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Chapter Twelve Commercial Banks’ Financial Statements and Analysis McGraw-Hill/Irwin 8-1 ©2009 The McGraw-Hill Companies, All Rights Reserved Regulators •• The TheFederal FederalDeposit DepositInsurance InsuranceCorporation Corporation(FDIC) (FDIC) insures insuresthe thedeposits depositsof ofcommercial commercialbanks banks •• The TheU.S. U.S.has hasaadual dualbanking bankingsystem—banks system—bankscan canbe be either eithernationally nationallyor orstate statechartered chartered –– the theOffice Officeof ofthe theComptroller Comptrollerof ofthe theCurrency Currency(OCC) (OCC)charters charters and andregulates regulatesnational nationalbanks banks –– state stateagencies agenciescharter charterand andregulate regulatestate statebanks banks •• The TheFederal FederalReserve ReserveSystem System(FRS) (FRS)has hasregulatory regulatory power powerover overnationally nationallychartered charteredbanks banksand andtheir theirholding holding companies companiesand andstate statebanks banksthat thatopt optin into tothe theFederal Federal Reserve ReserveSystem System –– aaholding holdingcompany companyisisaaparent parentcompany companythat thatowns ownsaacontrolling controlling interest in a subsidiary bank or other FI interest in a subsidiary bank or other FI McGraw-Hill/Irwin 11-2 ©2009 The McGraw-Hill Companies, All Rights Reserved Financial Statements •• The TheFederal FederalFinancial FinancialInstitutions InstitutionsExamination ExaminationCouncil Council (FFIEC) (FFIEC)prescribes prescribesuniform uniformprinciples, principles,standards, standards,and andreport report forms formsfor fordepository depositoryinstitutions institutions –– –– –– balance balancesheets sheetsare arereported reportedon onreport reportof ofcondition conditionforms forms income incomestatements statementsare arereported reportedon onreport reportof ofincome incomeforms forms commercial commercialbanks banksreport reportcontingent contingentassets assetsand andliabilities liabilitieson onoffoffbalance-sheet reports balance-sheet reports •• Retail Retailbanks banksfocus focusbusiness businessactivities activitieson onconsumer consumerbanking banking relationships relationships •• Wholesale Wholesalebanks banksfocus focusbusiness businessactivities activitieson oncommercial commercial banking bankingrelationships relationships –– most mostwholesale wholesalebanks banksalso alsoengage engageininretail retailbanking banking McGraw-Hill/Irwin 12-3 ©2009 The McGraw-Hill Companies, All Rights Reserved Financial Statements •• •• Comparative Comparativeanalysis analysisof ofBOA BOAand andWebster Webster Retail Retailbanks banksfocus focusbusiness businessactivities activitieson onconsumer consumer banking bankingrelationships relationships--WBS WBS •• Wholesale Wholesalebanks banksfocus focusbusiness businessactivities activitieson oncommercial commercial banking bankingrelationships relationships –– –– most mostwholesale wholesalebanks banksalso alsoengage engageininretail retailbanking banking BOA BOAhas hastrust trustservices, services,investment investmentmanagement managementand andcredit creditcards cards businesses businessesas aswell welland andisisthe theleading leadingsmall smallbusiness businesslender lenderininthe the counry counry McGraw-Hill/Irwin 12-4 ©2009 The McGraw-Hill Companies, All Rights Reserved CAMELS Ratings •• Regulators Regulatorsuse useCAMELS CAMELSratings ratingsto toevaluate evaluatethe thesafety safety and andsoundness soundnessof ofbanks banks •• CAMELS CAMELSratings ratingsrely relyheavily heavilyon onfinancial financialstatement statementdata data •• Components Components –– –– –– –– –– –– Capital Capitaladequacy adequacy Asset Assetquality quality Management Managementquality quality Earnings Earningsquality quality Liquidity Liquidity Sensitivity Sensitivitytotomarket marketrisk risk McGraw-Hill/Irwin 12-5 ©2009 The McGraw-Hill Companies, All Rights Reserved CAMELS Ratings •• CAMELS CAMELSratings ratingsrange rangefrom from11to