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
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Chapter 5: Accounting and Economic Models of
Bank Performance and Valuation
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Chapter 6: Case Studies in Bank Valuation and
Performance
Chapter 4
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CHAPTER 4
Sources and Uses of Bank Funds
and the Risks of Banking
Chapter 4
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LEARNING OBJECTIVES
TO UNDERSTAND...
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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
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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
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Functions that a Bank Performs
1. Chest: the safekeeping or
risk-control function
2. Bench: the transactions
function
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Cash, Check, Credit/Debit Card
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Banks As Portfolios: Two-Way Funds
Rental and Risk Control
Risks
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Credit Risk
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Interest-Rate Risk
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Liquidity Risk
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Prepayment Risk
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Foreign-Exchange Risk
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Bank Financial Statements
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Balance Sheet: A = L + NW
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Income-Expense Statement:
P=R-C-T
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Book Values
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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
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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
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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
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Interest-Earning Assets
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Loans and leases
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C&I, real estate, and consumer
Investment securities
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Investment account
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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)
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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
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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
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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”)
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Total revenue or “sales” for a bank:
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Interest Income
From Loans, Securities, Federal Funds Sold
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Non-Interest Income
From Fees and Service Charges
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Bank Costs
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Interest Expenses
On Deposits and other Interest-Bearing
Liabilities
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Non-Interest Expenses
Administrative and Operating Expenses
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PLL is so important that it is treated
separately
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A Bank’s Income-Expense
Statement
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Net Interest Income =
Interest Income - Interest Expense
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Net Interest Margin =
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Net Interest Income / Total Assets
PLL = Provision for loan loss
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Net Noninterest Income: “Burden”
Noninterest Income - Noninterest Expense
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Taxes
Net income
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A BANK’S “BURDEN”
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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
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Return on Assets (ROA)
Net Income / Total Assets
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Return on Equity (ROE)
Net Income / Total Equity
or
ROA x Equity Multiplier (EM)
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A Bank’s Income-Expense
Statement
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Dividends and Additions to
Retained Earnings
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Internal Capital Generation Rate
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RECAP OF BANK INCOME AND
EXPENSES
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Four key components:
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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
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Three alternative ways of viewing a
bank are:
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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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