Understanding Bank Financial Statements and Performance

2020

Understanding Bank Financial Statements and Performance Executive Development Program

Jeffery W. Johnson BANKERS INSIGHT GROUP, LLC

Bankers Insight Group, LLC

INTRODUCTION

Financial statements for banks present a different analytical perspective because they reflect the

business of banking, which differs significantly from other business entities. As a result,

analysis of a bank's financial statements requires a distinct approach that recognizes a bank's

somewhat unique risks.

The beauty of proper financial reporting is the transformation of what a company does into what

we can see on the financial statements. All is required is to understand that major Accounting

Principles and Assumptions and the Rules of Debits & Credits that apply to all industries,

including banks. I often hear that the Rules of Debits & Credits do not apply to banking because

certain economic events do not agree with the Rules of Debits & Credit. This is simply not true.

As long as an economic entity have Assets, Liability and Net Worth Accounts, the Rules of

Debits & Credit will apply.

THE UNIQUENESS OF BANKING

The concept and functions of banks is quite simple. Banks employ cash taken from depositors,

stockholders and earnings and lend the funds to creditworthy borrowers and invest the remainder

in safe securities at an interest rate higher than the rate paid to depositors and cost of capital.

Cash derived from depositors and savers, become the banks’ inventory.

Profits are derived from the spread between the rate they pay for funds and the rate they receive

from borrowers. This ability to pool deposits from many sources and then lend to many different

borrowers creates the flow of funds inherent in the banking system. By managing this flow of

funds, banks generate profits, acting as the intermediary of interest paid and interest received and

taking on the risks of offering credit.

LEVERAGE

Banking is a highly leveraged business requiring regulators to dictate minimal capital levels to

help ensure the solvency of each bank and the banking system. In the U.S., a bank's primary

regulator could be the Federal Reserve Board, the Office of the Comptroller of the Currency, the

Federal Deposit Insurance Corporation, the National Credit Union Administration and the

Consumer Finance Protection Bureau plus any one of 50 state regulatory bodies, depending on

the charter of the bank.

The Office of the Comptroller of the Currency is responsible for regulating National Chartered

Banks that are members of the Federal Reserve Bank

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The Federal Reserve Board is responsible for regulating Fed Member State Chartered Banks and

many large banking institutions because it is the federal regulator for bank holding companies

(BHCs).

The FDIC is responsible for regulating State Chartered Banks that are not Fed Member Banks

The CFPB is responsible for regulating all financial institution as it relates to consumer lending

and other consumer related issues with a primary focus on financial institution with assets in

excess of $10 billion.

The National Credit Union Administration is responsible for regulating Credit Unions

nationwide

Within the Federal Reserve Board, there are 12 districts with 12 different regulatory staffing

groups. These regulators focus on compliance with certain requirements, restrictions and

guidelines, aiming to uphold the soundness and integrity of the banking system.

As one of the most highly regulated industries in the world, depositors and investors have some

level of assurance in the soundness of the banking system. As a result, they can focus most of

their efforts on how a bank will perform in different economic environments.


RISK

Risk is defined as the potential that events, expected or unexpected, may have an adverse impact

on the bank’s earnings and capital. Regulators define nine categories of risk:

❑ Credit

❑ Interest Rate

❑ Liquidity

❑ Price

❑ Foreign Exchange

❑ Transaction

❑ Compliance

❑ Strategic

❑ Reputation

❑ Technology

❑ Cyber / Security

Risk Management is

• A continuous process (not a static exercise) of identifying risks that is sometimes

subject to quick and volatile changes. The identification of risks may result in

opportunities for portfolio growth or may aid in avoiding unacceptable exposures for

the institution.

Although banks face many risks on a day to day basis that extend well beyond the risks listed

above, there are two critical risk factors proven to affect all banks over the history of banking.

Those risks are Interest Rate Risk and Credit Risk.

Interest rate risk is the management of the spread between interest paid on deposits and received

on loans over time. Credit risk is the likelihood that a borrower or counter party will default

on its loan, lease or other binding agreement, causing the bank to lose any potential interest

earned as well as the principal that was loaned to the borrower or suffering losses due to the

default of counter party such as a major vendor. These are the primary elements that need to be

understood when analyzing a bank's financial statement.

Interest Rate Risk

One of the primary business of a bank is managing the spread between deposits and

loans/investments. Basically, interest earned from loans and investments is greater than the

interest it pays on deposits, it generates a positive interest spread or net interest income. If the

opposite occurs, banks will be in a negative interest spread. The size of this spread is a major

determinant of the profit generated by a bank.

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Also, banks must be mindful of deposits, loans and investments maturities. If more deposits are

maturing and being repriced before loans and investments mature, it could be problematic for

banks, especially in a rising rate environment. This interest rate risk is primarily determined by

the shape of the yield curve.

A yield curve is a line that plots interest rates of investments at a set point in time having

equal credit quality but, differing maturity dates. The most frequently reported yield curve

compares the three-month, two-year, five-year and 30-year U S. Treasury debt. The yield curve

is used as a benchmark for other debt in the market, such as mortgage rates, bank lending rates

and bank deposits.

Below is an example of three Yield Curves, including Normal, Flat and Inverted.

The first is a Normal Curve which indicates a higher rate of investment return on investments as

the maturity date is extended.

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The second example is that of a Flat Yield Curve where there is little difference between short-

term and long-term rates of equal credit quality. This type of yield curve is often seen during

transitions between normal and inverted curves.


An Inverted Yield Curve is an interest rate environment in which long term debt instruments

have a lower yield than short-term debt instruments of the same credit quality. This type of yield

curve is the rarest of the three main curve types and is a predictor of an economic recession.

An example of an Inverter Yield Curve is shown below:

Banks, in the normal course of business, assume financial risk by making loans at interest rates

that differ from rates paid on deposits. Deposits often have shorter maturities than loans and

adjust to current market rates faster than loans. This result is a balance sheet mismatch between

assets (loans) and liabilities (deposits).

An upward sloping yield curve is favorable to a bank as the bulk of its deposits are short term

and their loans are longer term. This mismatch of maturities generates the net interest revenue

banks enjoy. When the yield curve flattens, this mismatch causes net interest revenue to

diminish. As a result, net interest income will vary, due to differences in the timing of accrual

changes and changing rate and yield curve relationships. Changes in the general level of market

interest rates also may cause changes in the volume and mix of a bank's balance sheet products.

For example, when economic activity continues to expand while interest rates are rising,

commercial loan demand may increase while home mortgage loan sand prepayments slow.

