Financial Analysis of Depository Institutions

1. Financial Analysis ofDepository Institutions Finance 129 Drake University

2. Basic Financial Statements • Report of Condition • Balance Sheet • Report of Income • Income Statement • Funds Flow Statement • Sources and Uses of Funds • Statement of Stockholders Equity

3. Financial Outputs (uses of Bank Funds or Assets) Cash (primary reserves) Liquid Security Holdings (secondary Reserves) Investments in Securities Loans Consumer Real Estate Ag Fin Institutions Mics Loans Misc Financial Inputs (Sources of Funds or Liabilities and Owners Equity) Deposits from Public Demand NOW’s Money markets Savings Time Nondeposit Borrowings Equity Capital Stock Surplus Retained Earnings Capital reserves Balance Sheet

4. Balance Sheet continued • As with any balance sheet Assets = Liabilities + Owners Equity or Accumulated uses Accumulated sources of bank funds of bank funds =

5. Balance Sheet Components Assets • The Cash Account • includes: Cash in the vault, deposits with other banks, cash items in the process of collection and reserve accounts with the Federal Reserve • Traditionally banks attempt to keep this account as low as possible • Primary reserves since it is banks first line of defense against withdraws • Generate little income

6. Balance Sheet Components Assets • Investment Securities: The Liquid Portion • Quickly converted into cash • Secondary reserves • Investment Securities: Income Generating Portion • Taxable and nontaxable • Can be recorded at original cost or market value or the lower of the two • More important recently

7. Balance Sheet Components Assets • Loans • Largest Asset • Generally broken down by purpose of loans – • Different risk (& return) and liquidity of each loan type • Choice of loan type impacts interest income • Gross loans -- total of all outstanding • Allowance for Loan losses (ALL account) • PLL on income statement • Gross minus ALL = Net Loans

8. Balance Sheet Components Assets • ALL account • often divided into two sections, specific reserves, and general reserves • Tax reform Act of 1986 • only loans actually declared uncollectable can be expensed through the ALL accounts • decreased use of ALL accounts • Permanent capital

9. Balance Sheet Components Assets • Federal Funds Sold • Securities Purchased under Resale Agreements • Customers liability Acceptances • Misc Assets

10. Balance Sheet Components Liabilities • Deposits (Impacts Interest expense) • Noninterest bearing • Savings • NOW accounts • Money Market Accounts • Time Deposits • Borrowings from Nondeposit sources (IntExp) • Capital Accounts

11. Book vs. “Fair Value” • Banks have traditionally recorded balance sheet entries at original cost (book value or historical cost accounting -- ammoritzed cost) • Implies that interest rate fluctuations would not impact values • Fair Value -- current market value

12. Arguments against Fair Value • Increased in the volatility of earnings • Greater instability in stock prices of banks • Loss of bank capital cushions • Lack of resale market

13. Income Statement or Report of Income • Revenue Items • Interest Income (interest generated from loans normally accounts for most income -- generally more than 2/3 of total income) • Non interest income (fee income, etc.) Increasingly important. • Non interest income also includes securities gains (or losses). Now subject to standard tax rate

14. Report of IncomeExpenses • Interest Expense • largest expense is interest paid on deposits, often between 50 and 60% of total expenses • Varies based on type of deposits • fed funds borrowing and repurchase agreements have grown in importance. • Non interest expense • wages, salaries and other personnel expenses+

15. Income • Net Interest Income = Total Interest Income -Total Interest Expense Also referred to as interest margin • Net income • Adds non interest income and subtracts non interest expense to net interest income.

16. Income Statement Interest Income Interest on loans, Interest on securities, Other Interest Expense Deposit Interest, Short term debt, Long Term debt Net Interest Income Non interest Income Service Charges, Trust Department, Other Non interest Expense Wages, Net occupancy, Other operating expenses Income before taxes Provision for income taxes Net income after taxes

17. Funds from operations + decreases in bank assets + increases in bank liabilities Funds provided to the bank Dividends paid out to stockholders + increase in banks assets + decreases in bank liabilities Funds Used by the bank Funds - Flow Statement =

18. Capital Account Statement Beginning Balance + Net income - Dividends paid to shareholders + New Shares of Stock issued - Purchases of treasury stock Balance at end of period

19. Common Characteristics of Banks Financial Statements • Heavy dependence on borrowed funds • Earnings are exposed to risk if borrowings cannot be repaid • Growing use of nondeposit borrowings • Bank must hold a significant proportion of high quality and marketable securities • Financial Assets are more important than plants and equipment • few fixed costs and limited use of operating leverage.

20. Evaluating and Measuring Bank Performance • Going to use ratio analysis to evaluate the performance of depository institutions • Bank data is available in the call reports and via the Uniform Bank Performance Report (UBPR).

21. Obtaining Information on Banks • Data for banks is available from the Uniform Bank Performance Report (UBPR). • UBPR developed by the Fed, FDIC, and office of the comptroller of Currency so that there would be a standardized way to compare institutions. • Also peer group and state reports for comparable banks.

22. UBPR • Goal is to provide uniform reporting of information • Developed by the Federal Financial Institutions Examination Council’s quarterly reports. • Available online at www.FFIEC.org

23. Using the UBPR • Compare across years • each report has 5 years of data • Year end or current quarter plus 1 year prior to current and three previous years • Compare to peer groups • also available are peer groups reports based on both size of bank and geographic location • Allows you to benchmark

24. ROE and ROA ROE measure the rate of return flowing to the banks shareholders ROA measures managerial efficiency -- how well management converts assets into net earnings. The UBPR uses average assets instead of total assets.

25. Relationship between ROE and ROA

26. DuPont Identity

27. Decomposition

28. Decomposition • Equity Multiplier • Reflects the leverage or financing policies (the choice of debt or equity) • Profit Margin • Reflects the effectiveness of expense management control • Asset utilization • Reflects the ability to manage the mix and yield on the banks assets

29. Asset Utilization and Profit Margin • Both reflect Management decisions regarding: • Mix of funds raised and invested • Size of Bank • control of operating Expenses • Pricing of Services • Minimization of tax liability

30. Asset Utilization

31. Asset Utilization

32. Profit Margin

33. Decomposition of ROA

34. Decomposition of ROA Part 2

35. Decomposition of ROA Part 2

36. Other Important Ratios

37. Harris National • Net Income / Average Assets • Large decline • Better relative to industry

38. Decomposition: Intrust Bank

39. Using the UBPR Intrust BankPage 1 • Improvement in ROE, but decrease in ROA • Decrease in Int Income – Low Relative to Industry • High real to peers in Non Int Income and Non IntExp

40. Questions: Intrust Bank • Does well in Net Income – how is there business model different than a traditional bank? How does it generate income – how well does it manage expense? • Does the loan mix used by Intrust add risk?