (financial inputs) drawn upon to finance lending and investing
activities and how much has been allocated to loans, securities, and
other funds uses (financial outputs) at any given point in time
• In contrast, the financial inputs and outputs on the Report of Income
show how much it has cost to acquire funds and to generate revenues
from the uses the financial firm has made of those funds
• The Report of Income also shows the revenues (cash flow) generated
by selling services to the public, including making loans and servicing
customer deposits
• The Report of Income shows net earnings after all costs are deducted
from the sum of all revenues, some of which will be reinvested in the
financial firm for future growth and some of which will flow to
stockholders as dividends
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-4
TABLE 5–1 Key Items on Bank Financial Statements
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-5
The Balance Sheet (Report of Condition)
• A balance sheet lists the assets, liabilities, and equity
capital (owners’ funds) held by or invested in a bank or
other financial firm on any given date
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-6
The Balance Sheet (Report of Condition)
(continued)
• For banks and other depository institutions the assets on the
balance sheet are of four major types:
▫ Cash in the vault and deposits held at other depository institutions (C) –
Primary Reserves
▫ Government and private interest-bearing securities purchased in the open
market (S) – Secondary Reserves (Liquid & Income-Generating
Portions,Federal Funds and RRA)
▫ Loans and lease financings made available to customers (L) (>75%!)
▫ Miscellaneous assets (MA)
• Liabilities fall into two principal categories:
▫ Deposits made by and owed to various customers (D)
▫ Nondeposit borrowings of funds in the money and capital markets (NDB)
• Equity capital represents long-term funds the owners contribute
(EC)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-7
The Balance Sheet (Report of Condition)
(continued)
• 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)
• Deposits (D) are typically the main source of funding for banks
▫ Nondeposit borrowings (NDB) are carried out mainly to supplement
deposits and provide the additional liquidity that cash assets and
securities cannot provide
• 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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-8
The Balance Sheet (Report of Condition)
(continued)
• One useful way to view the balance sheet identity is to note that
liabilities and equity capital represent accumulated sources of funds,
which provide the needed spending power to acquire assets
• A bank’s assets, on the other hand, are its 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
• Thus, the balance sheet identity can be pictured simply as:
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-9
TABLE 5–2 Highlighted Bank Financial Data ($ million)
from the FDIC (December 31, 2009)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-10
TABLE 5–3 Report of Condition (Balance Sheet) for BB&T
(Year-End 2008 and 2009)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-11
The Balance Sheet (Report of Condition)
(continued)
• 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 Federal Reserve
▫ Sometimes called primary reserves
▫ First line of defense against customer deposit withdrawals
▫ First source of funds for loan request from customers
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-12
The Balance Sheet (Report of Condition)
(continued)
• Investment Securities - The Liquid Portion
▫ Short Term Government Securities
▫ Privately Issued Money Market Securities
▫ Interest Bearing Time Deposits
▫ Commercial Paper
▫ Often called secondary reserves
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-13
The Balance Sheet (Report of Condition)
(continued)
• Investment Securities - The Income-Generating
Portion
▫ Taxable Securities
▫ U.S. Government Notes
▫ Government Agency Securities
▫ Corporate Bonds
▫ Tax-Exempt Securities
▫ Municipal Bonds
▫ Investment securities are recorded at original or market value
whichever is lower.
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-14
The Balance Sheet (Report of Condition)
(continued)
• Trading Account Assets
▫ Securities purchased to provide short-term profits from
short-term price movements
▫ Occurs when the bank acts as a securities dealer
▫ Valued at Market – FASB 115
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-15
The Balance Sheet (Report of Condition)
(continued)
• Federal Funds Sold and Reverse Repurchase Agreements
▫ Includes mainly temporary loans (usually extended overnight,
with the funds returned the next day) made to other
depository institutions, securities dealers, or major industrial
corporations
▫ The funds for these temporary loans often come from the
reserves a bank has on deposit with the Federal Reserve Bank
in its district
▫ “Fed funds”
▫ 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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-16
The Balance Sheet (Report of Condition)
(continued)
• Loan Accounts
▫ The Major Asset
▫ Gross Loans – Sum of All Loans
▫ Allowance for Possible Loan Losses (ALL)
▫ Contra Asset Account
▫ For Potential Future Loan Losses
▫ Net Loans
▫ Unearned Discount Income
▫ Nonperforming Loans
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-17
The Balance Sheet (Report of Condition)
(continued)
• 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
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-18
The Balance Sheet (Report of Condition)
(continued)
• Loan Losses
• Allowance for loan loss(ALL) – reserves for future loan
losses, contra asset (negative account)
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
• *When a loan is considered uncollectible , the accounting
department will write-off (charge) the book by reducing the
ALL account by the amount of uncollected loan and
simultaneously decreasing the asset account (loan).
• Addition to ALL are usually made as the loan portfolio grows.
