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Problems: Know how to construct a balance sheet or income ...
 

Problems: Know how to construct a balance sheet or income ...

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    Problems: Know how to construct a balance sheet or income ... Problems: Know how to construct a balance sheet or income ... Document Transcript

    • CHAPTER 4: THE FINANCIAL STATEMENTS OF BANKS AND THEIR COMPETITORS An Overview of Bank Balance Sheets and Income Statements A. Financial Inputs and Outputs on Bank Balance Sheets and Income Statements B. The Bank's Balance Sheet (Report of Condition) 1. The Principal Types of Accounts on a Bank's Report of Condition 2. Bank Assets a. Cash and Due from Depository Institutions b. Investment Securities (liquidity and income purposes) c. Trading Account Assets d.. Federal Funds Sold and Securities Purchased under Resale Agreements Note: The order of b,c, and d may vary within that subset. e. Gross or Total Loans and Leases (aka Advances) f. Less: Allowances for Loan Losses g. Less: International Loan Reserves h. Less: Unearned Discount Income i. Net Loans and Leases j. Bank Premises and Fixed Assets k. Other Real Estate Owned (OREO) l. Goodwill and Other Intangible Assets Note: The order of j, k, and l may vary within that subset. n. All Other Assets 3. Bank Liabilities a. Deposits (checking, savings, time) b. Borrowings from Nondeposit Sources (large denominations) 1. Fed Funds Purchased and Securities Sold Under Agreements to Repurchase c. Trading Liabilities d. Subordinated Debt e. Equity Capital Accounts 1. Preferred Stock 2. Common Equity a. Common Stock b. Surplus or Additional Paid-in Capital c. Undivided Profits or Retained Earnings 4. Comparative Balance-Sheet Ratios for Different Size Banks 5. Recent Expansion of Off-Balance-Sheet Items in Banking 6. The Problem of Book-Value Accounting in Banking C. Components of the Income Statement (Report of Income) 1. The Determinants of a Bank's Net Income 2. Financial Flows and Stocks a. Interest Income b. Interest Expenses c. Net Interest Income 33
    • d. Provision for Loan Losses (Similar to Loan-Loss Expense) e. Noninterest Income (Service Charges on Deposits, Fiduciary Activities Fees, Investment Banking and Brokerage Fees, Other) f. Noninterest Expenses (Employee Expenses, Occupancy Expenses, Outside Processing Expenses, Other) g. Security Gains or Losses (may not be recurring) Note: Security Gains/Losses may be included in noninterest income/expenses or separated since it may not be recurring. h. Pre-tax income before extraordinary items i. +/- Extraordinary Items (should not be recurring) j. Income after extraordinary items k. Applicable Taxes l. Net Income After Taxes 3. Comparative Income-Statement Ratios for Different-Size Banks D. Other Useful Bank Financial Statements 1. The Funds-Flow Statement (Sources-and-Uses-of-Funds Statement) 2. Statement of Stockholders' Equity Which accounts are most important and least important on the asset side of a bank's balance sheet? The rank order of assets and liabilities by % of total assets on U.S. bank balance sheets (2002) are as follows but may vary by size of institution: Rank Order : Assets: Loans (58%) + Investment Securities (19%) + Cash and Due (5%) + Other Assets (18%) Rank Order Liabilities and Equity Capital: Deposits (66%) + Nondeposit Borrowings (25%) + Equity Capital (9%) What are the essential differences between demand deposits, savings deposits, and time deposits? Demand deposits are regular checking accounts against which a customer can write checks or make any number of personal withdrawals. Regular checking accounts do not bear interest under current U.S. law and regulation. Savings deposits bear interest (normally, they carry the lowest rate paid on bank deposits) but may be withdrawn at will (though a bank usually will reserve the right to require advance notice of a planned withdrawal). Time deposits carry a fixed maturity and the bank may impose a penalty if the customer withdraws funds before the maturity date is reached. The interest rate posted on time deposits is negotiated between the bank and its deposit customer and may be either fixed or floating. A NOW account combines features of a savings account and a checking account, while a money market deposit account encompasses transactional powers similar to a regular checking account (though usually with limitations on the number of checks or drafts that may be written against the account) but also resembles a time deposit with an interest rate fixed for a brief period (such as weekly) but then becomes changeable over longer periods to reflect current market conditions. 34
