Week 2: Bank Financials & Performance PDF

🏦Performance Week 2: Bank Financials & Tags Course 5 Bank Financials n Performance.pdf Bank Financial Statements Bank financial statements reflect the services a bank chooses to offer, the...

🏦Performance Week 2: Bank Financials & Tags Course 5 Bank Financials n Performance.pdf Bank Financial Statements Bank financial statements reflect the services a bank chooses to offer, the overall size of its organization and where the bank has been in the past, where it is now and where it may be heading in the future *course focuses on income statement and balance sheet Income Statement Provisions for Loan/Credit Loss (”PLL”) An expense set aside to cover potential future losses in the bank’s loan/credit and other financial assets an estimate of the amount that may be uncollectible based on the bank’s assessment of its asset portfolio to create a reserve (aka Allowance for Loan and Lease Losses) to absorb potential future losses from loan defaults 🏦Week 2: Bank Financials & Performance 1  Income Statement can be divided into 2 main sections 🏦Week 2: Bank Financials & Performance 2  1. Interest Income and expenses 2. Non-interest income and expenses Interest Income Items Non-Interest Income Items - Interest and Fees on credit-risk businesses - Fees and other non-interest income from - bank products & services Interest Income from interest-generating - Net gain from trading in financial assets securities, such as bonds, owned by the - Net gain from investment securities bank - Net gain from disposal of assets - Interest & dividend income from other investments Interest-related Expense Items Non-interest Expense Items - Wages, salaries, and employee benefits - Deposit and other funding interest costs - Premises and equipment expense - Interest cost for borrowing from bank, - Advertising and marketing money and capital market - Other operating expenses Provisions for loan/credit loss (PLL) Balance Sheet Assets Liabilities Accumulated uses of funds, which are made to Accumulated sources of funds, generate income for returns to stockholders, interest which provide the needed spending to depositors, compensation for employees etc… power to acquire assets 4 major types of assets 2 principal categories of liabilities - Cash (C) in the vault and deposits held at other depository institutions - - Deposits (D) made by and owed to Securities & Investments (S) held by the bank for various customers trading or ST purposes - - Non-deposit borrowings (NDB) of Loans and lease financings (L) made available to funds by the bank in bank, money, customers capital markets - Other miscellaneous assets (MA) 🏦Week 2: Bank Financials & Performance 3  Assets - Cash (C) “Cash and Deposits Due from other banks/institutions” Designed to meet the bank’s needs for liquidity aka “primary reserves” Includes: Cash at the branches Vault Cash Cash items in Process of Collection 🏦Week 2: Bank Financials & Performance 4  Deposits with Other Banks (e.g. “Correspondent Deposits”) Reserve Account with the central bank Assets - Securities & Investment (S) Liquid Investment Position (”secondary liquidity reserves”) Money Market Securities such as treasury bills, commercial paper Commercial Paper ST government securities Interest bearing time deposits (placed out by the bank) Trading Account Assets (for ST profits) Government, state, federal agency, and municipal debt securities Mortgage-backed securities, asset-back securities Marketable equity securities Financial derivative assets Physical commodities inventory Securities purchased when bank acts as dealer to provide market liquidity Temporary Loans & Reverse Repos Overnight/temporary loans made to other depository institutions, securities dealers, or major industrial corporations Often extended in the form of reverse repurchase agreements or resale agreements in which the bank acquires temporary title to securities until the loan is paid off 🏦Week 2: Bank Financials & Performance 5  Assets - Loans and Leases (L) Major revenue-generating asset in a bank Appears on balance sheet often as: (1) Gross Loans and Leases → sum of all o/s loans and leases by the bank (2) Allowance for Loan/Credit Loss (”ALL”) → reserves for loan losses built over time (from cumulative PLL) (3) Net Loans and Leases → expected net realizable of all loans and leases o/s 🏦Week 2: Bank Financials & Performance 6  Specific Allowance: refers to those made when loans breach certain credit or regulatory conditions, independent of the overdue period 🏦Week 2: Bank Financials & Performance 7  General Allowance: refers to those made when loans are overdue for repayment of principle or interests by at least 90 days Allowance for Loan/Credit Loss (“ALL”) represents an accumulated reserve against which loans