Analyzing A Bank's Financial Statements

October 27 2012| Filed Under Balance Sheet, Banking Industry, Federal Reserve Board, Financial Statements, Fundamental Analysis, Income Statement, Office of Thrift Supervision Financial statements for banks present a different analytical problem than statements for manufacturing and service companies. As a result, analysis of a bank's financial statements requires a distinct approach that recognizes a bank's unique risks. Banks take deposits from savers and pay interest on some of these accounts. They pass these funds on to borrowers and receive interest on the loans. Their profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers. This ability to pool deposits from many sources that can be lent to many different borrowers creates the flow of funds inherent in the banking system. By managing this flow of funds, banks generate profits, acting as the intermediary of interest paid and interest received, and taking on the risks of offering credit. Leverage and Risk Banking is a highly leveraged business requiring regulators to dictate minimal capital levels to help ensure the solvency of each bank and the banking system. In the U.S., a bank's primary regulator could be the Federal Reserve Board, the Office of the Comptroller of the Currency, the Office of Thrift Supervision or any one of 50 state regulatory bodies, depending on the charter of the bank. Within the Federal Reserve Board, there are 12 districts with 12 different regulatory staffing groups. These regulators focus on compliance with certain requirements, restrictions and guidelines, aiming to uphold the soundness and integrity of the banking system. As one of the most highly regulated banking industries in the world, investors have some level of assurance in the soundness of the banking system. As a result, investors can focus most of their efforts on how a bank will perform in different economic environments. Below is a sample income statement and balance sheet for a large bank. The first thing to notice is that the line items in the statements are not the same as your typical manufacturing or service firm. Instead, there are entries that represent interest earned or expensed, as well as deposits and loans.

Figure 1: The Income Statement

Figure 2: The Balance Sheet

As financial intermediaries, banks assume two primary types of risk as they manage the flow of money through their business. Interest rate risk is the management of the spread between interest paid on deposits and received on loans over time. Credit risk is the likelihood that a borrower will default on a loan or lease, causing the bank to lose any potential interest earned as well as the principal that was loaned to the borrower. As investors, these are the primary elements that need to be understood when analyzing a bank's financial statement. Interest Rate Risk The primary business of a bank is managing the spread between deposits (liabilities, loans and assets). Basically, when the interest that a bank earns from loans is greater than the interest it must pay on deposits, it generates a positive interest spread or net interest

income. The size of this spread is a major determinant of the profit generated by a bank. This interest rate risk is primarilydetermined by the shape of the yield curve. As a result, net interest income will vary, due to differences in the timing of accrual changes and changing rate and yield curve relationships. Changes in the general level of market interest rates also may cause changes in the volume and mix of a bank's balance sheet products. For example, when economic activity continues to expand while interest rates are rising, commercial loan demand may increase while residential mortgage loan growth and prepayments slow. Banks, in the normal course of business, assume financial risk by making loans at interest rates that differ from rates paid on deposits. Deposits often have shorter maturities than loans and adjust to current market rates faster than loans. The result is a balance sheet mismatch between assets (loans) and liabilities (deposits). An upward sloping yield curve is favorable to a bank as the bulk of its deposits are short term and their loans are longer term. This mismatch of maturities generates the net interest revenue banks enjoy. When the yield curve flattens, this mismatch causes net interest revenue to diminish. A Banking Balance Sheet The table below ties together the bank's balance sheet with the income statement and displays the yield generated from earning assets and interest bearing deposits. Most banks provide this type of table in their annual reports. The following table represents the same bank as in the previous examples:

Figure 3: Average Balance and Interest Rates

First of all, the balance sheet is an average balance for the line item, rather than the balance at the end of the period. Average balances provide a better analytical framework to help understand the bank's financial performance. Notice that for each average balance item there is a corresponding interest-related income, or expense item, and the average yield for the time period. It also demonstrates the impact that a flattening yield curve can have on a bank's net interest income. The best place to start is with the net interest income line item. The bank experienced lower

