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©2009 The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Twelve Commercial Banks’ Financial Statements and Analysis.

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Presentation on theme: "©2009 The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Twelve Commercial Banks’ Financial Statements and Analysis."— Presentation transcript:

1 ©2009 The McGraw-Hill Companies, All Rights Reserved 8-1 McGraw-Hill/Irwin Chapter Twelve Commercial Banks’ Financial Statements and Analysis

2 ©2009 The McGraw-Hill Companies, All Rights Reserved 11-2 McGraw-Hill/Irwin Regulators The Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks The U.S. has a dual banking system—banks can be either nationally or state chartered –the Office of the Comptroller of the Currency (OCC) charters and regulates national banks –state agencies charter and regulate state banks The Federal Reserve System (FRS) has regulatory power over nationally chartered banks and their holding companies and state banks that opt in to the Federal Reserve System –a holding company is a parent company that owns a controlling interest in a subsidiary bank or other FI The Federal Deposit Insurance Corporation (FDIC) insures the deposits of commercial banks The U.S. has a dual banking system—banks can be either nationally or state chartered –the Office of the Comptroller of the Currency (OCC) charters and regulates national banks –state agencies charter and regulate state banks The Federal Reserve System (FRS) has regulatory power over nationally chartered banks and their holding companies and state banks that opt in to the Federal Reserve System –a holding company is a parent company that owns a controlling interest in a subsidiary bank or other FI

3 ©2009 The McGraw-Hill Companies, All Rights Reserved 12-3 McGraw-Hill/Irwin Financial Statements The Federal Financial Institutions Examination Council (FFIEC) prescribes uniform principles, standards, and report forms for depository institutions –balance sheets are reported on report of condition forms –income statements are reported on report of income forms –commercial banks report contingent assets and liabilities on off- balance-sheet reports Retail banks focus business activities on consumer banking relationships Wholesale banks focus business activities on commercial banking relationships –most wholesale banks also engage in retail banking The Federal Financial Institutions Examination Council (FFIEC) prescribes uniform principles, standards, and report forms for depository institutions –balance sheets are reported on report of condition forms –income statements are reported on report of income forms –commercial banks report contingent assets and liabilities on off- balance-sheet reports Retail banks focus business activities on consumer banking relationships Wholesale banks focus business activities on commercial banking relationships –most wholesale banks also engage in retail banking

4 ©2009 The McGraw-Hill Companies, All Rights Reserved 12-4 McGraw-Hill/Irwin Financial Statements Comparative analysis of BOA and Webster Retail banks focus business activities on consumer banking relationships - WBS Wholesale banks focus business activities on commercial banking relationships –most wholesale banks also engage in retail banking –BOA has trust services, investment management and credit cards businesses as well and is the leading small business lender in the counry Comparative analysis of BOA and Webster Retail banks focus business activities on consumer banking relationships - WBS Wholesale banks focus business activities on commercial banking relationships –most wholesale banks also engage in retail banking –BOA has trust services, investment management and credit cards businesses as well and is the leading small business lender in the counry

5 ©2009 The McGraw-Hill Companies, All Rights Reserved 12-5 McGraw-Hill/Irwin CAMELS Ratings Regulators use CAMELS ratings to evaluate the safety and soundness of banks CAMELS ratings rely heavily on financial statement data Components –Capital adequacy –Asset quality –Management quality –Earnings quality –Liquidity –Sensitivity to market risk Regulators use CAMELS ratings to evaluate the safety and soundness of banks CAMELS ratings rely heavily on financial statement data Components –Capital adequacy –Asset quality –Management quality –Earnings quality –Liquidity –Sensitivity to market risk

6 ©2009 The McGraw-Hill Companies, All Rights Reserved 12-6 McGraw-Hill/Irwin CAMELS Ratings CAMELS ratings range from 1 to 5 –Composite “1”—banks are basically sound in every respect –Composite “2”—banks are fundamentally sound, but may have modest weaknesses correctable in the normal course of business –Composite “3”—banks exhibit financial, operational, or compliance weaknesses ranging from moderately severe to unsatisfactory –Composite “4”—banks have an immoderate volume of serious financial weaknesses or a combination of other conditions that are unsatisfactory –Composite “5”—banks have an extremely high immediate or near term probability of failure CAMELS ratings range from 1 to 5 –Composite “1”—banks are basically sound in every respect –Composite “2”—banks are fundamentally sound, but may have modest weaknesses correctable in the normal course of business –Composite “3”—banks exhibit financial, operational, or compliance weaknesses ranging from moderately severe to unsatisfactory –Composite “4”—banks have an immoderate volume of serious financial weaknesses or a combination of other conditions that are unsatisfactory –Composite “5”—banks have an extremely high immediate or near term probability of failure