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-19
The Balance Sheet (Report of Condition)
(continued)
• 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
▫ Loans to lesser developed countries require allocated
transfer-risk reserves (ATRs)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-20
The Balance Sheet (Report of Condition)
(continued)
• Non-performing loans: A loan is placed in the nonperforming category if the loan repayment is due for
more than 90 days.
• Miscellaneous Assets
▫ Bank Premises and Fixed Assets
▫ Other Real Estate Owned (OREO)
▫ Goodwill and Other Intangibles
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-21
The Balance Sheet (Report of Condition)
(continued)
• Liabilities of the Banking Firm
▫ Deposits (Most important, 60% to 80% of funding assets)
▫ Non interest-Bearing Demand Deposits (regular checking
account – no interest rate)
▫ Savings Deposits (lowest rate of interest)
▫ NOW Accounts – bear interests (Negotiable Order of
Withdrawal)
▫ Money Market Deposit Accounts (MMDA)
▫ Time Deposits (CDs)- Fixed deposit
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-22
The Balance Sheet (Report of Condition)
(continued)
• Liabilities of the Banking Firm
▫ Nondeposit Borrowings
▫ Fed Funds Purchased
▫ Securities Sold Under Agreement to Repurchase (Repurchase
Agreements)
▫ Acceptances Outstanding
▫ Eurocurrency Borrowings
▫ Subordinated Debt
▫ Limited Life Preferred Stock
▫ Other Liabilities
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-23
The Balance Sheet (Report of Condition)
(continued)
• Equity Capital of the Banking Firm (High Leverage in
Financial Companies)
▫
▫
▫
▫
▫
▫
▫
Preferred Stock
Common Stock
Common Stock Outstanding (Par value/Market value)
Capital Surplus
Retained Earnings (Undivided Profits)
Treasury Stock
Contingency Reserve (Protection against unforeseen losses)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-24
TABLE 5-4 The Composition of Bank Balance Sheets (Percentage
Mix of Sources and Uses of Funds for (Year-End 2009)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-25
The Balance Sheet (Report of Condition)
(continued)
• Recent Expansion of Off-Balance-Sheet (OBS) Items
in Banking
▫ Unused Commitments (Not yet transferred to borrower)
▫ Standby Credit Agreements (guarantee from bank that
customer will repay loan to another lender)
▫ Derivative Contracts
▫ Futures Contracts
▫ Options
▫ Swaps
▫ OBS transactions expose a firm to counterparty risks
▫ OBS items have grown so rapidly that, for the banking
industry as a whole, they exceed total bank assets many
times over
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-26
TABLE 5–5 Examples of Off-Balance-Sheet Items Reported
by FDIC-Insured Banks
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-27
Components of the Income Statement (Report
of Income)
• Indicates the amount of revenue received and
expenses incurred over a specific period of time
• Shows how much it has cost to acquire funds and to
generate revenues from the uses of funds in the Report
of Conditions
• Shows the revenues (cash flow) generated by selling
services to the public
• Shows net earnings after all costs are deducted from
the sum of all revenues
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-28
Components of the Income Statement (Report
of Income) (continued)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-29
Components of the Income Statement (Report
of Income) (continued)
• Income statements are a record of financial flows over
time
• Therefore, we can represent the income statement as a
report of financial outflows (expenses) and financial
inflows (revenues)
• Four main sections
1.
2.
3.
4.
Interest income (Most important)
Interest expenses (Deposit!)
Noninterest income (different types of fees)
Noninterest expenses(personnel and equipment expenses)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-30
TABLE 5–6 Report of Income (Income Statement) for BB&T
(2008 and 2009)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-31
Components of the Income Statement (Report
of Income) (continued)
• Net Interest Income = Interest Income – Interest
Expenses
• Interest Income Sources
▫
▫
▫
▫
Interest and Fees on Loans
Taxable Securities Revenue
Tax-Exempt Securities Revenue
Other Interest Income
• Interest Expense Sources
▫ Deposit Interest Costs
▫ Interest on Short-Term Debt
▫ Interest on Long-Term Debt
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-32
Components of the Income Statement (Report
of Income) (continued)
• Net Noninterest Income = Noninterest Income –
Noninterest Expenses – Provision for Loan Losses)
• Noninterest Income Sources
▫
▫
▫
▫
Fees Earned from Fiduciary Activities
Service Charges on Deposit Accounts
Trading Account Gains and Fees
Additional Noninterest Income
• Noninterest Expense Sources
▫ Wages, Salaries, and Employee Benefits
▫ Premises and Equipment Expense
▫ Other Operating Expenses
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-33
Components of the Income Statement (Report
of Income) (continued)
• Net Interest Income + Net Noninterest Income
= Net Operating Income (Pretax)
• Net Operating Income + Security Gains or Losses =
Income before Extraordinary Items
• Extraordinary Items (Sales of financial or real
assets)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-34
TABLE 5–7 The Composition of Bank Income Statements
(Percentage of Total Assets Measured as of Year-End 2009)
McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
5-35