FMI Spring 2021 Lecture 5 Handout

Overview Commercial Bank Industry CB Balance Sheets
Financial Markets and Institutions: Lecture 5
Anurag Singh
Instituto Tecnológico Autónomo de México (ITAM)
Spring 2021
Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 0 / 25

The Course Outline
Introduction and Motivation
Types of Financial Institutions
Risk: Types of Risk and Measuring the Risk
Managing Risk

The Course Outline
Introduction and Motivation
Types of Financial Institutions
Depository Institutions
Finance Companies
Securities Firms and Investment Banks
Mutual Funds and Hedge Fund Companies
Insurance Companies
Risk: Types of Risk and Measuring the Risk
Managing Risk

Topic to be Covered Today

Financial Intermediation & Financial Institutions: An Overview
Commercial Banks (CB)
Size, Structure and Composition of Commercial Banking Industry

Financial Statement Analysis of Commercial Banks
Balance Sheet
Off-Balance-Sheet (OBS) Assets and Liabilities
Income Statements
Financial Statement Analysis Using A Return on Equity Framework
Regulation
Industry Performance

Depository Institutions: An Overview
In 1999, the U.S. Congress passed the Financial Services

Modernization Act (FSMA)
Repealed regulations that set barriers between commercial banking,
insurance, and investment banking
Led to the creation of financial services holding companies allowing
them to engage in banking activities, insurance activities, and securities
activities
During the financial crisis, several non-depository financial institutions

(Goldman Sachs, Morgan Stanley) became bank holding companies
Their models of finance and investing were risky and they needed the
cushion of bank deposits (faced significantly tighter regulations and
much closer supervision by bank examiners at the same time)


More from the article:

Examining the banks that failed during the crisis strongly suggests that
firewalling commercial from investment banking would have done little
to stop the downfall.
As Peter Wallison of the American Enterprise Institute notes: “None of
the investment banks that have gotten into trouble—Bear, Lehman,
Merrill, Goldman or Morgan Stanley—were affiliated with commercial
banks. . . the banks that have succumbed to financial
problems—Wachovia, Washington Mutual and IndyMac, among
others—got into trouble by investing in bad mortgages or
mortgage-backed securities, not because of the securities activities of
an affiliated securities firm.”
As our own John Berlau notes, “In reality, it was poorly written
mortgage loans, spurred on by the government-sponsored enterprises
Fannie Mae and Freddie Mac, and low-income housing lending quotas
imposed by the Community Reinvestment Act that were at the heart of
the mortgage crisis.”

Depository Institutions: Then and Now

Depository Institutions
Three main depository institutions:

Commercial banks: Have large concentration of residential mortgage
assets but hold commercial loans and consumer loans as well
Savings institutions: Have concentrated primarily on residential
mortgages
Credit unions: Have historically focused on consumer loans funded
with member deposits
Major characteristics we focus on:
Size, structure, and composition of the industry group
Balance sheets and recent trends
Regulation
Industry performance

Commercial Bank Industry: Size, structure, & composition
Number of banks: Went down from 14,483 in 1984 to 5,472 in 2015

Asset concentration: Reduced asset share of smallest banks—36.6% in
1984 to 7.5% in 2015


Decrease in Number of Banks
Change in the size, structure, and composition of this industry is the result
of mergers and acquisitions - Regulation required?
Only after 1980s and 1990s, bank mergers with other banks across state
lines (interstate mergers) were allowed
The Riegle-Neal Act 1994 eased branching by banks across state lines
(number of branches increased from 43,293 in 1985 to 82,613 in 2015)

Change in Asset Concentration
Smaller or community banks tend to specialize in retail or consumer

banking, such as providing residential mortgages and consumer loans and
accessing the local deposit base
The majority of banks in the two largest size classes are often either regional
or superregional banks
Headquartered in larger regional cities and often have offices and
branches in locations throughout the United States
Engage in complete array of wholesale commercial banking activities,
encompassing consumer and residential lending as well as commercial
and industrial lending (C&I loans), both regionally and nationally
Lend to large corporate customers (many of the regional banks have
developed sophisticated electronic and branching services to consumer
and residential customers)
Utilize retail deposit bases for funding, but also access markets for
purchased funds—such as the interbank or federal funds market—to
finance their lending and investment activities