to55 –– –– –– –– –– Composite Composite“1”—banks “1”—banksare arebasically basicallysound soundininevery everyrespect respect Composite Composite“2”—banks “2”—banksare arefundamentally fundamentallysound, sound,but butmay mayhave have modest modestweaknesses weaknessescorrectable correctableininthe thenormal normalcourse courseof ofbusiness business Composite Composite“3”—banks “3”—banksexhibit exhibitfinancial, financial,operational, operational,or or compliance complianceweaknesses weaknessesranging rangingfrom frommoderately moderatelysevere severetoto unsatisfactory unsatisfactory Composite Composite“4”—banks “4”—bankshave havean animmoderate immoderatevolume volumeof ofserious serious financial financialweaknesses weaknessesor oraacombination combinationof ofother otherconditions conditionsthat thatare are unsatisfactory unsatisfactory Composite Composite“5”—banks “5”—bankshave havean anextremely extremelyhigh highimmediate immediateor ornear near term termprobability probabilityof offailure failure McGraw-Hill/Irwin 12-6 ©2009 The McGraw-Hill Companies, All Rights Reserved Commercial Bank Assets •• Cash Cashand andbalances balancesdue duefrom fromother otherdepository depositoryinstitutions institutions –– Consist Consistofofvault vaultcash, cash,currency currencyininthe theprocess processofofcollection collection(CIPC), (CIPC),correspondent correspondent balances and reserves at the Fed. Also called primary reserves. balances and reserves at the Fed. Also called primary reserves. •• Investment Investmentsecurities securities –– short-term short-termsecurities securities(e.g, (e.g,Treasury Treasurybills billsand andfed fedfunds fundssold, sold,Interest Interestbearing bearingdeposits depositsatat other otherFIs, FIs,Fed Fedfunds fundssold, sold,Reverse ReverseRepos, Repos,U.S. U.S.Treasury Treasuryand andagency agencysecurities securities –– long-term securities (e.g., Treasury bonds, munis, MBSs) long-term securities (e.g., Treasury bonds, munis, MBSs) •• Loans Loans –– –– –– –– commercial commercialand andindustrial industrial real estate real estate consumer consumer other otherloans loans •• Unearned Unearnedincome incomeand andallowance allowancefor forloan loanand andlease leaselosses losses •• Other Otherassets assets(e.g., (e.g.,fixed fixedassets, assets,goodwill, goodwill,etc.) etc.) McGraw-Hill/Irwin 12-7 ©2009 The McGraw-Hill Companies, All Rights Reserved Commercial Bank Liabilities •• Core Coredeposits deposits –– demand demanddeposits deposits –– negotiable negotiableorder orderof ofwithdrawal withdrawal(NOW) (NOW)accounts accounts –– money moneymarket marketdeposit depositaccounts accounts(MMDAs) (MMDAs) –– other othersavings savingsdeposits deposits –– retail retailcertificates certificatesof ofdeposits deposits •• Other Otherdeposits deposits –– wholesale wholesalecertificates certificatesof ofdeposits deposits(> (>$100,000) $100,000) •• negotiable negotiableinstruments instrumentstraded tradedininsecondary secondarymarkets markets •• brokered brokereddeposits deposits McGraw-Hill/Irwin 12-8 ©2009 The McGraw-Hill Companies, All Rights Reserved Commercial Bank Liabilities and Equity •• Non-deposit Non-depositliabilities liabilities –– borrowed borrowed(purchased) (purchased)funds funds •• fed fedfunds fundspurchased purchasedand andrepos repos •• other otherborrowed borrowedfunds funds(e.g., (e.g.,banker’s banker’sacceptances, acceptances,commercial commercial paper, paper,discount discountwindow windowloans) loans) –– subordinated subordinatednotes notesand anddebentures debentures –– other otherliabilities liabilities--non-interest non-interestbearing bearing •• accrued accruedinterest, interest,deferred deferredtaxes, taxes,dividends dividendspayable, payable,etc. etc. •• Equity Equity –– preferred preferredand andcommon commonstock stock –– surplus surplusor oradditional additionalpaid paidin incapital capital –– retained retainedearnings earnings McGraw-Hill/Irwin 12-9 ©2009 The McGraw-Hill Companies, All Rights Reserved Off-Balance-Sheet Items •• Off-balance-sheet Off-balance-sheetitems itemsare arecontingent contingentassets assetsand andliabilities liabilitiesthat that may mayaffect affectaacommercial commercialbank’s bank’sbalance balancesheet sheetand/or and/orincome income statement statement •• Loan Loancommitments commitments –– –– up-front up-frontfees feesare arecharged chargedfor formaking makingfunds fundsavailable available commitments commitmentsfees feesare arecharged chargedon onunused unusedportion portionof ofcommitments commitments –– –– commercial commercialletters lettersof ofcredit credit standby standbyletters lettersof ofcredit credit •• Letters Lettersof ofcredit credit •• Loans Loanssold sold –– loans loanscan canbe besold soldwith withor orwithout withoutrecourse recourse •• Derivative Derivativecontracts contracts –– futures, futures,forwards, forwards,swaps, swaps,and andoptions options McGraw-Hill/Irwin 12-10 ©2009 The McGraw-Hill Companies, All Rights Reserved Other Fee Generating Activities • Correspondent banking and trust services • Processing Services • McGraw-Hill/Irwin 9-11 ©2009 The McGraw-Hill Companies, All Rights Reserved Income Statement •• Interest Interestincome income––interest interestexpense expense==net netinterest interest income income •• Noninterest Noninterestincome income––noninterest noninterestexpense expense==net net noninterest noninterestincome income •• Net Netinterest interestincome income––provision provisionfor forloan loanlosses losses++net net noninterest noninterestincome income==income incomebefore beforetaxes taxesand and extraordinary extraordinaryitems items(EBTEI) (EBTEI) •• EBTEI EBTEI––income incometaxes taxes––extraordinary extraordinaryitems items==net net income income McGraw-Hill/Irwin 12-12 ©2009 The McGraw-Hill Companies, All Rights Reserved Income Statement •• There Thereisisaadirect directrelationship relationshipbetween betweenthe theincome income statement statementand andthe thebalance balancesheet sheetof ofcommercial commercialbanks banks N M n =1 m NI = ∑ rn An −∑ rm Lm − P + NII − NIE − T NI NI==net netincome income AAn ==dollar dollarvalue valueofofthe thebank’s bank’snth nthasset asset n LLm ==dollar value of the bank’s mth liability dollar value of the bank’s mth liability rrn =m=rate rateearned earnedon onthe thebank’s bank’snth nthasset asset n rrm ==rate paid on the bank’s mth liability rate paid on the bank’s mth liability m PP==provision provisionfor forloan loanlosses losses NII = non-interest income NII = non-interest incomeearned, earned,including includingincome incomefrom fromOBS OBSactivities activities NIE = non-interest expenses NIE = non-interest expenses TT ==taxes taxesand andextraordinary extraordinaryitems items NN==number of assets the bank number of assets the bankholds holds M = number of liabilities the bank M = number of liabilities the bankholds holds McGraw-Hill/Irwin 12-13 ©2009 The McGraw-Hill Companies, All Rights Reserved Finding the required dollar interest spread • Suppose that a bank has equity of $200, interest expense of $90, P = $20, net noninterest income of -$15 and a tax rate of 34%. What is the minimum total interest revenue required to give a ROE of 15%? • Required NI = NI/$200 = 0.15 or NI = $30 • NI = [Interest revenue– Interest expense – P + (NII – NIE)] X (1 – Tax rate) or • $30 = [Interest revenue – $90 – $20 + –$15] (1 – 0.34) • Required interest revenue = $170.45 McGraw-Hill/Irwin 9-14 ©2009 The McGraw-Hill Companies, All Rights Reserved Illustrative loan pricing • If securities are $500 and are earning an average rate of return of 5% and the bank has $1500 in loans, what must be the average loan rate to generate interest revenue of $170.45? • $170.45 = ($500 x 0.05) + ($1500 x Avg. Loan Rate) • Avg. Loan Rate required = 9.7% McGraw-Hill/Irwin 9-15 ©2009 The McGraw-Hill Companies, All Rights Reserved Financial Statement Analysis •• Financial Financialstatement statementanalysis analysisisisbased basedon onaccounting accounting ratios ratios •• Time Timeseries seriesanalysis analysisisisthe