Bank Balance Sheets and Income Statements

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Bank Balance Sheets and Income Statements

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Bank Balance Sheets and Income Statements : 

Bank Balance Sheets and Income Statements

Unit Agenda : 

Unit Agenda FDIC Website: UBPR, SDI, CTR Overview of Bank Balance Sheets Overview of The Income Statement Components of Profits Profitability Analysis

Unit Objectives : 

Unit Objectives Students will be able to obtain information on bank profitability from publicly available records. Students will be able to calculate measures of bank profitability and explain the significance. Students will be able to use 6 steps of profitability analysis for trend and peer comparisons.

FDIC Data : 

FDIC Data In USA, bank deposits are insured by government owned Federal Deposit Insurance Corporation are required to submit quarterly data on income and balance sheets to regulator which is available on-line in easy to use form. UBPR – Comprehensive set of quarterly data for every bank in the US collected by Federal Financial Instituting Examination Council. Link.

Additional Data : 

Additional Data Additional macro or industry level data from FDIC & Fed linkable from the site. Call and Thrift Reports Detailed Balance Sheet and Income Statement for each bank. Link Statistics on Depositary Institutions Create reports with customized peer groups. Link

Analyzing Bank Performance in HK : 

Analyzing Bank Performance in HK Data less easily available in consistent comparable form. Main source of bank data will be bank annual reports. Most information is available in annual and interim reports on the web. Less useful, because the data is not as consistent across banks and not reported as frequently.

Analysis : 

Analysis Peer Analysis - Compare with others in same business situation Trend Analysis – Compare performance with previous periods. Learn About Bank Balance Sheets at HSBC Subsidiary HSBC National Association, USA

Balance Sheets : 

Balance Sheets Assets Loans Investment Securities Noninterest Cash & Due from Banks Other Liabilities Transactions Accounts Savings and Time Deposits Other Borrowings Equity

Peer Comparison: Assets : 

Peer Comparison: Assets Source: SDI Cert. 57890

Types of Bank AssetsShow Website on Screen : 

Types of Bank AssetsShow Website on Screen Cash and Funds Due: Vault Cash Deposits at Central Bank Cash items in process of Collection

Types of Bank Assets cont. : 

Types of Bank Assets cont. Investments Deposits at other banks Lending of central bank reserves (to other banks) Securities:

Composition of Securities : 

Composition of Securities

Types of Bank Assets, cont. : 

Types of Bank Assets, cont. Net Loans and Leases, Loans to customers less the allowances for loan losses. Loan loss accounts are contra-assets, deductions from value of loans which are chosen subjectively (subject to regulatory approval).

Liabilities : 

Liabilities

Types of Liabilities : 

Types of Liabilities Deposits: Main source of funding for commercial banks. Volatile Liabilities in Red

Types of Liabilities, cont. : 

Types of Liabilities, cont. Fed Funds Purchased: Short-term loans from one bank to another with securities as collateral. Trading liabilities: Obligations of banks’ securities dealers. Other Borrowed Money: Short-term borrowings and commercial paper. Subordinated Debt: Debt w/ maturity > 1 yr. and junior to deposits. Foreign Office Deposits: Deposits at Foreign Subsidiaries.

Income Statement : 

Income Statement

Statistics For Depository Institutions : 

Statistics For Depository Institutions

Net Interest:Key Source of Profits : 

Net Interest:Key Source of Profits Main business of commercial banks is taking deposits at interest and making loans or buying interest paying assets. Net Interest Income (NII) = Interest Revenue – Interest Expenses HSBC USA N.A., 12/31/2005 Statistics For Depository Institutions

Sources of Interest IncomeHSBC USA N.A., 12/31/2005 CTR : 

Sources of Interest IncomeHSBC USA N.A., 12/31/2005 CTR U.S. Banks heavily dependent on income from property sector like Hong Kong! Statistics For Depository Institutions

Sources of Interest ExpenseHSBC USA N.A., 12/31/05 SDI & CTR : 

Sources of Interest ExpenseHSBC USA N.A., 12/31/05 SDI & CTR

Other sources of profits : 

Other sources of profits Banks face other expenses (salaries, rent, etc.) and have other sources of income such as fees and services. Banks have an increasing role in providing services to financial markets. In HK, banks have many financial businesses including credit cards, insurance, etc. Burden = Noninterest Expenses – Noninterest Revenues

Sources of Non-Interest IncomeHSBC USA N.A., 12/31/2005 SDI : 

