Financial Statements of

Commercial Banks – I
(Balance Sheet)
Dr. Shabir Hakim
Introduction
• Financial statements are literally a "road map" telling us where a
financial firm has been in the past, where it is now, and, perhaps,
where it is headed in the future.
• They are invaluable guideposts that can, if properly constructed and
interpreted, signal success or disaster.
• However, the faulty and misleading financial statements that placed
Enron and Lehman Brothers in the headlines not long ago have also
visited some financial-service providers, teaching us to be cautious in
reading and interpreting the financial statements financial-service
providers routinely publish.
FIN 342: Commercial Banking 2
Financial Statements
• The two main financial statements that managers,
customers (particularly large depositors not fully protected
by deposit insurance), and the regulatory authorities rely
upon are:
1. the balance sheet (Report of Condition), and
2. the income statement (Report of Income)

FIN 342: Commercial Banking 3

Financial Statements
• The Report of Condition shows the amount and
composition of funds sources (financial inputs) drawn upon
to finance lending and investing activities (financial
outputs)
– How much has been allocated to loans, securities, and other uses
at any given point in time.
• The Report of Income shows how much it has cost to
acquire funds and to generate revenues from the uses the
financial firm has made of those funds.
FIN 342: Commercial Banking 4
The Balance Sheet (Report of Condition)
• The Principal Types of Accounts
1. The assets on the balance sheet are of four major types:
a. Cash in the vault and deposits held at other depository institutions
b. Government and private interest-bearing securities purchased in the open market
c. Loans and lease financings made available to customers
d. Miscellaneous assets

2. The Liabilities fall into two principal categories:

a. Deposits made by and owed to various customers
b. Nondeposit borrowings of funds in the money and capital markets

3. The equity capital represents long-term funds the owners contribute

FIN 342: Commercial Banking 5

The Balance Sheet—Assets
• Cash and Due from Depository Institutions
• The first asset item normally listed on a banking firm's Report of Condition is cash and due
from depository institutions.
• This item includes cash held in the bank's vault, any deposits placed with other depository
institutions (usually called correspondent deposits), cash items in the process of collection
(mainly uncollected checks), and the banking firm's reserve account held with the Federal
Reserve bank in the region.
• The cash and due from depository institutions account is also referred to as primary reserves.
– These assets are the first line of defense against customer deposit withdrawals and the first source of
funds to look to when a customer comes in with a loan request.

• Normally, banks strive to keep the size of this account as low as possible, because cash
balances earn little or no interest income.

FIN 342: Commercial Banking 6

The Balance Sheet—Assets
• Investment Securities: The Liquid Portion
• A second line of defense to meet demands for cash is liquid security
holdings, often called secondary reserves or “the investment securities
available for sale."
– Short-term government securities and privately issued money market securities,
including interest-bearing time deposits held with other banking firms and
commercial paper.

• Secondary reserves occupy the middle ground between cash assets and loans
• They earn some income but are also held for the ease with which they can be
converted into cash on short notice.

FIN 342: Commercial Banking 7

The Balance Sheet—Assets
• Investment Securities: The Income-Generating Portion
• Bonds, notes, and other securities held primarily for their expected rate of return or
yield are known as the income-generating portion of investment securities.
– These are called held-to-maturity securities
• The investments are divided into:
• Taxable securities: U.S. government bonds and notes, and corporate bonds and notes
• Tax-exempt securities: State and local government (municipal) bonds.
– They are exempt from federal income taxes.
• Investment securities may be recorded on the books of a banking firm at their original
cost or at market value, whichever is lower.

FIN 342: Commercial Banking 8

The Balance Sheet—Assets
• Trading Account Assets
• Securities purchased to provide short-term profits from short-
term price movements are not included in "Securities" on the
Report of Condition.
• They are reported as trading account assets.
• If the banking firm serves as a securities dealer, securities
acquired for resale are included here.
• The amount recorded in the trading account is valued at market.
FIN 342: Commercial Banking 9
The Balance Sheet—Assets
• Federal Funds Sold and Reverse Repurchase Agreements
• Federal funds includes mainly temporary loans (usually extended overnight,
with the funds returned the next day) made to other depository institutions,
securities dealers, or even major industrial corporations.
– The funds for these temporary loans often come from the reserves a bank has on deposit
with the central bank.

