Part 2: Bank Financial Statements, Risks, and Valuation Chapter 4:
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Transcript Part 2: Bank Financial Statements, Risks, and Valuation Chapter 4:
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
1
CHAPTER 4
Sources and Uses of Bank Funds
and the Risks of Banking
Chapter 4
2
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
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CHAPTER THEME
The traditional business of banking is funding
loans (use of funds) with deposits (source of
funds). This function generates the “breadand-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.
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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
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Banks As Portfolios: Two-Way Funds
Rental and Risk Control
Risks
Credit Risk
Interest-Rate Risk
Liquidity Risk
Prepayment Risk
Foreign-Exchange Risk
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Bank Financial Statements
Balance Sheet: A = L + NW
Income-Expense Statement:
P=R-C-T
Book Values
Market Value of Equity
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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
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Bank Balance Sheets
Sources of Funds: Managed Liabilities
Managed Liabilities
As the antithesis of core deposits, managed
liabilities are more volatile and more ratesensitive 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
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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)
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Bank Balance Sheets
Sources and Uses of Funds
Federal Funds
and
Repurchase Agreements
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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 incomeexpense 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
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Bank Equity Capital
Equity Capital = Net Worth =
Book Value of Equity =
Assets - Liabilities
Regulatory capital
Market value of equity
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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
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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
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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
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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
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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
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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)
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A Bank’s Income-Expense
Statement
Dividends and Additions to
Retained Earnings
Internal Capital Generation Rate
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RECAP OF BANK INCOME AND
EXPENSES
Four key components:
1.
2.
3.
4.
Net interest income
PLL
Net noninterest income (”burden”)
Taxes
Net income is the bottom line
ROA is the key accounting measure of
bank performance
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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
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