Sources of Non-Interest IncomeHSBC USA N.A., 12/31/2005 SDI US$, 000, CTR

Sources of Non-Interest ExpenseHSBC USA N.A., 12/31/05 SDI : 

Sources of Non-Interest ExpenseHSBC USA N.A., 12/31/05 SDI CTR

Loan Provisions : 

Loan Provisions When loans are not repaid, these losses occur they will have a negative impact on profits. To prevent unexpected losses from leading to fluctuations in profits, banks create a loan reserve account. Loan reserves are a contra-asset account, i.e. an account of deductions from stock of loans. Net Loans = Gross Loans – Loan Reserves When loans are not repaid, their amount is deducted from Gross Loans & Loan Reserves When bank makes Provisions for Loan Losses this amount is added to Loan Reserves & deducted from profits.

Etc. : 

Etc. Securities Gains: Changes in Mark-to-Market value of financial assets. Extraordinary Items: One time gains and losses on asset sales. Taxes

Evaluating Bank Performance : 

Evaluating Bank Performance ROE Analysis

Measures of Performance : 

Measures of Performance Benchmark measure of a banks profitability is the return on equity which is profits per unit of dollars invested by the banks owners. i.e. dollars of income divided by equity in the bank. Corresponds with a rate of return on investment. Items on the Income Statement are generated over a period of time while items on the Balance sheet are at a point in time.

Averaging Stock Variables : 

Averaging Stock Variables Example: Consider equity value of HSBC USA, N.A., at ends of 2004 and 2005 compared with income earned over 2005. Most appropriate to average balance sheet variables over the year.

Averages : 

Averages Average of available balance sheets. Quarterly (and semi-annual) income statements report on a year-to-date basis. [e.g. income on 9/30 is the income earned from January through September]. To get appropriate denominator, start with end of previous year and take average of end of period balance sheets over the year. Annualize.

HSBC USA Return on Equity : 

HSBC USA Return on Equity Year to Date Averages, Check against UBPR

Last YearHSBC National Assoc.Qtr by Qtr Averages SDI : 

Last YearHSBC National Assoc.Qtr by Qtr Averages SDI Compare Q-by-Q ROE with UBPR

Quarterly Averages : 

Quarterly Averages For some balance sheet variables, such as assets, banking firms construct day-by-day or week-by-week averages and report these on a quarterly basis. Averages (across quarters) of these daily/weekly averages are used to most accurately calculate yields for UBPR.

Determinants of ROE : 

Determinants of ROE The first step in analyzing profits is to decompose returns into the profitability of assets and the leverage of the bank. Leverage Profitability of Banks Assets

Equity Multiplier : 

Equity Multiplier Banks’ owners earn profits on the spread between interest on lending and the interest on deposits. When the leverage (EM) is high, banks are accepting a lot of deposits and can earn high income levels. A high multiplier multiplies profits when profits are positive. But in periods with negative profits, negative profits may also be multiplied. A high EM is a risk factor since it reduces the amount of assets that can go bad without the bank itself going bankrupt. Capitalization is a key pillar of bank regulation

Dupont Analysis : 

Dupont Analysis ROA Expense Ratio Asset Utilization Income Management Cost Management

Dupont Analysis (Bank Version) : 

Dupont Analysis (Bank Version) ROA for all types of firms can be decomposed into revenue and cost management. AU = Asset Utilization (Revenue Management) ER = Expense Ratio (Cost Management)

II. Earnings and Profitability Analysis : 

II. Earnings and Profitability Analysis The Dupont Analysis can decompose owner’s returns into cost management and revenue management. Profitability Analysis decomposes cost management and revenue management into narrower categories of cost and revenue to evaluate the source of profits.

Asset Utilization : 

Asset Utilization Asset Utilization (UA) Non Interest Revenue/ Assets Interest Revenue/ Assets Rate Composition Volume Effects + = Securities Gains

Non Interest Income is growing as a share of operating income : 

Non Interest Income is growing as a share of operating income Source: Hoshi and Kashyap, 2002

Determinants of Net Interest Income : 

Determinants of Net Interest Income Interest Earning assets as a share of assets Volume Effects Rate Effects: Level of interest earned on assets of a given type. Composition/Mix Effects: Types of interest earning assets.

