THE FINANCIAL

STATEMENTS OF BANKS AND

THEIR PRINCIPAL
COMPETITORS
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INTRODUCTION
 Financial Statements
 Services offered
 Size

 Road Map
 Hasbeen in the past
 Where it is now
 Where it is headed in the future

 Faulty and misleading statements

 Enron

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AN OVERVIEW OF BALANCE SHEETS
AND INCOME STATEMENTS
 Report of condition
 Amount and composition of funds sources
 How much has been allocated to loans, securities, and other
funds uses at any given point in time
 Report of income
 Cost to acquire funds and to generate revenues from the uses
the financial firm has made of those funds
 Over a time period
 Net Earning
 Retained Earning
 Dividend

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THE BALANCE SHEET (REPORT OF
CONDITION)

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THE BALANCE SHEET (REPORT OF
CONDITION)
 For banks and other depository institutions the assets on
the balance sheet are of four major types:
 Cash in the vault and deposits held at other depository
institutions (C),
 Government and private interest-bearing securities purchased
in the open market ( S),
 Loans and lease financings made available to customers (L),
and
 Miscellaneous assets (MA).

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THE BALANCE SHEET (REPORT OF
CONDITION)
 Liabilities fall into two principal categories:
 Deposits made by and owed to various customers (D) and
 Non-deposit borrowings of funds in the money and capital
markets (NDB).

 Finally, equity capital represents long-term funds the

owners contribute (EC).

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 Cash assets ( C) are designed to meet the financial firm's need for liquidity
(i.e., immediately spendable cash) in order to meet deposit withdrawals,
customer demands for loans, and other unexpected or immediate cash
needs.
 Security holdings (S) are a backup source of liquidity and include
investments that provide a source of income.
 Loans (L) are made principally to supply income,

 while miscellaneous assets (MA) are usually dominated by fixed assets

(plant and equipment) and investments in subsidiaries (if any).
 Deposits (D) are typically the main source of funding for banks, and
comparable institutions with non-deposit borrowings (NDB) carried out
mainly to supplement deposits and provide the additional liquidity that cash
assets and securities cannot provide.
 Finally, equity capital (EC) supplies the long-term, relatively stable base of
financial support upon which the financial firm will rely to grow and to 9
cover any extraordinary losses it incurs.
THE BALANCE SHEET (REPORT OF
CONDITION)

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ASSETS OF THE BANKING FIRM
 Cash and Due from Depository Institutions
 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.
 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.
 Banks strive to keep the size of this account as low as
possible, because cash balances earn little or no interest 11
income
ASSETS OF THE BANKING FIRM
 Investment Securities: The Liquid Portion
 A second line of defense to meet demands for cash is liquid
security holdings, often called secondary reserves or
referenced on regulatory reports as "investment securities
available for sale."
 These typically include holdings of short-term government
securities and privately issued money market securities,
including interest-bearing time deposits held with other
banking firms and commercial paper.

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ASSETS OF THE BANKING FIRM
 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 often called held-to-maturity securities on
regulatory reports.
 Frequently investments are divided into taxable securities-for
example, U.S. government bonds and notes, securities issued
by various federal agencies (such as the Federal National
Mortgage Association, or Fannie Mae), and corporate bonds
and notes-and tax-exempt securities, which consist
principally of state and local government (municipal) bonds.
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ASSETS OF THE BANKING FIRM
 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.

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ASSETS OF THE BANKING FIRM
 Federal Funds Sold and Reverse Repurchase Agreements
 This item 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 Federal Reserve Bank in
its district-hence the name federal funds, or, more popularly, "fed
funds."
 Some of these temporary credits are extended in the form of
reverse repurchase (resale) agreements (RPs) in which 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). 15
ASSETS OF THE BANKING FIRM
 Loans and Leases
 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.

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LOANS AND LEASES
 Commercial and industrial (or business) loans.
 Consumer (or household) loans; on regulatory reports
these are referenced as Loans to Individuals.
 Real estate (or property-based) loans.

 Financial institutions loans (such as loans made to other

depository institutions as well as to nonbank financial
institutions).
 Foreign (or international) loans (extended to foreign
governments and institutions).