FDIC QUARTERLY BANKING PROFILE - THIRD QUARTER 2019

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According to the Remarks by FDIC Chairman Jelena McWilliams and Director of the Division

of Insurance and Research Diane Ellis on the Third Quarter 2019 Quarterly Banking Profile,

“Overall, the banking industry reported positive results, despite non-recurring events at three

large institutions. While these events resulted in a modest decline in aggregate quarterly net

income, the industry reported loan growth and the number of problem banks remained low.

Community banks also reported another positive quarter. Net income rose at community banks

primarily because of higher net operating revenue. Additionally, the annual rate of loan growth

at community banks outpaced the overall industry.

The record-long economic expansion continued in the United States. With two reductions in

short-term rates and a flat yield curve this quarter, challenges in lending and funding continued.

The competition to attract and maintain loan customers and depositors remains strong;

consequently, banks need to maintain rigorous underwriting standards and prudent risk

management.

Awareness of interest rate, liquidity, and credit risks at this stage of the economic cycle will

position banks to be more resilient in maintaining lending through the economic cycle”.


ACCOUNTING PRINCIPLES AND ASSUMPTIONS

The first requirement to understanding bank financing statements is to have a working

knowledge of Accounting Principles, Rules and Assumptions. Obviously, this session will not

allow a thorough coverage all you need to know about accounting however, a reminder of what

is important to know about accounting as it relates to the preparation of bank financial statements

can be useful.

Generally accepted accounting principles (GAAP):

The rules financial accountants must follow when recording accounting transactions and

preparing financial statements. Financial accountants can’t just throw numbers on the income

statement, balance sheet, or statement of cash flows; a level playing field must exist between

businesses so that the individuals reading the financial statements can compare one company to

another.

GAAP is heavily influenced by the influential organizations in the accounting field. These

organizations include the American Institute of Certified Public Accountants (AICPA); Financial

Accounting Standards Board (FASB); Governmental Accounting Standards Board (GASB); and

the Financial Accounting Foundation (FAF).

The FAF is the independent private-sector and not-for-profit organization responsible for the

oversight, administration, financing and board appointment of FASB and GASB. Located in

Norwalk, Connecticut, it was established in 1972 and comprises the FAF Board, two standard

setting Boards (FASB and GASB) and the FAF management team.

When these organizations act in terms of creating or amending an accounting standard, the whole

world of accounting statement production must react. There actions have greatly affected the

financial institution industry.

ACCOUNTING ASSUMPTIONS

Accounting principles and assumptions are the essential guidelines under which businesses

prepare their financial statements. These principles guide the methods and decisions for a

business over a short and long term. For both internal and external reporting purposes, it is

important to understand accounting assumptions.

There are several accounting assumptions affecting all economic entities that should be

understood by anyone reviewing financial statements. The two Accounting Assumptions

highlighted here are the Revenue Recognition and Fair Value Principles. There is a recent

change the Revenue Recognition Principle, as shown in the following paragraph.


Historical Cost Principle

The historical cost principle deals with the valuation of both assets and liabilities. The value at

the time of acquisition is used to value most assets and liabilities. The term "cost" refers to the

amount spent (cash or the cash equivalent) when an item was originally obtained, whether that

purchase happened last year or thirty years ago.

For this reason, the amounts shown on financial statements are referred to as historical cost

amounts. Because of this accounting principle asset amounts are not adjusted upward for

inflation. In fact, generally, asset amounts are not adjusted to reflect any type of increase in

value.

Hence, an asset amount does not reflect the amount of money a company would receive if it were

to sell the asset at today's market value. (An exception is certain investments in stocks and bonds

that are actively traded on a stock exchange.) If you want to know the current value of a

company's long-term assets, you will not get this information from a company's financial

statements–you need to look elsewhere, perhaps to a third-party appraiser.

Revenue Recognition Principle

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU)

2014-09 – Revenue from Contracts with Customers, in May 2014 which created a new principle-

based framework to determine when and how an entity recognizes revenue from its customer

contracts.

This new FASB’s model is codified in Topic 606, Revenue from contracts with customers,

applies to a company's contracts with customers, except for contracts that are within the scope of

other standards (e.g., leases, insurance, financial instruments). Elements of contracts or

arrangements that are in the scope of other standards (e.g., leases) will be separated and

accounted for under those standards. (Accounting Standards Codification [ASC] 606).

Sweeping changes in the FASB’s new revenue recognition model became effective in 2018

(including interim periods therein) for most calendar year-end public business entities (PBEs).

Non-PBEs have an additional year: the new standard becomes effective in 2019 for calendar

year-end non-PBEs, and effective in interim periods in 2020 for those companies. The Securities

and Exchange Commission will not object to certain PBEs (i.e., entities that are PBEs solely due

to the inclusion of their financial statements or financial information in another entity’s filing

with the SEC) adopting the new revenue standard using the timeline otherwise afforded private

companies. The new standard will significantly affect the current revenue recognition practices

of many companies, particularly those that follow industry-specific guidance under US GAAP.

We expect the Aerospace & Defense, Automotive, Communications, Engineering &

Construction, Entertainment & Media, Pharmaceuticals & Life Sciences, and Technology

industries to be impacted the most.


All financial institutions are affected to some extent by the new revenue recognition guidance

therefore, management was required to evaluate how policies, procedures, and guidelines may

need to change to support the accounting and reporting for the new criteria.

FASB has established core principles for recognizing revenue, which states that revenue should

only be recorded when services are provided, or goods are transferred to customers at the agreed

price.

FASB provides five steps for organizations to determine how to recognize revenue from

customers:

• Identify the contract(s) with a customer

• Identify the separate performance obligations in the contract

• Determine the transaction price

• Allocate the transaction price to the separate performance obligations in the contract

• Recognize revenue when (or as) the entity satisfies a performance obligation

Almost all existing revenue recognition guidance will be replaced by ASC 606, but the effects of

the new revenue recognition guidance on financial statements are expected to be somewhat

limited within the financial institutions industry.

The following revenue streams are already accounted for in various established accounting topics

and therefore are not expected to be impacted by the new revenue recognition guidance:

• Loan interest income

• Investment interest income and dividends

• Loan servicing revenue and gains/losses

• Loan related fees (e.g., prepayment, late fees, commitment fees, and origination fees)

• Fees related to financial guarantees

Sources of revenue for financial institutions that are expected to fall under the new revenue

recognition guidance include the following:

• Sales of foreclosed real estate property

• Certain asset management-related fee revenue

• Certain credit card related revenue, including interchange revenue rewards programs and

annual fees

• Certain deposit account fees

Credit Administrators including Lenders must be aware of the potential impact of the new

standard on financial statements of current and prospective borrowers. Management should

assess how revenue recognition changes might impact current and future financial covenants,

and how borrower financial information is evaluated.