    • What are primary and secondary (liquidity) reserves and what are they supposed to do? Primary reserves consist of cash, including a bank's vault cash and checkable deposits held with other banks or any other funds that are accessible immediately to meet demands for liquidity made against the bank. Secondary reserves consist of assets that pay some interest (though usually pay returns that are much lower than earned on other assets, such as loans) but their principal feature is ready marketability. Both primary and secondary reserves are held to keep the bank in readiness to meet demands for cash (liquidity) from whatever source those demands may arise. What are off-balance-sheet items and why are they important to some banks and other financial firms? Off-balance-sheet items are usually transactions that generate fee income for a bank (such as standby credit guarantees) or help hedge against risk (such as financial futures contracts). They are important as a supplement to income from loans and to help a bank reduce its exposure to interest-rate risk. Why are bank accounting practices under attack right now? In what ways could banks and similar financial institutions improve their accounting methods? The traditional practice of banks has been to record the value of assets and liabilities at their value on the day the accounts were originally created and not changing those values over the life of the account. The SEC and FASB started questioning this practice in the 1980’s because they were concerned that investors on bank securities would be misled about the true value of the bank. Using this historical value accounting method may in fact conceal a bank that insolvent in a current market value sense. The biggest controversy centered on the banks’ investment portfolio which would appear to be easy to value at its current market price. At a minimum, banks could help themselves by marking their investment portfolio to market. This would give investors an indication of the true value of the bank’s investment portfolio. Banks could also consider using the lower of historical or market value for other accounts on the balance sheet. What accounts make up the Report of Income (income statement) of a bank? The Report of Income includes all sources of bank revenue (loan income, investment security income, revenue from deposit service fees, trust fees, and miscellaneous service income) and all bank expenses (including interest on all borrowed funds, salaries, wages, and employee benefits, overhead costs, loan-loss expense, taxes, and miscellaneous operating costs.) The difference between operating revenues and expenses (including tax obligations) is referred to as net income. Income statement as a % of total assets (2002) (There may be slight rounding errors.) (+)Total Interest and Fee Income 5.06% (loans 3.77%) (-) Total Interest Expense 1.71 35
    • Net Interest Income 3.35 (-) Provision for Loan Losses 0.68 (+) Noninterest (fee) Income 2.42 (-) Noninterest Expense 3.29 Net Operating Income 1.81 (+/-) Securities Gains/Losses 0.09 (+/-) Extraordinary items 0.00 Net Income before tax 1.90 Taxes 0.62 Net Income after tax 1.27 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? Gross loans equal the total of all loans currently outstanding that are recorded on the bank's books. Net loans are equal to gross loans less any interest income on loans already collected by the bank but not yet earned and also less the allowance for loan-loss account (or bad-debt reserve). The allowance for loan losses is built up gradually over time by an annual noncash expense item that is charged against the bank's current income, known as the Provision for Loan Losses. The dollar amount of the annual loan-loss provision plus the amount of recovered funds from any loans previously declared worthless (charged off) less any loans charged off as worthless in the current period is added to the allowance-for-loan-losses account. If current charge-offs of worthless loans exceed the annual loan-loss provision plus any recoveries on previously charged-off loans the annual net figure becomes negative and is subtracted from the allowance-for-loan-losses account. Suppose a bank has an allowance for loan losses of $1.25 million at the beginning of the year, charges current income for a $250,000 provision for loan losses, charges off worthless loans of $150,000, and recovers $50,000 on loans previously charged off. What will be the balance in the bank's allowance for loan losses at year-end? The balance in the allowance for loan loss (ALL) account at year end will be: Beginning ALL = $1.25 million Plus: Annual Provision for Loan Losses = +0.25 Recoveries on Loans Previously = +0.05 Charged Off Minus: Charge Offs of Worthless = -0.15 Loans Ending ALL = $1.40 million What types of information does a Funds-Flow or Sources-and-Uses-of-Funds Statement provide? 36