declared to be uncollectible can be charged against or be written off built over time by deduction from income and through any write-off recovery Assets - Net Loans and Leases 🏦Week 2: Bank Financials & Performance 8 🏦Week 2: Bank Financials & Performance 9  Unearned Income Fees or earnings that have been collected on a loan by a bank but has not yet been counted as income, as the service has not been delivered aka “discount on loans” e.g. upfront fee payments $500k for a 5-yr syndicated loan US GAAP: the fees must be amortized or recognized evenly over the 5-yr period 🏦Week 2: Bank Financials & Performance 10  The fee that can be recognized on Y1 and each year is only $100k At the end of Y1, the Unearned income is $400k Prevent banks from converting interest spread into fees and recognizing them all upfront Unearned income is rightfully a liability item on B/S As the loan progresses, proportionate parts of the fees/interests collected upfront are removed from the liabilities and counted as income However, banks using US GAAP, incorporate ~ into Net Loans and Leases on the Asset side of the B/S Assets - Miscellaneous (MA) Long-term financial investments Bank premises and fixed assets Goodwill and Other Intangibles Prepayments by the bank Deferred tax assets Ownership in subsidiaries Ownership in associate companies Other LT investments Balance Sheet - Liabilities Deposits made by Customers (D) Main source of funding for commercial banks and includes: Non-interest bearing demand/current deposits Saving deposits Time deposits Money market deposit accounts (MMDA) 🏦Week 2: Bank Financials & Performance 11  Non-deposit Borrowings (NDB) by the Bank This is the bank’s borrowings in the bank, money and capital markets → supplement its deposits and provide additional liquidity Loans taken up by the bank Debts issued by the bank As well as other non-deposit Liabilities Financial derivative liabilities → part of Trading Account liabilities Cash collateral received Accrued payables (non-loan related unearned income) Short sales of securities Current tax liabilities 🏦Week 2: Bank Financials & Performance 12 🏦Week 2: Bank Financials & Performance 13  Balance Sheet - Equity Equity of Bank (EQ) Supplies the LT, relatively stable base of financial support to banks Provide ability to cover extraordinary losses Those items categorized as Equity includes: Common shares Treasury shares (shares re-acquired by banks) Preferred shares (issued by banks) Other mezzanine equity issued by banks 🏦Week 2: Bank Financials & Performance 14  Retained earnings General, Capital or other Contigency reserves Capital surpluses (amount above the par value of bank’s shares sold) Off Balance Sheet Items (OBS) Items found within the Notes to Financial Statements that are important for assessing the financial status of a bank OBS Items OBS transactions expose a firm to risks that are not directly obvious from the financial statements. They have grown so rapidly for many banks that they can exceed total bank assets OBS Contingent Liabilities Amount that a bank must pay only if its commitments are called upon Letter of Credits Standby Credit Agreements 🏦Week 2: Bank Financials & Performance 15  Banker’s Guarantees Committed loan facilities but unused Financial assets sold with recourse (e.g. a put) back to the bank Certain derivative contracts that can’t be MTM OBS Contingent Assets Amount that a bank would gain if it called on those commitments Commitment received from 3rd parties Standby Credit issued by another institution in favor of the bank Banking Book Refers to assets and liabilities on the B/S which are expected to be held to maturity and not traded Valued at historical cost, except when they are impaired Loans to customers Deposits from customers Credit cards exposure to customers Trading Book Refers to assets and liabilities on the B/S which are available for sales and/or traded regularly Trading book has to be marked-to-market (MTM) daily Derivatives contract Investment in or trading of options, FX, equity and debt securities Bank Performance Banks need to operate in a manner that reward their stakeholders and be able to attract capital to fund their operations 🏦Week 2: Bank Financials & Performance 16  If profits are inadequate, or if risk is excessive, they can have difficulties: Raising capital or its funding costs are increased, further eroding profitability Rewarding and retaining stakeholders including shareholders, employees, depositors, customers, service/liquidity providers Meeting certain regulatory requirements 2 important angles in performance measurements and management: 1. Maximizing Profitability 2. Reducing Risk Exposure Profitability Metrics 1. Return on Assets (ROA) → RoRWA 2. Return on Equity (ROE) → Pre-tax ROE, ROTCE 3. Net