Commercial banks’ financial statements and analysis

Chapter Twelve
Commercial Banks’
Financial Statements and
Analysis
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Regulators
•• The
TheFederal
FederalDeposit
DepositInsurance
InsuranceCorporation
Corporation(FDIC)
(FDIC)
insures
insuresthe
thedeposits
depositsof
ofcommercial
commercialbanks
banks
•• The
TheU.S.
U.S.has
hasaadual
dualbanking

bankingsystem—banks
system—bankscan
canbe
be
either
eithernationally
nationallyor
orstate
statechartered
chartered

–– the
theOffice
Officeof
ofthe
theComptroller
Comptrollerof
ofthe
theCurrency
Currency(OCC)
(OCC)charters
charters
and
andregulates
regulatesnational
nationalbanks
banks
–– state
stateagencies
agenciescharter

charterand
andregulate
regulatestate
statebanks
banks

•• The
TheFederal
FederalReserve
ReserveSystem
System(FRS)
(FRS)has
hasregulatory
regulatory
power
powerover
overnationally
nationallychartered
charteredbanks
banksand
andtheir
theirholding
holding
companies
companiesand
andstate
statebanks
banksthat
thatopt
optin

into
tothe
theFederal
Federal
Reserve
ReserveSystem
System

–– aaholding
holdingcompany
companyisisaaparent
parentcompany
companythat
thatowns
ownsaacontrolling
controlling
interest
in
a
subsidiary
bank
or
other
FI
interest in a subsidiary bank or other FI

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Financial Statements
•• The
TheFederal
FederalFinancial
FinancialInstitutions
InstitutionsExamination
ExaminationCouncil
Council
(FFIEC)
(FFIEC)prescribes
prescribesuniform
uniformprinciples,
principles,standards,
standards,and
andreport
report
forms
formsfor
fordepository
depositoryinstitutions
institutions
––
––
––

balance
balancesheets

sheetsare
arereported
reportedon
onreport
reportof
ofcondition
conditionforms
forms
income
incomestatements
statementsare
arereported
reportedon
onreport
reportof
ofincome
incomeforms
forms
commercial
commercialbanks
banksreport
reportcontingent
contingentassets
assetsand
andliabilities
liabilitieson
onoffoffbalance-sheet
reports
balance-sheet reports

•• Retail
Retailbanks
banksfocus
focusbusiness
businessactivities
activitieson
onconsumer
consumerbanking
banking
relationships
relationships
•• Wholesale
Wholesalebanks
banksfocus
focusbusiness
businessactivities
activitieson
oncommercial
commercial
banking
bankingrelationships
relationships
–– most
mostwholesale
wholesalebanks
banksalso
alsoengage
engageininretail
retailbanking
banking

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Financial Statements
••
••

Comparative
Comparativeanalysis
analysisof
ofBOA
BOAand
andWebster
Webster
Retail
Retailbanks
banksfocus
focusbusiness
businessactivities
activitieson
onconsumer
consumer
banking
bankingrelationships
relationships--WBS

WBS
•• Wholesale
Wholesalebanks
banksfocus
focusbusiness
businessactivities
activitieson
oncommercial
commercial
banking
bankingrelationships
relationships
––
––

most
mostwholesale
wholesalebanks
banksalso
alsoengage
engageininretail
retailbanking
banking
BOA
BOAhas
hastrust
trustservices,
services,investment
investmentmanagement
managementand

andcredit
creditcards
cards
businesses
businessesas
aswell
welland
andisisthe
theleading
leadingsmall
smallbusiness
businesslender
lenderininthe
the
counry
counry

McGraw-Hill/Irwin

12-4

©2009 The McGraw-Hill Companies, All Rights Reserved


CAMELS Ratings
•• Regulators
Regulatorsuse
useCAMELS
CAMELSratings
ratingsto

toevaluate
evaluatethe
thesafety
safety
and
andsoundness
soundnessof
ofbanks
banks
•• CAMELS
CAMELSratings
ratingsrely
relyheavily
heavilyon
onfinancial
financialstatement
statementdata
data
•• Components
Components
––
––
––
––
––
––

Capital
Capitaladequacy
adequacy

Asset
Assetquality
quality
Management
Managementquality
quality
Earnings
Earningsquality
quality
Liquidity
Liquidity
Sensitivity
Sensitivitytotomarket
marketrisk
risk