theanalysis analysisof offinancial financial statements statementsover overaaperiod periodof oftime time •• Cross-sectional Cross-sectionalanalysis analysisisisthe theanalysis analysisof offinancial financial statements statementscomparing comparingone onefirm firmwith withothers others –– the theUniform UniformBank BankPerformance PerformanceReport Report(UBPR) (UBPR)maintained maintainedby by the theFFIEC FFIECallows allowsbanks bankstotoobserve observecompetitor competitorfinancial financial statements statements •• Most Mostfinancial financialstatement statementanalyses analysesisisaacombination combinationof oftime time series seriesanalysis analysisand andcross-sectional cross-sectionalanalysis analysis McGraw-Hill/Irwin 12-16 ©2009 The McGraw-Hill Companies, All Rights Reserved RETURN ON EQUITY AND ITS COMPONENTS 2007 Full Year Data Interest Expense Operating Income Profit Margin Net Income Operating Income 11.89% ROA Net Income Total Assets 0.93% ROE Net Income Total Equity Capital 9.13% Equity Multiplier McGraw-Hill/Irwin Total Assets Total Equity Capital 9.65x Asset Utilization Operating Income Total Assets 7.15% 9-17 37.46% PLL 6.95% Operating Income Noninterest expense Operating Income 38.20% Income Taxes Operating Income 5.21% Interest Income Total Assets Noninterest income Total Assets 5.47% 1.89% ©2009 The McGraw-Hill Companies, All Rights Reserved Return on Equity (ROE) Framework •• Return Returnon onEquity Equity(ROE) (ROE)analysis analysisbegins beginswith withROE ROEand and then thenbreaks breaksititdown downinto intoits itscomponents components •• ROE ROEmeasures measuresthe theoverall overallprofitability profitabilityof ofthe thebank bankper per dollar dollarof ofequity equity net income ROE = total equity capital •• ROE ROEcan canbe bebroken brokendown downinto intoits itscomponents components ROE = McGraw-Hill/Irwin net income total assets × = ROA × EM total assets total equity capital 12-18 ©2009 The McGraw-Hill Companies, All Rights Reserved Return on Equity (ROE) Framework •• Return Returnon onAssets Assets(ROA) (ROA)measures measuresprofit profitgenerated generated relative relativethe thebanks banksassets assets •• Equity EquityMultiplier Multiplier(EM) (EM)measures measuresthe theextent extentto towhich which assets assetsare arefunded fundedwith withequity equityrelative relativeto todebt debt(i.e., (i.e.,ititisisaa measure measureof ofleverage) leverage) •• ROA ROAcan canalso alsobe bebroken brokendown downinto intoits itscomponents components net income total operating income × total operating income total assets = PM × AU ROA = McGraw-Hill/Irwin 12-19 ©2009 The McGraw-Hill Companies, All Rights Reserved Return on Equity (ROE) Framework •• Profit ProfitMargin Margin(PM) (PM)measures measuresthe theability abilityto topay payexpenses expensesand and generate generatenet netincome incomefrom frominterest interestand andnoninterest noninterestincome incomeand andisis composed composedof of –– –– –– –– interest interestexpense expenseratio ratio provision provisionfor forloan loanloss lossratio ratio noninterest noninterestexpense expenseratio ratio tax taxratio ratio –– –– interest interestincome incomeratio ratio noninterest noninterestincome incomeratio ratio •• Asset AssetUtilization Utilization(AU) (AU)measures measuresthe theamount amountof ofinterest interestand and noninterest noninterestincome incomegenerated generatedper perdollar dollarof oftotal totalassets assetsand andisis composed composedof of McGraw-Hill/Irwin 12-20 ©2009 The McGraw-Hill Companies, All Rights Reserved Other Ratios •• The Thenet netinterest interestmargin margin(NIM) (NIM)measures measuresthe thenet netreturn return on onaabank’s bank’searning earningassets assets NIM = net interest income interest income − interest expense = earning assets investment securities + net loans and leases •• The Thespread spreadmeasures measuresthe thedifference differencebetween betweenthe the average averageyield yieldon onearning earningassets assetsand andaverage averagecost