Fair Value Principle

Note that another basis for valuing elements of financial statements is coming into play. The

new basis is fair value. With the convergence of global standards, fair value is used more in the

United States to value elements of financial statements.

Fair value accounting is a financial reporting approach in which companies are required or

permitted to measure and report on an ongoing basis certain assets and liabilities (generally

financial instruments) at estimates of the prices they would receive if they were to sell the assets

or would pay if they were to be relieved of the liabilities.

In September 2006, the Financial Accounting Standards Board (FASB) issued an important and

controversial new standard, Statement of Financial Accounting Standards No. 157, which

provides significantly more comprehensive guidance to assist companies in estimating fair

values

Some parties (generally financial institutions) have criticized fair value accounting, including

FAS 157’s measurement guidance. Those criticisms have included:

◦ Reported losses are misleading because they are temporary and will reverse as

markets return to normal

◦ Fair values are difficult to estimate and thus are unreliable

◦ Reported losses have adversely affected market prices yielding further losses and

increasing the overall risk of the financial system.


THE ACCOUNTING EQUATION

Assets = Liabilities + Stockholders’ Equity

After each economic event is recorded into the records of an economic entity, the Accounting

Equation must always balance after the transaction is documented. This will ensure that the

Balance Sheet Assets will equal the Liabilities and Stockholders’ Equity and the results of the

Income Statement is properly reflected in Retained Earnings. Bottom Line: “The equation must

always be in balance”.

RULES OF DEBITS AND CREDITS

Assets = Liabilities + Stockholders' Equity

Asset Accounts Liability Accounts

Stockholders' Equity

Accounts

Debit * Credit Debit Credit* Debit Credit*

Debit for

Increase

Credit for

Decrease

Debit for

Decrease

Credit for

Increase

Debit for

Decrease

Credit for

Increase

Cost and Expense Accounts Revenue Accounts

Debit * Credit Debit Credit*

Debit for

Increase

Credit for

Decrease

Debit for

Decrease

Credit for

Increase

DEBITS CREDITS

Increase assets Decrease assets

Decrease liabilities Increase liabilities

Decrease stockholders' equity Increase stockholders' equity

Decrease revenues Increase revenues

Increase expenses Decrease expenses

Increase dividends Decrease dividends

*Normal balance


BALANCE SHEET ANALYSIS

ASSETS

Cash

Cash typically consists of cash equivalents to include cash on hand, amounts due from banks

(including cash items in process of clearing), and amounts held at other financial institutions

with an initial maturity of 90 days or less.

Fed Funds Sold:

Federal funds, or fed funds, are unsecured loans of reserve balances at Federal Reserve Banks

that depository institutions make to one another. Banks keep reserve balances at the Federal

Reserve Banks to meet their reserve requirements and to clear financial transactions.

Transactions in the fed funds market enable depository institutions with reserve balances in

excess of reserve requirements to lend them, or “sell” as it is called by market participants, to

institutions with reserve deficiencies. Fed Funds are sold daily to various financial institutions

(commercial banks, thrift institutions, agencies and branches of foreign banks in the United

States, federal agencies, and government securities dealers) throughout the United States. The

most common duration or term for fed funds transaction is overnight, though longer-term deals

are arranged. The rate at which these transactions occur is called the fed funds rate.

Fed funds transactions can be initiated by either a funds lender or a funds borrower. An

institution seeking to lend fed funds identifies a borrower directly, through an existing banking

relationship, or indirectly, through a fed funds broker. The most used method to transfer funds

between depository institutions is for the lending institution to authorize its district Federal

Reserve Bank to debit its reserve account and to credit the reserve account of the borrowing

institution.

Most overnight loans are booked without a contract. The borrowing and lending institutions

exchange verbal agreements based on various considerations, particularly their experience in

doing business together, and limit the size of transactions to established credit lines to minimize

the lender's exposure to default risk.

Overnight fed funds transactions under a continuing contract are renewed automatically until

termination by either the lender or the borrower. This type of agreement is used most frequently

by correspondent banks that borrow overnight fed funds from a respondent bank.


Investment Securities:

Investment securities can be classified as Trading Securities, Available-For-Sale securities or in

the case of debt investments, Held-to-Maturity Securities. The classification is based on the

intent of the bank as to the length of time it will hold each investment.

Trading Securities

These securities are those bought to sell within a short time of their purchase. They could be

sold daily, weekly or monthly as long as they are negotiated within a one-year period.

Due to their short-term purpose, accounting rules require them to be revalued at each balance

sheet date to their current fair market value. Any gains or losses due to changes in fair market

value during the period are reported as gains or losses on the income statement in “non-Interest

Income” because a trading security will be sold soon at its market value.

A valuation account in the net worth section of the balance sheet is created and utilized to hold

the adjustment for the gains and / or losses so when each security is sold, the actual gain or loss

can be determined. This valuation account is used to adjust the value in the trading securities

account reported on the balance sheet.

For example, if a bank has the following investments classified as trading securities, an

adjustment for $17,000 is necessary to record the trading securities at their fair market value.

Valuation of Trading Securities

Cost

Fair Market

Value

Unrealized Gain

(Loss)

State Revenue Bonds $35,000 $34,000 $(1,000)

Gov’t Security $67,000 $85,000 $18,000

Total Trading

Securities

$102,000 $119,000 $17,000

The entry to record the valuation adjustment is:


General Journal

Date Account Title and Description Ref. Debit Credit

20X0

Dec. 31 Trading Securities Market Value

Adjustment

$17,000

Non-Interest Income $17,000

Explanation Adjust trading securities to MV

Available-for-Sale Securities

These securities may be classified as either short-term or long-term assets based on

management's intention of when to sell the securities and are also valued at fair market

value. Any resulting gain or loss is recorded to an unrealized gain and loss account that is

reported as a separate line item in the stockholders' equity section of the balance sheet. The

gains and losses for available-for-sale securities are not reported on the income statement

until the securities are sold. Unlike trading securities that will be sold soon, there is a longer

time before available-for-sale securities will be sold, and therefore, greater potential exists

for changes in the fair market value. For example, assume a bank has available-for-sale

securities, whose cost and fair market value are:

Valuation of Available-for-Sale Securities

Cost Fair Market Value Unrealized Gain (Loss)

TLM Bonds $40,000 $38,000 $(2,000)

Security I 50,000 70,000 20,000

Security G 25,000 22,000 (3,000)

Total Available-for-Sale Securities $115,000 $130,000 $15,000

The entry to record the valuation adjustment is:


General Journal

Date Account Title and Description Ref. Debit Credit

20X0

Dec. 31 Available-for-Sale Securities Market Value Adjustment

15,000

Unrealized Gains and Losses Available-for-Sale Securities

15,000

Adjust available-for-sale securities to market value

In the balance sheet the market value of short-term available-for-sale securities is classified

as short-term investments, also known as marketable securities, and the unrealized gain

(loss) account balance of $15,000 is considered a stockholders' equity account and is part of

comprehensive income. When the balance is a net loss, it is subtracted from stockholders'

equity.

