copyright © 2000 by harcourt, inc. all rights reserved. 5-1 chapter 5 overview of financial...

Copyright © 2000 by Harcourt, Inc. All rights reserved.

5-1

Chapter 5Overview of Financial Statements For

Depository Institutions


5-2

13%

5%

60%

22%

22%

70%

8%

Securities

Cash and DueLoans

Other

Deposits

Other Debt

Equity

Assets and Liabilities for an Average FDIC Insured Bank

Source: FDIC Statistics on Banking, 1996


5-3

Trends in Balance Sheet Composition

Loans have grown from 32% of assets in 1950 to 60% by 1996.

Deposit financing fell from 90% in 1950 to 70% in 1996.

• Banks have had to rely on more expensive nondeposit funds, increasing their interest expense.

Large banks ( > $1b in assets) hold a smaller percentage of securities than smaller banks because they can meet liquidity needs through financial market borrowings.


5-4

Bank Assets in More Detail

Cash and due

• Vault cash, deposits at the Federal Reserve, deposits at other financial institutions and cash in the process of collection.

• Large banks hold a larger percentage of cash to meet their comparatively high reserve requirements that result from their large volume of deposits.


5-5

Fed funds

• Excess reserves at the Fed that are traded among banks.

• Fed funds rate is an indicator of liquidity in bank markets.

• Fed funds sold are assets while Fed funds purchased are liabilities.

Repurchase agreements (repos)

• Short-term sale of Treasury bills or other liquid securities that are repurchased at a higher price than Fed funds.


5-6 Assets held in trading accounts

• Securities that are traded by large banks.

• Securities must appear on the balance sheet at market value, with any market value losses or gains reflected in income.

Investment securities• Securities which provide additional income and long-term

liquidity.

• Include U.S Treasury and federal agency securities, general obligation municipal bonds, and limited amounts of investment grade corporate bonds and municipal revenue bonds.


5-7

Investment securities (continued)

• Securities must be pledged against uninsured government deposits held as liabilities.

• Securities must be classified as “available for sale” or “held to maturity.”

• During recessions when loan demand falls, the securities portfolio grows, providing countercyclical income.


5-8

Loans

• Gross loans and leases reports the book value of loans and leases.

• Allowance for loan losses records an offsetting account to cover expected loan losses.

– Actual net charge-offs are subtracted from allowance for loan losses.

– Additions to allowance for loan losses are made yearly through provision for loan loss expense.

• Net loans and leases reports gross loans minus allowance for loan losses.


5-9

• Commercial loans (22.6% of loans in 1997) generally have intermediate-term maturities.

• Consumer loans (18.7% of loans in 1997) generally have short-term maturities.

• Real estate loans (46.8% of loans in 1997) are secured by real estate and generally have long-term maturities.

– Real estate loans expose banks to market value risk and reinvestment risk.

• Other loans (11.9% of loans in 1997).


5-10

Other assets

• Bank premises and equipment

• Other real estate owned (OREO)

• Intangible assets


5-11

Bank Liabilities, Stocks, and Equity Capital

Transactions deposits (22% of deposits in 1997)

• Accounts with check-writing privileges.

• Regulation prohibits payment of interest on demand deposits for businesses.

• NOW accounts and MMDAs have limited check-writing privileges but pay interest on balances.

– Accounts considered part of the core deposit base.


5-12 Nontransaction deposits (67% of deposits in

1997)

• Passbook savings.

• Small time deposits or retail CDs.

• Passbook savings and retail CDs are considered part of the core deposit base.

– Core deposits are stable and less interest-sensitive than other sources of funds.

Large time deposits (11% of deposits in 1997)

• Include Jumbo CDs and brokered deposits.

• Considered part of the purchased funds base. – Purchased funds are uninsured deposits and other

borrowings.


5-13

Fed funds purchased and repos Other borrowed money

• Commercial paper.

• Eurodollar CDs.

• Bankers acceptances.

Subordinate notes and debentures

• All notes and bonds issued with maturities of 1 year or greater.

• Claims are subordinate to those of depositors.

• Included as secondary capital for regulatory capital requirement purposes.