coston on interest-bearing interest-bearingliabilities liabilities Spread = McGraw-Hill/Irwin interest income interest expense − earning assets interest - bearing liabilities 12-21 ©2009 The McGraw-Hill Companies, All Rights Reserved Other Ratios •• Overhead Overheadefficiency efficiencymeasures measuresaabank’s bank’sability abilityto to generate generatenoninterest noninterestincome incometo tocover covernoninterest noninterestexpenses expenses Overhead efficiency = noninterest income noninterest expense •• Many Manyadditional additionalratios ratiosare arecommonly commonlyused usedto toanalyze analyze commercial commercialbanks banksby bybreaking breakingdown downthe thecomponents components of ofROE ROEeven evenfurther further(see (seeTables Tables12-6 12-6and and12-7) 12-7) McGraw-Hill/Irwin 12-22 ©2009 The McGraw-Hill Companies, All Rights Reserved Comparison of WFS and BOA ROA Net Income ROE Net Income Total Equity Capital Equity Multiplier Total Assets Total Equity Capital WFS = 8.51 BOA = 9.33 WFS = 38.40% BOA = 37.16% PLL Operating Income WFS = 1.14% BOA = 5.33% Noninterest expense WFS = 38.50% Total Assets WFS = 0.99% BOA = 1.43% WFS = 8.45% BOA = 13.36% McGraw-Hill/Irwin Profit Margin Net Income Operating Income WFS = 14.02% BOA = 18.18% Interest Expense Operating Income Asset Utilization Operating Income Total Assets WFS = 7.08% BOA = 7.91% 9-23 Operating Income BOA = 30.25% Income Taxes Operating Income WFS = 6.94% BOA = 9.15% Interest Income Total Assets WFS = 5.95% BOA = 5.57% Noninterest income Total Assets WFS = 1.13% BOA = 2.34% ©2009 The McGraw-Hill Companies, All Rights Reserved The Impact of Market Niche and Size •• Retail Retail and and wholesale wholesale commercial commercial banks banksoperate operate in in different different market market niches niches that that should should be be noted noted when when performing performing financial financial statement statement analysis analysis •• Webster Webster Financial Financial Bancorp Bancorp (WBS) (WBS) –– WBS WBSisisaaprofitable profitableand andefficient efficientretail retailbank bank –– invests investsmainly mainlyin inreal realestate estateloans loans –– uses useslow lowcost costretail retaildeposits depositsto tofund fundits itsassets assets –– holds holdsrelatively relativelymore moreequity equitycapital capitalthan thanBank Bankof of America America McGraw-Hill/Irwin 12-24 ©2009 The McGraw-Hill Companies, All Rights Reserved The Impact of Market Niche and Size •• Bank Bank of of America America (BOA) (BOA) –– BOA BOAisisboth bothaaretail retailand andaawholesale wholesalebank bank –– has hasaarelatively relativelymore morediversified diversifiedportfolio portfoliothan thanWBS WBS –– uses usesaabroader broaderarray arrayof ofdeposits depositsand andmore morepurchased purchased funds funds(i.e., (i.e.,fewer fewercore coredeposits) deposits)than thanWBS WBS –– offers offersaabroad broadspectrum spectrumof offinancial financialservices services •• BOA BOA isisthe the more more profitable profitable bank bank –– uses usesless lessequity, equity,which whichcontributes contributesto toaahigher higherROE ROE –– generates generatesmuch muchmore morenoninterest noninterestincome income McGraw-Hill/Irwin 12-25 ©2009 The McGraw-Hill Companies, All Rights Reserved [...]... analysisisisbased basedon onaccounting accounting ratios ratios •• Time Timeseries seriesanalysis analysisisisthe theanalysis analysisof offinancial financial statements statementsover overaaperiod periodof oftime time •• Cross-sectional Cross-sectionalanalysis analysisisisthe theanalysis analysisof offinancial financial statements statementscomparing comparingone onefirm firmwith withothers others –– the theUniform... bankstotoobserve observecompetitor competitorfinancial financial statements statements •• Most Mostfinancial financialstatement statementanalyses analysesisisaacombination combinationof oftime time series seriesanalysis analysisand andcross-sectional cross-sectionalanalysis analysis McGraw-Hill/Irwin 12-16 ©2009 The McGraw-Hill