A debt investment classified as held-to-maturity means the business has the intent and ability

to hold the bond until it matures. The balance sheet classification of these investments as short-

term (current) or long-term is based on their maturity dates.

Repurchase Agreement (REPO)

In a typical Repurchase Agreement / REPO transaction, the holder of a security sells it to a

counterparty and simultaneously agrees to buy it back again on a pre-determined date.

Conversely, on the other side of the typical Repurchase Agreement / REPO transaction, one

party lends cash and receives delivery of the security as collateral and simultaneously agrees to

sell it back again on the same pre-determined date.

The party borrowing the cash and pledging the security as collateral is entering a Repurchase

Agreement as they have contractually committed to "repurchase" the security on the expiration

date of the Agreement.

The party lending the cash and taking the security as collateral is entering a Reverse Repurchase

Agreement as they have contractually committed to "sell" the security on the expiration date of

the Agreement.

The Reverse Repurchase Agreement party (the one taking delivery of the security and lending

cash) deposits cash in an amount less than the full price of the security with the original owner

(money is usually lent at a discount to the mark-to-market value of the security).


The price of a repo transaction is always expressed as an interest rate. The "repo rate" reflects

the rate on the cash extended but also considers the coupon and yield of the fixed income

security offered as collateral in the repo transaction. The repo rate is usually lower than the rate

of interest the bond pays. The lender of the cash earns the "repo rate." The lender of the bond

earns the coupon the bond pays less the repo rate.

In this manner, the Reverse Repurchase Agreement party has essentially made a short-term,

secured loan with minimal risk to the seller of the security and has earned a discount to yield

return by lending less than the value of the security but receiving an amount equal to the value of

the security at the end of the Agreement.

Conversely, the Repurchase Agreement party (the one that borrowed the cash and pledged the

security as collateral) received a low cost, short-term loan and does not have to lose control over

a desirable security in their portfolio.

Thus, REPOS cover a wide range of fixed income securities and is a sale and forward repurchase

of a security at a specified price for a specified time. There are no restrictions during the term of

the transaction on the use of either the cash or the collateral, other than the agreement that the

transaction will be unwound. The yields established in repo transactions are in part a function of

the quality of the underlying collateral.

Collateral is generally delivered to the lender through: Actual delivery, either physically or by

wire with simultaneous payment; also, referred to as delivery vs. payment.

Third party custody, also known as a Tri-party Repo, which refers to having a third party

involved in the transaction who acts as the custodian and transfer agent for both parties, in a tri-

party repo, both parties to the repo must have cash and collateral accounts at the same tri-party

agent. The tri-party agent will ensure that collateral pledged is sufficient and meets eligibility

requirements, and all parties agree to use collateral prices supplied by the tri-party agent.

Hold in Custody, sometimes also referred to as Due bill, is when the seller of the security does

not deliver the securities for settlement but holds them as the custodian in the repo transaction,

while it is more lucrative to both parties as they do not incur the delivery expense this situation

can lead to fraud, sometimes it is the only route as the securities may only settle locally.

On maturity date, the cash plus accrued interest is exchanged for the securities (usually

"substantially identical" securities).

A back-to-back Repurchase Agreement is one in which the counterparties receive and redeliver

the security in the same day.


The United States is the largest repo market followed by France. The U.K. has the largest cross

border, multi-currency repo market. In Germany, repo transactions are subject to the same

minimum reserve requirements as sight demand deposits (2%).

Loans or Receivables

Lending represents one of the main business activities of the bank and may account for the

largest percentage of total assets. A loan is an extension of credit resulting from direct

negotiations between a lender and a borrower. Loans may be held until maturity, may be sold in

whole or a portion to third parties, and may also be obtained through purchase in whole or in

portion from third parties.

The Type of Loans in a typical bank portfolio include: Corporate / commercial loans (secured /

unsecured, fixed-term / revolving): Construction loans (this is one of the riskiest types of loan),

Commercial lease financing, Mortgages (residential or commercial), secured loans, loans to

public authorities, consumer loans such as credit card, home equity and personal loans; consumer

lease financing.

Collateralized loans mean that the grantor has in its possession (or a fiduciary, administrator,

trustee) readily marketable or highly liquid instruments (cash, CDs, stocks and bonds). Sufficient

margin on collateralized credits should also be provided (due to interest rate and market

sensitivity).

Secured loans are secured by assets that are not readily marketable and/or under the control of

the recipient of the loan (UCC filings on receivables, pledges of inventory, equipment,

assignment of real estate mortgages or rents, contracts). Pledge of inventory and real estate

should be adequately insured and in the name the Grantor.

Loans secured by real estate are loans predicated upon a security interest in real property. A loan

predicated upon a security interest in real property is a loan secured wholly or substantially by a

lien on real property for which the lien is central to the extension of the credit.

Credit Administration within a financial institution is the primarily function responsible for the

quality of loans extended by banks. Therefore, having the ability to observe, identify, measure

and manage risk is paramount for a bank to be successful in the underwriting process.

Also, closely connected to loans is the Allowance for Loans and Lease Losses (“ALLL”). This

account represents the estimated amount of losses a bank believes it will incur in the loan

portfolio. In determining the amount that should be included in the ALLL, banks must follow

two accounting standards called Accounting Standard Codification 450 and 310 in additional

regulatory guidance on the calculation and maintenance of an adequate ALLL.


What is the difference between the Allowance for Loans and Lease Losses and the Loan Loss

Provision? ALLL is the balance sheet component that has already been established (to cover

actual or anticipated deterioration of the loan assets). The provision is the income statement

component amount that is charged against earnings and will be added to the Reserves (thus

increasing the Reserve account).

Derivative Contracts

A derivative is a financial security having a value that is reliant upon or derived from an

underlying asset or group of assets. The derivative itself is a contract between two or more

parties, and its price is determined by fluctuations in the underlying asset(s). Common

underlying assets include interest rates, currencies, market indexes, bonds, stocks and

commodities. Derivatives are commonly purchased through brokers and are often traded Over

the Counter (OTC) or on an exchange. Derivatives traded OTC are not normally standardized

derivatives traded on exchanges are standardized and more heavily regulated. OTC Derivatives

generally have greater counterparty risk than standardized derivatives.