5-14

Other liabilities• Include taxes and dividends payable, acceptances,

and trade credit financing

Stockholder’s equity• Common stock

• Surplus

• Undivided profits

• Other equity or contingency reserves


5-15

Income Statement

Total interest revenue- Interest expense Net interest income + Total noninterest revenue- Total noninterest expense- Provision for loan losses

Pretax operating income- Gains and losses on securities- Applicable taxes Income before extraordinary items- Extraordinary items, net

Net Income


5-16

Bank Operations in 1996

Noninterest revenue for banks greater than $1 billion was over 25% of total revenue compared to only 12.5% for those in small categories.

Noninterest expense was 39.55% of revenues, while interest expense was 36.92%.

The average operating NPM was 19.54%.


5-17

Looking More Closely at Bank Profits

NI = (NII - PLL - Burden) (1-t)where:

NI= net income excluding extraordinary items and gains and losses, NII=net interest income, PLL = provision for loan losses, and the Burden = Noninterest expense - Noninterest revenue, t=

tax rate.

ROA = (NIM -PLL% -Burden%)(1-t)where:NIM = Net interest margin

Expressed as a percentage of assets:


5-18

Trends in NIM

NIM = Interest Revenue - Interest ExpenseAssets Assets

NIM is a function of changes in IR and changes in IE. From 1992 to 1997 NIM was very stable because IR

and IE changed by similar amounts. Relative changes in IR and IE depend on the mix of

assets and liabilities, as well as on how much their values change due to changes in interest rates.


5-19

Repricing Gap

Repricable assets include short-term maturing securities and loans and variable rate loans.

Repricable liabilities included short-term deposits and other maturing liabilities.

Repricing gap = Repricable assets - Repricable liabilitiesand

Expected change in NII = Repricing gap × Change in rates


5-20

A bank’s repricing gap determines whether NII will remain stable, fall, or rise when interest rates increase.

• If the repricing gap is positive, NII will rise with a rise in rates.

• If the repricing gap is negative, NII will fall with a rise in rates.

• If the repricing gap is zero, NII will remain stable with a rise in rates.


5-21

Effects on ROA of PLL and Burden (1992-1997)

PPL% fell from 0.77% to 0.42%. Noninterest expense fell by 0.15% and

noninterest revenue increased by .35%, resulting in a drop in the Burden% from 1.96% in 1992 to 1.46% in 1997.

The pre-tax ROA increased from 1.35% in 1992 to 2.02% in 1997.


5-22

Suppose you are a manager for Bank Star National Bank, which has a target for ROA of 1.24%. The company has a marginal tax rate of 30%, a PLL% of .30%, and a burden% of 1.5% What NIM must the company achieve to make its target ROA?

ROA = (NIM - PLL% - Burden%) × (1-t)

NIM = ROA + PLL% + Burden% (1 -t)

NIM = 1.24% + 0.3% + 1.5% = 3.57% (1-.3)


5-23

What ratio of interest revenue to assets would Bank Star have to average to reach the NIM goal, if its interest expense amount to 3.61% of assets?

NIM = IR% - IE%

IR% = NIM + IE%

IR% = 3.57% + 3.61% = 7.18%


5-24

Suppose Bank Star has set a target ROE of 18%. Assume also that the bank’s equity capital ratio is 8%, the burden is 1%, the expected PLL% is 0, and the marginal tax rate is 34%. What target NIM does Bank Star need to achieve?

ROE = ROA × EM ROA = ROE ÷ (Asset/Equity)

Substituting this expression into ROA expressed as a function of NIM, PLL% and the Burden% results in:

NIM = ROE × Equity/Assets + PLL% + Burden%( 1-t)


5-25

Target NIM = (18% × 0.08) + 0% + 1% = 3.18%

(1-.34)

If the desired equity-capital ratio is 6%, the target NIM would be:

Target NIM = (18% × 0.06) + 0% + 1% = 2.64%

(1-.34)

Examples illustrate that financial leverage is an important component in daily bank decisions to determine the NIM needed to achieve a target return for bank stockholders.


5-26

Trends in ROA, ROE and EM for U.S. Commercial Banks

Due to a recession ROA was .49% in 1990 but increased to 1.30% by 1997.

Increased capital requirements in 1992 helped push EM down from 15.59% in 1990 to 11.89% in 1997.

ROE over the period 1990 to 1997 increased from 7.64% to 15.46%

Improvements in NPM help explain the rise in ROA and ROE.

copyright © 2000 by harcourt, inc. all rights reserved. 5-1 chapter 5 overview of financial...

Documents

securities cash

loans gross loans

securities portfolio

liquid securities

net loans

commercial loans

consumer loans

federal agency securities