Chapter Thirteen

1. Chapter Thirteen Depository Institutions’ Financial Statements and Analysis

2. Why evaluate Performance of Depository Institutions (DIs) • DIs - unique in the special services they perform (e.g., assistance in the implementation of monetary policy) and the level of regulatory attention they receive • Unique in the types of assets and liabilities they hold • Managers, stockholder, depositors, regulators, and other parties use performance, earnings, and other measures obtained from financial statements to evaluate which DI stocks they will purchase

3. Financial Statements of Commercial Banks • Report of condition - balance sheet of a commercial bank reporting information at a single point in time • Report of income - income statement of a commercial bank reporting revenues, expenses, net profit or loss, and cash dividends over a period of time • Retail bank - one that focuses its business activities on consumer banking relationships • Wholesale bank - one that focuses its business activities on commercial banking relationships

4. Assets • Four major subcategories • cash and balances due from other depository institutions • vault cash, deposits at the Federal Reserve, deposits at other FIs, and cash items in the process of collection • investment securities • interest-bearing deposits at other FIs, fed funds sold, RPs, U.S. Treasury and agency securities, securities issued by states and political subdivisions, mortgage-backed securities, and other debt and equity securities • loans and leases • other assets • premises and fixed assets, real estate owned, investments in unconsolidated subsidiaries, intangible assets, other fees receivable

5. Liabilities • NOW account - negotiable order of withdrawal account, similar to a demand deposit with minimum balance • MMDAs - money market deposit accounts with retail savings accounts and limited checking account • Other savings deposits - other than MMDAs • Retail CDs - time deposits with face value below $100,000 • Wholesale CDs - time deposits with face value above $100,000 (continued)

6. Liabilities • Negotiable instrument - an instrument whose ownership can be transferred in the secondary market • Brokered deposits - wholesale CDs obtained through a brokerage house • Core deposits - deposits of the bank that are stable over short periods of time and thus provide a long-term funding source to a bank • Purchased funds - rate-sensitive funding sources of the bank

7. Equity Capital • Preferred and common stock (listed at par value) • Surplus or additional paid-in capital • Retained earnings • Regulations require banks to hold a minimum level of equity capital to act as a buffer against losses from their on- and off-balance sheet assets

8. Off-Balance-Sheet Assets and Liabilities • Contingent assets and liabilities that may affect the future status of the FIs balance sheet • OBS activities grouped into 5 major categories • Loan commitments - contractual commitment to loan to a firm a certain maximum amount at given interest rate terms • up-front fee - fee charged for making funds available through a loan commitment • back-end fee - fee charged on the unused component of a loancommitment (continued)

9. Commercial Letters of Credit and Standby Letter of Credit • letters of credit - contingent guarantees sold by an FI to underwrite the trade or commercial performance of the buyer of the guarantee • standby letter of credit - guarantees issued to cover contingencies that are potentially more sever and less predictable than contingencies covered under trade-related or commercial letters of credit • Forward Purchases and Sales of When-Issued Securities • when-issued securities - commitments to buy or sell securities before they are issued • Loans Sold • loans that a bank originated and then sold to other investors that may be returned (with recourse) to the originating institution in the future • recourse - the ability to put an asset or loan back to the seller should the credit quality of that asset deteriorate • Derivative Contracts • futures, forward, swap, and option positions taken by the FI for hedging or other purposes

10. Income Statement • Interest Income • Interest Expenses • Net Interest Income • Provision for Loan Losses • Noninterest Income • Noninterest Expense • Income before Taxes and Extraordinary Items • Income Taxes • Extraordinary Items • Net Income

11. The Direct Relationship between the Income Statement and the Balance Sheet NM NI =  rnAn-rmIm- P + NII - NIE - T n=1 m=1 where NI = Bank’s net income An = Dollar value of the bank’s nth asset Lm = Dollar value of the bank’s nth liability rn = Rate earned on the bank’s nth asset rm = Rate paid on the bank’s nth liability P = Provision for loan losses NII = noninterest income earned, including OBS NIE = noninterest expenses incurred T = Bank’s taxes N = number of assets the bank holds M = number of liabilities the bank holds

12. Financial Statement Analysis Using a Return on Equity Framework Time series analysis - analysis of financial statements over a period of time Cross-sectional analysis - analysis of financial statements comparing one firm with others Return on equity (ROE) - measures overall profit- ability of the FI per dollar of equity ROE = Net income  Total Assets Total Assets Total equity capital = ROA  EM

13. Return on Assets and Its Components Return on Assets (ROA) - measures profit generated relative to the FI’s assets ROA = Net Income  Total operating income Total operating income Total assets = PM  AU

14. Profit Margin Profit Margin (PM) - measures the ability to pay expenses and generate income from interest and noninterest income Interest expense ratio = Interest expense Total operating income Provision for loan loss ration = Provision for loan losses Total operating income Noninterest expense ratio = Noninterest expense Total operating income Tax Ratio = Income taxes Total operating income

15. Asset Utilization Asset utilization (AU) - measures the amount of interest/ noninterest income generated per dollar of total assets AU = Total operating income = Interest + Noninterest Total assets income income ratio ratio

16. Net Interest Margin Net interest margin - interest income minus interest expense divided by earning assets Net interest = Net interest income margin Earning assets = Interest income - Interest expense Investment securities + Net loans and leases

17. Spread Spread - the difference between lending and deposit rates spread = Interest income - Interest expense Earning assets Interest-bearing liabilities

18. Overhead Efficiency Overhead efficiency - a bank’s ability to generate noninterest income to cover noninterest expenses Overhead efficiency = Noninterest income Noninterest expense