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Chapter Twelve Commercial Banks’ Financial Statements and Analysis

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1 Chapter Twelve Commercial Banks’ Financial Statements and Analysis

2 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 McGraw-Hill/Irwin

3 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 McGraw-Hill/Irwin

4 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 McGraw-Hill/Irwin

5 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 McGraw-Hill/Irwin

6 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 McGraw-Hill/Irwin

7 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.) McGraw-Hill/Irwin

8 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 McGraw-Hill/Irwin

9 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 McGraw-Hill/Irwin

10 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 McGraw-Hill/Irwin

11 Other Fee Generating Activities
Correspondent banking and trust services Processing Services McGraw-Hill/Irwin

12 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 McGraw-Hill/Irwin

13 Income Statement There is a direct relationship between the income statement and the balance sheet of commercial banks NI = 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 = 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 McGraw-Hill/Irwin

14 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 = $170.45 McGraw-Hill/Irwin

15 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% McGraw-Hill/Irwin

16 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 McGraw-Hill/Irwin

2007 Full Year Interest Expense 37.46% Data Operating Income Profit Margin Net Income PLL 6.95% 11.89% ROA Noninterest expense 38.20% Total Assets 0.93% ROE Income Taxes 5.21% Total Equity Capital 9.13% Asset Utilization Interest Income 5.47% Equity Multiplier 7.15% Noninterest income 1.89% 9.65x McGraw-Hill/Irwin

18 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 McGraw-Hill/Irwin

19 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 McGraw-Hill/Irwin

20 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 McGraw-Hill/Irwin

21 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 McGraw-Hill/Irwin

22 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) McGraw-Hill/Irwin

23 Comparison of WFS and BOA
Interest Expense WFS = 38.40% BOA = 37.16% Operating Income Profit Margin Net Income PLL WFS = % WFS = 14.02% BOA = 5.33% ROA BOA = 18.18% Noninterest expense WFS = 38.50% Total Assets BOA = 30.25% WFS = 0.99% ROE BOA = 1.43% Income Taxes WFS = 6.94% BOA = 9.15% Total Equity Capital WFS = 8.45% Asset Utilization Interest Income WFS = % BOA = 13.36% BOA = % Equity Multiplier WFS = 7.08% Noninterest income WFS = % BOA = 7.91% BOA = % WFS = 8.51 BOA = 9.33 McGraw-Hill/Irwin

24 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 McGraw-Hill/Irwin

25 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 McGraw-Hill/Irwin

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