Small vs Large Banks: Competition
The bigger banks tend to fund themselves in national markets and lend to
larger corporations
Their spreads (i.e., the difference between lending and deposit rates) in the
past (the 1990s and early 2000s) often were narrower than those of smaller
regional banks
She smaller banks were more sheltered from competition in highly localized
markets
Small banks have been able to control credit risk more efficiently
As the barriers to interstate competition and expansion in banking fell in the

1990s and as large banks focused more on off-balance-sheet activities to
generate income, things changed

Commercial Banks: Balance Sheets

Like any for-profit corporation, the ultimate measure of a CB’s performance
is the value of its common equity to its shareholders1
Managers, stockholders, depositors, regulators, and other parties use

measures obtained from financial statements to evaluate commercial banks
Financial information on commercial banks is reported in two basic

documents
Report of condition (or balance sheet) presents financial information
on a bank’s assets, liabilities, & equity at a single point in time
Report of income (or the income statement) presents the major
categories of revenues and expenses (or costs) and the net profit or loss
for a bank over a period of time2
1
Shareholder equity (SE) is a corporation’s owners’ residual claim after debts have been paid. Equity is equal to a firm’s
total assets minus its total liabilities. Shareholder equity represents the amount of money that would be returned to shareholders
if all of the assets were liquidated and all of the company’s debt was paid off. Retained earnings is part of shareholder equity and
is the percentage of net earnings that were not paid to shareholders as dividends.
2
Commercial banks engage in off-balance-sheet (OBS) activities that produce income (and sometimes losses) for the FI
which are reported on the income statement
Balance Sheets
How to access them?
Go to Yahoo Finance: https://finance.yahoo.com
Search for any company, Bank of America for example3
Go to the “Financials” tab4
Find Income Statement, Balance Sheet, and Cash Flow5
Call Reports: Most detailed6
3
https://finance.yahoo.com/quote/BAC/
4
https://finance.yahoo.com/quote/BAC/financials?p=BAC
5
https://finance.yahoo.com/quote/BAC/balance-sheet?p=BAC
6
Download call reports of citibank from 2007Q1 to 2008Q1 https://cdr.ffiec.gov/public/ManageFacsimiles.aspx
Balance Sheets: A look at the Balance Sheets

Balance Sheets
Balance Sheet Structure
Assets
Cash and Due from Depository Institutions
Investment Securities
Loans and Leases
Other Assets
Liabilities and Equity Capital

Deposits
Borrowed Funds
Other Liabilities
Equity Capital

Balance Sheets: Assets


Vault cash: currency and coin needed to meet customer withdrawals
Deposits at the Federal Reserve: to meet legal reserve requirements,
to assist in check clearing, wire transfers, and the purchase or sale of
Treasury securities
Deposits at other financial institutions: to purchase services (check
collection, check processing, fed funds trading, and investment advice
from correspondent banks) from those institutions
Cash items in the process of collection: checks written against
accounts at other institutions that have been deposited at the bank


Generate some income, also used for liquidity risk management
purposes
Highly liquid, have low default risk, and can usually be traded in
secondary markets
Banks generally maintain significant amounts of these securities to
ensure that they can easily meet liquidity needs that arise unexpectedly
Since the revenue generated from investment securities is low compared
to that from loans and leases, many (particularly larger) banks attempt
to minimize the amount of investment securities they hold

Federal funds sold and RPs: Short maturity (generally 1 day)
Lend for short intervals to other banks seeking short-term funding
(interbank market for excess reserves is called the federal funds market
and the interest charged is the fed funds rate)
Repurchase agreements (RPs or repos) can be viewed as collateralized
federal funds transactions (due to credit risk exposure, sellers may seek
collateral backing for the one-day fed funds loan and the interest
charged is the RP rate)7
7
Collateral remains on the balance sheet of the seller (even though he has sold legal title to the collateral to the buyer).
Cash received is added as an asset while it is balanced on the liability side by the repayment due to the buyer at maturity. The
idea is to show that leverage has gone up and the balance sheet is expanded.