Derivatives are used to manage hedging or positioning exposure to various types of risks

including market, interest and foreign exchange, cash flow, operating and trading risk. The

accounting and reporting standards for Derivative instruments, including certain derivative

instruments embedded in other contracts, and for hedging activities are set forth in FASB

Statement No. 133, "Accounting for Derivative Instruments and Hedging Activities," as

amended. Statement No. 133 requires all derivatives to be recognized at their fair value. (Source:

Credfinrisk.com; Credit & Financial Risk Analysis)

A common form or Derivative Contracts utilized by financial institutions is an Interest Rate

Swap, which is a forward contract in which one stream of future interest payments is exchanged

for another based on a specified principal amount. The Counter Parties do not swap the financial

asset upon which the Interest Rate Swap is based or their entire interest payments. They agree to

make payments to one another based upon the rise or fall of the floating interest rate; Swaps are

utilized to:

1. Manage Debt and Risk More Effectively

2. Hedge Potential Losses

3. Earn Income Through Speculation

For example: Suppose Bank A (Receiver) makes a $1,000,000 loan to a borrower at a Fixed Rate

of 6%. In order to manage the risk of the bank losing potential interest income if interest rates

increase, Bank A decides to enter an Interest Rate Swap with Bank B (Payer) which also made a

loan to a borrower for $1,000,000 at Prime + .75% (Prime is 5.25%). If the Prime Rate

increases to 6.25%, which boost Bank B’s Interest Rate it will receive from the borrower to


7.00%, (6.25% + .75%) Bank B must pay to Bank A the difference between the 6% Fixed Rate it

receives and 7.00% (1.0%). In this case, Bank A benefits because it is receiving interest at a rate

higher than the original fixed rate of 6%. Conversely, If the Prime Rate decreases to 4.25%,

which lowers Bank B’s Interest Rate it will receive from the borrower to 5.00% (4.25% + .75%),

Bank A (which is still receiving interest at 6%) must pay Bank B the difference between 6% and

5.00% ( a 1.0% difference) In this case, Bank B benefits because it is receiving the same rate of

interest even though the Prime Rate decreased.

Mortgage Servicing Rights (MSRs):

Many banks that originate primary residential mortgages and then sell them into the secondary

market retain the servicing rights of the mortgage. This means that for a fee the bank collects the

monthly payment from the mortgagee and passes on the principal and interest components of the

payment to the trust that owns the mortgage and then also makes the insurance and real estate tax

payments from the escrow account that is maintained.

Mortgage servicing rights represent a future stream of payments. The on-balance sheet carrying

value of these MSRs is still subject to a fair value test under FAS 140, Accounting for Transfers

and Servicing of Financial Assets and Extinguishments of Liabilities. The value of the MSRs are

affected by the prepayment speed of the underlying mortgages being serviced because if they pay

off faster than had been assumed then there are fewer mortgages to be serviced and a resultant

lower income stream than had been anticipated. Thus, in a declining interest rate environment

where homeowners are refinancing to a lower rate or selling and purchasing a new home and the

original MSR is rapidly losing mortgages from the original group to be serviced the bank must

now write down the value of the MSR portfolio. Conversely, in a rising interest rate environment

the MSRs tend to have a stable or increasing value as the maturity of the MSRs lengthens (as no

one is refinancing).

Deferred Tax Assets (DTA)

Due to the financial crisis which commenced in the fourth quarter of 2007 and ending in the

second quarter of 2009 and but the effects were evident through 2010, U.S. regulators have

allowed banks to book losses that can be utilized to reduce future income tax payments as an

asset on the bank's balance sheet. The accounting treatment of determining the asset size is

somewhat discretionary, which is based on management's estimate of future earnings and

projected tax liabilities. In the event that the United States enacts tax reform, which would result

in a corporate tax rate lower than the present 35% rate, then the present value of the DTA would

be lower as the actual future tax liability would be lower, hence a lower tax deduction would be


necessary (at a 35% tax rate, the deduction is worth $350,000 per $1.0 million in positive

earnings; at a tax rate of 25%, the deduction is now only worth $250,000 per $1.0 million in

positive earnings, thus the bank would be required to write-down the value of the DTA at the

moment of corporate tax reform). (Source: Credfinrisk.com; Credit & Financial Risk Analysis)

Fixed Assets

Leasehold and freehold land and buildings (at historical cost or at revised market value at time of

statements, less depreciation and amortization).

Tangible fixed assets: fixtures, equipment, motor vehicles (depreciated or amortized).

Other Assets

Bank-Owned Life Insurance

Other real estate owned ("OREO")

Foreclosed property held by the bank.

Intangibles and Goodwill

Goodwill is generated when a bank purchases an operating company more than its book value.

U.S. Banks are required under GAAP accounting guidelines to perform goodwill impairment

tests periodically.

LIABILITIES

Core Deposits

Core Deposits consist of all interest-bearing and noninterest-bearing deposits, except certificates

of deposit over $100,000. They include checking interest deposits, money market deposit

accounts, time and other savings, plus demand deposits. These are funds due to depositors (on

sight or time deposits)

Core deposits represent the most significant source of funding for a bank and are comprised of

noninterest-bearing deposits, interest-bearing transaction accounts, non-brokered savings

deposits and non-brokered domestic time deposits under $100,000. The branch network is a

bank's principal source of core deposits, which generally carry lower interest rates than

wholesale funds of comparable maturities.


Brokered Deposits

These deposits represent funds which the bank obtains, directly or indirectly, by or through any

deposit broker for deposit into one or more deposit accounts. Thus, brokered deposits include

both those in which the entire beneficial interest in each bank deposit account or instrument is

held by a single depositor and those in which the deposit broker sells participations in each bank

deposit account or instrument to one or more investors. Fully insured brokered deposits are

brokered deposits that are issued in denominations of $100,000 or less or that are issued in

denominations greater than $100,000 and participated out by the deposit broker in shares of

$100,000 or less.

Commercial Paper

An unsecured, short-term debt instrument issued by a corporation, typically for the financing of

accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial

paper rarely range any longer than 270 days.

Short Term Borrowings

Short-term borrowings are usually from banks, securities dealers, the Federal Home Loan Bank,

unsecured federal funds borrowings, which generally mature daily. Advances from a Federal

Home Loan Bank are fully collateralized by loans on the bank's asset-side of the balance sheet.

