BANKINGSummer Term (I), 2015Instructor: Sumaira Hamid

Chapter 4:The Financial Statements of a Bank

Balance Sheet

Balance Sheet – Report of ConditionTA = TL + EQ• Balance Sheet – Report of Condition

• Balance Sheet is also known as the report of condition because it shows the amount and composition of funds sources (Financial Inputs i.e. OE and Liab) the bank has drawn upon to finance to its lending & investing activities i-e how much has been allocated to loans, securities & other funds uses ( Financial Outputs i.e. Assets) at any given time.

• Users of Funds: (Assets) - Financial Outputs - Spending cash on

• Sources of Funds: (Liab + OE) – Financial Inputs - Raising funds from

TA = TL + EQInvesting Decision = Financing DecisionUses of Funds = Sources of FundsFinancial Output = Financial Input

Assets = Liabilities+ EquityC+S+L+MA = D+NDB+EC

ASSETS(C) = CASH ASSETS -> Designed to meet bank’s immediate need for liquidity(S) = SECURITY HOLDINGS -> Backup source of liquidity & another source of Income(L) = LOANS -> Are made principally to supply Income(MA) = Miscellaneous Assets -> Dominated by fixed Assets or Investment in subsidiaries if any.

LIABILITIES

(D) = Deposit Borrowings -> Main source of Funding [Customer’s deposits](NDB) = Non Deposit Borrowings ->To supplement deposits, provide additional source of funding & liquidity

EQUITY

(EC) Equity Capital ->Providing long-term, relatively stable base of financial support

Balance Sheet – Report of ConditionTA = TL + EQ

ASSETS

1. The Cash Account - Primary Reserves Account

• Designed to meet bank’s immediate need for liquidity – Most Liquid Asset

– Cash held in the bank’s vault– Any deposits the bank has placed with other banks

(correspondent deposits) – The bank’s reserve account held with the Federal Reserve Bank– Cash items in the process of collection (mainly uncollected

check)

All above four categories are Non-Earning Assets (non- interest earning assets)

ASSETS

2. Investment Securities (The Liquid Portion) - Secondary Reserves Account

• Designed as a backup source of liquidity and to earn low rate interest income

– Interest bearing time & saving deposits held with other banks

– Money Market Instruments – Short term debt instruments with a maturity of maximum one year or less

• for e.g short term government (Treasury Bills – T-bills) municipal (state and local) securities, privately issued money market securities, commercial papers.

Earning Assets (Interest is earned on Investments)

ASSETS

3. Investment Securities (The Income generating Portion) -

Capital Market Instrument ( Long term Investments)

i) Equity Investments – Investment in Shares ( Non- Earning but generates dividend income) – Income generating asset but not an earning asset

Note: Definition of earning is on the basis of interest earned on any asset

ii) Investments in Long term Debt Instruments Maturity more than 1 yearEarning Asset

For Example: Notes, bonds and other security held by the bank primarily for their expected rate of return or yield. like Investments in Treasury Bonds, corporate bondsetc

ASSETS

Other Classification of Investment Securities

• Taxable and Tax-Exempt Securities

• HTM, AFS, Trading Account Securities

– HTM ( Held Till Maturity) – Intend and ability to hold till maturity for capital gains

– AFS( Available for Sale) – Those securities which bank may choose to sell for any need of liquidity

– Trading Account Securities – Held for resale in short-term with intend to make profit out of short term price movement ( to be sold within 90 days)

Concept Check 4-6 , page 127

Suppose that a bank holds cash in its vault of $1.4 mill, short-term government security of $12.4 mill, privately issued money market instrument of $5.2 mill, deposits at Federal Reserve Bank (non-interest) 20.1 mill, cash items in the process of collection of $0.6 mill, and non-interest deposits placed with the other banks of $16.4 mill. How much does this bank hold in its Primary and Secondary Reserves?