Companies, All Rights Reserved RETURN ON EQUITY AND ITS COMPONENTS 2007 Full Year... Niche and Size •• Retail Retail and and wholesale wholesale commercial commercial banks banksoperate operate in in different different market market niches niches that that should should be be noted noted when when performing performing financial financial statement statement analysis analysis •• Webster Webster Financial Financial Bancorp Bancorp (WBS) (WBS) –– WBS WBSisisaaprofitable profitableand andefficient... $500 and are earning an average rate of return of 5% and the bank has $1500 in loans, what must be the average loan rate to generate interest revenue of $170.45? • $170.45 = ($500 x 0.05) + ($1500 x Avg Loan Rate) • Avg Loan Rate required = 9.7% McGraw-Hill/Irwin 9-15 ©2009 The McGraw-Hill Companies, All Rights Reserved Financial Statement Analysis •• Financial Financialstatement statementanalysis analysisisisbased... Reserved Return on Equity (ROE) Framework •• Profit ProfitMargin Margin(PM) (PM)measures measuresthe theability abilityto topay payexpenses expensesand and generate generatenet netincome incomefrom frominterest interestand andnoninterest noninterestincome incomeand andisis composed composedof of –– –– –– –– interest interestexpense expenseratio ratio provision provisionfor forloan loanloss lossratio ratio... additionalratios ratiosare arecommonly commonlyused usedto toanalyze analyze commercial commercialbanks banksby bybreaking breakingdown downthe thecomponents components of ofROE ROEeven evenfurther further(see (seeTables Tables12-6 12- 6and and12-7) 12-7) McGraw-Hill/Irwin 12-22 ©2009 The McGraw-Hill Companies, All Rights Reserved Comparison of WFS and BOA ROA Net Income ROE Net Income Total Equity Capital Equity... Companies, All Rights Reserved The Impact of Market Niche and Size •• Bank Bank of of America America (BOA) (BOA) –– BOA BOAisisboth bothaaretail retailand andaawholesale wholesalebank bank –– has hasaarelatively relativelymore morediversified diversifiedportfolio portfoliothan thanWBS WBS –– uses usesaabroader broaderarray arrayof ofdeposits depositsand andmore morepurchased purchased funds funds(i.e., (i.e.,fewer... Noninterest income Total Assets 5.47% 1.89% ©2009 The McGraw-Hill Companies, All Rights Reserved Return on Equity (ROE) Framework •• Return Returnon onEquity Equity(ROE) (ROE )analysis analysisbegins beginswith withROE ROEand and then thenbreaks breaksititdown downinto intoits itscomponents components •• ROE ROEmeasures measuresthe theoverall overallprofitability profitabilityof ofthe thebank bankper... beforetaxes taxesand and extraordinary extraordinaryitems items(EBTEI) (EBTEI) •• EBTEI EBTEI––income incometaxes taxes––extraordinary extraordinaryitems items==net net income income McGraw-Hill/Irwin 12-12 ©2009 The McGraw-Hill Companies, All Rights Reserved Income Statement •• There Thereisisaadirect directrelationship relationshipbetween betweenthe theincome income statement statementand andthe thebalance... noninterest noninterestincome incomeratio ratio •• Asset AssetUtilization Utilization(AU) (AU)measures measuresthe theamount amountof ofinterest interestand and noninterest noninterestincome incomegenerated generatedper perdollar dollarof oftotal totalassets assetsand andisis composed composedof of McGraw-Hill/Irwin 12-20 ©2009 The McGraw-Hill Companies, All Rights Reserved Other Ratios •• The Thenet netinterest ... theanalysis analysisof offinancial financial statements statementsover overaaperiod periodof oftime time •• Cross-sectional Cross-sectionalanalysis analysisisisthe theanalysis analysisof offinancial... competitorfinancial financial statements statements •• Most Mostfinancial financialstatement statementanalyses analysesisisaacombination combinationof oftime time series seriesanalysis analysisand andcross-sectional... Reserved Financial Statement Analysis •• Financial Financialstatement statementanalysis analysisisisbased basedon onaccounting accounting ratios ratios •• Time Timeseries seriesanalysis analysisisisthe