Chapter 41 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 42 CHAPTER 4 Sources and Uses of Bank Funds and the Risks of Banking

Chapter 43 LEARNING OBJECTIVES 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 TO UNDERSTAND...

Chapter 44 CHAPTER THEME The traditional business of banking is funding loans (use of funds) with deposits (source of funds). This function generates the “bread- and-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 45 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 46 Banks As Portfolios: Two-Way Funds Rental and Risk Control Risks Credit Risk Interest-Rate Risk Liquidity Risk Prepayment Risk Foreign-Exchange Risk

Chapter 47 Bank Financial Statements Balance Sheet: A = L + NW Income-Expense Statement: P = R - C - T Book Values Market Value of Equity

Chapter 48 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 49 Bank Balance Sheets Sources of Funds: Managed Liabilities Managed Liabilities As the antithesis of core deposits, managed liabilities are more volatile and more rate- sensitive 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 410 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 411 Bank Balance Sheets Sources and Uses of Funds Federal Funds and Repurchase Agreements

Chapter 412 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 income- expense 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 413 Bank Equity Capital Equity Capital = Net Worth = Book Value of Equity = Assets - Liabilities Regulatory capital Market value of equity

Chapter 414 COMPONENTS OF BANK EQUITY CAPITAL 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 415 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 416 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 417 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 418 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 419 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 420 A Bank’s Income-Expense Statement Dividends and Additions to Retained Earnings Internal Capital Generation Rate

Chapter 421 RECAP OF BANK INCOME AND EXPENSES Four key components: 1. Net interest income 2. PLL 3. Net noninterest income (”burden”) 4. Taxes Net income is the bottom line ROA is the key accounting measure of bank performance

Chapter 422 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