Chap005(2)bank.ppt

Chapter Five The Financial Statements of Banks and Their Principal Competitors McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.  Introduction The particular services each financial firm chooses to offer and...

Chapter Five The Financial Statements of Banks and Their Principal Competitors McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.  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. Financial statements can be viewed as a “road map” ▫ Tell us where a financial firm has been in the past, where it is now, and possibly where it is headed in the future The two main financial statements that managers, customers, and the regulatory authorities rely upon are ▫ The balance sheet (Report of Condition) ▫ The income statement (Report of Income) McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-2  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. In contrast, the financial inputs and outputs on the Report of Income show how much it has cost to acquire funds and to generate revenues from the uses the financial firm has made of those funds. The Report of Income also shows the revenues (cash flow) generated by selling services to the public, including making loans and servicing customer deposits. The Report of Income shows 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 McGraw-Hill/Irwin dividends. Bank Management and Financial © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 5-3  TABLE 5–1 Key Items on Bank Financial Statements McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-4  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. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-5  The Balance Sheet (continued) 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 securities purchased in the open market (S) ▫ Loans and lease financings made available to customers (L) ▫ Miscellaneous assets (MA) Liabilities fall into two 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) McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-6  The Balance Sheet (continued) Cash assets (C) are designed to meet the financial firm’s need for liquidity. 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. 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. ▫ Nondeposit borrowings (NDB) are carried out mainly 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. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-7  The Balance Sheet (continued) 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: McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-8  TABLE 5–3 Report of Condition (Balance Sheet) for BB&T (Year-End 2008 and 2009) McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-9  The Balance Sheet (continued) Cash Assets ▫ Account is called Cash and Deposits Due from Bank ▫ Includes: ▫ Vault Cash. ▫ Deposits with Other Banks (Correspondent Deposits). ▫ Cash Items in Process of Collection. ▫ Reserve Account with the Federal Reserve. ▫ Sometimes called primary reserves. ▫ These assets are the first line of defense against customer deposits withdrawal. ▫ Also, these assets are the first source of fund when a customer comes with a loan request. ▫ The banks strive to keep the size of this account as low as possible!!! Because cash balance earn little or no interest income McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-10  The Balance Sheet (continued) Investment Securities which can be divided into: 1. The Liquid Portion ▫ Short Term Government Securities. ▫ Privately Issued Money Market Securities. ▫ Interest Bearing Time Deposits. ▫ Commercial Paper. ▫ Often called secondary reserves which is the second line of defense to meet demands for cash. 2. The Income-Generating Portion ▫ All the securities held for their rate of return. ▫ Often called “held-to-maturity” securities. ▫ Recorded on the books of a banking firm at their original cost McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights or at market Bank Management value, whichever and Financial is lower. Reserved. 5-11  The Balance Sheet (continued) Trading Account Assets ▫ Securities purchased to provide short-term profits from short-term price movements. ▫ Not included in “Securities” on the Report of Condition. ▫ They are reported as trading account assets. Federal Funds ▫ Includes mainly temporary loans (usually extended overnight, with the funds returned the next day) made to other depository institutions. ▫ The funds for these temporary loans often come from the reserves a bank has on deposit with the Federal Reserve Bank. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-12  The Balance Sheet (continued) Loan Accounts ▫ The major (largest) asset item. ▫ Usually account for half to three-quarters of the total value of all bank assets. ▫ A bank’s loan account can be divided into several groups: 1. By the Purpose for borrowing money ▫ Commercial and industrial (or business) loans ▫ Consumer and industrial (or business) loans ▫ Real estate (or property-based) loans ▫ Financial institutions loans ▫ Foreign (or international) loans ▫ Agricultural production loans ▫ Security loans ▫ Leases McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-13  The Balance Sheet (continued) 2. By the Maturity ▫ Short-term loans ▫ Long-term loans 3. By the Collateral ▫ Secured loans ▫ Unsecured loans 4. By the Pricing Terms ▫ Floating-rate loans ▫ Fixed-rate loans McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-14  The Balance Sheet (continued) Loan Losses ▫ Loan losses, both current and projected, are deducted from the amount of gross loans. ▫ By law, the banks are allowed to build up a reserve for future loan losses, called allowance for loan losses (ALL) ▫ The ALL represents an accumulated reserve against uncollectable loans. Many financial firm divided the ALL into: 1. Specific Reserves ▫ Set aside to cover a particular loan(s) expected to be a problem. 2. General Reserves ▫ The remaining reserves in the loan loss account. Unearned Income ▫ This item consists of interest income on loans received from customer, but not earned under the accrual method of accounting banks use today. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-15  The Balance Sheet (continued) Miscellaneous Assets ▫ Bank Premises and Fixed Assets ▫ The fixed assets represented by building & equipment needed to carry on daily operations. ▫ The net (adjusted for depreciation) value of building and equipment. ▫ Other Real Estate Owned ▫ Includes direct and indirect investments in real estate. ▫ Goodwill and Other Intangibles ▫ Goodwill occurs when a firm acquires another firm and pays more than the market value of its net assets. ▫ All Other Assets  Customers liability on acceptances outstanding  Income earned but not collected McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-16  The Balance Sheet- Liabilities of the Banking Firm ▫ Deposits ▫ The largest of fund sources for banks. ▫ The principal liability of any bank. ▫ Representing financial claims held by customers against the banking firm. ▫ The major types of deposits: ▫ Noninterest-bearing Demand Deposits ▫ Generally permit unlimited check writing, cannot pay any interest rate. ▫ Savings Deposits ▫ Bear the lowest interest rate, permit a customer withdrawal at will. ▫ Time Deposits ▫ Usually carry a fixed maturity and a stipulated interest rate. ▫ Certificates of Deposits (CDs). McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-17  Liabilities of the Banking Firm (continued) ▫ Non-deposit Borrowings ▫ Most of the banks tend to make of non-deposits source of funds! Why? ▫ No reserves requirements and insurance fees on most of these funds, which lower the cost of non-deposits funding. ▫ Amongst the most important non-deposits funding sources: ▫ Federal funds purchased and repurchase agreements. ▫ Borrowing reserves from the discount windows of the Federal Reserve banks. ▫ Issuing commercial papers. ▫ Acceptances outstanding ▫ Eurocurrency borrowings ▫ Subordinated debt ▫ Limited life preferred stock ▫ Other liabilities McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-18  The Balance Sheet - Equity Capital of the Banking Firm The equity capital accounts of the banking firm represent the owners share of the business. ▫ Preferred Stock ▫ Common Stock ▫ Common Stock Outstanding ▫ Capital Surplus ▫ Retained Earnings (Undivided Profits) ▫ Treasury Stock ▫ Contingency Reserve McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-19  Recent Expansion of Off-Balance-Sheet (OBS) Items in Banking The balance sheet does not tell the whole story about the financial firm. 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: ▫ Unused Commitments ▫ A lender receives a fee to lend up a certain amount of money over a defined period of time, these funds have not yet been transferred from lender to borrower. ▫ Standby Credit Agreements ▫ A financial firm receives a fee to guarantee repayment of a loan that a customer has received from another lender. ▫ Derivative Contracts ▫ A financial institution has the potential to make a profit (or a loss) on an asset that it presently does not own (for instance, Futures Contracts, Options, and Swaps). ▫ OBS transactions expose a firm to counterparty risks. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-20  Income Statement (Report of Income) Indicates the amounts of revenues and expenses over a specific period of time. Shows how much it has cost to acquire funds and to generate revenues from the uses of funds in the Report of Conditions. Shows the revenues (cash flow) generated by selling services to the public. Shows net earnings after all costs are deducted from the sum of all revenues. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-21  Income Statement (continued) The major source of revenues: ▫ The principal source of bank revenue is the interest income generated by earning assets (loans and investments). ▫ Also, revenue is provided by the fees charged by specific services. The major components of expenses: ▫ Interest paid out to depositors. ▫ Interest owed on non-deposits borrowings. ▫ The cost of equity capital. ▫ Salaries & Wages. ▫ Benefits paid to employees. ▫ Overhead expenses associated with the physical plant. ▫ Fund set aside for possible loan losses. ▫ Taxes owed. The deference between all revenues and expenses is net income. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-22  Income Statement (continued) McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-23  Income Statement (continued) The financial firms interested in increasing their net earnings, number of options are available: ▫ Increase the net yield on each asset held. ▫ Redistributed earning assets toward those assets with higher yields. ▫ Increase the volume of services that provided fee income. ▫ Increase fees associated with various services. ▫ Shift funding sources toward less-costly borrowings. ▫ Reduce employee, overhead, loan-loss, and miscellaneous operating expenses. ▫ Reduce owed tax through improved tax management practices. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-24  Income Statement (continued) Income statements are a record of financial flows over time. Therefore, we can represent the income statement as a report of financial outflows (expenses) and financial inflows (revenues). The main components of income statement: ▫ Interest Income. ▫ Interest Expenses. ▫ Net Interest Income. ▫ Loan Loss Expense. ▫ Noninterest Income. ▫ Noninterest Expenses. ▫ Net Operating Income and Net Income. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-25  Income Statement (continued) 1. Interest Income:  Interest earned from loans and security investments accounts represent the majority of revenues for most depository institutions. 2. Interest Expenses:  Interest on deposits. 3. Net Interest Income:  Total interest expenses subtracted from total interest income.  Often referred to as the interest margin.  The gap between interest income and interest cost.  It is a key determinants (measure) of profitability.  Net Interest Income = Interest Income – Interest Expenses. 4. Loan Loss Expense:  The annual loan loss provision is deducted from current revenues before taxes. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-26  Income Statement (continued) 5. Noninterest Income:  Sources of income other than revenues from loans and investment securities (or fee income).  Fees earned from fiduciary activities.  Service charges on deposit accounts.  Trading account gains and fees.  Additional noninterest income (including revenues from investment banking, security brokerage, and insurance services).  Net noninterest income = non interest income – noninterest expense – provision for loan losses.  Recently, financial firms have focused on noninterest income as a key target for future expansion. 6. Noninterest Expenses:  Wages, salaries, and employee benefit are the key components of noninterest expenses.  The costs of maintaining, rental fees, and the costs of furniture.  The legal fees, office supplies expenses, and repaid costs. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-27  Income Statement (continued) 7. Net Operating Income and Net Income:  The sum of interest income and net noninterest income is a pretax net operating income.  The key bottom-line item in any income statement is net income which usually divided into two categories:  Cash dividends.  Retained earnings (undivided profit). McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-28  TABLE 5–6 Report of Income for BB&T (2008 and 2009) McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-29  TABLE 5–8 Features and Consequences of the Financial Statements of Banks and Similar Financial Firms McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-30  Quick Quiz What are the principal accounts that appear on a bank’s balance sheet? Which accounts are most important and which are least important on the asset side of a bank’s balance sheet? What accounts are most important on the liability side of a balance sheet? What are primary reserves and secondary reserves, and what are they supposed to do? What accounts make up the Report of Income (income statement of a bank)? What is the relationship between the provision for loan losses on a bank’s Report of Income and the allowance for loan losses on its Report of Condition? What are the key features or characteristics of the financial statements of banks and similar financial firms? McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Bank Management and Financial Reserved. 5-31