Commercial Banks’ Financial Statements and Analysis

8-1McGraw-Hill/IrwinChapter TwelveCommercial Banks’ Financial Statements and Analysis12-2McGraw-Hill/IrwinCAMELS RatingsRegulators use CAMELS ratings to evaluate the safety and soundness of banksCAMELS ratings rely heavily on financial statement dataComponentsCapital adequacyAsset qualityManagement qualityEarnings qualityLiquiditySensitivity to market risk12-3McGraw-Hill/IrwinCAMELS RatingsCAMELS ratings range from 1 to 5Composite “1”—banks are basically sound in every respectComposite “2”—banks are fundamentally sound, but may have modest weaknesses correctable in the normal course of businessComposite “3”—banks exhibit financial, operational, or compliance weaknesses ranging from moderately severe to unsatisfactoryComposite “4”—banks have an immoderate volume of serious financial weaknesses or a combination of other conditions that are unsatisfactoryComposite “5”—banks have an extremely high immediate or near term probability of failure12-4McGraw-Hill/IrwinFinancial StatementsThe Federal Financial Institutions Examination Council (FFIEC) prescribes uniform principles, standards, and report forms for depository institutionsbalance sheets are reported on report of condition formsincome statements are reported on report of income formscommercial banks report contingent assets and liabilities on off-balance-sheet reportsRetail banks focus business activities on consumer banking relationshipsWholesale banks focus business activities on commercial banking relationshipsmost wholesale banks also engage in retail banking12-5McGraw-Hill/IrwinCommercial Bank AssetsCash and balances due from other depository institutionsInvestment securitiesshort-term securities (e.g, Treasury bills and fed funds sold)long-term securities (e.g., Treasury bonds, munis, MBSs)Loanscommercial and industrialreal estateconsumerother loansUnearned income and allowance for loan and lease lossesOther assets (e.g., fixed assets, goodwill, etc.)12-6McGraw-Hill/IrwinCommercial Bank LiabilitiesCore depositsdemand depositsnegotiable order of withdrawal (NOW) accountsmoney market deposit accounts (MMDAs)other savings depositsretail certificates of depositsOther depositswholesale certificates of depositsnegotiable instruments traded in secondary marketsbrokered deposits12-7McGraw-Hill/IrwinCommercial Bank Liabilities and EquityNon-deposit liabilitiesborrowed fundsfed funds purchased and reposother borrowed funds (e.g., banker’s acceptances, commercial paper, discount window loans)subordinated notes and debenturesother liabilitiesaccrued interest, deferred taxes, dividends payable, etc.Equitypreferred and common stocksurplus or additional paid in capitalretained earnings12-8McGraw-Hill/IrwinOff-Balance-Sheet ItemsOff-balance-sheet items are contingent assets and liabilities that may affect a commercial bank’s balance sheet and/or income statementLoan commitmentsup-front fees are charged for making funds availablecommitments fees are charged on unused portion of commitmentsLetters of creditcommercial letters of creditstandby letters of creditLoans soldloans can be sold with or without recourseDerivative contractsfutures, forwards, swaps, and options12-9McGraw-Hill/IrwinIncome StatementInterest income – interest expense = net interest incomeNoninterest income – noninterest expense = net noninterest incomeNet interest income – provision for loan losses + net noninterest income = income before taxes and extraordinary items (EBTEI)EBTEI – income taxes – extraordinary items = net income12-10McGraw-Hill/IrwinIncome StatementThere is a direct relationship between the income statement and the balance sheet of commercial banks NI = net income An = dollar value of the bank’s nth asset Lm = dollar value of the bank’s mth liability rn = rate earned on the bank’s nth asset rm = rate paid on the bank’s mth liability P = provision for loan losses NII = non-interest income earned, including income from OBS activities NIE = non-interest expenses T = taxes and extraordinary items N = number of assets the bank holds M = number of liabilities the bank holds12-11McGraw-Hill/IrwinFinancial Statement AnalysisFinancial statement analysis is based on accounting ratiosTime series analysis is the analysis of financial statements over a period of timeCross-sectional analysis is the analysis of financial statements comparing one firm with othersthe Uniform Bank Performance Report (UBPR) maintained by the FFIEC allows banks to observe competitor financial statementsMost financial statement analyses is a combination of time series analysis and cross-sectional analysis12-12McGraw-Hill/IrwinReturn on Equity (ROE) FrameworkReturn on Equity (ROE) analysis begins with ROE and then breaks it down into its componentsROE measures the overall profitability of the bank per dollar of equityROE can be broken down into its components12-13McGraw-Hill/IrwinReturn on Equity (ROE) FrameworkReturn on Assets (ROA) measures profit generated relative the banks assetsEquity Multiplier (EM) measures the extent to which assets are funded with equity relative to debt (i.e., it is a measure of leverage)ROA can also be broken down into its components12-14McGraw-Hill/IrwinReturn on Equity (ROE) FrameworkProfit Margin (PM) measures the ability to pay expenses and generate net income from interest and noninterest income and is composed ofinterest expense ratioprovision for loan loss rationoninterest expense ratiotax ratioAsset Utilization (AU) measures the amount of interest and noninterest income generated per dollar of total assets and is composed ofinterest income rationoninterest income ratio12-15McGraw-Hill/IrwinOther RatiosThe net interest margin (NIM) measures the net return on a bank’s earning assetsThe spread measures the difference between the average yield on earning assets and average cost on interest-bearing liabilities12-16McGraw-Hill/IrwinOther RatiosOverhead efficiency measures a bank’s ability to generate noninterest income to cover noninterest expensesMany additional ratios are commonly used to analyze commercial banks by breaking down the components of ROE even further (see Tables 12-6 and 12-7)12-17McGraw-Hill/IrwinThe Impact of Market Niche and SizeRetail and wholesale commercial banks operate in different market niches that should be noted when performing financial statement analysisWebster Financial Bancorp (WBS)WBS is a profitable and efficient retail bankinvests mainly in real estate loansuses low cost retail deposits to fund its assetsholds relatively more equity capital than Bank of America12-18McGraw-Hill/IrwinThe Impact of Market Niche and SizeBank of America (BOA)BOA is both a retail and a wholesale bankhas a relatively more diversified portfolio than WBSuses a broader array of deposits and more purchased funds (i.e., fewer core deposits) than WBSoffers a broad spectrum of financial servicesBOA is the more profitable bankuses less equity, which contributes to a higher ROEgenerates much more noninterest income