• Reverse Repurchase Agreements are temporary credits extended in the form of

reverse repurchase (resale) agreements (RPs).
• The banking firm acquires temporary title to securities owned by the borrower
and holds those securities as collateral until the loan is paid off (normally after
only a few days).
FIN 342: Commercial Banking 10
The Balance Sheet—Assets
• Loans and Leases
• The largest asset item is loans and leases, which often
account for half to almost three-quarters of the total value
of all bank assets.
• A bank's loan account typically is broken down into
several groups of similar type loans.
• For example, one commonly used breakdown is by the
purpose for borrowing money.
FIN 342: Commercial Banking 11
The Balance Sheet—Assets
• Loans and Leases
• The following loan types may be listed on a banking firm's balance sheet :
1. Commercial and industrial (or business) loans.
2. Consumer or household loans (Loans to Individuals
3. Real estate (or property-based) loans
4. Financial institutions loans (loans made to other depository institutions as well as to nonbank
financial institutions).
5. Foreign (or international) loans (extended to foreign governments and institutions).
6. Agricultural production loans
7. Security loans (to aid investors and dealers in their security trading activities).
8. Leases (buying equipment for its business customers and making that equipment available for the
customer's use for a stipulated period of time in return for a series of rental payments).

FIN 342: Commercial Banking 12

The Balance Sheet—Assets
• Bank Premises and Fixed Assets
• Bank assets also include the net value of buildings and equipment.
• A banking firm usually devotes only a small percentage (less than 2 percent)
of its assets to the institution's physical plant.
• The fixed assets typically generate fixed operating costs in the form of
depreciation expenses, property taxes, and so on
• The fixed assets provide operating leverage, which banks cane use to boost its
operating earnings.
– But with so few fixed assets relative to other assets, banks cannot rely heavily on
operating leverage.

FIN 342: Commercial Banking 13

The Balance Sheet—Assets
• Intangible and Miscellaneous ("Other") Assets
• Most banking firms have some purchased assets lacking physical
substance but still generating income for the banks holding them.
– The intangibles include goodwill, mortgage loan servicing rights, and purchased
credit card relationships.

• Near the bottom of the balance sheet on the asset side are other or
miscellaneous assets.
– This account typically includes investments in subsidiary firms, customers' liability
on acceptances outstanding, income earned but not collected on loans, net deferred
tax assets, excess residential mortgage servicing fees, and any remaining assets.

FIN 342: Commercial Banking 14

The Balance Sheet—Liabilities
• Deposits
• The principal liability of any bank is its deposits, representing
financial claims held by businesses, households, and governments
against the banking firm.
• In the event a bank is liquidated, the proceeds from the sale of its
assets must first be used to pay off the claims of its depositors.
• Other creditors and the stockholders receive whatever funds
remain.

FIN 342: Commercial Banking 15

The Balance Sheet—Liabilities
• Deposits
• There are five major types of deposits:
1. Noninterest-bearing demand deposits, or regular checking accounts, generally permit
unlimited check writing.
– Banks cannot pay any explicit interest rate, but many offer "free" services that yield the demand-
deposit customer an implicit rate of return

2. Savings deposits generally bear the lowest rate of interest offered to depositors but may
be of any denomination and permit the customer to withdraw at will.
– Most depository institutions impose a minimum size requirement

3. NOW accounts, which can be held by individuals and nonprofit institutions, bear interest
and permit drafts (checks) to be written against each account to pay third parties.
– Dodd Frank Act of 2011 prohibits payment of interest on demand deposits

FIN 342: Commercial Banking 16

The Balance Sheet—Liabilities
• Deposits
4. Money market deposit accounts (MMDAs) can pay whatever interest rate the
offering institution feels is competitive and have limited check-writing privileges
attached.
– No minimum denomination or maturity is required by law, though depository
institutions must reserve the right to require seven days' notice before any
withdrawals are made.
5. Time deposits (mainly certificates of deposit, or CDs) usually carry a fixed
maturity (term) and a stipulated interest rate but may be of any denomination,
maturity, and yield agreed upon by the offering institution and its depositor.
– Included are large ($100,000-plus) negotiable CDs-interest-bearing deposits