    • A bank's sources-and-uses-of-funds statement captures changes in its assets and liability items as well as income from bank operations. It shows where the bank has raised its operating funds over a given period of time and how those funds were allocated over that same time period. Generally, increases in any liability item (such as deposits) represent a source of funds, while increases in any asset item are uses of funds. Suppose a bank has an initial balance in its capital account of $26 million, receives net income during the year of $3 million, pays out stockholder dividends of $2 million, and issues $1 million in new stock during the year. What balance remained in the bank's capital account at the end of the year? Beginning Capital Account Balance = $26 million Plus: Net Income During Year = +3 New Shares of Stock Issues = +1 Less: Stockholders Dividends = -2 Ending Capital Account Balance = $28 million. The main competitors in the financial services marketplace are thrift institutions like credit unions and savings associations and financial services firms such as finance companies, insurance companies and mutual funds. Their financial statements increasingly resemble bank financial statements. Among the common features are the heavy use of leverage, the dominance of financial assets over real assets and the concentration of revenues from making loans and assisting businesses in selling their securities. The assets of nonbank thrifts (savings banks, savings and loans, and credit unions) are dominated by loans (especially mortgages and consumer installment loans) and their funding comes primarily from deposits and money market borrowings. As a result, most of their revenue is generated by their loans and most of their expenses are interest expenses on the deposits and the money market borrowings. How are the balance sheets and income statements of finance companies, insurers, and securities firms similar to those of banks and in what way are they different? The main similarities can be found on the asset side of their balance sheets. All of the above rely on loans and securities, although they normally label them differently. The main difference is the source of funds. None of the aforementioned competitors can draw upon deposits and has to rely on money market, other borrowings and equity. These differences are rooted in the nature of their line of business and underlying regulations. Fee income may also be a much larger percentage of their income. Problems: Know how to construct a balance sheet or income statement. The following balance sheet and income statement items are listed in random order. Rearrange the items into a balance sheet and an income statement. 37
    • Allowances for Loan Losses Applicable Income Taxes Bank Premises and Fixed Assets Cash and Due from Depository Institutions Common Stock Deposits Employee Expenses Extraordinary Items Federal Funds Purchased Federal Funds Sold Fiduciary Activities Fees Goodwill and Other Intangible Assets Gross Loans Interest Income on Loans Interest Income on Securities Investment Banking and Brokerage Fees Investment Securities Net income after taxes Net Interest Income Net Loans Non-deposit borrowings Occupancy Expenses Other Assets Other Real Estate Owned (OREO) Outside Processing Expenses Interest Expense on Deposits Interest Expense on Non-deposit funding Preferred Stock Provisions for Loan Losses Security Gains/Losses Service Charges on Deposits Subordinated Debt Surplus or Additional Paid-in Capital Trading Account Assets Trading Liabilities Undivided Profits or Retained Earnings Answer: Balance Sheet Assets Cash and Due from Depository Institutions Investment Securities Trading Account Assets 38
    • Federal Funds Sold and Securities Purchased under Resale Agreements Note: The order of the three items above may vary within that subset. Gross or Total Loans and Leases Less: Allowances for Loan Losses Less: International Loan Reserves Less: Unearned Discount Income Net Loans and Leases Bank Premises and Fixed Assets Other Real Estate Owned (OREO) Goodwill and Other Intangible Assets Note: The order of the three items above may vary within that subset. All Other Assets Liabilities and Equity Deposits (checking, savings, time) Borrowings from Nondeposit Sources (large denominations) 1. Fed Funds Purchased and Securities Sold Under Agreements to Repurchase 2. Othe Trading Liabilities Subordinated Debt Equity Capital Accounts 1. Preferred Stock 2. Common Equity a. Common Stock b. Surplus or Additional Paid-in Capital c. Undivided Profits or Retained Earnings Income Statement (Report of Income) Interest Income (Loans, Securities, Other) Interest Expenses (Deposits, Nondeposit Borrowings, Other) Net Interest Income Provision for Loan Losses Noninterest Income (Service Charges on Deposits, Fiduciary Activities Fees, Investment Banking and Brokerage Fees, Other) Noninterest Expenses (Employee Expenses, Occupancy Expenses, Outside Processing Expenses, Other) Security Gains or Losses (may not be recurring); Security Gains/Losses may be included in noninterest income/expenses or separated since it may not be recurring. Income before extraordinary items +/- Extraordinary Items (should not be recurring) Income after extraordinary items Applicable Taxes Net Income After Taxes 39