net interest income even though it had grown average balances. To help understand how this occurred, look at the yield achieved on total earning assets. For the current period, it is actually higher than the prior period. Then examine the yield on the interest-bearing assets. It is substantially higher in the current period, causing higher interest-generating expenses. This discrepancy in the performance of the bank is due to the flattening of the yield curve. As the yield curve flattens, the interest rate that the bank pays on shorter-term deposits tends to increase faster than the rates it can earn from its loans. This causes the net interest income line to narrow, as shown above. One way banks try to overcome the impact of the flattening of the yield curve is to increase the fees they charge for services. As these fees become a larger portion of the bank's income, it becomes less dependent on net interest income to drive earnings. Changes in the general level of interest rates may affect the volume of certain types of banking activities that generate fee-related income. For example, the volume of residential mortgage loanoriginations typically declines as interest rates rise, resulting in lower originating fees. In contrast, mortgage-servicing pools often face slower prepayments when rates are rising, since borrowers are less likely to refinance. As a result, fee income and associated economic value arising from mortgage servicing-related businesses may increase or remain stable in periods of moderately rising interest rates. When analyzing a bank, you should also consider how interest rate risk might act jointly with other risks facing the bank. For example, in a rising rate environment, loan customers may not be able to meet interest payments because of the increase in the size of the payment or a reduction in earnings. The result will be a higher level of problem loans. An increase in interest rates exposes a bank with a significant concentration in adjustable rate loans to credit risk. For a bank that is predominately funded with short-term liabilities, a rise in rates may decrease net interest income at the same time that credit quality problems are on the rise. Credit Risk Credit risk is most simply defined as the potential of a bank borrower or counterparty to fail in meeting its obligations in accordance with agreed terms. When this happens, the bank will experience a loss of some or all of the credit it provided to its customer. To absorb these losses, banks maintain an allowance for loan and lease losses.

In essence, this allowance can be viewed as a pool of capital specifically set aside to absorb estimated loan losses. This allowance should be maintained at a level that is adequate to absorb the estimated amount of probable losses in the institution's loan portfolio. Actual losses are written off from the balance sheet account "allowance" for loan and lease losses. The allowance for loan and lease losses is replenished through the income statement line item "provision" for loan losses. Figure 4 shows how this calculation is performed for the bank being analyzed.

Figure 4: Loan Losses

Investors should consider a couple points from Figure 4. First, the actual write-offs were more than the amount management included in the provision for loan losses. While this in itself isn't necessarily a problem, it is suspect because the flattening of the yield curve has likely caused a slowdown in the economy and put pressure on marginal borrowers. Arriving at the provision for loan losses involves a high degree of judgment, representing management's best evaluation of the appropriate loss to reserve. Because it is a management judgment, the provision for loan losses can be used to manage a bank's earnings. Looking at the income statement for this bank shows that it had lower net income due primarily to the higher interest paid on interest-bearing liabilities. The increase in the provision for loan losses was 1.8%, while actual loan losses were significantly higher. Had the bank's management just matched its actual losses, it would have had a net income that was $983 less (or $1,772). An investor should be concerned that this bank is not reserving sufficient capital to cover its future loan and lease losses. It also seems that this bank is trying to manage its net income. Substantially higher loan and lease losses would decrease its loan and lease reserve account to the point where this bank would have to increase the future provision for loan losses on the income statement. This could cause the bank to report a loss in income. In addition, regulators could place the bank on a watch list and possibly require that it take

further corrective action, such as issuing additional capital. Neither of these situations benefits investors. The Bottom Line A careful review of a bank's financial statements can highlight the key factors that should be considered before making a trading or investing decision. Investors need to have a good understanding of the business cycle and the yield curve - both have a major impact on the economic performance of banks. Interest rate risk and credit risk are the primary factors to consider as a bank's financial performance follows the yield curve. When it flattens or becomes inverted, a bank's net interest revenue is put under greater pressure. When the yield curve returns to a more traditional shape, a bank's net interest revenue usually improves. Credit risk can be the largest contributor to the negative performance of a bank, even causing it to lose money. In addition, management of credit risk is a subjective process that can be manipulated in the short term. Investors in banks need to be aware of these factors before they commit their capital.

Banks are important to the efficient functioning of the financial system. Learn the basics of banks balance sheet and understand the meaning of items that are generally shown in the balance sheet of a commercial bank. Understand the basics of commercial banking from an accountants perspective. As we have discussed in the earlier article that commercial banking is a business and banks play a role by providing a service and they earn a profit by charging customers for that service. The key commercial banking activities are taking in deposits from savers and making loans to households and firms. We also discussed how bank makes profits by receiving funds from depositors and giving them on higher interest to the borrowers. In this article, we will look at the balance sheet items of commercial banks; will explain the items that come under banks sources of funds and the items where these funds may be applied. And finally how these items are summarized on its balance sheet.

The Bank Balance Sheet

A balance sheet is a statement that shows an individuals or a firms financial position on a particular day. Learn more about Balance Sheet under General Ledger Tutorials. Balance sheet sheets show monetary values for each entry expressed in terms of currency of the market in which bank is registered. The typical layout of a balance sheet has liabilities on one site and assets shown on the other side and is based on the following accounting equation:

Assets = Liabilities + Shareholders equity The accounting equation tells us that the left side of a firms balance sheet must always have the same value as the right side. We can think of a banks liabilities and its capital as the sources of its funds, and we can think of a banks assets as the uses of its funds.

