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CHAPTER 4

THE FINANCIAL STATEMENTS OF BANKS AND SOME OF THEIR CLOSEST COMPETITORS

Goal of This Chapter: The purpose of this chapter is to acquaint the reader with the content, structure and purpose of bank financial statements and to help managers understand how information from bank financial statements can be used as tools to reveal how well their banks are performing.

Key Topics in this Chapter • An Overview of Bank Balance Sheets and Income Statements • The Bank’s Balance Sheet • Bank Assets • Bank Liabilities • Recent Expansion of Off-Balance Sheet Items • The Problem of Book-Value Accounting • Components of the Income Statement

Chapter Outline

I. Introduction: The Statements We Will Review in This Chapter II. An Overview of Bank Balance Sheets and Income Statements

A. Financial Inputs and Outputs on Bank Balance Sheets and Income Statements B. The Bank's Balance Sheet (Report of Condition)

1. The Principal Types of Accounts on a Bank's Report of Condition 2. Bank Assets

a. Cash and Due from Depository Institutions b. Investment Securities: The Liquid Portion c. Investment Securities: The Income-Generating Portion d. Trading Account Assets e. Federal Funds Sold and Securities Purchased under Resale

Agreements f. Loans and Leases g. Loan Losses h. International Loan Reserves i. Unearned Discount Income j. Nonperforming (noncurrent) Loans k. Bank Premises and Fixed Assets l. Other Real Estate Owned (OREO) m. Goodwill and Other Intangible Assets n. All Other Assets

3. Bank Liabilities a. Deposits

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b. Borrowings from Nondeposit Sources c. Equity Capital Accounts

1. Preferred Stock 2. Common Equity

4. Comparative Balance-Sheet Ratios for Different Size Banks 5. Recent Expansion of Off-Balance-Sheet Items in Banking 6. The Problem of Book-Value Accounting in Banking

C. Components of the Income Statement (Report of Income) 1. The Determinants of a Bank's Net Income 2. Financial Flows and Stocks

a. Interest Income b. Interest Expenses c. Net Interest Income d. Loan-Loss Expense e. Noninterest Income f. Noninterest Expenses g. Net Income

3. Comparative Income-Statement Ratios for Different-Size Banks

D. Other Useful Bank Financial Statements 1. The Funds-Flow Statement (Sources-and-Uses-of-Funds Statement) 2. Statement of Stockholders' Equity III. The Financial Statements of Leading Nonbank Financial Firms: A Comparison to Bank

Statements IV. An Overview of Key features of Financial Statements and Their Consequences V. Summary of the Chapter

Concept Checks 4-1. What are the principal accounts that appear on a bank's balance sheet (or Report of Condition)? The principal asset items on a bank's Report of Condition are loans, investments in marketable securities, cash, and miscellaneous assets. The principal liability items are deposits and nondeposit borrowings in the money market. Equity capital supplied by the stockholders rounds out the total sources of funds for a bank. 4-2. Which accounts are most important and least important on the asset side of a bank's balance sheet? The rank order of assets by dollar volume appearing on U.S. bank balance sheets are as follows: Rank Order Assets 1 Loans

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2 Investment Securities 3 Cash 4 Miscellaneous Assets 4-3. What accounts are most important on the liability side of a bank's balance sheet? The principal bank liability items from most important to least important are:

Rank Order Liabilities and Equity Capital 1 Deposits 2 Nondeposit Borrowings 3 Equity Capital 4 Miscellaneous Liabilities 4-4. What are the essential differences between demand deposits, savings deposits, and time deposits? Demand deposits are regular checking accounts against which a customer can write checks or make any number of personal withdrawals. Regular checking accounts do not bear interest under current U.S. law and regulation. Savings deposits bear interest (normally, they carry the lowest rate paid on bank deposits) but may be withdrawn at will (though a bank usually will reserve the right to require advance notice of a planned withdrawal). Time deposits carry a fixed maturity and the bank may impose a penalty if the customer withdraws funds before the maturity date is reached. The interest rate posted on time deposits is negotiated between the bank and its deposit customer and may be either fixed or floating. A NOW account combines features of a savings account and a checking account, while a money market deposit account encompasses transactional powers similar to a regular checking account (though usually with limitations on the number of checks or drafts that may be written against the account) but also resembles a time deposit with an interest rate fixed for a brief period (such as weekly) but then becomes changeable over longer periods to reflect current market conditions. 4-5. What are primary and secondary reserves and what are they supposed to do? Primary reserves consist of cash, including a bank's vault cash and checkable deposits held with other banks or any other funds that are accessible immediately to meet demands for liquidity made against the bank. Secondary reserves consist of assets that pay some interest (though usually pay returns that are much lower than earned on other assets, such as loans) but their principal feature is ready marketability. Both primary and secondary reserves are held to keep the bank in readiness to meet demands for cash (liquidity) from whatever source those demands may arise. 4-6. Suppose that a bank holds cash in its vault of $1.4 million, short-term government securities of $12.4 million, privately issued money market instruments of $5.2 million, deposits at the Federal Reserve banks of $20.1 million, cash items in the process of collection of $0.6 million, and deposits placed with other banks of $16.4 million. How much in primary reserves does this bank hold? In secondary reserves?

