1. The Financial Statements of Banks and Their Principal Competitors
Chapter Five
The Financial Statements of Banks and Their Principal Competitors

2. 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

3. 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)

4. 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

5. TABLE 5–1 Key Items on Bank Financial Statements

6. 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

7. 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)
Government and private interest-bearing securities purchased in the open market (S)
Loans and lease financings made available to customers (L)
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)

8. 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

9. 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:

10. TABLE 5–2 Highlighted Bank Financial Data ($ million) from the FDIC (December 31, 2009)

11. TABLE 5–3 Report of Condition (Balance Sheet) for BB&T (Year-End 2008 and 2009)

12. 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

13. 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

14. 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

15. 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

16. 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

17. The Balance Sheet (Report of Condition) (continued)
Loan Accounts
The Major Asset
Gross Loans – Sum of All Loans
Allowance for Possible Loan Losses
Contra Asset Account
For Potential Future Loan Losses
Net Loans
Unearned Discount Income
Nonperforming Loans

18. 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

19. The Balance Sheet (Report of Condition) (continued)
Loan Losses
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

20. 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 reserves

21. The Balance Sheet (Report of Condition) (continued)
Miscellaneous Assets
Bank Premises and Fixed Assets
Other Real Estate Owned (OREO)
Goodwill and Other Intangibles

22. The Balance Sheet (Report of Condition) (continued)
Liabilities of the Banking Firm
Deposits
Non interest-Bearing Demand Deposits
Savings Deposits
Now Accounts
Money Market Deposit Accounts (MMDA)
Time Deposits

23. 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

24. The Balance Sheet (Report of Condition) (continued)
Equity Capital of the Banking Firm
Preferred Stock
Common Stock
Common Stock Outstanding
Capital Surplus
Retained Earnings (Undivided Profits)
Treasury Stock
Contingency Reserve

25. TABLE 5-4 The Composition of Bank Balance Sheets (Percentage Mix of Sources and Uses of Funds for (Year-End 2009)

26. The Balance Sheet (Report of Condition) (continued)
Recent Expansion of Off-Balance-Sheet (OBS) Items in Banking
Unused Commitments
Standby Credit Agreements
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

27. TABLE 5–5 Examples of Off-Balance-Sheet Items Reported by FDIC-Insured Banks

28. The Balance Sheet (Report of Condition) (continued)
The Problem with Book-Value Accounting
Original (historical, book-value) cost
Amortized cost
Market-value
Held-to-maturity and available-for-sale securities
Window Dressing
Auditing Financial Statements
Audit Committees
Sarbanes-Oxley Accounting Standards Act

29. 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

30. Components of the Income Statement (Report of Income) (continued)

31. 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
Interest income
Interest expenses
Noninterest income
Noninterest expenses

32. TABLE 5–6 Report of Income (Income Statement) for BB&T (2008 and 2009)

33. 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

34. Components of the Income Statement (Report of Income) (continued)
Net Noninterest Income = Noninterest Income – Noninterest Expenses
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

35. The Financial Statements of Leading Nonbank Financial Firms: A Comparison to Bank Statements
The financial statements of nonbank financial firms have, in recent years, come closer and closer to what we see on bank statements
Especially true of thrift institutions
Thrifts’ balance sheet are dominated by loans, deposits from customers, and borrowings in the money market
Thrifts’ income statements are heavily tilted toward revenue from loans and by the interest they must pay on deposits and money market borrowings
Other groups in the financial-service industries such as finance companies, life and property/casualty insurers, mutual funds, and security brokers and dealers
Their financial statements include sources and uses of funds unique to the functions of these industries

36. TABLE 5–7 The Composition of Bank Income Statements (Percentage of Total Assets Measured as of Year-End 2009)

37. An Overview of Key Features of Financial Statements and Their Consequences
Table 5–8 provides a useful overview of the key features of the financial statements of financial institutions and their consequences for the managers of financial firms and for the public

38. TABLE 5–8 Features and Consequences of the Financial Statements of Banks and Similar Financial Firms

39. 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)?
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?