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LOANS AND LEASES
 Agricultural production loans (or farm loans, extended
primarily to farmers and ranchers to harvest crops and raise
livestock).
 Security loans (to aid investors and dealers in their security
trading activities).
 Leases (usually consisting of the bank 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-the functional equivalent of a
regular loan)
 short-term versus long-term

 secured versus unsecured

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 floating-rate versus fixed-rate loans
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ASSETS OF THE BANKING FIRM
 Loan Losses
 The gross loan figure encompassed net loans and leases plus loan loss
allowance.
 Loan losses, both current and projected, are deducted from the amount of
gross loans and leases.
 Under current U.S. tax law, depository institutions are allowed to build up a
reserve for future loan losses, called the allowance for loan losses (ALL),
from their flow of income based on their recent loan-loss experience.
 The ALL, which is a contra-asset (negative) account, represents an
accumulated reserve against which loans declared to be uncollectible can be
charged off.
 This means that bad loans normally do not affect current income. Rather,
when a loan is considered uncollectible, the accounting department will
write (charge) it off the books by reducing the ALL account by the amount
of the uncollectible loan while simultaneously decreasing the asset account 20
for gross loans.
LOAN LOSSES
 For example, suppose a bank granted a $10 million loan
to a property development company to build a shopping
center and the company subsequently went out of
business. If the bank could reasonably expect to collect
only $1 million of the original $10 million owed, the
unpaid $9 million would be subtracted from total (gross)
loans and from the ALL account.

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LOAN LOSSES
 The allowance for possible loan losses is built up gradually
over time by annual deductions from current income. These
deductions appear on the banking firm's income and
expense statement (or Report of Income) as a noncash
expense item called the provision for loan losses (PLL).
 For example, suppose a banking firm anticipated loan
losses this year of $1 million and held $100 million already
in its ALL account. It would take a noncash charge against
its current revenues, entering $1 million in the provision for
loan loss account (PLL) on its Report of Income.
 Now suppose the bank subsequently discovers that its truly
worthless loans, which must be written off, total only 22
$500,000.
LOAN LOSSES
 Now suppose the bank subsequently discovers that its
truly worthless loans, which must be written off, total
only $500,000.
 At about the same time suppose that management
discovers it has been able to recover some of the funds
(say $ 1.5 million) that it had previously charged off as
losses on earlier loans. Often this belated cash inflow
arises because the banking firm was able to take
possession of and then sell the collateral that a borrower
had pledged behind a defaulted loan. These so-called
recoveries, then, are added back to the allowance for
loan loss account (ALL) . 23
ASSETS OF THE BANKING FIRM
 Specific and General Reserves
 Many financial firms divide the ALL account into two parts:
specific reserves and general reserves.
 Specific reserves are set aside to cover a particular loan or
loans expected to be a problem or that represent above-
average risk.
 Management may simply designate a portion of the reserves
already in the ALL account as specific reserves or add more
reserves to cover specific loan problems.
 The remaining reserves in the loan loss account are called
general reserves.

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ASSETS OF THE BANKING FIRM
 International Loan Reserves
 The largest U.S. banks that make international loans to lesser-
developed countries are required to set aside allocated
transfer-risk reserves (A TRs).
 A TRs were created to help American banks deal with
possible losses on loans made to lesser-developed countries.
Like the ALL account, the ATR is deducted from gross loans
to help determine net loans.
 These international-related reserve requirements are
established by the inter-country Exposure Review Committee
(ICERC), which consists of representatives from the Federal
Deposit Insurance Corporation, the Federal Reserve System,
and the Comptroller of the Currency. 25
ASSETS OF THE BANKING FIRM
 Unearned Income
 This item consists of interest income on loans received
from customers, but not yet earned under the accrual
method of accounting banks use today.
 For example, if a customer receives a loan and pays all
or some portion of the interest up front, the banking firm
cannot record that interest payment as earned income
because the customer involved has not yet had use of the
loan for any length of time.
 Over the life of the loan, the bank will gradually earn the
interest income and will transfer the necessary amounts
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from unearned discount to the interest income account.
ASSETS OF THE BANKING FIRM
 Nonperforming (Noncurrent) Loans
 Credits that no longer accrue interest income or that have
had to be restructured to accommodate a borrower's
changed circumstances.
 A loan is placed in the nonperforming category when any
scheduled loan repayment is past due for more than 90 days.
 Once a loan is classified as "nonperforming," any accrued
interest recorded on the books, but not actually received,
must be deducted from loan revenues.
 The bank is then forbidden to record any additional interest
income from the loan until a cash payment actually comes
in. 27
ASSETS OF THE BANKING FIRM
 Bank Premises and Fixed Assets
 Bank assets also include the net (adjusted for depreciation)
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
that is, the fixed assets represented by buildings and
equipment needed to carry on daily operations.
 However, fixed assets typically generate fixed operating costs
in the form of depreciation expenses, property taxes, and so
on, which provide operating leverage, enabling the
institution to boost its operating earnings if it can increase its
sales volume high enough and earn more from using its fixed
assets than those assets cost. 28
ASSETS OF THE BANKING FIRM
 Other Real Estate Owned (OREO)
 This asset category includes direct and indirect
investments in real estate.
 The principal component of OREO is commercial and
residential properties obtained to compensate for
nonperforming loans.
 While "kids" may want as many Oreos as possible,
bankers like to keep the OREO account small by lending
funds to borrowers who will make payments in a timely
fashion.
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ASSETS OF THE BANKING FIRM
 Intangible and Miscellaneous ("Other") Assets
 The most familiar of these intangibles is goodwill, which occurs when
one firm acquires another and pays more than the market value of the
acquired firm's net assets (i.e., all its assets less all its liabilities).
 Other intangible assets include mortgage loan servicing rights and
purchased credit card relationships that generate extra income for the
financial firm managing aspects of these loans on behalf of another
lending institution.
 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. 30
LIABILITIES OF THE BANKING FIRM
 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