The Banks Equity:

Shareholders equity is the difference between the value of a firms assets and the value of its liabilities. Bank capital, also called shareholders equity, or bank net worth, is the difference between the value of a banks assets and the value of its liabilities. Shareholders equity represents the dollar amount the owners of the firm would be left with if the firm were to be closed, its assets sold, and its liabilities paid off. For a public firm, the owners are the shareholders. Shareholders equity is also referred to as the firms net worth. In banking, shareholders equity is usually called bank capital. Bank capital is the funds contributed by the shareholders through their purchases of the banks stock plus the banks accumulated, retained profits.

The Banks Liabilities:

A liability is something that an individual or a firm owes, or, in other words, a claim on an individual or a firm. A liability, in financial terms, is a cash obligation. The most important bank liabilities are the funds a bank acquires from savers. Have you ever wondered if these deposit a form of bank income? Actually not, as the money received as deposits, does not really belong to the bank. For banks, deposits are liabilities. Depositors have the right to request their funds, and the bank must pay them. The bank is liable to pay this money back to the depositors on demand. The bank uses the funds to makes investments or loans to borrowers. Banks offer a variety of deposit accounts because savers have different needs. Money the bank borrowed is also a liability, a debt to be paid. Note: You may not like to think of your savings account as a problem for the bank, but it is one in theory. As explained below, all the deposits are payable on demand, means, depositors can ask for payback of their money at any time and if depositors simultaneously want all their money from all their accounts, banks would be in trouble. In such a case, the bank must either break its promise to depositors or pay until its reserves are gone. If the bank fails, unpaid depositors lose their money. The bank's liquidity depends on this principle and is based on the assumption that depositors will not demand their money quickly. A bank's liabilities exceed its reserves. The money is loaned out, and the reserves do not match the total of deposits (liabilities). However, the money is out working, financing businesses and expanding the economy.

The Bank Assets:

An asset is anything of value. An asset is something of value that an individual or a firm owns. In financial terms, that usually means money. A liquid asset is anything that can readily be exchanged, like cash. A bank's assets are its loans and investments, which may be less liquid by contract than deposits. Deposits may have to be returned any time, but assets can arrive in small amounts over a long period. Banks, like people and other corporations, make money on investments. They invest in stock markets and some types of securities and government bonds. While investing their money in instruments other than government bonds, they face the same risks as other investors. They hire professional investment staff to maximize their return on investments. Investments are assets for the banks. A bank's liabilities are more liquid than its assets. A bank must give depositors their money if they request it. The bank's assets, however, may be less liquid because they are tied up in longer-term loans or investments, so the bank cannot get them as quickly.

The balance sheet of a commercial bank is a statement of its assets and liabilities. Assets are what others owe the bank, and what the bank owes others constitutes its liabilities. The business of a bank is reflected in its balance sheet and hence its financial position as well. The balance sheet is issued usually at the end of every financial year of the bank. The balance sheet of the bank comprises of two sides; the assets side and the liabilities side. It is customary to record liabilities on the left side and assets on the right side. The following is the proforma of a balance sheet of the bank.

Balance Sheet of the Bank

Liabilities Assets

1. Capital

1. Cash

a. Authorised capital

a. Cash on hand

b. Issued capital

b. Cash with central bank and other banks

c. Subscribed capital

Liabilities

Assets

d. Paid-up-capital

2. Reserve fund

2. Money at call and short notice

3. Deposits

3. Bills discounted

4. Borrowings from other banks

4. Bills for collection

5. Bills payable

5. Investments

6. Acceptances and endorsements

6. Loans and advances

7. Contingent liabilities

7. Acceptances and endorsement

8. Profit and loss account

8. Fixed assets

9. Bills for collection

Liabilities
Liabilities are those items on account of which the bank is liable to pay others. They denote others claims on the bank. Now we have to analyse the various items on the liabilities side.

Capital
The bank has to raise capital before commencing its business. Authorised capital is the maximum capital upto which the bank is empowered to raise capital by the Memorandum of Association. Generally, the entire authorised capital is not raised from the public. That part of authorised capital which is issued in the form of shares for public subscription is called the issued capital. Subscribed capital represents that part of issued capital which is actually subscribed by the public. Finally, paid-up capital is that part of the subscribed capital which the subscribers are actually called upon to pay.

Reserve Fund
Reserve fund is the accumulated undistributed profits of the bank. The bank maintains reserve fund to tide over any crisis. But, it belongs to the shareholders and hence a liability on the bank. In India, the commercial bank is required by law to transfer 20 per cent of its annual profits to the Reserve fund.

Deposits
The deposits of the public like demand deposits, savings deposits and fixed deposits constitute an important item on the liabilities side of the balance sheet. The success of any banking business depends to a large extent upon the degree of confidence it can instill in the minds of the depositors. The bank can never afford to forget the claims of the depositors. Hence, the bank should always have enough cash to honour the obligations of the depositors.