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The bank holds primary reserves of:

Vault Cash + Deposits at the Fed + Cash Items in Collection + Deposits With Other Banks

= $1.4 mill. + $20.1 mill. + $0.6 mill. + $16.4 mill.

= $38.5 million

The bank has secondary reserves of:

Short-term Government Securities + Private Money-Market Instruments

= $12.4 mill. + $5.2 mill.

= $17.6 million 4-7. What are off-balance-sheet items and why are they important to some banks and other financial firms? Off-balance-sheet items are usually transactions that generate fee income for a bank (such as standby credit guarantees) or help hedge against risk (such as financial futures contracts). They are important as a supplement to income from loans and to help a bank reduce its exposure to interest-rate risk. 4-8. Why are bank accounting practices under attack right now? In what ways could banks and similar financial institutions improve their accounting methods? The traditional practice of banks has been to record the value of assets and liabilities at their value on the day the accounts were originally created and not changing those values over the life of the account. The SEC and FASB started questioning this practice in the 1980’s because they were concerned that investors on bank securities would be misled about the true value of the bank. Using this historical value accounting method may in fact conceal a bank that is insolvent in a current market value sense. The biggest controversy centered on the banks’ investment portfolio which would appear to be easy to value at its current market price. At a minimum, banks could help themselves by marking their investment portfolio to market. This would give investors an indication of the true value of the bank’s investment portfolio. Banks could also consider using the lower of historical or market value for other accounts on the balance sheet. 4-9. What accounts make up the Report of Income (income statement) of a bank? The Report of Income includes all sources of bank revenue (loan income, investment security income, revenue from deposit service fees, trust fees, and miscellaneous service income) and all bank expenses (including interest on all borrowed funds, salaries, wages, and employee benefits,

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overhead costs, loan-loss expense, taxes, and miscellaneous operating costs.) The difference between operating revenues and expenses (including tax obligations) is referred to as net income. 4-10. In rank order what are the most important revenue and expense items on a bank's Report of Income? By dollar volume in most recent years the rank order of the revenue and expense items on a bank's Report of Income is:

Rank Order Revenue Items Expense Items 1 Loan Income Deposit Interest 2 Security Income Interest on Nondeposit Borrowings 3 Service Charges on Deposits Salaries, Wages, and and Other Deposit Fees Employee Benefits 4 Other Operating Revenues Miscellaneous Expenses 4-11. What is the relationship between the Provision for Loan Losses on a bank's Report of Income and the Allowance for Loan Losses on its Report of Condition? Gross loans equal the total of all loans currently outstanding that are recorded on the bank's books. Net loans are equal to gross loans less any interest income on loans already collected by the bank but not yet earned and also less the allowance for loan-loss account (or bad-debt reserve). The allowance for loan losses is built up gradually over time by an annual noncash expense item that is charged against the bank's current income, known as the Provision for Loan Losses. The dollar amount of the annual loan-loss provision plus the amount of recovered funds from any loans previously declared worthless (charged off) less any loans charged off as worthless in the current period is added to the allowance-for-loan-losses account. If current charge-offs of worthless loans exceed the annual loan-loss provision plus any recoveries on previously charged-off loans the annual net figure becomes negative and is subtracted from the allowance-for-loan-losses account. 4-12. Suppose a bank has an allowance for loan losses of $1.25 million at the beginning of the year, charges current income for a $250,000 provision for loan losses, charges off worthless loans of $150,000, and recovers $50,000 on loans previously charged off. What will be the balance in the bank's allowance for loan losses at year-end? The balance in the allowance for loan loss (ALL) account at year end will be: Beginning ALL = $1.25 million Plus: Annual Provision for Loan Losses = +0.25 Recoveries on Loans Previously = +0.05 Charged Off Minus: Charge Offs of Worthless = -0.15