7 ©2009 The McGraw-Hill Companies, All Rights Reserved 12-7 McGraw-Hill/Irwin Commercial Bank Assets Cash and balances due from other depository institutions –Consist of vault cash, currency in the process of collection (CIPC), correspondent balances and reserves at the Fed. Also called primary reserves. Investment securities –short-term securities (e.g, Treasury bills and fed funds sold, Interest bearing deposits at other FIs, Fed funds sold, Reverse Repos, U.S. Treasury and agency securities –long-term securities (e.g., Treasury bonds, munis, MBSs) Loans –commercial and industrial –real estate –consumer –other loans Unearned income and allowance for loan and lease losses Other assets (e.g., fixed assets, goodwill, etc.) Cash and balances due from other depository institutions –Consist of vault cash, currency in the process of collection (CIPC), correspondent balances and reserves at the Fed. Also called primary reserves. Investment securities –short-term securities (e.g, Treasury bills and fed funds sold, Interest bearing deposits at other FIs, Fed funds sold, Reverse Repos, U.S. Treasury and agency securities –long-term securities (e.g., Treasury bonds, munis, MBSs) Loans –commercial and industrial –real estate –consumer –other loans Unearned income and allowance for loan and lease losses Other assets (e.g., fixed assets, goodwill, etc.)

8 ©2009 The McGraw-Hill Companies, All Rights Reserved 12-8 McGraw-Hill/Irwin Commercial Bank Liabilities Core deposits –demand deposits –negotiable order of withdrawal (NOW) accounts –money market deposit accounts (MMDAs) –other savings deposits –retail certificates of deposits Other deposits –wholesale certificates of deposits (> $100,000) negotiable instruments traded in secondary markets brokered deposits Core deposits –demand deposits –negotiable order of withdrawal (NOW) accounts –money market deposit accounts (MMDAs) –other savings deposits –retail certificates of deposits Other deposits –wholesale certificates of deposits (> $100,000) negotiable instruments traded in secondary markets brokered deposits

9 ©2009 The McGraw-Hill Companies, All Rights Reserved 12-9 McGraw-Hill/Irwin Commercial Bank Liabilities and Equity Non-deposit liabilities –borrowed (purchased) funds fed funds purchased and repos other borrowed funds (e.g., banker’s acceptances, commercial paper, discount window loans) –subordinated notes and debentures –other liabilities - non-interest bearing accrued interest, deferred taxes, dividends payable, etc. Equity –preferred and common stock –surplus or additional paid in capital –retained earnings Non-deposit liabilities –borrowed (purchased) funds fed funds purchased and repos other borrowed funds (e.g., banker’s acceptances, commercial paper, discount window loans) –subordinated notes and debentures –other liabilities - non-interest bearing accrued interest, deferred taxes, dividends payable, etc. Equity –preferred and common stock –surplus or additional paid in capital –retained earnings

10 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Off-Balance-Sheet Items Off-balance-sheet items are contingent assets and liabilities that may affect a commercial bank’s balance sheet and/or income statement Loan commitments –up-front fees are charged for making funds available –commitments fees are charged on unused portion of commitments Letters of credit –commercial letters of credit –standby letters of credit Loans sold –loans can be sold with or without recourse Derivative contracts –futures, forwards, swaps, and options Off-balance-sheet items are contingent assets and liabilities that may affect a commercial bank’s balance sheet and/or income statement Loan commitments –up-front fees are charged for making funds available –commitments fees are charged on unused portion of commitments Letters of credit –commercial letters of credit –standby letters of credit Loans sold –loans can be sold with or without recourse Derivative contracts –futures, forwards, swaps, and options

11 ©2009 The McGraw-Hill Companies, All Rights Reserved Other Fee Generating Activities Correspondent banking and trust services Processing Services 9-11 McGraw-Hill/Irwin