McGraw-Hill/Irwin

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CAMELS Ratings
•• CAMELS
CAMELSratings
ratingsrange
rangefrom
from11to
to55

––
––
––
––
––

Composite
Composite“1”—banks
“1”—banksare
arebasically
basicallysound
soundininevery
everyrespect
respect
Composite
Composite“2”—banks
“2”—banksare
arefundamentally
fundamentallysound,
sound,but
butmay
mayhave
have
modest
modestweaknesses
weaknessescorrectable
correctableininthe
thenormal
normalcourse
courseof

ofbusiness
business
Composite
Composite“3”—banks
“3”—banksexhibit
exhibitfinancial,
financial,operational,
operational,or
or
compliance
complianceweaknesses
weaknessesranging
rangingfrom
frommoderately
moderatelysevere
severetoto
unsatisfactory
unsatisfactory
Composite
Composite“4”—banks
“4”—bankshave
havean
animmoderate
immoderatevolume
volumeof
ofserious
serious
financial
financialweaknesses
weaknessesor

oraacombination
combinationof
ofother
otherconditions
conditionsthat
thatare
are
unsatisfactory
unsatisfactory
Composite
Composite“5”—banks
“5”—bankshave
havean
anextremely
extremelyhigh
highimmediate
immediateor
ornear
near
term
termprobability
probabilityof
offailure
failure

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Commercial Bank Assets
•• Cash
Cashand
andbalances
balancesdue
duefrom
fromother
otherdepository
depositoryinstitutions
institutions

–– Consist
Consistofofvault
vaultcash,
cash,currency
currencyininthe
theprocess
processofofcollection
collection(CIPC),
(CIPC),correspondent
correspondent
balances
and
reserves
at
the
Fed.
Also

called
primary
reserves.
balances and reserves at the Fed. Also called primary reserves.

•• Investment
Investmentsecurities
securities

–– short-term
short-termsecurities
securities(e.g,
(e.g,Treasury
Treasurybills
billsand
andfed
fedfunds
fundssold,
sold,Interest
Interestbearing
bearingdeposits
depositsatat
other
otherFIs,
FIs,Fed
Fedfunds
fundssold,
sold,Reverse
ReverseRepos,
Repos,U.S.

U.S.Treasury
Treasuryand
andagency
agencysecurities
securities
–– long-term
securities
(e.g.,
Treasury
bonds,
munis,
MBSs)
long-term securities (e.g., Treasury bonds, munis, MBSs)

•• Loans
Loans
––
––
––
––

commercial
commercialand
andindustrial
industrial
real
estate
real estate
consumer
consumer

other
otherloans
loans

•• Unearned
Unearnedincome
incomeand
andallowance
allowancefor
forloan
loanand
andlease
leaselosses
losses
•• Other
Otherassets
assets(e.g.,
(e.g.,fixed
fixedassets,
assets,goodwill,
goodwill,etc.)
etc.)

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Commercial Bank Liabilities
•• Core
Coredeposits
deposits
–– demand
demanddeposits
deposits
–– negotiable
negotiableorder
orderof
ofwithdrawal
withdrawal(NOW)
(NOW)accounts
accounts
–– money
moneymarket
marketdeposit
depositaccounts
accounts(MMDAs)
(MMDAs)
–– other
othersavings
savingsdeposits
deposits
–– retail
retailcertificates
certificatesof
ofdeposits
deposits

•• Other
Otherdeposits
deposits
–– wholesale
wholesalecertificates
certificatesof
ofdeposits
deposits(>
(>$100,000)
$100,000)

•• negotiable
negotiableinstruments
instrumentstraded
tradedininsecondary
secondarymarkets
markets
•• brokered
brokereddeposits
deposits

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12-8

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Commercial Bank
Liabilities and Equity

•• Non-deposit
Non-depositliabilities
liabilities

–– borrowed
borrowed(purchased)
(purchased)funds
funds

•• fed
fedfunds
fundspurchased
purchasedand
andrepos
repos
•• other
otherborrowed
borrowedfunds
funds(e.g.,
(e.g.,banker’s
banker’sacceptances,
acceptances,commercial
commercial
paper,
paper,discount
discountwindow
windowloans)
loans)

–– subordinated

subordinatednotes
notesand
anddebentures
debentures
–– other
otherliabilities
liabilities--non-interest
non-interestbearing
bearing

•• accrued
accruedinterest,
interest,deferred
deferredtaxes,
taxes,dividends
dividendspayable,
payable,etc.
etc.

