Chapter Five

The Financial Statements of Banks and

Their Principal Competitors

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 Key Topics
• An Overview of the Balance Sheets and Income Statements of
Banks and Other Financial Firms
• The Balance Sheet or Report of Condition
• Asset Items
• Liability Items
• Recent Expansion of Off-Balance-Sheet Items
• Components of the Income Statement: Revenues and Expenses

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 Introduction
• The particular services each financial firm chooses to offer
and the overall size of each financial-service organization
are reflected in its financial statements
• FS can be viewed as a “road map”
▫ Where a financial firm has been in the past,
▫ where it is now,
▫ where it is headed in the future
• FS that managers, customers, and the regulatory
authorities rely upon are
▫ The balance sheet (Report of Condition)
▫ The income statement (Report of Income)

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 An Overview of Balance Sheets and Income
Statements

• The Report of Condition shows

• the amount and composition of funds sources (financial
inputs) drawn upon to finance lending and investing
activities
• and how much has been allocated to loans, securities,
and other funds uses (financial outputs) at any given
point in time

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 An Overview of Balance Sheets and Income
Statements

• The financial inputs and outputs on the Report of Income show

• how much it has cost to acquire funds and to generate revenues

• The Report of Income also shows

• the revenues (cash flow) generated by selling services to the public,
including making loans and servicing customer deposit
• net earnings after all costs are deducted from the sum of all
revenues, some of which will be reinvested in the financial firm for
future growth and some of which will flow to stockholders as
dividends

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 TABLE 5–1 Key Items on Bank Financial Statements

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 The Balance Sheet (Report of Condition)
• A balance sheet lists the assets, liabilities, and equity
capital (owners’ funds) held by or invested in a bank or
other financial firm on any given date

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 The Balance Sheet (Report of Condition)
• The assets are of 4 major types:
▫ Cash in the vault and deposits held at other depository institutions (C)
▫ Government and private interest-bearing securities (S)
▫ Loans and lease financings made available to customers (L)
▫ Miscellaneous assets (MA)

• Liabilities fall into 2 principal categories:

▫ Deposits made by and owed to various customers (D)
▫ Nondeposit borrowings of funds in the money and capital markets (NDB)

• Equity capital represents long-term funds the owners

contribute (EC)

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 The Balance Sheet
• Cash assets (C) - to meet the financial firm’s need for liquidity

• Security holdings (S) - backup source of liquidity and include

investments that provide a source of income

• Loans (L) - principally to supply income

• Miscellaneous assets (MA) - fixed assets (plant and equipment)

and investments in subsidiaries (if any)

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 The Balance Sheet

• Deposits (D) - main source of funding for banks

▫ Nondeposit borrowings (NDB) - to supplement deposits and provide
the additional liquidity that cash assets and securities cannot
provide

• Equity capital (EC) - supplies the long-term, relatively stable

base of financial support upon which the financial firm will rely
to grow and to cover any extraordinary losses it incurs

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 The Balance Sheet
• One useful way to view the balance sheet identity is to note that
liabilities and equity capital represent accumulated sources of funds,
which provide the needed spending power to acquire assets
• A bank’s assets, on the other hand, are its accumulated uses of funds,
which are made to generate income for its stockholders, pay interest to
its depositors, and compensate its employees for their labor and skill
• Thus, the balance sheet identity can be pictured simply as:

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 The Balance Sheet
• Cash Assets
▫ Cash and Deposits Due from Bank :
▫ Vault Cash
▫ Deposits with Other Banks (Correspondent Deposits)
▫ Cash Items in Process of Collection
▫ Reserve Account with the Federal Reserve

▫ Sometimes called primary reserves

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 The Balance Sheet
• Investment Securities - The Liquid Portion

▫ Short Term Government Securities

▫ Privately Issued Money Market Securities
▫ Interest Bearing Time Deposits
▫ Commercial Paper

▫ Often called secondary reserves

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 The Balance Sheet
• Investment Securities - The Income-Generating
Portion

▫ Taxable Securities
▫ U.S. Government Notes
▫ Government Agency Securities
▫ Corporate Bonds
▫ Tax-Exempt Securities
▫ Municipal Bonds

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 The Balance Sheet
• Trading Account Assets

