1. Chapter Twelve Commercial Banks’ Financial Statements and Analysis
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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
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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
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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
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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
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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
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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.)
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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
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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
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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
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11. Other Fee Generating Activities
Correspondent banking and trust services
Processing Services
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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
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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
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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
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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%
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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
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17. RETURN ON EQUITY AND ITS COMPONENTS
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
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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
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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
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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
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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
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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)
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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
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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
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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
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