•• Equity
Equity

–– preferred
preferredand
andcommon
commonstock
stock
–– surplus
surplusor
oradditional

additionalpaid
paidin
incapital
capital
–– retained
retainedearnings
earnings

McGraw-Hill/Irwin

12-9

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Off-Balance-Sheet Items
•• Off-balance-sheet
Off-balance-sheetitems
itemsare
arecontingent
contingentassets
assetsand
andliabilities
liabilitiesthat
that
may
mayaffect
affectaacommercial
commercialbank’s
bank’sbalance

balancesheet
sheetand/or
and/orincome
income
statement
statement
•• Loan
Loancommitments
commitments
––
––

up-front
up-frontfees
feesare
arecharged
chargedfor
formaking
makingfunds
fundsavailable
available
commitments
commitmentsfees
feesare
arecharged
chargedon
onunused
unusedportion
portionof
ofcommitments

commitments

––
––

commercial
commercialletters
lettersof
ofcredit
credit
standby
standbyletters
lettersof
ofcredit
credit

•• Letters
Lettersof
ofcredit
credit
•• Loans
Loanssold
sold

–– loans
loanscan
canbe
besold
soldwith
withor

orwithout
withoutrecourse
recourse

•• Derivative
Derivativecontracts
contracts

–– futures,
futures,forwards,
forwards,swaps,
swaps,and
andoptions
options

McGraw-Hill/Irwin

12-10

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Other Fee Generating Activities
• Correspondent banking and trust services
• Processing Services
•

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Income Statement
•• Interest
Interestincome
income––interest
interestexpense
expense==net
netinterest
interest
income
income
•• Noninterest
Noninterestincome
income––noninterest
noninterestexpense
expense==net
net
noninterest
noninterestincome
income
•• Net
Netinterest
interestincome
income––provision
provisionfor
forloan
loanlosses

losses++net
net
noninterest
noninterestincome
income==income
incomebefore
beforetaxes
taxesand
and
extraordinary
extraordinaryitems
items(EBTEI)
(EBTEI)
•• EBTEI
EBTEI––income
incometaxes
taxes––extraordinary
extraordinaryitems
items==net
net
income
income
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12-12

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Income Statement

•• There
Thereisisaadirect
directrelationship
relationshipbetween
betweenthe
theincome
income
statement
statementand
andthe
thebalance
balancesheet
sheetof
ofcommercial
commercialbanks
banks
N

M

n =1

m

NI = ∑ rn An −∑ rm Lm − P + NII − NIE − T
NI
NI==net
netincome
income
AAn ==dollar

dollarvalue
valueofofthe
thebank’s
bank’snth
nthasset
asset
n
LLm ==dollar
value
of
the
bank’s
mth
liability
dollar value of the bank’s mth liability
rrn =m=rate
rateearned
earnedon
onthe
thebank’s
bank’snth
nthasset
asset
n
rrm ==rate
paid
on
the
bank’s
mth

liability
rate paid on the bank’s mth liability
m
PP==provision
provisionfor
forloan
loanlosses
losses
NII
=
non-interest
income
NII = non-interest incomeearned,
earned,including
includingincome
incomefrom
fromOBS
OBSactivities
activities
NIE
=
non-interest
expenses
NIE = non-interest expenses
TT ==taxes
taxesand
andextraordinary
extraordinaryitems
items
NN==number

of
assets
the
bank
number of assets the bankholds
holds
M
=
number
of
liabilities
the
bank
M = number of liabilities the bankholds
holds
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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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©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?
• $170.45 = ($500 x 0.05) + ($1500 x Avg. Loan
Rate)
• Avg. Loan Rate required = 9.7%

McGraw-Hill/Irwin

9-15

©2009 The McGraw-Hill Companies, All Rights Reserved


Financial Statement Analysis
•• Financial
Financialstatement

statementanalysis
analysisisisbased
basedon
onaccounting
accounting
ratios
ratios
•• Time
Timeseries
seriesanalysis
analysisisisthe
theanalysis
analysisof
offinancial
financial
statements
statementsover
overaaperiod
periodof
oftime
time
•• Cross-sectional
Cross-sectionalanalysis
analysisisisthe
theanalysis
analysisof
offinancial
financial
statements
statementscomparing

comparingone
onefirm
firmwith
withothers
others

–– the
theUniform
UniformBank
BankPerformance
PerformanceReport
Report(UBPR)
(UBPR)maintained
maintainedby
by
the
theFFIEC
FFIECallows
allowsbanks
bankstotoobserve
observecompetitor
competitorfinancial
financial
statements
statements