Fed Funds Purchased are short-term, unsecured borrowings as well.

Dividend payable (preferred stock dividend in arrears) is a form of Short Term Borrowings when

Dividends are declared but there is a delay in the actual payment of them.

Long-Term Liabilities

Subordinated Note (or debenture) is a form of debt issued by a bank or a consolidated subsidiary.

When issued by a bank, a subordinated note or debenture is not insured by a federal agency, is

subordinated to the claims of depositors, and has an original weighted average maturity of five

years or more. Such debt shall be issued by a bank with the approval of, or under the rules and

regulations of, the appropriate federal bank supervisory agency.

Stockholder's Equity / Share Capital

Common shares authorized and outstanding represent a pro-rata share of ownership in a financial

institution. Preferred stock is a form of ownership interest in a bank or other company which

entitles its holders to some preference or priority over the owners of common stock, usually with

respect to dividends or asset distributions in liquidation.

Some trust related preferred securities may have equity characteristics and are treated favorably

under Tier 1 guidelines; and may have lower interest costs. The instruments are deeply


subordinated (just ahead of common stock) and have long maturities although they may have call

provisions. Dividend payments may have some favorable tax treatment for the issuers. However,

these securities generally have debt-like characteristics. The bank is unlikely to defer dividend

payments due to the message it may send to other sources of funding.

Capital Adequacy

Capital Adequacy is a measurement of a bank to determine if solvency can be maintained due to

risks that have been incurred as a course of business. Capital allows a financial institution to

grow, establish and maintain both public and regulatory confidence, and provide a cushion

(reserves) to be able to absorb potential loan losses above and beyond identified problems. A

bank must be able to generate capital internally, through earnings retention, as a test of capital

strength. An increase in capital because of restatements due to accounting standard changes is

not an actual increase in capital.

The Capital Growth Rate indicates that either earnings are extremely good, minimal dividends

are being extracted or additional capital funds have been received through the sale of new stock

or a capital infusion, or it can mean that earnings are low or that dividends are excessive. The

capital growth rate generated from earnings must be sufficient to maintain pace with the asset

growth rate.

Capital levels in financial institutions are always evolving especially after the economic crises

experienced 10 years age. To aid in the understanding of the capital requirements, the Board of

Governors of the Federal Reserve Bank, the Federal Insurance Deposit Corporation and the

Office of the Comptroller of the Currency issued “New Capital Rule Community Bank Guide” to

clarify the capital levels required by banks to meet certain designations.

Any bank that does not meet the minimum risk-based capital ratio, or whose capital is otherwise

considered inadequate, generally will be expected to develop and implement a capital plan for

achieving an adequate level of capital (usually under the terms of an FDIC Order to Cease and

Desist). The concept of prompt corrective action by the FDIC was introduced with the Federal

Deposit Insurance Corporation Improvement Act of 1991 (FDICIA). When a bank becomes

“Undercapitalized” (below "Adequately Capitalized") in many cases it means that unless it can

rapidly turn the operation around it will be shut down by the respective supervisors.

While "Undercapitalized" a bank:

• must cease paying dividends

• is generally prohibited from paying management fees to a controlling person

• must file and implement a capital restoration plan


• cannot accept, renew or roll over any brokered deposit. Effective yield on deposits

solicited by the bank cannot be more than 75 basis points or .75% over local market

yields for comparable size and maturity deposits.

When a bank becomes “Critically Undercapitalized” in many cases it means that unless it can

rapidly turn the operation around it will be shut down by the respective supervisors. A critically

undercapitalized bank must be placed in receivership within 90 days unless the FDIC and the

bank’s primary federal regulator concur that other action would better achieve the purposes of

prompt corrective action. Additionally, a "Critically Undercapitalized" bank is prohibited, unless

it obtains prior written FDIC approval, from:

• entering any material transaction not in the usual course of business

• extending credit for any highly-leveraged transaction (any transaction in which the

borrower has very little equity)

• paying excessive compensation or bonuses

paying interest on new or renewed deposits that would increase the bank’s weighted average cost

of funds significantly above prevailing interest rates in its normal markets

INCOME STATEMENT

Interest Income

Interest and Fee Income represent the largest source of revenue for banks therefore, it is vital that

thorough credit analysis be performed before loans are approved and funded. Interest accrues

daily on outstanding loans based upon a simple interest basis. If a loan becomes seriously

delinquent and future payments are in jeopardy, the loan may or should be placed on a non-

accrual basis which means that the bank will no longer accrue interest income on that loan. All

payments received will be applied to principal reduction.

Interest expense

Subtracted from Interest Income Only. It represents the cost of funds the company borrows on a

short- and long-term basis, buys in the money markets, or takes in from depositors. Competition

for customer funding will increase interest expense, placing pressure on margins. Some banks

and financial services companies will also break out the average annual interest rate paid on the

various sources of funds.


If interest expense is increasing it may be caused by competition forcing the bank to pay more

for deposits. Check to see if management relies on high cost funds instead of alternative lower-

cost funds to meet the bank’s funding needs.

Net Interest Income

This is interest income minus interest expense. Even a small decline in net interest income can

result in a large decline in net income if not offset by a decline in expenses.

Non-interest Income

It is important that banks develop/increase revenues derived from non-interest sources (bank

services, fees such service charges on deposits, trust income, mortgage servicing fees, securities

processing and brokerage services, results of trading operations) that have more stable growth

rates and are not tied to loan growth cycles, and can provide an offset if loan growth slows.

Other Income

Types of other income include:

• Dividend income: from third party investment or subsidiary/affiliate

• Net/gain loss from securities trading: volatility from year to year.

• Foreign exchange: based on customer activity and volatility in the market.

• Sale of investments

• Net commission/fee income; based on transactions such as insurance brokering, stock-

broking

• Related party transaction(s)

Watch-out for financial institutions that utilize "gain on sale" accounting which means that the

company records the sale of a loan immediately, but the actual profit is received over the life of

the loan. The profit is the difference between the spread that the loan is sold at to the investor and

what the seller receives from the Obligor. The problem is that the application of estimated future

interest rates (and default rates) is incorrect and the loans are over-valued compared to where

interest rates may be during the life-time of the loan and whether it will prepay if rates decline,

and/or if the loan will default and become un-collectible.

Non-interest expense

The largest Non-Interest Expense is Personnel costs. There are certain restrictions on executive

compensation because of the Dobb-Frank Act. Other types of expenses include:


• Premises / branch operating expenses (rent).

