Chapter 4 1

Part 2:Bank Financial Statements, Risks, and Valuation

Chapter 4: Sources and Uses of Bank Funds

and the Risks of Banking

Chapter 5: Accounting and Economic Models

of Bank Performance and Valuation

Chapter 6: Case Studies in Bank Valuation

and Performance

Chapter 4 2

CHAPTER 4

Sources and Uses of Bank Funds and the Risks of

Banking

Chapter 4 3

LEARNING OBJECTIVES

Three Views of a Bank: As a Portfolio or Balance Sheet, as an Information Processor, and as a Regulated Firm

A Bank’s Sources and Uses of Funds The Components of a Bank’s Income-Expense

Statement The Linkage Between Bank Financial Statements

and the Risks of Banking

TO UNDERSTAND...

Chapter 4 4

CHAPTER THEME The traditional business of banking is

funding loans (use of funds) with deposits (source of funds). This function generates the “bread-and-butter cash flow” of a bank – net interest income. Netting out the provision for loan loss and net noninterest income gets to a bank’s pre-tax net income. Measuring and managing the risks associated with this business represents the hear of bank financial management, which is risk management.

Chapter 4 5

Bank’s Evolution from Money Changers to Dealer-Makers, Information Processors, and Regulated Firms

Functions that a Bank Performs

1. Chest: the safekeeping or risk-control function

2. Bench: the transactions function

Cash, Check, Credit/Debit Card

Chapter 4 6

Banks As Portfolios: Two-Way Funds Rental and Risk Control

Risks Credit Risk Interest-Rate Risk Liquidity Risk Prepayment Risk Foreign-Exchange Risk

Chapter 4 7

Bank Financial Statements

Balance Sheet: A = L + NW Income-Expense Statement:

P = R - C - T

Book Values Market Value of Equity

Chapter 4 8

Bank Balance Sheets Sources of Funds: Core Deposits

CORE DEPOSITSGathered in Local Markets andTypically have Lower InterestCosts than Purchased Fund

Demand Deposit Accounts Other Checkable Balances Savings Accounts Small Time Deposits

Chapter 4 9

Bank Balance Sheets Sources of Funds: Managed Liabilities

Managed Liabilities As the antithesis of core deposits,

managed liabilities are more volatile and more rate-sensitive funds that are gathered in national and international money markets rather than local markets

Examples: Foreign deposits, large CDs, FF purchases, repos, demand notes, subordinated notes and debentures, and other borrowed money

Chapter 4 10

Bank Balance Sheets Uses of Funds Interest-Earning Assets

Loans and leases C&I, real estate, and consumer

Investment securities Investment account

Held to Maturity (historical cost or book value) Available for Sale (market value)

Trading account (recorded at market value under “trading assets”)

Fee-Based Assets (e.g., trust services) Nonearning Assets (e.g., cash and due

and premises)

Chapter 4 11

Bank Balance Sheets Sources and Uses of Funds

Federal Funds

and

Repurchase Agreements

Chapter 4 12

CREDIT RISK, PLL, AND LLR OR ALLL (see Box 4-1, p. 112) Credit or default risk results in loan losses

– an accepted part of the business of lending

Banks set aside funds for such purpose, called the provision for loan loss (PLL) – a noncash outlay that runs through the income-expense statement to a contra-asset account on the balance sheet called the loan-loss reserve (LLR) or the allowance for loan and lease loss (ALLL)

“Bathtub Analogy” in Box 4-1, p. 112

Chapter 4 13

Bank Equity Capital Equity Capital = Net Worth =

Book Value of Equity = Assets - Liabilities

Regulatory capital Market value of equity

Chapter 4 14

COMPONENTS OF BANK EQUITY CAPITAL Common stock ($32.4 billion, par value) Surplus ($238 billion) Undivided profits ($203.3 billion) Book values for all insured commercial

banks at the beginning of 2000 are in parentheses

External equity: issue equity or hybrid securities (e.g., trust preferred stock, TPS)

Internal equity: retained earnings or undivided profits

Chapter 4 15

Sources of Bank Revenue (“Sales” and “Cross-Selling”)

Total revenue or “sales” for a bank:

Interest IncomeFrom Loans, Securities, Federal Funds Sold

Non-Interest IncomeFrom Fees and Service Charges

Chapter 4 16

Bank Costs Interest Expenses

On Deposits and other Interest-Bearing Liabilities

Non-Interest ExpensesAdministrative and Operating Expenses

PLL is so important that it is treated separately

Chapter 4 17

A Bank’s Income-Expense Statement

Net Interest Income = Interest Income - Interest Expense

Net Interest Margin = Net Interest Income / Total Assets

PLL = Provision for loan loss Net Noninterest Income: “Burden”

Noninterest Income - Noninterest Expense Taxes Net income

Chapter 4 18

A BANK’S “BURDEN” For almost all banks, net interest income

is negative (< 0) because noninterest expense exceeds noninterest income

For this reason, it can be described as a bank’s “burden”

Since NII has the tremendous job of having to cover a bank’s PLL, its burden, and its taxes, it is the “bread and butter” of the business of traditional banking

Chapter 4 19

A Bank’s Income-Expense Statement

Return on Assets (ROA)Net Income / Total Assets

Return on Equity (ROE)Net Income / Total Equity

orROA x Equity Multiplier (EM)

Chapter 4 20

A Bank’s Income-Expense Statement

Dividends and Additions to Retained Earnings

Internal Capital Generation Rate

Chapter 4 21

RECAP OF BANK INCOME AND EXPENSES Four key components:

1. Net interest income 2. PLL 3. Net noninterest income (”burden”) 4. Taxes

Net income is the bottom line ROA is the key accounting

measure of bank performance

Chapter 4 22

CHAPTER SUMMARY Three alternative ways of viewing

a bank are: 1. Portfolio or balance sheet 2. Information processor 3. Regulated firm

This chapter has focused on the first view and the income and expenses that flow from a bank’s portfolio or balance sheet