▫ Securities purchased to provide short-term profits from

short-term price movements

▫ Occurs when the bank acts as a securities dealer

▫ Valued at Market – FASB 115

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 The Balance Sheet
• Federal Funds Sold and Reverse Repurchase Agreements
▫ Temporary loans (usually extended overnight, with the funds
returned the next day) made to other depository institutions,
securities dealers, or major industrial corporations
▫ Come from the reserves a bank has on deposit with the
Federal Reserve Bank in its district
▫ “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
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 The Balance Sheet
• Loan Accounts
▫ The Major Asset
▫ Gross Loans – Sum of All Loans
▫ Allowance for Possible Loan Losses
▫ Contra Asset Account
▫ For Potential Future Loan Losses
▫ Net Loans
▫ Unearned Discount Income
▫ Nonperforming Loans

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 The Balance Sheet
• Types of Loans
▫ Commercial and industrial (or business) loans
▫ Consumer (or household) loans
▫ Real estate (or property-based) loans
▫ Financial institutions loans
▫ Foreign (or international) loans
▫ Agricultural production loans
▫ Security loans
▫ Leases

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 The Balance Sheet
• Loan Losses

Beginning Allowance for Loan Losses

+ This Year’s Provision for Loan Loss
= Adjusted Allowance for Loan Losses
- Actual Charge-Offs of Worthless Loans
+ Recoveries from Previous Charge-Offs
= Ending Allowance for Loan Losses

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 The Balance Sheet
• Specific and General Reserves
▫ Specific Reserves
▫ Set aside to cover a particular Loan
▫ Designate a portion of ALL or
▫ Add more reserves to ALL
▫ General Reserves
▫ Remaining ALL
▫ Determined by management but influenced by taxes and
government regulation
▫ Loans to lesser developed countries require allocated
transfer reserves

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 The Balance Sheet
• Miscellaneous Assets
▫ Bank Premises and Fixed Assets
▫ Other Real Estate Owned (OREO)
▫ Goodwill and Other Intangibles

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 The Balance Sheet
• Liabilities of the Banking Firm
▫ Deposits
▫ Non interest-Bearing Demand Deposits
▫ Savings Deposits
▫ Now Accounts
▫ Money Market Deposit Accounts (MMDA)
▫ Time Deposits

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 The Balance Sheet
• Liabilities of the Banking Firm
▫ Nondeposit Borrowings
▫ Fed Funds Purchased
▫ Securities Sold Under Agreement to Repurchase (Repurchase
Agreements)
▫ Acceptances Outstanding
▫ Eurocurrency Borrowings
▫ Subordinated Debt
▫ Limited Life Preferred Stock
▫ Other Liabilities

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 The Balance Sheet
• Equity Capital of the Banking Firm
▫ Preferred Stock
▫ Common Stock
▫ Common Stock Outstanding
▫ Capital Surplus
▫ Retained Earnings (Undivided Profits)
▫ Treasury Stock
▫ Contingency Reserve

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 The Balance Sheet
• Recent Expansion of Off-Balance-Sheet (OBS) Items
in Banking
▫ Unused Commitments
▫ Standby Credit Agreements
▫ Derivative Contracts
▫ Futures Contracts
▫ Options
▫ Swaps
▫ OBS transactions expose a firm to counterparty risks
▫ OBS items have grown so rapidly that, for the banking
industry as a whole, they exceed total bank assets many
times over
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 Components of the Income Statement
• Indicates the amount of revenue received and
expenses incurred over a specific period of time
• Shows cost to acquire funds and to generate revenues
from the uses of funds in the Balance Sheet
• Shows the revenues (cash flow) generated by selling
services
• Shows net earnings after all costs are deducted from
the sum of all revenues

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 Components of the Income Statement

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 Components of the Income Statement
• a record of financial flows over time
• a report of financial outflows (expenses) and financial
inflows (revenues)
• Four main sections
1. Interest income
2. Interest expenses
3. Noninterest income
4. Noninterest expenses

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 Components of the Income Statement
• Net Interest Income = Interest Income – Interest
Expenses
• Interest Income Sources
▫ Interest and Fees on Loans
▫ Taxable Securities Revenue
▫ Tax-Exempt Securities Revenue
▫ Other Interest Income
• Interest Expense Sources
▫ Deposit Interest Costs
▫ Interest on Short-Term Debt
▫ Interest on Long-Term Debt
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 Components of the Income Statement
• Net Noninterest Income = Noninterest Income –
Noninterest Expenses
• Noninterest Income Sources
▫ Fees Earned from Fiduciary Activities
▫ Service Charges on Deposit Accounts
▫ Trading Account Gains and Fees
▫ Additional Noninterest Income
• Noninterest Expense Sources
▫ Wages, Salaries, and Employee Benefits
▫ Premises and Equipment Expense
▫ Other Operating Expenses
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