Borrowings from Other Banks

Under this head, the bank shows those loans it has taken from other banks. The bank takes loans from other banks, especially the central bank, in certain extraordinary circumstances.

Bills Payable
These include the unpaid bank drafts and telegraphic transfers issued by the bank. These drafts and telegraphic transfers are paid to the holders thereof by the banks branches, agents and correspondents who are reimbursed by the bank.

Acceptances and Endorsements

This item appears as a contra item on both the sides of the balance sheet. It represents the liability of the bank in respect of bills accepted or endorsed on behalf of its customers and also letters of credit issued and guarantees given on their behalf. For rendering this service, a commission is charged and the customers to whom this service is extended are liable to the bank for full payment of the bills. Hence, this item is shown on both sides of the balance sheet.

Contingent Liabilities
Contingent liabilities comprise of those liabilities which are not known in advance and are unforeseeable. Every bank makes some provision for contingent liabilities.

Profit and Loss Account

The profit earned by the bank in the course of the year is shown under this head. Since the profit is payable to the shareholders it represents a liability on the bank.

Bills for Collection

This item also appears on both the sides of the balance sheet. It consists of drafts and hundies drawn by sellers of goods on their customers and are sent to the bank for collection, against delivery documents like railway receipt, bill of lading, etc., attached thereto. All such bills in hand at the date of the balance sheet are shown on both the sides of the balance sheet because they form an asset of the bank, since the bank will receive payment in due course, it is also a liability because the bank will have to account for them to its customers.

Assets
According to Crowther, the assets side of the balance sheet is more complicated and interesting. Assets are the claims of the bank on others. In the distribution of its assets, the bank is governed by certain well defined principles. These principles constitute the principles of the investment policy of the bank or the principles underlying the distribution of the assets of the bank. The most important guiding principles of the distribution of assets of the bank are liquidity, profitability and safety or security. In fact, the various items on the assets side are distributed according to the descending order of liquidity and the ascending order of profitability. Now, we have to analyse the various items on the assets side.

Cash
Here we can distinguish cash on hand from cash with central bank and other banks cash on hand refers to cash in the vaults of the bank. It constitutes the most liquid asset which can be immediately used to meet the obligations of the depositors. Cash on hand is called the first line of defence to the bank. In addition to cash on hand, the bank also keeps some money with the central bank or other commercial banks. This represents the second line of defence to the bank.

Money at Call and Short Notice

Money at call and short notice includes loans to the brokers in the stock market, dealers in the discount market and to other banks. These loans could be quickly converted into cash and without loss, as and when the bank requires. At the same time, this item yields income to the bank. The significance of money at call and short notice is that it is used by the banks to effect desirable adjustments in the balance sheet. This process is called Window Dressing. This item constitutes the third line of defence to the bank.

Bills Discounted
The commercial banks invest in short term bills consisting of bills of exchange and treasury bills which are self-liquidating in character. These short term bills are highly negotiable and they satisfy the twin objectives of liquidity and profitability. If a commercial bank requires additional funds, it can easily rediscount the bills in the bill market and it can also rediscount the bills with the central bank. Bills for Collection: As mentioned earlier, this item appears on both sides of the balance sheet.

Investments
This item includes the total amount of the profit yielding assets of the bank. The bank invests a part of its funds in government and non-government securities.

Loans and Advances

Loans and advances constitute the most profitable asset to the bank. The very survival of the bank depends upon the extent of income it can earn by advancing loans. But, this item is the least liquid asset as well. The bank earns quite a sizeable interest from the loans and advances it gives to the private individuals and commercial firms.

Acceptances and Endorsements

As discussed earlier, this item appears as a contra item on both sides of the balance sheet.

Fixed Assets
Fixed assets include building, furniture and other property owned by the bank. This item includes the total volume of the movable and immovable property of the bank.

Fixed assets are referred to as dead stocks. The bank generally undervalues this item deliberately in the balance sheet. The intention here is to build up secret reserves which can be used at times of crisis. Balance sheet of a bank acts as a mirror of its policies, operations and achievements. The liabilities indicate the sources of its funds; the assets are the various kinds of debts incurred by a bank to its customers. Thus, the balance sheet is a complete picture of the size and nature of operations of a bank.

Key financials and performance ratios for banks

Credit Risk provides extensive financial data including pre-calculated ratios on global banks and financial institutions from the last four years, enabling you to accurately assess new and existing counterparty risk. Financial data is derived directly from Annual Reports, however some ratio calculations may vary according to each bank or financial institution, country regulations or regional variations.

Total assets Total equity Pre-tax profits Post-tax profits Pre-tax profits / total assets (av) Pre-tax profits / total equity (av) Tier 1 capital ratio Total capital ratio Total equity / net loans Net loans / total deposits Loan loss reserves / gross loans (av) Loan loss reserves / net loans Loan loss reserves / net loans (av) Total deposits / net loans ratio