Because learning changes everything.

Chapter 12
Commercial Banks’
Financial Statements and
Analysis

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 Why Evaluate the Performance of
Commercial Banks?
Commercial banks (CB’s) are unique in the special
services they perform and the level of regulatory
attention they receive.
• As a result, they are also unique in the type of assets and
liabilities they hold.
Ultimate measure of a CB’s performance is the value of
its common equity to its shareholders.
Financial statements of commercial banks are ideal
candidates to use in examining the performance of
depository institutions, given the extensive regulation
and accompanying requirements for public availability of
financial information.
© McGraw Hill 2
 CAMELS Ratings
Regulators use CAMELS ratings to evaluate the safety
and soundness of banks.
CAMELS ratings rely heavily on financial statement data.
Components.
• Capital adequacy.
• Asset quality.
• Management.
• Earnings.
• Liquidity.
• Sensitivity to market risk.

© McGraw Hill 3
 CAMELS Ratings Components 1

Capital adequacy.
• Evaluated in relation to the volume of risk assets; the volume of
marginal and inferior quality assets; the bank’s growth experience,
plan, and prospects; and the strength of management.

Asset quality.
• Evaluated by the level, distribution, and severity of adversely classified
assets; the level and distribution of nonaccrual and reduced-rate
assets; the adequacy of the allowance for loan losses; and
management’s demonstrated ability to administer and collect problem
credits.
Management.
• Evaluated against virtually all factors considered necessary to operate
the bank within accepted banking practices and in a safe and sound
manner.
© McGraw Hill 4
 CAMELS Ratings Components 2

Earnings.
• Evaluated with respect to their ability to cover losses and provide
adequate capital protection; trends; peer group comparisons; the
quality and composition of net income; and the degree of reliance on
interest-sensitive funds.

Liquidity.
• Evaluated in relation to the volatility of deposits; the frequency and
level of borrowings; the use of brokered deposits; technical
competence; availability of assets readily convertible into cash; and
access to money markets or other ready sources of funds.

Sensitivity to market risk.

• Reflects the degree to which changes in interest rates, foreign
exchange rates, commodity prices, or equity prices can adversely
affect an FI’s earnings or economic capital.
© McGraw Hill 5
 CAMELS Ratings Components 3

CAMELS ratings range from 1 to 5:

• Composite “1”— Institutions in this group are basically sound in every
respect.
• Composite “2”— Institutions in this group are fundamentally sound
but may reflect modest weaknesses correctable in the normal course
of business.
• Composite “3”— Institutions in this group exhibit financial,
operational, or compliance weaknesses ranging from moderately
severe to unsatisfactory.
• Composite “4”— Institutions in this group have an immoderate
volume of serious financial weaknesses or a combination of other
conditions that are unsatisfactory.
• Composite “5”— Reserved for institutions that have an extremely
high immediate or near-term probability of failure.

© McGraw Hill 6
 Financial Statements
Federal Financial Institutions Examination Council (F FIEC)
prescribes uniform principles, standards, and report forms for
depository institutions.
• Financial statements of CB’s must be submitted to regulators and
stockholders at the end of each calendar quarter.

Financial information on C B’s is reported in two basic documents:

1. Report of condition (or balance sheet) presents financial
information on a bank’s assets, liabilities, and equity capital.
2. Report of income (or income statement) presents major categories
of revenues and expenses and the net profit (or loss) for a bank over
a period of time.

All FI’s, and particularly commercial banks, are engaging in an

increased level of off-balance-sheet (OBS) activities.

© McGraw Hill 7
 Assets 1

1. Cash and due from depository institutions.

• Consists of vault cash, deposits at the Federal Reserve,
deposits at other financial institutions, and cash items in the
process of collection.
• None of these generates much income for the bank.
2. Investment securities.
• Consists of federal funds sold, repurchase agreements (R P’s or
repos), U.S. Treasury and agency securities, securities issued
by states and political subdivisions (municipals), mortgage-
backed securities, and other debt and equity securities.
• Generate some income for the bank.
• Highly liquid, low default risk, and can usually be traded in
secondary markets.
© McGraw Hill 8
 Assets 2

3. Loans and leases.

• Categorized as commercial and industrial (C&I) loans, loans
secured by real estate, individual or consumer loans, and other
loans.
• Major asset items on the bank’s balance sheet and generate the
largest flow of revenue income.
• Least liquid asset items and a major source of credit and
liquidity risk for most banks.

4. Other assets.
• Consists of items such as trading assets, premises and fixed
assets, other real estate owned, intangible assets, and other.
• Generally a small part of the bank’s overall assets.
© McGraw Hill 9
 Liabilities 1

Liabilities consist of various types of deposit accounts

and other borrowings used to fund the investments and
loans on the asset side of the balance sheet.
1. Deposits.
• Demand deposits are transaction accounts that generally pay no
explicit interest.
• Negotiable order of withdrawal (NOW) accounts pay interest
when a minimum balance is maintained.
• Money market deposit accounts (MMDA’s) have retail
savings accounts and some limited checking account features.
• Other savings deposits include all savings accounts other than
MMDA’s.