12 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Income Statement Interest income – interest expense = net interest income Noninterest income – noninterest expense = net noninterest income Net interest income – provision for loan losses + net noninterest income = income before taxes and extraordinary items (EBTEI) EBTEI – income taxes – extraordinary items = net income Interest income – interest expense = net interest income Noninterest income – noninterest expense = net noninterest income Net interest income – provision for loan losses + net noninterest income = income before taxes and extraordinary items (EBTEI) EBTEI – income taxes – extraordinary items = net income

13 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Income Statement There is a direct relationship between the income statement and the balance sheet of commercial banks NI = net income A n = dollar value of the bank’s nth asset L m = dollar value of the bank’s mth liability r n = rate earned on the bank’s nth asset r m = rate paid on the bank’s mth liability P = provision for loan losses NII = non-interest income earned, including income from OBS activities NIE = non-interest expenses T = taxes and extraordinary items N = number of assets the bank holds M = number of liabilities the bank holds There is a direct relationship between the income statement and the balance sheet of commercial banks NI = net income A n = dollar value of the bank’s nth asset L m = dollar value of the bank’s mth liability r n = rate earned on the bank’s nth asset r m = rate paid on the bank’s mth liability P = provision for loan losses NII = non-interest income earned, including income from OBS activities NIE = non-interest expenses T = taxes and extraordinary items N = number of assets the bank holds M = number of liabilities the bank holds

14 ©2009 The McGraw-Hill Companies, All Rights Reserved Finding the required dollar interest spread Suppose that a bank has equity of $200, interest expense of $90, P = $20, net noninterest income of -$15 and a tax rate of 34%. What is the minimum total interest revenue required to give a ROE of 15%? Required NI = NI/$200 = 0.15 or NI = $30 NI = [Interest revenue– Interest expense – P + (NII – NIE)] X (1 – Tax rate) or $30 = [Interest revenue – $90 – $20 + –$15]  (1 – 0.34) Required interest revenue = $ McGraw-Hill/Irwin

15 ©2009 The McGraw-Hill Companies, All Rights Reserved Illustrative loan pricing If securities are $500 and are earning an average rate of return of 5% and the bank has $1500 in loans, what must be the average loan rate to generate interest revenue of $170.45? $ = ($500 x 0.05) + ($1500 x Avg. Loan Rate) Avg. Loan Rate required = 9.7% 9-15 McGraw-Hill/Irwin

16 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Financial Statement Analysis Financial statement analysis is based on accounting ratios Time series analysis is the analysis of financial statements over a period of time Cross-sectional analysis is the analysis of financial statements comparing one firm with others –the Uniform Bank Performance Report (UBPR) maintained by the FFIEC allows banks to observe competitor financial statements Most financial statement analyses is a combination of time series analysis and cross-sectional analysis Financial statement analysis is based on accounting ratios Time series analysis is the analysis of financial statements over a period of time Cross-sectional analysis is the analysis of financial statements comparing one firm with others –the Uniform Bank Performance Report (UBPR) maintained by the FFIEC allows banks to observe competitor financial statements Most financial statement analyses is a combination of time series analysis and cross-sectional analysis

17 ©2009 The McGraw-Hill Companies, All Rights Reserved 9-17 McGraw-Hill/Irwin RETURN ON EQUITY AND ITS COMPONENTS 2007 Full YearInterest Expense 37.46% DataOperating Income Profit Margin Net Income Operating Income PLL 6.95% 11.89%Operating Income ROA Net IncomeNoninterest expense 38.20% Total AssetsOperating Income 0.93% ROEIncome Taxes 5.21% Net IncomeOperating Income Total Equity Capital 9.13%Asset UtilizationInterest Income 5.47% Operating Income Total Assets Equity Multiplier7.15%Noninterest income 1.89% Total Assets Total Equity Capital 9.65x

18 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Return on Equity (ROE) Framework Return on Equity (ROE) analysis begins with ROE and then breaks it down into its components ROE measures the overall profitability of the bank per dollar of equity ROE can be broken down into its components Return on Equity (ROE) analysis begins with ROE and then breaks it down into its components ROE measures the overall profitability of the bank per dollar of equity ROE can be broken down into its components