• Systems development costs

• Merger of networks: as companies, must compete based on the ability to provide state-of-

the art trading, retail access and information service, these costs have risen.

Operating income

After expenses but before provisions and taxes and extraordinary items.

Extraordinary / Non-recurring Items

Material events and transactions that are unusual and infrequent. For example, Profit (gains) or

loss on sale of fixed assets.

Provision (for loan losses)

Whenever it is determined that loans may not be collected, a charged to current earnings is made

to reflect this potential event. The account charged on the Income Statement is the Provision for

Loans and Lease Losses. It is similar to the Bad Debt Expense Account utilized in industry. For

a provision to be made, there must exist a potential loss in the portfolio and that loss must be

estimable. This is called the Incurred Loss Model which will be changed soon under a new

methodology called Current Expected Credit Losses. Market conditions where the bank operates

may result in a deterioration of loan and lease assets, which may result in actual and anticipated

losses (write-down or write-off the asset's value). The accumulated loss may exceed the existing

Loan Reserve thus earnings may have to added to the Loan Reserve account to either increase or

replenish the amount to meet an actual or anticipated loss.

The loan loss account has an opening balance at the beginning of the year, it receives additional

provisions based on actual losses and anticipated losses for the coming year; has actual charged-

off loans subtracted from the account and then has a closing balance for the year).

Classified Loans - loans that have been determined to be not collectable for the full amount due

to the deteriorating performance and/or condition of the borrower. The "classification" is based

upon internal examination and rating system (based on generally accepted industry practices)

such as non-performing accrual, non-accrual. The Office of the Comptroller of the Currency

(OCC) also rates loans are classified as substandard, doubtful, and loss.

Taxation

Current taxation (tax payable on recognized income for the fiscal year, which was paid to

federal, state and local, and foreign revenue authorities).


RATIO ANALYSIS TO DETERMINE FINANCIAL STRENGTH

ASSET QUALITY RATIOS

Past Due plus Nonaccrual Loans

Total Loans

This ratio measures the percent of loans and leases that are 30 days or more past due or in

nonaccrual status compared to the total Loan portfolio, The higher the ratio the lower the Asset

Quality and the higher probability of potential losses for the bank

Nonaccrual Loans

Total Loans

This ratio measures the percent of loans and leases that are 90 days or more past due or in

nonaccrual status compared to the total loan portfolio. The higher the ratio the lower the Asset

Quality and the higher probability of potential losses for the bank.

Allowance for Loan and Lease Losses

Total Loans

This ratio measures the coverage of loans where there is a probability of a loan loss to the

amount in the Loan Loss Reserve (Allowance for Loan and Lease Losses). The amount in the

ALLL is estimated utilizing recommended accounting standards (ASC 350 and ASC 420). The

higher the ratio the more coverage a bank has in absorbing a confirmed loss without the need to

provision for more losses during the year or tapping into Capital.

Although it would appear that banks desire to have this ratio as high as possible however, there

are strict accounting guidelines that limits the amount in the Allowance to what the bank can

justify as being reasonable.

. Allowance for Loan and Lease Losses

Noncurrent loans

This ratio measures the coverage of loan that are 90 days or more past due and are in a

nonaccrual status to the amount in the Loan Loss Reserve (Allowance for Loan and Lease

Losses). The amount in the ALLL is estimated utilizing recommended accounting standards

(ASC 350 and ASC 420). The higher the ratio the more coverage a bank has in absorbing a

confirmed loss without the need to provision for more losses during the year or tapping into

Capital.


Although it would appear that banks desire to have this ratio as high as possible however, there

are strict accounting guidelines that limits the amount in the Allowance to what the bank can

justify as being reasonable.

Net Loan Losses

Total Loans

This ratio measures the percent of net loan losses compared to the average total loans. Net loan

losses are total loans and leases charged off, less amounts recovered on loans and leases

previously charged off. The higher the ratio indicates the bank is experiencing a higher loss on

loans (minus the amounts recovered) compared to the total average loan portfolio.

CAPITAL / EARNINGS RATIOS The common Capital Ratios are as follows:

• Common Equity Tier 1 Ratio

• Tier 1 Capital

• Tier 2 Capital

• Tier 1 Capital Ratio

• Total Capital Ratio

• Leverage Ratio

Each of the above ratios are explained in the New Capital Rules Documents as follows:

Common Equity Tier 1 Capital

CET1 Capital is a relative new measurement of Capital Adequacy which became effective as of

January 1, 2015. It is defined as Common Stock (plus related Surplus), Retained Earnings, plus

limited amounts of Minority Interest in the form of Common Stock, less most of the regulator

deduction. The higher the CET1 Capital the stronger the financial institution’s capital adequacy

Tier 1 Capital

Tier 1 Capital It is defined as Common Stock (plus related Surplus), Retained Earnings, Non-

Cumulative Preferred Stock plus Related Surplus (Instruments must meet new eligibility

criteria), Grandfathered Cumulative Preferred Stock plus Related Surplus, Trust Preferred


Securities (for Bank Holding Companies), limited amounts of Minority Interest in the form of

additional Tier 1 Capital Instruments, less certain deductions.

Tier 2 Capital

Tier 2 Capital is measured by Tier 1 Capital (as defined above) plus Certain Capital Instruments

(e.g. Subordinated Debt subject to meeting certain criteria) and limited amounts of the

Allowance for Loans and Lease Losses, less certain deductions.

Tier 1 Capital Ratio

Tier 1 Capital Ratio is calculated by dividing Tier 1 Capital (as defined) by Total Average Assets

Total Capital Ratio

Total Capital Ratio is calculated by dividing Total Capital by Total Average Assets

Leverage Ratio

A bank’s Leverage Ratio is calculated by dividing Total Average Assets by Total Capital

The calculation of ratios below are defined in the FDIC State Profile. Please note that there

may be slight variation in the calculations of certain ratios depending upon the source from

which they are presented

Tier 1 Leverage Ratio

Tier 1 capital is the sum of common stockholders' equity, noncumulative perpetual preferred

stock (including any related surplus), and minority interests in consolidated subsidiaries, minus

ineligible intangible assets. The Tier 1 leverage ratio is Tier 1 capital divided by average total

assets (less disallowed intangibles).

Return on Assets

This ratio indicates how financial institutions utilize their assets to generate income. Be mindful

about what is considered Income. For example, the inclusion of an extra ordinary gain may

distort the true ROA. It is wise to calculate the ROA void of any non-recurring income. This

ratio is calculated by dividing net income (including gains or losses on securities and

extraordinary items) by average total assets


Pre-Tax Return on Assets

This measure is often useful since Subchapter S institutions will have significantly different

return on asset figures from other insured institutions. It is the ratio of pretax Net Income divided

by the Average Total Assets.