© McGraw Hill 10
 Liabilities 2

Deposits in foreign offices are generally large and held by

corporations with a high level of international transactions and
activities.
Retail certificates of deposits (CD’s) are time deposits with a
face value below $100,000.
Core deposits.
Wholesale certificates of deposits (CD’s) are time deposits with
a face value of $100,000 or more.
• Negotiable instruments, meaning they can be resold by title
assignment in a secondary market to other investors.
• If wholesale CD’s are obtained through a brokerage or investment
house rather than directly from a customer, they are referred to as
brokered deposits.

© McGraw Hill 11
 Liabilities 3

2. Borrowed funds.
Federal funds.
Repurchase agreements (RP’s or repos).
Other borrowing.
• Banker’s acceptances (BA’s), commercial paper, medium-term notes, and
discount window loans.

3. Other liabilities.
Do not require interest to be paid.
• Accrued interest, deferred taxes, dividends payable, minority interests in
consolidates subsidies, and other miscellaneous claims.

4. Equity capital.
• Preferred and common stock.
• Surplus and additional paid-in capital.
• Retained earnings.
© McGraw Hill 12
 Off-Balance-Sheet Assets and
Liabilities 1

Off-balance-sheet items are contingent assets and liabilities

that may affect future status of a FI’s balance sheet.
Loan commitments are contractual commitments to loan to a
firm a certain maximum amount at given interest rate terms.
• Bank may charge up-front fee and/or commitment fee.
• Only when the borrower draws on the commitment do the loans
made under the commitment appear on the balance sheet.
Letters of credit (LC’s).
• Commercial LC’s are contingent guarantees sold by an F I to
underwrite the trade or commercial performance of the buyers of
the guarantees.
• Standby L C’s cover contingencies that are potentially more
severe than contingencies covered under trade/commercial L C’s.
© McGraw Hill 13
 Off-Balance-Sheet Assets and
Liabilities 2

Loans sold are loans originated by the bank and then

sold to other investors that can be returned (sold with
recourse) to the originating institution.
• Recourse is the ability to put an asset or loan back to the
seller should the credit quality of that asset deteriorate.
Derivative securities include futures, forward, swap,
and option positions taken by the FI for hedging or other
purposes.
• Banks can be either users or dealers of derivatives.
• Counterparty, or contingent credit, risk is likely to be
present when banks expand their positions in futures,
forward, swap, and option contracts.
© McGraw Hill 14
 Other Fee-Generating Activities
Trust services.
• Trust departments of commercial banks hold and manage
assets for individuals or corporations.
Processing services.
• Commercial banks have traditionally provided financial
data processing services for their business customers,
including managing a customer’s accounts receivable and
accounts payable.
• Bank cash management services include the provision of
lockbox services.
Correspondent banking.
• Provision of banking services to other banks that do not
have the staff resources to perform the service themselves.
© McGraw Hill 15
 Income Statement 1

Income statement identifies interest income and expenses, net

interest income, provision for loan losses, noninterest income and
expenses, income before taxes and extraordinary items, and net
income from on- and off-balance sheet activities.
Interest income is taxable, except for that on municipal securities
and tax-exempt income from direct lease financing.
• Interest and fee income on loans and leases is the largest interest
income-producing category.
• Taxable equivalent interest income is equal to interest income divided
by 1 minus the banks’ tax rate.

Interest expense is the second major category on a bank’s

income statement, and items listed here come directly from the
liability section of the balance sheet.

© McGraw Hill 16
 Income Statement 2

Net interest income = interest income − interest expense.

Provision for loan losses is a noncash, tax-deductible expense,
and it is the current period’s allocation to the allowance for loan
losses listed on the balance sheet.
Noninterest income include all other income received by the
bank as a result of its on- and off-balance sheet activities.
• Total operating income = interest income + noninterest income.

Noninterest expense items consist mainly of personnel expenses

and are generally large relative to noninterest income.
• Items in this category include salaries and employee benefits, expenses
of premises and fixed assets, and other operating expenses.
• For almost all banks, noninterest expense is greater than noninterest
income.
© McGraw Hill 17
 Income Statement 3

Income before taxes and extraordinary items (that is, operating

profit) is calculated as net interest income minus provisions for
loan losses plus noninterest income minus noninterest expense.
Income taxes include federal, state, local, and foreign income
taxes due from the bank.
Extraordinary items and other adjustments are events or
transactions that are both unusual and infrequent.
• For example, changes in accounting rules, corrections of accounting
errors made in previous years, and equity capital adjustments.