FIN 342: Commercial Banking 17

The Balance Sheet—Liabilities
• Deposits
4. Money market deposit accounts (MMDAs) can pay whatever interest rate the
offering institution feels is competitive and have limited check-writing privileges
attached.
– No minimum denomination or maturity is required by law, though depository
institutions must reserve the right to require seven days' notice before any
withdrawals are made.
5. Time deposits (mainly certificates of deposit, or CDs) usually carry a fixed
maturity (term) and a stipulated interest rate but may be of any denomination,
maturity, and yield agreed upon by the offering institution and its depositor.
– Included are large ($100,000-plus) negotiable CDs-interest-bearing deposits

FIN 342: Commercial Banking 18

The Balance Sheet—Liabilities
• Deposits
• Many banking firms are heavily dependent upon their deposits, which often support
between 60 and 80 percent of their total assets.
• The financial claims of the public are often volatile and because they are so large
relative to the owners’ equity, the average depository institution has considerable
exposure to failure risk.
– It must continually stand ready (be liquid) to meet deposit withdrawals.
• These twin pressures of risk and liquidity force bankers to exercise caution in their
choices of loans and other assets.
– Failure to do so threatens the institution with collapse under the weight of
depositors' claims.

FIN 342: Commercial Banking 19

The Balance Sheet—Liabilities
• Borrowings from Nondeposit Sources
• Although deposits typically represent the largest portion of funds sources
for many banks, sizable amounts of funds also stem from miscellaneous
liability accounts.
• Ceteris paribus, the larger the depository institution, the greater use it
tends to make of nondeposit sources of funds.
• One reason nondeposit funds sources have grown rapidly in recent years is
that there are no reserve requirements or insurance fees on most of these
funds, which lowers the cost of nondeposit funding.
– However, the interest rates on nondeposit funds are highly volatile.

FIN 342: Commercial Banking 20

The Balance Sheet—Liabilities
• Borrowings from Nondeposit Sources
• The most important nondeposit funding source for most depository institutions are
federal funds purchased and repurchase agreements.
• Federal funds purchased account tracks temporary borrowings in the money
market, mainly from reserves loaned by other institutions
• Repurchase agreements are borrowed funds collateralized by some of its own
securities from another institution.
• Other borrowed funds that may be drawn upon include short-term borrowings such
as borrowing reserves from the discount windows of the Federal Reserve banks,
issuing commercial paper, or borrowing in the Eurocurrency market from
multinational banks.

FIN 342: Commercial Banking 21

The Balance Sheet—Liabilities
• Borrowings from Nondeposit Sources
• Many banks also issue long-term debt, which include:
– Real estate mortgages for the purpose of constructing new office
facilities or modernizing plant and equipment.
– Subordinated debt (notes and debentures)
– Limited-life preferred stock (that is, preferred stock that eventually
matures) and any noncollateralized borrowings.
– The other liabilities account serves as a catch-all of miscellaneous
amounts owed, such as a deferred tax liability and obligations to pay off
investors who hold bankers’ acceptances.
FIN 342: Commercial Banking 22
The Balance Sheet—Equity Capital
• Bank capital accounts typically include:
• Par (face) value of common stock outstanding
• Surplus, the excess market value of the stock flows into a account when the stock is
sold for more than its par value.
• Preferred stock, which guarantees its holders an annual dividend before common
stockholders receive any dividend payments.
• Retained earnings is the largest item in the capital account
• Contingency reserve held as protection against unforeseen losses
• Treasury stock that has been retired, and other (miscellaneous) equity capital
components.

FIN 342: Commercial Banking 23

The Balance Sheet—Off-Balance-Sheet
Items
• The balance sheet, although a good place to start, does not tell the whole story about a
financial firm.
• For more of the story, we must turn to “off-balance-sheet items”.
• Prominent examples of the off-balance-sheet items include:
1. Unused loan commitments, in which a lender receives a fee to lend up to a certain amount of
money over a defined period of time; however, these funds have not yet been transferred from
lender to borrower.
2. Standby credit agreements, in which a financial firm receives a fee to guarantee repayment of
a loan that a customer has received from another lender.
3. Derivative contracts include futures contracts, options, and swaps that can be used to hedge
credit risk, interest rate risk, foreign exchange (currency) risk, commodity risk, and risk
surrounding the ownership of equity securities.

FIN 342: Commercial Banking 24