Answer - Check 4-6 , page 127

Primary Reserve:• Cash $1.4 m• Dep at Fed $20.1m• Cash Item $0.6m• Non. Interest Dep with other banks $16.4m Total $38.5

m

Secondary Reserves:• Sh.Term govt sec $12.4m• Privately issued money mkt invest $5.2m

Total $17.6m

ASSETS

4. Loans – Largest Asset item and source of income

Classification By Purpose of Borrowing Money

– Commercial and Industrial Loans – Consumer Loans– Real Estate Loans– Financial Institutions Loans– Foreign Loans– Agricultural Loans– Security Loans– Leases

ASSETSOther Classifications of Loans

1. Loan, by Origin and Source

By Origin

• Domestic Loan: Denominated in the local currency on terms and conditions prevailing in the local market regardless of the source of loan, that is local banks or branches of foreign banks operating locally.

• Foreign Loans: Denominated in a foreign currency such as US Dollars, Pounds, Japanese Yen or any other currency and is extended on the interest rates, terms and conditions prevailing in the market or country of currency of the loan, by any lender or bank located in any country.

By Source

• Bank Loan: A formal Loan, a loan extended by a banking institution.

• Informal Loan: A loan obtained from informal sources such as money lenders, unregistered cooperatives, personal credit sources etc.

ASSETS2. Loan, by Terms and Conditions:

• Soft Loans: Extended on concessional rates of interest, generous grace period and maturity suited to the needs of the borrower.

• Hard Loans: Reflect Full market costs of the loan plus a spread or premium depending on the borrower’s credit worthiness and competitive terms and conditions prevailing in the market.

• Term loans: of medium to long-term maturity at variable interest rates

• Fixed or variable rate loans: where interest is either fixed or is variable

• Guaranteed Loans: issued with a third party guarantee besides the collateral e.g a government guarantee, foreign currency deposit guarantee etc.

• Secured or unsecured loan: depending on the credit worthiness of the borrower

ASSETS3. Loan, by Type of Borrower:

• Government or sovereign loans: borrowed by government or a government department or agency

• Cooperation, a company, or a business, borrowing from the banking system to finance their routine business needs

• Individual or personal loans borrowed by households

4. By Type of Maturity: • Short term loan: usually up to 90 days for a maximum of 180 days, in established

business up to 1 yr

• Medium term Loan: usually for a period of one to two years and maximum three years

• Long term Loan: typically for a period of 3 to 5 years or more.

ASSETSNet Loans = Gross Loans - Allowance for Loan Loss - Unearned Discounts

Unearned Discounts: Interest Income from loans that has been received but not yet earned

Gross Loans = Sum of all standing lOUs (sum of loans or total loans)

Allowance for Loan Loss (ALL) - balance sheet item • Reserve for possible (future) loan losses • Estimated Provision for doubtful loans • Accumulated Account • Contra Asset Account (to write off uncollectable loans or add recoveries)

Two components of ALL (Allowance for Loan loss) • Specific Reserves: for specific loan problems, are set aside to cover; particular loan or loans expected to be a

problem or that present an above average risk • General Reserves: remaining reserves in the loan loss account, this helps banks better understand their needs for

protection against current or future loan defaults.

Provision for Loan Loss (PLL) - Income statement item • Non-cash expense item • Annual deductions for loan losses

ASSETS

Additions to ALL are usually made

1) when a bank’s loan portfolio grows in size, 2) when any sizable loan is judged to be completely or

partially uncollectible, or3) when an unexpected loan default occurs that has not

already been reserved

The required accounting entries simply increase the contra asset ALL account and the expense account PLL

ASSETS

Formula to Calculate ending ALL balance

End ALL = Beginning ALL + PLL – Write offs + Recoveries

And

Net Loans = Gross Loan – Ending ALL – Unearned Discounts

ASSETS

Suppose a bank anticipated loan losses this year of $1 mill and held $ 100 mill already in its ALL account. It would take non cash charge against its current revenues, entering $1 mill in the PLL account in its I/S.