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LIABILITIES OF THE BANKING FIRM
 Borrowings from Non-deposit Sources
 Although deposits typically represent the largest portion of
funds sources for many banks, sizable amounts of funds also
stem from miscellaneous liability accounts.
 The larger the depository institution, the greater use it tends
to make of non-deposit sources of funds.
 One reason borrowings from non-deposit 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 non-deposit funding.
 Also, borrowings in the money market usually can be
arranged in a few minutes and the funds wired immediately 32
to the depository institution that needs them.
LIABILITIES OF THE BANKING FIRM
 Equity Capital for the Banking Firm
 The equity capital accounts on a depository institution's Report of
Condition represent the owners' (stockholders') share of the
business.
 Bank capital accounts typically include many of the same items
that other business corporations display on their balance sheets.
 They list the total par (face) value of common stock outstanding.
When that stock is sold for more than its par value, the excess
market value of the stock flows into a surplus account.
 Not many banking firms issue preferred stock, which guarantees
its holders an annual dividend before common stockholders
receive any dividend payments.
 However, the bail-out plan that emerged during the 2007-09 credit
crisis included a program to get many U.S. banks to build up their 33
preferred stock position in order to strengthen their capital.
RECENT EXPANSION OF OFF-
BALANCE-SHEET ITEMS IN BANKING
 Financial firms offer their customers a number of fee-based
services that normally do not show up on the balance sheet.
Prominent examples of these off-balance-sheet items include:
 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.
 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.
 Derivative contracts, in which a financial institution has the potential
to make a profit or incur a loss on an asset that it presently does not
own. This category includes 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
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ownership of equity securities.
RECENT EXPANSION OF OFF-
BALANCE-SHEET ITEMS IN BANKING
 The problem with these off-balance-sheet transactions is
that they often expose a financial firm to considerable
risk that conventional financial reports simply won't pick
up.
 Unauthorized trading in derivatives has created notorious
losses for financial institutions around the world.
 For example, in 1995 Nicholas Leeson's estimated losses
from trading futures contracts amounted to $1 .4 billion
and led to the collapse of Barings Great Britain's 242-
year-old merchant bank.

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RECENT EXPANSION OF OFF-
BALANCE-SHEET ITEMS IN BANKING
 The Financial Accounting Standard's Board (FASB) Statement
No. 133-Accounting for Derivative Instruments and Hedging
Activities-and its amendments, labelled FASB 138, are
designed to make derivatives more publicly visible on
corporate financial statements and to capture the impact of
hedging transactions on corporate earnings.
 Gains or losses on derivative contracts must be marked to
market value as they accrue, which affects a financial firm's
Report of Income and may increase the volatility of its
earnings.
 Moreover, heavily regulated financial firms must connect their
use of hedging contracts to actual risk exposures in their
operations (thereby curbing speculative use of derivatives). 36
THE PROBLEM OF BOOK-VALUE
ACCOUNTING
 The book-value accounting method assumes all balance-
sheet items will be held to maturity. It does not reflect the
impact on a balance sheet of changing interest rates and
changing default risk, which affect both the value and cash
flows associated with loans, security holdings, and debt.
 For example, if market interest rates on government bonds
maturing in one year are currently at 10 percent, a $1,000
par-value bond promising an annual interest (coupon) rate
of 10 percent would sell at a current market price of $1,000.
However, if market interest rates rise to 12 percent, the
value of the bond must fall to about $980 so that the
investment return from this asset is also 12 percent.
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AUDITING: ASSURING RELIABILITY
OF FINANCIAL STATEMENTS
 U.S. banks (especially those holding $500 million or
more in assets) are required to file with the FDIC and
with the federal or state agency that chartered them
financial statements audited by an independent public
accountant within 90 days of the end of each fiscal year.
 Larger U.S. banks, with $3 billion or more in assets, must
meet even more stringent requirements for setting up
outside audit committees, including requiring at least two
audit committee members to have prior banking
experience, prohibiting the most significant customers
from serving on such a committee, and mandating that
audit committees have access to legal counsel that is 38
independent of bank management.
COMPONENTS OF THE INCOME
STATEMENT (REPORT OF INCOME)