•• Most
Mostfinancial
financialstatement
statementanalyses

analysesisisaacombination
combinationof
oftime
time
series
seriesanalysis
analysisand
andcross-sectional
cross-sectionalanalysis
analysis
McGraw-Hill/Irwin

12-16

©2009 The McGraw-Hill Companies, All Rights Reserved


RETURN ON EQUITY AND ITS COMPONENTS
2007 Full Year
Data

Interest Expense
Operating Income
Profit Margin
Net Income
Operating
Income
11.89%
ROA
Net Income

Total Assets
0.93%

ROE
Net Income
Total Equity
Capital
9.13%

Equity Multiplier

McGraw-Hill/Irwin

Total Assets
Total Equity
Capital
9.65x

Asset Utilization
Operating
Income
Total Assets
7.15%

9-17

37.46%

PLL
6.95%

Operating Income
Noninterest
expense
Operating Income

38.20%

Income Taxes
Operating Income

5.21%

Interest Income
Total Assets
Noninterest
income
Total Assets

5.47%

1.89%

©2009 The McGraw-Hill Companies, All Rights Reserved


Return on Equity (ROE) Framework
•• Return
Returnon
onEquity
Equity(ROE)

(ROE)analysis
analysisbegins
beginswith
withROE
ROEand
and
then
thenbreaks
breaksititdown
downinto
intoits
itscomponents
components
•• ROE
ROEmeasures
measuresthe
theoverall
overallprofitability
profitabilityof
ofthe
thebank
bankper
per
dollar
dollarof
ofequity
equity
net income
ROE =
total equity capital

•• ROE
ROEcan
canbe
bebroken
brokendown
downinto
intoits
itscomponents
components
ROE =

McGraw-Hill/Irwin

net income
total assets
×
= ROA × EM
total assets total equity capital

12-18

©2009 The McGraw-Hill Companies, All Rights Reserved


Return on Equity (ROE) Framework
•• Return
Returnon
onAssets
Assets(ROA)

(ROA)measures
measuresprofit
profitgenerated
generated
relative
relativethe
thebanks
banksassets
assets
•• Equity
EquityMultiplier
Multiplier(EM)
(EM)measures
measuresthe
theextent
extentto
towhich
which
assets
assetsare
arefunded
fundedwith
withequity
equityrelative
relativeto
todebt
debt(i.e.,
(i.e.,ititisisaa
measure
measureof

ofleverage)
leverage)
•• ROA
ROAcan
canalso
alsobe
bebroken
brokendown
downinto
intoits
itscomponents
components
net income
total operating income
×
total operating income
total assets
= PM × AU

ROA =

McGraw-Hill/Irwin

12-19

©2009 The McGraw-Hill Companies, All Rights Reserved


Return on Equity (ROE) Framework
•• Profit

ProfitMargin
Margin(PM)
(PM)measures
measuresthe
theability
abilityto
topay
payexpenses
expensesand
and
generate
generatenet
netincome
incomefrom
frominterest
interestand
andnoninterest
noninterestincome
incomeand
andisis
composed
composedof
of
––
––
––
––

interest
interestexpense

expenseratio
ratio
provision
provisionfor
forloan
loanloss
lossratio
ratio
noninterest
noninterestexpense
expenseratio
ratio
tax
taxratio
ratio

––
––

interest
interestincome
incomeratio
ratio
noninterest
noninterestincome
incomeratio
ratio

•• Asset
AssetUtilization

Utilization(AU)
(AU)measures
measuresthe
theamount
amountof
ofinterest
interestand
and
noninterest
noninterestincome
incomegenerated
generatedper
perdollar
dollarof
oftotal
totalassets
assetsand
andisis
composed
composedof
of

McGraw-Hill/Irwin

12-20

©2009 The McGraw-Hill Companies, All Rights Reserved


Other Ratios

•• The
Thenet
netinterest
interestmargin
margin(NIM)
(NIM)measures
measuresthe
thenet
netreturn
return
on
onaabank’s
bank’searning
earningassets
assets
NIM =

net interest income
interest income − interest expense
=
earning assets
investment securities + net loans and leases