U.S. Treasury and agency securities: Longer maturity, higher
returns. Fully backed by the U.S. government, carry no default risk.8
Securities issued by states and political subdivisions: Longer
maturity, higher returns. Carry some default risk.9
8
agency securities can be backed by Government National Mortgage Association carry no default risk
9
backed by Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation, and not directly by
the full faith and credit of the U.S. government

Mortgage-backed securities: Collateralized mortgage obligations and
mortgage-backed bonds
Other debt and equity securities: Investment-grade corporate bonds,
foreign debt securities, and securities such as U.S. Treasury securities
and municipals held for short-term trading purposes


Loans and Leases
Loans and Leases

Major asset items on balance sheet
Generate the largest flow of revenue income
Least liquid asset items
Major sources of credit and liquidity risk
Leases are used as alternatives to loans when the bank, as owner of a
physical asset, allows a customer to use an asset in return for periodic
lease payments

Loans and Leases
Loans and Leases

Commercial and Industrial Loans: finance a firm’s capital needs,
equipment purchases, and plant expansion
Can be made at fixed rates or floating rates of interest (longer-term
loans are more likely to be made under floating-rate)
Can be short-term commercial loans (< 1 year maturity) or long-term
commercial loans
Can be secured or unsecured

Loans and Leases
Loans and Leases

Real Estate Loans: mortgage loans and some revolving home equity
loans. Very long term ( 20 years)
Consumer Loans: personal and auto loans
Other Loans: loans to nonbank financial institutions, state and local
governments, foreign banks, and sovereign governments


Loans and Leases
Loans and Leases

Unearned Income: the amount of income that the bank has received
on a loan (e.g. interest income) from a customer but has not yet
recorded as income on the income statement
Reserve for Loan and Lease Losses: allowance for loan losses that is
adjusted each period as management recognizes the possibility of bad
loans (might be different than actual losses)


Other Assets
Other Assets
Physical assets and real estate
Intangible assets can be goodwill and mortgage servicing rights10
Deferred taxes, prepaid expenses, and mortgage servicing fees
receivable
10
MSRs have ongoing administrative duties that are regularly processed for the entire length of a mortgage. Common rights
included are the right to collect mortgage payments monthly, to set aside taxes and insurance premiums in escrow, and to
forward the interest and principal portions to the mortgage lender.

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Overview Commercial Bank Industry CB Balance Sheets

Financial Markets and Institutions: Lecture 5

Instituto Tecnológico Autónomo de México (ITAM)

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 0 / 25

The Course Outline

Introduction and Motivation

Types of Financial Institutions

Risk: Types of Risk and Measuring the Risk

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 1 / 25

The Course Outline

Introduction and Motivation

Types of Financial Institutions

Securities Firms and Investment Banks

Mutual Funds and Hedge Fund Companies

Risk: Types of Risk and Measuring the Risk

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 1 / 25

Topic to be Covered Today

Commercial Banks (CB)

Size, Structure and Composition of Commercial Banking Industry

Off-Balance-Sheet (OBS) Assets and Liabilities

Financial Statement Analysis Using A Return on Equity Framework

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 2 / 25

Depository Institutions: An Overview

In 1999, the U.S. Congress passed the Financial Services

During the financial crisis, several non-depository financial institutions

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 3 / 25

Depository Institutions: An Overview

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 4 / 25

Depository Institutions: An Overview

More from the article:

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 5 / 25

Depository Institutions: Then and Now

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 6 / 25

Three main depository institutions:

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 7 / 25

Commercial Bank Industry: Size, structure, & composition

Number of banks: Went down from 14,483 in 1984 to 5,472 in 2015

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 8 / 25

Commercial Bank Industry: Size, structure, & composition

Commercial Bank Industry: Size, structure, & composition

Smaller or community banks tend to specialize in retail or consumer

Commercial Bank Industry: Size, structure, & composition

As the barriers to interstate competition and expansion in banking fell in the

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 11 / 25

Commercial Banks: Balance Sheets

Managers, stockholders, depositors, regulators, and other parties use

Financial information on commercial banks is reported in two basic

Go to Yahoo Finance: https://finance.yahoo.com

Search for any company, Bank of America for example3

Go to the “Financials” tab4

Find Income Statement, Balance Sheet, and Cash Flow5

Call Reports: Most detailed6

Balance Sheets: A look at the Balance Sheets

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 14 / 25

Liabilities and Equity Capital

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 15 / 25

Balance Sheets: Assets

Cash and Due from Depository Institutions

Anurag Singh (ITAM) Financial Markets and Institutions Spring 2021 16 / 25

Balance Sheets: Assets

Balance Sheets: Assets

Balance Sheets: Assets

Balance Sheets: Assets