Net Interest Margin

The NIM is a ratio closely watched by bank management. It is the ratio of interest income less

interest expense divided by average earning assets.

This ratio indicates how well management employs earning assets to generate income. The NIM

may come under pressure from offering preferential rates to the customer base, a low level of

growth in savings and the higher percentage of more expensive wholesale funds available. The

lower the net interest margin, approximately 3.0% or lower, generally it is reflective of a bank

with a large volume of non-earning or low-yielding assets.

Conversely, a high or increasing NIM may be the results of a favorable interest rate environment

or are they the result of the bank moving out of safe but low-yielding, low-return securities into

higher-risk, higher yielding and less liquid loans or investment securities.

Yield on Earning Assets

The Yield of Earning Assets is the ratio of interest, dividend and fee income earned on loans and

investments divided by average earning assets. Just as the name indicates, it measures the rate of

return on the Earning Assets of a financial institution. The higher the ratio the more profitable

the financial institution.

Cost of Funding Earning Assets

This is a ratio of interest expense paid (primarily on deposits and other borrowed money) divided

by average earning assets. It measures the cost to banks to fund the Earning Assets on the bank’s

balance sheet. The lower the ratio, the more profits are earned by the financial institution.

Provisions to Average Assets

This is a ratio of expenses recognized to increase the Allowance for Loan and Lease Losses

divided by average assets. The higher the Provisions indicates that certain assets are expected to

result in a loss from credit or investment risk (primarily credit risks)


Noninterest Income to Average Assets

This is a ratio of noninterest income divided by average assets. It measures the ability of average

assets to generate noninterest income. The higher the ratio, the more efficient the average assets

are in generating income that is not related to loans and investments.

Overhead to Average Assets

This is a ratio of noninterest expense divided by average assets. It measures the noninterest cost

to carry the average assets of the financial institution. A decreasing ratio indicates an efficient

bank because the cost to posses assets is lower than in earlier periods.

LIQUIDITY / SENSITIVITY

Loans to Assets

The median ratio of total loans divided by total assets. This measures the percent of assets that

are contained in the highest earning asset of a financial institution. The higher the ratio the

higher the chances of earning more interest income because of the yields earned on loans

compared to other earning assets. Banks should desire to have the highest percentage of its assts

in the loan portfolio.

Noncore Funding to Assets

The median ratio of the sum of foreign deposits, large time deposits, brokered deposits, and other

borrowings divided by total assets. The definitions for core and noncore funding were changed

as of first quarter 2010 to reflect the increase in the amount of insurable deposits from $100,000

to $250,000. This ratio measures the reliance on noncore deposits to fund or support the assets

on the balance sheet. A high ratio can be risky for banks because these noncore deposits are

more volatile than core deposits because they tend to be more rate sensitive. In other words, they

are prone to leave a bank if another financial institution offers a higher interest rate on those

noncore deposits.

Long-Term Assets to Assets

This is a ratio of assets that mature or reprice in over five years plus collateralized mortgage

obligations with an expected life greater than three years divided by total assets This ratio

indicates the ability of a bank to reprice assets as they mature. A high Long term asset to asset

ratio is detrimental to financial institutions in a rising rate environment because liabilities

(deposits) often reprice faster than assets and if a bank has a high ratio, their Net Interest Margin

may suffer.


Brokered Deposits to Assets

This is a ratio of brokered deposits divided by total assets as of the end of the listed period.

OTHER VITAL BANK RATIOS

Texas Ratio

Delinquent Loans + Non-performing Assets / Capital + Loan Loss Reserves.

If the ratio is 100% or higher, the bank may be in imminent danger of failing. If the ratio is

between 50% and 100% then a capital infusion is necessary. The ratio is a quick way to

determine the bank's ability to absorb losses.

Return on Average Equity (ROAE)

Net operating income after taxes (including realized gain or loss on investment securities) / Total

(average) equity (common stock) for a given fiscal year. This ratio is affected by the level of

capitalization of the financial institution. It measures the ability to augment capital internally

(increase net worth) and pay a dividend. It measures the return on the stockholder's investment

(not considered an effective measure of earnings performance from the bank's standpoint).

In the long run, a return of around 15% to 17% is regarded as necessary to provide a proper

dividend to shareholders and maintain necessary capital strengths.

Adjusted ROE or ROAE:

Net income / Total equity plus loan loss reserves more than 10% of equity.

Operating Profit Margin

Operating profits (before the loan loss provision and excluding gains or losses from asset sales

and amortization expense of intangibles) / Net operating revenues (interest income less interest

expense plus noninterest income)

This ratio measures the percent of net operating revenues consumed by operating expenses,

providing the remaining operating profit (the higher the margin the more efficient the bank).

Inverse of the efficiency ratio.

Average Collection of Interest (Days)

Accrued Interest Receivable / Interest Income x 365


This is a measurement of the number of days interest on earning assets remains uncollected and

indicates that volume of overdue loans is increasing, or repayment terms are being extended to

accommodate a borrower's inability to properly service debt.

Overhead Ratio

Total Non-Interest Expenses (annualized) / Total Average Assets

Non-interest expenses (annualized), which are the normal operating expense associated with the

daily operation of a bank such as salaries and employee benefits plus occupancy / fixed asset

costs plus depreciation and amortization.

These costs tend to rise faster than income in a time of inflation or if the institution is expanding

by the purchase or construction of a new branches.

Provisions for loan and lease losses, realized losses on securities and income taxes should not be

included in non-interest expense.

Efficiency Ratio

Total Non-interest expenses / Total Net Interest Income (before provisions) plus Total Non-

Interest Income

Efficiency improves as the ratio decreases, which is obtained by increasing net interest income,

increasing non-interest revenues and/or reducing operating expenses.

Non-interest expenses (expenses other than interest expense and loan loss provisions, such as

salaries and employee benefits plus occupancy plus depreciation and amortization) tend to rise

faster than income in a time of inflation.

This is a measure of productivity of the bank and is targeted at the middle to low 50% range.

This may seem like break-even, but it is not; what this is saying is that for every dollar the bank

is earning it gets to keep 50 cents and it must spend 50 cents to earn that dollar. The ratio can be

as low as the mid to low 40% range, which means that for every dollar the bank earns it gets to

keep 60 cents and spends 40 cents, a very efficient bank. Ratios more than 75% mean the bank is

very expensive to operate.

Understanding Bank Financial Statements and Performance

Documents

Transcript of Understanding Bank Financial Statements and Performance