Part 2: Bank Financial Statements, Risks, and Valuation

Part 2:Bank Financial Statements, Risks, and Valuation • Chapter 4:Sources and Uses of Bank Funds and the Risks of Banking • Chapter 5: Accounting and Economic Models of Bank Performance and Valuation • Chapter 6: Case Studies in Bank Valuation and Performance Chapter 4

CHAPTER 4 Sources and Uses of Bank Funds and the Risks of Banking Chapter 4

LEARNING OBJECTIVES TO UNDERSTAND... • Three Views of a Bank: As a Portfolio or Balance Sheet, as an Information Processor, and as a Regulated Firm • A Bank’s Sources and Uses of Funds • The Components of a Bank’s Income-Expense Statement • The Linkage Between Bank Financial Statements and the Risks of Banking Chapter 4

CHAPTER THEME • The traditional business of banking is funding loans (use of funds) with deposits (source of funds). This function generates the “bread-and-butter cash flow” of a bank – net interest income. Netting out the provision for loan loss and net noninterest income gets to a bank’s pre-tax net income. Measuring and managing the risks associated with this business represents the hear of bank financial management, which is risk management. Chapter 4

Bank’s Evolution from Money Changers to Dealer-Makers, Information Processors, and Regulated Firms • Functions that a Bank Performs 1. Chest: the safekeeping or risk-control function 2. Bench: the transactions function • Cash, Check, Credit/Debit Card Chapter 4

Banks As Portfolios: Two-Way Funds Rental and Risk Control Risks • Credit Risk • Interest-Rate Risk • Liquidity Risk • Prepayment Risk • Foreign-Exchange Risk Chapter 4

Bank Financial Statements • Balance Sheet: A = L + NW • Income-Expense Statement: P = R - C - T • Book Values • Market Value of Equity Chapter 4

Bank Balance Sheets Sources of Funds: Core Deposits CORE DEPOSITS Gathered in Local Markets and Typically have Lower Interest Costs than Purchased Fund • Demand Deposit Accounts • Other Checkable Balances • Savings Accounts • Small Time Deposits Chapter 4

Bank Balance Sheets Sources of Funds: Managed Liabilities Managed Liabilities • As the antithesis of core deposits, managed liabilities are more volatile and more rate-sensitive funds that are gathered in national and international money markets rather than local markets • Examples: Foreign deposits, large CDs, FF purchases, repos, demand notes, subordinated notes and debentures, and other borrowed money Chapter 4

Bank Balance Sheets Uses of Funds • Interest-Earning Assets • Loans and leases • C&I, real estate, and consumer • Investment securities • Investment account • Held to Maturity (historical cost or book value) • Available for Sale (market value) • Trading account (recorded at market value under “trading assets”) • Fee-Based Assets (e.g., trust services) • Nonearning Assets (e.g., cash and due and premises) Chapter 4

Bank Balance Sheets Sources and Uses of Funds Federal Funds and Repurchase Agreements Chapter 4

CREDIT RISK, PLL, AND LLR OR ALLL (see Box 4-1, p. 112) • Credit or default risk results in loan losses – an accepted part of the business of lending • Banks set aside funds for such purpose, called the provision for loan loss (PLL) – a noncash outlay that runs through the income-expense statement to a contra-asset account on the balance sheet called the loan-loss reserve (LLR) or the allowance for loan and lease loss (ALLL) • “Bathtub Analogy” in Box 4-1, p. 112 Chapter 4

Bank Equity Capital • Equity Capital = Net Worth = Book Value of Equity = Assets - Liabilities • Regulatory capital • Market value of equity Chapter 4

COMPONENTS OF BANK EQUITY CAPITAL • Common stock ($32.4 billion, par value) • Surplus ($238 billion) • Undivided profits ($203.3 billion) • Book values for all insured commercial banks at the beginning of 2000 are in parentheses • External equity: issue equity or hybrid securities (e.g., trust preferred stock, TPS) • Internal equity: retained earnings or undivided profits Chapter 4

Sources of Bank Revenue (“Sales” and “Cross-Selling”) • Total revenue or “sales” for a bank: • Interest Income From Loans, Securities, Federal Funds Sold • Non-Interest Income From Fees and Service Charges Chapter 4

Bank Costs • Interest Expenses On Deposits and other Interest-Bearing Liabilities • Non-Interest Expenses Administrative and Operating Expenses • PLL is so important that it is treated separately Chapter 4

A Bank’s Income-Expense Statement • Net Interest Income = Interest Income - Interest Expense • Net Interest Margin = Net Interest Income / Total Assets • PLL = Provision for loan loss • Net Noninterest Income: “Burden” Noninterest Income - Noninterest Expense • Taxes • Net income Chapter 4

A BANK’S “BURDEN” • For almost all banks, net interest income is negative (< 0) because noninterest expense exceeds noninterest income • For this reason, it can be described as a bank’s “burden” • Since NII has the tremendous job of having to cover a bank’s PLL, its burden, and its taxes, it is the “bread and butter” of the business of traditional banking Chapter 4

A Bank’s Income-Expense Statement • Return on Assets (ROA) Net Income / Total Assets • Return on Equity (ROE) Net Income / Total Equity or ROA x Equity Multiplier (EM) Chapter 4

A Bank’s Income-Expense Statement • Dividends and Additions to Retained Earnings • Internal Capital Generation Rate Chapter 4

RECAP OF BANK INCOME AND EXPENSES • Four key components: • 1. Net interest income • 2. PLL • 3. Net noninterest income (”burden”) • 4. Taxes • Net income is the bottom line • ROA is the key accounting measure of bank performance Chapter 4

CHAPTER SUMMARY • Three alternative ways of viewing a bank are: • 1. Portfolio or balance sheet • 2. Information processor • 3. Regulated firm • This chapter has focused on the first view and the income and expenses that flow from a bank’s portfolio or balance sheet Chapter 4

Part 2: Bank Financial Statements, Risks, and Valuation