Net income is calculated as income before taxes and extraordinary

items minus income taxes plus (or minus) extraordinary items.
• Bottom line on the income statement.

© McGraw Hill 18
 Relationship Between Income
Statement and Balance Sheet
• There is a direct relationship between the income statement and the balance sheet of
commercial banks.
N M
NI =  rn An − rm Lm −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 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 = Noninterest income earned by the bank, including income from off-balance-sheet activities
NIE = Noninterest expenses incurred by the bank
T = Bank's taxes and extraordinary items
N = Number of assets the bank holds
M = Number of liabilities the bank holds

© McGraw Hill 19
 Income Statement Example
• Changing the mix of assets or liabilities on the balance
sheet has a direct effect on net income equal to the size of
the rate difference times the dollar value of the asset or
liability being changed.
• Suppose that a bank has the following net income:
NI = 0.046(1m.) + 0.06(3m.) − 0.035(3m.) − 0.0475(1m.) = $73,500

• The bank replaces $500,000 of assets currently yielding

4.60 percent with assets yielding 6 percent. As a result, net
income increases by $7,000 [(6% − 4.6%) × $500,000], or
NI = 0.046(0.5m.) + 0.06(3.5m.) − 0.035(3m.) − 0.0475(1m.) = $80,500

© McGraw Hill 20
 Financial Statement Analysis Using a
Return on Equity Framework
Ratio analysis allows a bank manager to evaluate the
bank’s:
• Current performance;
• The change in its performance over time (time series
analysis of ratios over a period of time); and,
• Its performance relative to that of competitor banks (cross-
sectional analysis of ratios across a group of firms).

The Uniform Bank Performance Report (UBPR), a tool

available to assist in cross-sectional analysis,
summarizes the performance of banks for various peer
groups, for various size groups, and by state.

© McGraw Hill 21
 Return on Equity (ROE) Framework 1

• Return on equity (ROE) framework starts with ROE, and

then breaks it down to identify strengths and weaknesses in
a bank’s performance.
• ROE measures the amount of net income after taxes earned
for each dollar of equity capital contributed by the bank’s
stockholders.
Net income
ROE =
Total equity capital

• ROE can be decomposed into two component parts:

Net income Total assets
ROE = 
Total assets Total equity capital
= R OAEM

© McGraw Hill 22
 Return on Equity (ROE) Framework 2

Return on assets (ROA) determines the net

income produced per dollar of assets.
Equity multiplier (EM) measures the dollar value of
assets funded with each dollar of equity capital.
• The higher this ratio, the more leverage or debt the
bank is using to fund its assets.

ROA can also be broken down into two components:

Net income Total operating income
ROA = 
Total operating income Total assets
= PMAU
© McGraw Hill 23
 Return on Assets (ROA) and Its
Components
Profit margin (PM) measures a bank’s ability to control
expenses and thus its ability to produce net income from its
operating income (or revenue).
• Breakdown of P M can isolate the various expense items listed
on the income statement as follows:
• Interest expense ratio.
• Provision for loan loss ratio.
• Noninterest expense ratio.
• Tax ratio.

Asset utilization (AU) measures the extent to which the

bank’s assets generate revenue.
Total operating income Interest Noninterest
Asset utilization ratio = = +
Total assets income ratio income ratio
© McGraw Hill 24
 Other Ratios 1

• Net interest margin (NIM) measures the net return

on a bank’s earning assets.
Net interest income Interest income − Interest expense
Net interest margin = =
Earning assets Investment securities + Net loans and leases

• Spread measures the difference between the

average yield on earning assets and average cost
of interest-bearing liabilities.
Interest income Interest expense
Spread = =
Earning assets Interest­bearing liabilities

© McGraw Hill 25
 Other Ratios 2

Overhead efficiency measures the bank’s ability to

generate noninterest income to cover noninterest
expenses.
Noninterest income
Overhead efficiency =
Noninterest expense
Many components of key ratios provide additional
insight into the financial stability of banks.
• See Table 12-6 for a decomposition of profit margin.
• See Table 12-7 for a decomposition of asset utilization.

© McGraw Hill 26
 The Impact of Market Niche and Bank
Size on Financial Statement Analysis
Retail, wholesale, and community banks operate in different
market niches that should be noted when performing financial
statement analysis.
Large banks have greater access to purchased funds and capital
markets compared to small banks.
• Large banks generally operating with lower amounts of equity capital
than small banks.
• Large banks generally use more purchased funds and fewer core
deposits than do small banks.
• Large banks tend to put more into salaries, premises, and other
expenses than do small banks.
• Large banks tend to diversity their operations and services more than
small banks, and they also generate more noninterest income.

© McGraw Hill 27
 Because learning changes everything. ®

[Link]

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.