19 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Return on Equity (ROE) Framework Return on Assets (ROA) measures profit generated relative the banks assets Equity Multiplier (EM) measures the extent to which assets are funded with equity relative to debt (i.e., it is a measure of leverage) ROA can also be broken down into its components Return on Assets (ROA) measures profit generated relative the banks assets Equity Multiplier (EM) measures the extent to which assets are funded with equity relative to debt (i.e., it is a measure of leverage) ROA can also be broken down into its components

20 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Return on Equity (ROE) Framework Profit Margin (PM) measures the ability to pay expenses and generate net income from interest and noninterest income and is composed of –interest expense ratio –provision for loan loss ratio –noninterest expense ratio –tax ratio Asset Utilization (AU) measures the amount of interest and noninterest income generated per dollar of total assets and is composed of –interest income ratio –noninterest income ratio Profit Margin (PM) measures the ability to pay expenses and generate net income from interest and noninterest income and is composed of –interest expense ratio –provision for loan loss ratio –noninterest expense ratio –tax ratio Asset Utilization (AU) measures the amount of interest and noninterest income generated per dollar of total assets and is composed of –interest income ratio –noninterest income ratio

21 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Other Ratios The net interest margin (NIM) measures the net return on a bank’s earning assets The spread measures the difference between the average yield on earning assets and average cost on interest-bearing liabilities The net interest margin (NIM) measures the net return on a bank’s earning assets The spread measures the difference between the average yield on earning assets and average cost on interest-bearing liabilities

22 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin Other Ratios Overhead efficiency measures a bank’s ability to generate noninterest income to cover noninterest expenses Many additional ratios are commonly used to analyze commercial banks by breaking down the components of ROE even further (see Tables 12-6 and 12-7) Overhead efficiency measures a bank’s ability to generate noninterest income to cover noninterest expenses Many additional ratios are commonly used to analyze commercial banks by breaking down the components of ROE even further (see Tables 12-6 and 12-7)

23 ©2009 The McGraw-Hill Companies, All Rights Reserved 9-23 McGraw-Hill/Irwin Comparison of WFS and BOA Interest ExpenseWFS = 38.40% BOA = 37.16% Operating Income Profit Margin Net Income Operating IncomePLLWFS = 1.14% WFS = 14.02%Operating IncomeBOA = 5.33% ROABOA = 18.18% Net IncomeNoninterest expenseWFS = 38.50% Total AssetsOperating IncomeBOA = 30.25% WFS = 0.99% ROEBOA = 1.43%Income TaxesWFS = 6.94% Net IncomeOperating IncomeBOA = 9.15% Total Equity Capital WFS = 8.45%Asset UtilizationInterest IncomeWFS = 5.95% BOA = 13.36%Operating IncomeTotal AssetsBOA = 5.57% Total Assets Equity MultiplierWFS = 7.08%Noninterest incomeWFS = 1.13% Total AssetsBOA = 7.91%Total AssetsBOA = 2.34% Total Equity Capital WFS = 8.51 BOA = 9.33

24 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The Impact of Market Niche and Size Retail and wholesale commercial banks operate in different market niches that should be noted when performing financial statement analysis Webster Financial Bancorp (WBS) –WBS is a profitable and efficient retail bank –invests mainly in real estate loans –uses low cost retail deposits to fund its assets –holds relatively more equity capital than Bank of America Retail and wholesale commercial banks operate in different market niches that should be noted when performing financial statement analysis Webster Financial Bancorp (WBS) –WBS is a profitable and efficient retail bank –invests mainly in real estate loans –uses low cost retail deposits to fund its assets –holds relatively more equity capital than Bank of America

25 ©2009 The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin The Impact of Market Niche and Size Bank of America (BOA) –BOA is both a retail and a wholesale bank –has a relatively more diversified portfolio than WBS –uses a broader array of deposits and more purchased funds (i.e., fewer core deposits) than WBS –offers a broad spectrum of financial services BOA is the more profitable bank –uses less equity, which contributes to a higher ROE –generates much more noninterest income Bank of America (BOA) –BOA is both a retail and a wholesale bank –has a relatively more diversified portfolio than WBS –uses a broader array of deposits and more purchased funds (i.e., fewer core deposits) than WBS –offers a broad spectrum of financial services BOA is the more profitable bank –uses less equity, which contributes to a higher ROE –generates much more noninterest income


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