Interest Margins (NIM) 4. Non-Interest Income Ratio 5. Cost-Income Ratio 6. EPS, Diluted EPS Profitability - Return on Assets Since the assets of a bank represent its accumulated uses of funds, one key indicator of a bank’s performance is its ROA 🏦Week 2: Bank Financials & Performance 17  ROA indicates managerial efficiency - how capable the management has been in converting assets into net earnings ROA >1% generally indicates strength Profitability - Return on RWA Taking into account the regulatory requirements and risk associated with different types of assets, ROA may be computed using the value of Risk- weighted Assets (RWA) instead of the face value of assets 🏦Week 2: Bank Financials & Performance 18  Size of RWA is a function of the riskiness of assets held For credit risk assets, a percentage factor that varies with risk rating is applied to the nominal value of the asset to obtain RWA e.g. Under Basel III, a corporate loan extended to a BB borrower attracts a 100% weight, while one to an AA borrower attracts only a 20% weight to the nominal loan value Profitability - Return on Equity Since a bank has to adequately capitalized in order to operate in a regulated environment, ROE is a performance indicator that affect the bank’s ability to attract capital ROE is a measure of the rate of return that can potentially flow to shareholders and investors ROE > 10% indicates strength 🏦Week 2: Bank Financials & Performance 19  What can bank management do to improve ROE? Management Decisions regarding (equity Management Decisions regarding (ROA) multiplier/financial leverage) - Revenues from asset-light business - Optimal pricing of pdt & services - What types of assets to invest in? - Pdt and services mix - How much dividends should be paid to - Control of operating expenses shareholders? - Choosing higher return markets & - What sources of equity funding to be used? segments - How much regulatory capital is put aside for - Mgmt of other P&L items that affect the bank’s asset? Net Income 🏦Week 2: Bank Financials & Performance 20  Profitability - Pre-tax ROE (ROTCE) Pre-tax ROE Return on Tangible Common Equity Measures the return for common stockholders Measures the pre-tax return on equity in the event of liquidation - Common Equity (CE) = SE - Preference Shares - Tangible Common Equity (TCE) is CE that is computed - Useful in comparing banks operating in without accounting for intangible assets (e.g. different tax jurisdictions Goodwill) - A return of 20% or above is commendable - Provides consistency measurement over time as a bank develops organically /inorganically through acquisitions - ROTCE > 12% is commendable Profitability - Net Interest Margins (NIM) How well a bank is able to generate earnings spread on its assets can directly affect profitability and its ROA 🏦Week 2: Bank Financials & Performance 21  Net Interest Margin (NIM) is a measure of how large an interest spread a bank can achieve for its loans and other interest earning assets Net Interest Income (NII) = Interest Income - Interest Expenses This spread refers to the gap between yield on earning assets and the rate paid on funds to support those assets Profitability - Non-Interest Income Ratio How a bank generate fees and other non-interest income, usually without dependence on its assets, can affect its ROA and ROE → Non-Interest Income to Total Income is an indicator of this ability 🏦Week 2: Bank Financials & Performance 22  Non-Interest Income includes fees and commission income, trading income, income from investment These can include income generated from investment bank, market treasury, and transaction banking Total Income = Net Interest Income + Non-Interest Income Commercial banks usually have a lower ratio than investment banks → the lower the ratio, the more a bank is affected by interest rate environment Profitability - Cost-Income Ratio (efficiency ratio) Non-interest cost to produce one unit of income is a good indicator of the bank’s efficiency in cost management Non-interest costs include non-interest expenses that are directly attributable to income generation, such as payroll, employee benefits, equipment expenses, advertising, etc 🏦Week 2: Bank Financials & Performance 23  EXCLUDES non-cash items such as goodwill and depreciation of intangible assets Total Income = Net Interest Income + Non-Interest Income A lower ratio supports bank’s profitability EPS & Diluted EPS Basic EPS Diluted EPS measures the amount of company’s assumes that all convertible securities profits on a per-share basis issued by the bank have been exercised - convertible securities include convertible preference shares, employee share options, convertible debt, stock warrants, etc 🏦Week 2: Bank Financials & Performance 24 🏦Week 2: Bank Financials & Performance 25