•• The
Thespread
spreadmeasures
measuresthe
thedifference
differencebetween
betweenthe

the
average
averageyield
yieldon
onearning
earningassets
assetsand
andaverage
averagecost
coston
on
interest-bearing
interest-bearingliabilities
liabilities
Spread =

McGraw-Hill/Irwin

interest income
interest expense
−
earning assets interest - bearing liabilities

12-21

©2009 The McGraw-Hill Companies, All Rights Reserved


Other Ratios
•• Overhead

Overheadefficiency
efficiencymeasures
measuresaabank’s
bank’sability
abilityto
to
generate
generatenoninterest
noninterestincome
incometo
tocover
covernoninterest
noninterestexpenses
expenses
Overhead efficiency =

noninterest income
noninterest expense

•• Many
Manyadditional
additionalratios
ratiosare
arecommonly
commonlyused
usedto
toanalyze
analyze
commercial
commercialbanks

banksby
bybreaking
breakingdown
downthe
thecomponents
components
of
ofROE
ROEeven
evenfurther
further(see
(seeTables
Tables12-6
12-6and
and12-7)
12-7)

McGraw-Hill/Irwin

12-22

©2009 The McGraw-Hill Companies, All Rights Reserved


Comparison of WFS and BOA

ROA
Net Income

ROE

Net Income
Total Equity Capital

Equity Multiplier
Total Assets
Total Equity Capital
WFS = 8.51
BOA = 9.33

WFS = 38.40%
BOA = 37.16%

PLL
Operating Income

WFS = 1.14%
BOA = 5.33%

Noninterest expense WFS = 38.50%

Total Assets
WFS = 0.99%
BOA = 1.43%

WFS = 8.45%
BOA = 13.36%

McGraw-Hill/Irwin

Profit Margin

Net Income
Operating Income
WFS = 14.02%
BOA = 18.18%

Interest Expense
Operating Income

Asset Utilization
Operating Income
Total Assets
WFS = 7.08%
BOA = 7.91%

9-23

Operating Income

BOA = 30.25%

Income Taxes
Operating Income

WFS = 6.94%
BOA = 9.15%

Interest Income
Total Assets

WFS = 5.95%

BOA = 5.57%

Noninterest income
Total Assets

WFS = 1.13%
BOA = 2.34%

©2009 The McGraw-Hill Companies, All Rights Reserved


The Impact of Market Niche and Size
•• Retail
Retail and
and wholesale
wholesale commercial
commercial banks
banksoperate
operate in
in
different
different market
market niches
niches that
that should
should be
be noted
noted when
when
performing

performing financial
financial statement
statement analysis
analysis
•• Webster
Webster Financial
Financial Bancorp
Bancorp (WBS)
(WBS)
–– WBS
WBSisisaaprofitable
profitableand
andefficient
efficientretail
retailbank
bank
–– invests
investsmainly
mainlyin
inreal
realestate
estateloans
loans
–– uses
useslow
lowcost
costretail
retaildeposits
depositsto
tofund

fundits
itsassets
assets
–– holds
holdsrelatively
relativelymore
moreequity
equitycapital
capitalthan
thanBank
Bankof
of
America
America
McGraw-Hill/Irwin

12-24

©2009 The McGraw-Hill Companies, All Rights Reserved


The Impact of Market Niche and Size
•• Bank
Bank of
of America
America (BOA)
(BOA)
–– BOA
BOAisisboth
bothaaretail

retailand
andaawholesale
wholesalebank
bank
–– has
hasaarelatively
relativelymore
morediversified
diversifiedportfolio
portfoliothan
thanWBS
WBS
–– uses
usesaabroader
broaderarray
arrayof
ofdeposits
depositsand
andmore
morepurchased
purchased
funds
funds(i.e.,
(i.e.,fewer
fewercore
coredeposits)
deposits)than
thanWBS
WBS
–– offers

offersaabroad
broadspectrum
spectrumof
offinancial
financialservices
services

•• BOA
BOA isisthe
the more
more profitable
profitable bank
bank
–– uses
usesless
lessequity,
equity,which
whichcontributes
contributesto
toaahigher
higherROE
ROE
–– generates
generatesmuch
muchmore
morenoninterest
noninterestincome
income
McGraw-Hill/Irwin

12-25

©2009 The McGraw-Hill Companies, All Rights Reserved