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Loans Ending ALL = $1.40 million 4-13. What types of information does a Funds-Flow or Sources-and-Uses-of-Funds Statement provide? A bank's sources-and-uses-of-funds statement captures changes in its assets and liability items as well as income from bank operations. It shows where the bank has raised its operating funds over a given period of time and how those funds were allocated over that same time period. Generally, increases in any liability item (such as deposits) represent a source of funds, while increases in any asset item are uses of funds. 4-14. What does the Statement of Stockholders' Equity reveal about how well a bank is being managed and what stresses it is under? The Statement of Stockholders' Equity Capital reflects any changes that have occurred in a bank's equity capital account. The most common items causing changes in a bank's equity capital account include the proportion of current profits (net after-tax income) retained in the bank (which, if positive, increases equity capital or, if negative, decreases equity) and changes in the number of shares of stock outstanding. If more stock is sold, the equity capital account increases. 4-15. Suppose a bank has an initial balance in its capital account of $26 million, receives net income during the year of $3 million, pays out stockholder dividends of $2 million, and issues $1 million in new stock during the year. What balance remained in the bank's capital account at the end of the year?

The balance in the bank's capital account at year end will be:

Beginning Capital Account Balance = $26 million

Plus: Net Income During Year = +3 New Shares of Stock Issues = +1

Less: Stockholders Dividends = -2

Ending Capital Account Balance = $28 million. 4-16. Who are banking’s chief competitors in the financial-services marketplace and how do their financial statements resemble or differ from bank financial statements? Why do these similarities and differences exist? What major trend is changing the content of bank and nonbank financial statements?

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The main competitors in the financial services marketplace are thrift institutions like credit unions and savings associations and financial services firms such as finance companies, insurance companies and mutual funds. Their financial statements increasingly resemble bank financial statements. Among the common features are the heavy use of leverage, the dominance of financial assets over real assets and the concentration of revenues from making loans and assisting businesses in selling their securities. Due to the increasing similarities in the products that banks and their non-bank competitors offer the resemblance in the makeup of the financial statements does not come as a surprise.

Problems 4-1. The missing items from the Report of Condition and Report of Income of Evergreen

National Bank are given below:

Report of Condition Items Cash and deposits due from Banks

$ 27 (550-43-18-10-348-11-6-87 = 27)

Gross Loans 373 (348+6+19 = 373) Savings Deposits and NOW Accounts

36 (440-21-227-49-107 = 36)

Stockholders' Equity Capital

50 (550-440-41-19 = 50)

Report of Income Items Interest and Fees on Loans

$168 (180-5-7 = 168)

Service Charges on Customer Deposits

11 (39-20-8 = 11)

Wages, Salaries, and Employee Benefits

42 (54-5-7 = 42)

Net Interest Income 21 (180-159 = 21) Net Noninterest Income

-15 (39-54 = -15)

Net Income After Taxes

0 (180+39-159-54-4-2= 0)

4-2. The items requiring calculation and their dollar amounts are:

Net Interest Income = Total Interest Income - Total Interest Expense = $271 -$205 = $66

Net Noninterest Income = Total Noninterest Income - Total Noninterest Expense

= $23- $40 = -$17

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Total Operating Revenues = Total Interest Income + Total Noninterest Income = $271 + $23 = $294

Total Operating Expense = Total Interest Expenses + Total Noninterest Expenses +

Provision for Loan Loss = $205 + $40 + $13 = $258

Net Income Before Taxes = Total Operating Revenues - Total Operating Expenses

= $294 - $258 = $36

Net Income After Taxes = Net Income Before Taxes - Income Taxes = $36 - $5 = $31

Increase in Bank's Undivided Profits = Net Income After Taxes - Common Dividends

= $31 -$11 = $20 4-3. The items requiring calculation and the dollar figures required are: a. Total Assets = total liabilities + Total Equity capital Total Assets = 380 + 49 = 429 b. Net Loans = Gross loans – (Allowance for loan losses + Unearned income on loans) Net Loans = 294 – (13 + 5) = 276 c. undivided profits = Total Equity capital – (perpetual preferred stock + Common stock +

