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Lecture 5

(3/11/10)

Presenter;ISMATULLAH BUTT

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Banks Income Statement

y The major expenses incurred in generating revenues include thefollowing:

Interest paid out to depositors (D).

Interest owed on non-deposit borrowings (NDB).

The cost of equity capital (EC).

Salaries, wages, and benefits paid to bank employees (SWB).

Overhead expenses associated with banks physical plant (O).

Funds set aside for possible loan losses (PLL).

Miscellaneous expenses (ME).

y The difference between all revenues and expenses is net income.

y Net Income = Total Revenue items Total expenses items

y Net income= (C x T cash + S x T sec + L x T loans + M x T m)

Less ( D x i d +NDB x i ndb + EC x i ec + SWB + O + PULL+ME +T)

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Banks Income Statement

A bank can increase itsNet Income in the following ways:1. By increasing the average yield on each asset held;

2. By redistributing their earning assets toward those assets with higheraverage yields;

3. By reducing their interest or non-interest expenses on deposits, non-deposit borrowings, and owners capital;

4. By shifting their funding sources toward less-costly deposits otherborrowings;

5. By finding ways to reduce their employees (SWB), overhead (O),loan-loss (PLL), and miscellaneous operating expenses(ME);

6. By reducing taxes owed (T), through improved tax managementpractices.

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Banks Income Statement

Management have limited control of items that affect the netincome as external environmental factors are beyond their control.

Factors like competition in the market, regulation by the authoritiesand the pressures of public demand.

However bank managements decisions can: Determine a particular mix of loans, securities, cash, and deposits

each bank holds.

Determine the size of its revenues and expenses.

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Banks Income Statement

Income Statement- A Record of Financial Flows:

A balance sheet shows details of assets, liabilities and equity held at anygiven point in time, whereas an Income statement is a record offinancial f lows over time.

A banks Income statement can therefore be represented as a report offinancial outflows (expenses) and financial inflows ( revenues).

The Income Statement (Report of Income)Financial Inflows Financial outflows

Loan income Deposit cost

Security income Non-deposit borrowing costs

Income from cash assets Salaries and wages expenses

Miscellaneous income Miscellaneous expensesTax expense

Total financial Inflows Total financial outflows = Net Income

(all revenues) (all expenses)

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Banks Income Statement

Interest Income: Interest and fees generated from loans account for 2/3 or more of banks

total revenue/income.

Next to loan revenues, in order of importance, are investment earningsfrom taxable and tax-exempt securities, interest earned on federal

funds loans and repurchase (resale) agreements and interest earned ontime deposits placed with other banks.

The relative importance of these income items fluctuates from year toyear with shifts in interest rates and loan demand.

Loan income always dominates.

Relative importance of loan revenue versus non-interest revenuesources (fee income), is changing rapidly and fee income growing fasterthan interest income.

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Banks Income Statement

Interest Expenses: Interest on deposits is the No. 1 expense item and accounts for 50 % or

more of total banks expenses.

Rapidly growing interest expense is the interest owed on short-termborrowings in the money market.

Net Interest Income: Many banks subtract total interest expenses from total income to yield

net income.

This gap between the interest income a bank receives on loans andsecurities and the interest cost of its borrowed funds is known as the

interest margin. Interest margin is the key determinant of bank profitability.

Fall in interest margin weakens the banks bottom line-net after taxearnings, rate of dividends paid on shares.

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Banks Income Statement

Loan-Loss Expense: It is a non-expense created by a simple bookkeeping entry and is

known as provision for possible loan losses.

It is created by debiting the current years income.

The purpose is to shelter a portion of the banks current earnings from

taxes to help prepare for bad loans. The amount of this provision is deducted from current revenues before

taxes are applied to earnings.

Previous to tax reforms Act 1986, banks in USA applied one of the twomethods to arrive at the amount of PLL every year namely:

a) The experience method orb) Reserve method

y In Pakistan this is governed by Prudential regulations.

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Banks Income Statement

Non-interest Income: Sources of income other than earnings from loans and securities are

called Non-interest income and usually include the following:

Fees earned from offering trust services,

Service charges on deposit accounts,

Miscellaneous fees and charges for other bank services.

y Recently bankers have targeted noninterest income, or fee income, as akey source of future revenues.

y This strategy helps them:

i. Boost bottom line on their income statement andii. Insulate them from fluctuations in interest rates.

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Banks Income Statement

Non-interest Expenses: The key non-interest expense for most banks is wages, salaries, and

other personnel expenses.

This expense item has been rapidly rising in recent years because of a

multitude of reasons. The cost of maintaining bank properties and rental fees on office space

is shown in net occupancy and equipment expense.

The cost of bank furniture and equipment also appears under the non-interest expense category, along-with numerous small items including

legal fees, office supplies and repair costs.

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Net Income:y Both noninterest and interest expenses are deducted from the sum

total of interest and noninterest income to yield income (loss) beforetaxes.

y Applicable federal/corporate income tax rates are applied to thisincome to derive the banks net after tax income (or loss).

y Gains or losses on investment securities are subject to full corporateincome tax rate and may be reported as under:

a) As a component of noninterest income, either as a separate line itemin the noninterest income section of the banks income statement, or

b) As a part of other (miscellaneous) noninterest income.

y A bank can use these gains or losses on securities to smooth out itsnet income from year to year.

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Banks Income Statement

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y Another method for stabilizing banks earnings consist of nonrecurringsales of assets.

y A bank may also sell real estate or subsidiary firms that it owns andsuch transactions have substantial effect on current earnings.

y The key bottom-line item on bank income statements is net income

after taxes which is divided into two categories by the Board ofdirectors, namely:

i. Some funds may flow to the stockholders as cash dividend.

ii. Another portion (usually the larger part) goes into retained earningsin the banks capital accounts to provide a larger capital base.

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Banks Income Statement