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PRINCIPLES TYPES OF NONINTEREST (FEE)
INCOME RECEIVED BY MANY FINANCIAL FIRMS
TODAY FIDUCIARY ACTIVITIES

 Fees for managing and protecting a customer's property.

 Fees for recordkeeping for corporate security
transactions and dispensing interest and dividend
payments.
 Fees for managing corporate and individual pension and
retirement plans.

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SERVICE CHARGES ON DEPOSIT
ACCOUNTS
 Checking account maintenance fees.
 Checking account overdraft fees.

 Fees for writing excessive checks.

 Savings account overdraft fees.

 Fees for stopping payment of checks

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ADDITIONAL NON INTEREST INCOME
 Investment banking, advisory, brokerage, and
underwriting.
 Venture capital revenue.

 Net servicing fees.

 Net securitization income.

 Insurance commission fees and income.

 Net gains (losses) on sales of loans.

 Net gains (losses) on sales of real estate owned.

 Net gains (losses) on sales of other assets (excluding

securities).
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THE COSMETICS OF "WINDOW DRESSING"
AND "CREATIVE ACCOUNTING"
 Some financial institutions are notorious for creating
"better looking" financial statements. The "window
dressing" of balance sheets and income statements can
occur at any time but is most common at the end of a
calendar quarter and especially at the end of a fiscal year.
For example, managers may decide they want their firm
to look "bigger," giving it an apparent increase in market
share.
 This is often accomplished by the firm borrowing in the
money market using federal funds, certificates of deposit,
or Eurocurrency deposits just prior to the end of the
quarter or year and reversing the transaction a few hours 44
or a few days later
THE FINANCIAL STATEMENTS OF LEADING
NONBANK FINANCIAL FIRMS: A COMPARISON TO
BANK STATEMENTS

 Like banks, the thrifts' balance sheet is dominated by

loans (especially home mortgage loans and consumer
installment loans), deposits from customers, and
borrowings in the money market. Also paralleling the
banking sector, the thrifts' income statements are heavily
tilted toward revenue from loans and by the interest they
must pay on deposits and money market borrowings.

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THE FINANCIAL STATEMENTS OF LEADING
NONBANK FINANCIAL FIRMS: A COMPARISON TO
BANK STATEMENTS

 Finance company balance sheets, like those of banks, are

dominated by loans, but these credit assets are usually
labelled "accounts receivable" and include business,
consumer, and real estate receivables, reflecting loans
made to these customer segments.
 Moreover, on the sources of funds side, finance company
financial statements show heavy reliance, not on deposits
for funding, but on borrowings from the money market
and from parent companies in those cases where a
finance company is controlled by a larger firm (e.g., as
GE Capital is controlled by General Electric).
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THE FINANCIAL STATEMENTS OF LEADING
NONBANK FINANCIAL FIRMS: A COMPARISON TO
BANK STATEMENTS

 Life and property/casualty insurance companies also

make loans, especially to the business sector.
 But these usually show up on insurance company
balance sheets in the form of holdings of bonds, stocks,
mortgages, and other securities, many of which are
purchased in the open market.
 Key sources of funds for insurers include policyholder
premium payments to buy insurance protection, returns
from investments, and borrowings in the money and
capital markets.
 Most of the insurance industry's profits come from the
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investments they make, not policyholder premiums.
THE FINANCIAL STATEMENTS OF LEADING
NONBANK FINANCIAL FIRMS: A COMPARISON TO
BANK STATEMENTS

 Mutual funds hold primarily corporate stocks, bonds,

asset-backed securities, and money market instruments
that are financed principally by their net sales of shares
to the public and from occasional borrowings.
 Security dealers and brokers tend to hold a similar range
of investments in stocks and bonds, financing these
acquisitions by borrowings in the money and capital
markets and equity capital contributed by their owners.

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