Surplus) undivided profits = 49 – (3 + 12 + 19) = 15 d. total deposits = Non-Interest Demand Deposits + NOW accounts + Savings Deposit +

Money Market Deposits + Time Deposits = 270 total deposits = 0 + 10 + 12 + 88 + 160 = 270 e. demand deposits = Non-Interest Demand Deposits + NOW accounts + Savings Deposit demand deposits = 0 + 10 + 12 = 22 f. depreciation = Bank Premises & equipment, gross - Bank Premises & equipment, net depreciation = 34 – 29 = 5 g. investment securities = Total Assets – (Cash and due from banks + Federal funds sold + Net

Loans + Trading-account securities + Bank premises and equipment, net + Other real estate owned + good will and other intangibles + Miscellaneous assets)

investment securities = 429 – (9 + 26 + 276 + 2 + 29 + 4 + 3 + 38) = 42

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4-4. The reconstructed bank balance sheet is as follows: Name of Banking Company (A1) Report of Condition(A2) 12/31/yy Total assets(A4) $140,848,384

Cash and due from depository institutions (A5) $4,261,234Securities (A6) $10,123,678Federal funds sold & reverse repurchase agreements (A7) 3905000Gross loans & leases (A8) $113,541,458 (less) Loan loss allowance (A9) $2,098,598 (less) unearned income (A10) $9,164

Net Loans and leases (A11) $111,433,696Trading account assets (A12) $504,705Bank premises and fixed assets (A13) $863,791Other real estate owned (A14) $114,986Goodwill and other intangibles (A15) $1,705,130All other assets (A16) $7,936,164

Total liabilities and capital (A18) $140,848,384

Total liabilities(A19) $129,535,088Total deposits (A20) $79,737,777Federal funds purchased & repurchase agreements (A21) $8,839,291Trading liabilities (A22) $0Other borrowed funds (A23) $33,378,779Subordinated debt (A24) $2,036,099All other liabilities (A25) $5,543,142

Total equity capital(A27) $11,313,296

Perpetual preferred stock (A28) $0Common stock (A29) $300,000Surplus (A30) $5,346,354Undivided profits (A31) $5,666,942

The reconstructed bank income statement appears as follows: Report of Income(A33) Total interest income (A34) $7,207,221Total interest expense (A35) $3,043,563Net interest income (A36) $4,163,658Provision for loan and lease losses (A37) $681,717Total noninterest income (A38) $3,768,710

Fiduciary activities (A39) $372,024Service charges on deposit accounts (A40) $507,045Trading account gains & fees (A41) $67,021Additional noninterest income (A42) $2,822,620

Total noninterest expense (A43) $4,982,254

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Salaries and employee benefits (A44) $2,875,181Premises and equipment expense (A45) $564,398Additional noninterest expense (A46) $1,542,675

Pre-tax net operating income (A47) $2,268,397Securities gains (losses) (A48) $6,345Applicable income taxes (A49) $878,976

Income before extraordinary items (A50) $1,395,766Extraordinary gains - net (A51) $0Net income (A52) $1,395,766 4-5. First National Bank of Irwin reported loan losses for the current year of $ 1.34 million, $1.19 million one year ago, $1.08 million two years ago, $0.85 million three years ago, $ 0.71 million four years ago, and $ 0.59 million five years ago. With total assets of $465 million and eligible loans of $ 279 million First National in Irwin can use either the experience method (an average of actual losses for the current year plus the past five years) or the specific charge-off method (in which only loans declared uncollectible can be written off). After the 1986 Tax Reform Act, however, banks or bank holding companies with assets of $500 million or more must use the specific charge-off method. Therefore, when First National reached $507 million in total assets the following year it then had to use the specific-charge-off method in accounting for loan losses. 4-6. The correct accounts into which the transactions described would be entered are:

A. Office expenses F. Interest on loans B. Employee benefits G. Service charges on noninterest income H. Interest earned on securities C. Interest on deposits I. Overhead expense D. Provision for loan losses J. Securities gains, net of taxes E. Noninterest income

4-7. The balance-sheet transactions described in this problem would affect the following accounts:

A. Time Deposits $6,000; Automobile Loans $6,000 B. Demand Deposits $1, 000; Investment Securities $1,000 C. Common Stock $100,000; Plant and Equipment $100,000 D. Home Equity Loans - $2,500; Demand Deposits - $2,500 E. Lease Receivables or Gross Loans $750,000; Cash Assets - $750,000 F. Federal Funds Sold + $5 million; Reserves (cash assets) - $5 million; the next day

we have Federal Funds Sold - $5 million; and Reserves + $5 million G. Allowance for Loan Losses, -$1 million