Thus the Amount recorded on bank’s I/S would be

Annual loan loss expense ( PLL ) = $ 1 mill

Then adjust bank’s B/S in its ALL account

ALL = $100 mill + $ 1mill (PLL)=$101 mill

ASSETS

Now suppose bank discovers that its truly worthless loans which must be written of is $500,000 then

Beginning balance for ALL = $100 millPlus PLL = $1 mill

Adjusted ALL = $101 mill Less Actual charge offs of worthless loans = ($ 500,000)

Net Allowance for loan loss(ALL) after all charge offs =$100.5 mill

$100.5 mill is the ending balance after adjusting PLL and Charge offs

Now suppose bank recovers $1.5 Mill that it had previously charged off as losses as earlier loans then

Net allowance for the loan loss (ALL) after all charge off’s = $ 100.5 millPlus Recoveries from previously charged off loans = $1.5 millEnding Balance in ALL account = $ 1.2 mill

ASSETS

Concept check 4.12 (pp 134)

Suppose a bank has an allowance for loan losses of $1.25 million at the beginning of the year and charges current income for a $ 250,000 provisions 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?

ASSETS

Answer - Concept check 4.12 (pp 135)

Beg ALL = $ 1.25Plus PLL = 0.25 mLess Worthless loans = (0.15 m)Plus Recoveries = 0.05 m

Ending ALL = $ 1.4

End ALL = Beginning ALL + PLL – Write offs + Recoveries

ASSETS

5. Federal Funds Sold and Securities Purchased under Resale Agreement (Earning Asset) Lending to Financial Institutions

This item includes mainly temporary loans (Usually extended overnight, with the funds returned next day) made to the other banks or financial institutions • Federal Funds:

– Are unsecured loans of reserve balances at Federal Reserve Bank that depository institutions lend to one another at Federal Reserve Rate

Important: These are excess amount of reserve balances maintained with Federal Reserve Bank

• Federal Funds Sold is an ASSET and Federal Funds Purchased is LIABILITY.

ASSETS

• Resale Agreement (asset) / Repurchase Agreement (liab):

– Loan backed by investment security– Repurchase Agreement: Sale of investment securities by one party

to another with an agreement to purchase the securities at a specified date and price.

IMPORTANT

Securities purchased with Resale Agreement – ASSETSecurities sold with Repurchase Agreement – LIABILITY

ASSETS

6. Customers Liabilities on Acceptances ( Earning Asset only if Interest related)

– Large banks often provide a form of credit to their customers known as acceptance financing ( e.g. Bankers Acceptance or Letter of Credit ( LCs))

– Signed letter of credit to help customers pay their goods etc.

7. Miscellaneous Assets (Non-Earning Asset)

– Buildings, Equipment, Investment in subsidiary etc.

LIABILITIES

DEPOSITS • Non-interest-bearing demand deposit or regular checking accounts, generally permits

unlimited check writing.

• Saving Deposits generally bear the lowest rates of interest offered to depositors by a bank but may be of any denomination and permit the customer to withdraw at will- No Maturity

• NOW Accounts Negotiable Order of Withdrawals : which can be held only by individuals and nonprofit institutions bear interest and permit drafts to be written against each account to pay third parties.

• Money Market Deposit Accounts can pay whatever interest rates the offering bank feels is competitive and have limited check writing privileges attached. No minimum denomination or maturity is required by law, though depository institutions must reserve right to require seven days’ notice before any withdrawals are made.

• Time Deposits usually carry fixed maturity and a stipulated interest rate but may be of any denomination, maturity and yield agreed upon by the bank and its depositor. Included are large negotiable CDs, interest bearing deposits that banks use to raise money from their most well-to-do customers.

LIABILITIES

NON-DEPOSIT BORROWING

• Borrowings from Financial Institutions– Fed Funds Purchased – Securities Sold Under Agreement To Repurchase

• Acceptances Outstanding

• Eurocurrency Borrowings

• Short Term Debt

• Mortgage Indebtedness

• Subordinated Loans and Debentures – A subordinated loan, subordinated bond, subordinated debt that ranks below other debt or security

with regard to claim on assets or earnings– In case of bankruptcy, these debt holders would not get paid until senior debt holders are paid

in full

EQUITY-CAPITAL ACCOUNT

• Common stock outstanding : Total Par or stated value of outstanding shares

• Preferred Stock: Guarantees annual dividends before common stock holders

• Capital Surplus: Share premium or additional paid up capital

• Retained Earnings: Undivided profits

• Treasury Stock: Reacquired Stock- Stock which is bought back by the issuing company to avoid a takeover threat, to reissue later at a higher price, to retire or reduce number of outstanding shares to increase EPS etc

• Contingency Reserve: Reserve for unforeseen losses.