Yield AnalysisBanks with Assets > US$50 billion : 

Yield AnalysisBanks with Assets > US$50 billion Source: UBPR Custom Peer Group Reports

Expense Ratio and Cost Management : 

Expense Ratio and Cost Management ER Rate Composition Volume Effects

Efficiency Ratio : 

Efficiency Ratio One measure of the ability to manage costs is the ratio of expenses to revenue EFF = Efficiency Ratio

Analysis of Non Interest Expense : 

Analysis of Non Interest Expense We may also want to look carefully at the sources of efficiency with which banks deliver services % of Assets Personnel Expenses Total Expenses Burden Productivity Measures Efficiency Ratio Personnel Expense/Employee Assets/Employee

Decomposition of Expenses Banks with Assets > US$50 billion : 

Decomposition of Expenses Banks with Assets > US$50 billion

Determinants of Net Interest Expense : 

Determinants of Net Interest Expense Interest Paying liabilities as a share of assets – Volume Effects The interest paid on interest earning liabilities: Rate Effects: Level of interest paid on liabilities of a given type. (TREND Analysis) Composition/Mix Effects: Types of interest bearing liabilities

Cost AnalysisBanks with Assets > US$50 billion : 

Cost AnalysisBanks with Assets > US$50 billion Source: UBPR Custom Peer Group Reports

Net Interest Margin & Spread : 

Net Interest Margin & Spread Concentrates on Rate & Composition Effects

Increasing Competition? : 

Increasing Competition?

Profits vs. Risk : 

Profits vs. Risk Earning high profits in good or even normal times will be easier if the bank is willing to take on some risk. But this risk may be more problematic in bad times. Important to measure the risk of the banking system as well as the profits.

Types of Risk : 

Types of Risk Credit Risk Liquidity Risk Market Risk Interest Rate Risk Foreign Exchange Risk Stock market risk Operational Risk Business Risk Legal Risk Off-Balance Sheet Risk

Credit Risk: the risk that a borrower will not pay back interest or principal on a loan. : 

Credit Risk: the risk that a borrower will not pay back interest or principal on a loan. Evaluating Bank Credit Risk History of Credit Performance (Charge-offs) Future expected losses (non-performing loans, types of lending, diversification) Strength of bank preparation (reserves, earnings coverage).

Liquidity Risk Variation in Net income caused by banks difficulty in obtaining immediately available funds. : 

Liquidity Risk Variation in Net income caused by banks difficulty in obtaining immediately available funds. Short-term obligations to shareholders Liquid Assets Other sources of liquidity

Interest Rate Risk Variation in income and market value due to effects of interest rate changes on profits & present value of assets and liabilities. : 

Interest Rate Risk Variation in income and market value due to effects of interest rate changes on profits & present value of assets and liabilities. Gap between interest sensitivity of assets and liabilities at different maturities. Duration of assets and liabilities of bank.

Off-balance Sheet Items : 

Off-balance Sheet Items Commercial Letters of Credit – Banks guarantee payment on trade related items. Standby Letters of Credit – Banks make loans triggered by default on s-t borrowing or commercial paper. Loan Commitments – Banks commit to lending on borrowers demand. Securitization w/ Recourse Credit Derivatives – Credit Guarantees Financial Derivatives – Interest Rate, Forex, etc. Swaps, Futures & Options.

Comprehensive Risk Management : 

Comprehensive Risk Management Modern banks use computer models to measure market risk. Based on historical data on correlations between asset prices and assumptions about the distribution of shocks (i.e. assume shocks are normally distributed) the models will generate a distribution of returns over any horizon. Value at Risk models will predict some possible loss which will be the maximum possible loss with some percentage chance over some forecast horizon.

Problems with VAR’s : 

Problems with VAR’s Normal distributions assess a very low likelihood of extreme, crisis events. HKMA recommends balance sheets should be “stress-tested” against some Historical time series models are subject to unexpected structural change. Less good at evaluating losses from infrequently traded assets like loans.

Other Risks : 

Other Risks Operational Risk Risk that operating expenses may vary significantly. Crime & terrorism Employee error or fraud Legal Risk Risk that lawsuits or unenforcable contracts might affect profitability or solvency Reputation Risk Risk that negative publicity may affect customer base or business opportunities.

Market Measures of Bank Performance : 

Market Measures of Bank Performance Financial markets may be a measure of bank performance. Equity Markets: Common stock Book-to-Market ratio measures markets perception of growth potential and risk of assets. Preferred stock and subordinated debt holders are exposed to downside risk but not upside gains from risky activities. Price of these assets may help measure riskiness of activities.

Reading List : 

Reading List J.A. Lopez,  Methods for Evaluating Value-at-risk Estimates – SF FRB Economic Review, 1999 Clark, Dick, Hirtle, Stiroh, and William “The Role of Retail Banking in the U.S. Banking Industry: Risk, Return, and Industry Structure NY FRB Economic Review 2007