4-8. The balance sheet for River's Edge National Bank should appear as follows:

Balance Sheet (Report of Condition)

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Assets Liabilities Cash $ 13 Demand deposits 55 Deposits due from Savings deposits 15 other banks 25 Time deposits 25 U.S. Treasury bills 10 Money market deposits 31 Municipal bonds 12 Deposits due to other banks 5 Federal funds sold and Federal funds purchased 34 security RPs 5 Securities sold under

repurchase agreements 4

Loans to commercial Mortgages against the bank's building

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and industrial firms 64 Automobile loans 21 Subordinated notes and 20 Credit card loans 22 debentures Real estate loans 42 Equity Leases of assets to Equity capital 9 business customers 3 Total liabilities and equity

capital $224

Bank building and equipment 7 Total assets $224 Clearly, equity capital of $9 million must be added to bring the bank's balance sheet fully into balance. 4-9. The income statement for Rosebush State Bank should be arranged as follows: Interest Income 71 Interest (and fees) on loans 62 Interest and dividends earned on gov bonds and notes 9Interest expense 38 Interest paid on fed funds purchased 6 Interest paid to customers holding t&s deposits 32Net interest income 33non interest income 5 service charges paid by depositors 4 trust department fees 1noninterest expense 16 employee wages, salaries, and benefits 13 overhead expenses 3net noninterest income -11provision for loan losses 10pretax operating income 12taxes paid 3security gains or losses 1net after-tax income 10

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dividends paid 2addition to retained earnings 8 4-10. The items which would normally appear on a bank's balance sheet are:

Federal funds sold Savings deposits Credit card loans Common stock Vault cash Mortgage owed on the bank's

building Allowance for loan losses

Undivided profits

Deposits due to banks Commercial and Industrial loans Leases of business Retained earnings equipment to customers

Other Real Estate Owned

The items normally showing up on a bank's income statement are: Depreciation of bank Securities gains or losses plant and equipment Employee benefits Interest received on credit

Service charges on deposits

card loans Utility expenses Interest paid on money Provisions for loan losses market deposits

4-11. The following items are calculated given the information in the problem. Net Interest Income = Total Interest Income –Total Interest Expenses 750 = X - .5X Total Interest Income = $1500 Total Interest Expenses = $750 Net Noninterest Income = Total Noninterest Income – Total Noninterest Expenses -$300 = .75X –X Total Noninterest Expenses = $1200 Total Noninterest Income -= $900 PLL = .01 * Total Interest Income = .01*1500 = $15 Taxes = .25 * Net Income Before Taxes = .25*45 = $11.25 Dividends = .5*Net Income = .5*$20 = $10

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4-12. Why do financial statements issued by banks and nonblank financial service providers look increasingly similar today? Which nonbank financial firms have balance sheets and income statements that closely resemble those of commercial banks (especially community banks)? The resemblance between bank and nonbank financial service providers is caused by the intense competition between the sectors. Both groups of financial firms are offering more and more similar services and that development is widely reflected in their respective financial statements. This is particularly true for nonbank thrift institutions like credit unions and savings associations. Their balance sheets are dominated by loans, by deposits, and borrowings in the money market. In addition, the income statements are heavily tilted towards revenues on loans and interest expenses on their deposits and money market borrowings. 4-13 What principal types of assets and funds sources do nonbank thrifts (including savings banks, savings and loans, and credit unions) draw upon? Where does the bulk of their revenue come from and what are their principal expense items? The assets of nonbank thrifts are dominated by loans (especially mortgages and consumer installment loans) and their funding comes primarily from deposits and money market borrowings. As a result, most of their revenue is generated by their loans and most of their expenses are interest expenses on the deposits and the money market borrowings. 4-14. How are the balance sheets and income statements of finance companies, insurers, and securities firms similar to those of banks and in what way are they different? What might explain the differences you observe? The main similarities between these nonbank competitors can be found on the asset side of their balance sheets. All of the above rely on loans and securities, although they normally label them differently. The main difference is the source of funds. None of the aforementioned competitors can draw upon deposits and has to rely on money market and other borrowings and equity. These differences are rooted in the nature of their line of business and underlying regulations.