Analyzing A Bank's Financial Statements

Financial statements for banks present a different analytical problem than manufacturing and service companies. As a result, analysis of a bank's financial statements requires a distinct approach that recognizes a bank's somewhat unique risks. ( o learn more about reading financial statements, see What You Need To Know About Financial Statements and our Advanced Financial Statement Analysis tutorials.!

"anks take deposits from savers, paying interest on some of these accounts. hey pass these funds on to borrowers, receiving interest on the loans. heir profits are derived from the spread between the rate they pay for funds and the rate they receive from borrowers. his ability to pool deposits from many sources that can be lent to many different borrowers creates the flow of funds inherent in the banking system. "y 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 and Risk "anking is a highly leveraged business requiring regulators to dictate minimal capital levels to help ensure the solvency of each bank and the banking system. #n the $.%., a bank's primary regulator could be the Federal &eserve "oard, the 'ffice of the (omptroller of the (urrency, the 'ffice of hrift %upervision or any one of )* state regulatory bodies, depending on the charter of the bank. +ithin the Federal &eserve "oard, there are ,- districts with ,- different regulatory staffing groups. hese regulators focus on compliance with certain requirements, restrictions and guidelines, aiming to uphold the soundness and integrity of the banking system. ( o read more about leverage, see When Companies Borrow Money.! As one of the most highly regulated banking industries in the world, investors have some level of assurance in the soundness of the banking system. As a result, investors can focus most of their efforts on how a bank will perform in different economic environments. "elow is a sample income statement and balance sheet for a large bank. he first thing to notice is that the line items in the statements are not the same as your typical manufacturing or service firm. #nstead, there are entries that represent interest earned or e.pensed as well as deposits and loans. ( o find out more about balance sheets and income statements, see Find nvestment !uality n The ncome Statement, "nderstandin# The ncome Statement , $eadin# The Balance Sheet and Brea%in# &own The Balance Sheet.!

Figure ,/ he #ncome %tatement

Figure -/ he "alance %heet As financial intermediaries, banks assume two primary types of risk as they manage the flow of money through their business. #nterest rate risk is the management of the spread between interest paid on deposits and received on loans over time. (redit risk is the likelihood that a borrower will default on its loan or lease, causing the bank to lose any potential interest earned as well as the principal that was loaned to the borrower. As investors, these are the primary elements that need to be understood when analyzing a bank's financial statement. Interest Rate Risk he primary business of a bank is managing the spread between deposits (liabilities, loans and assets!. "asically, when the interest that a bank earns from loans is greater than the interest it must pay on deposits, it generates a positive interest spread or net interest income. he size of this spread is a ma0or determinant of the profit generated by a bank. his interest rate risk is primarily determined by the shape of the yield curve. (For more insight, see The mpact '( An nverted Yield Curve and Tryin# To )redict nterest $ates.! 3

As a result, net interest income will vary, due to differences in the timing of accrual changes and changing rate and yield curve relationships. (hanges in the general level of market interest rates also may cause changes in the volume and mi. of a bank's balance sheet products. For e.ample, when economic activity continues to e.pand while interest rates are rising, commercial loan demand may increase while residential mortgage loan growth and prepayments slow. "anks, in the normal course of business, assume financial risk by making loans at interest rates that differ from rates paid on deposits. 1eposits often have shorter maturities than loans and ad0ust to current market rates faster than loans. he 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. his mismatch of maturities generates the net interest revenue banks en0oy. +hen the yield curve flattens, this mismatch causes net interest revenue to diminish. A Banking Balance Sheet he table below ties together the bank's balance sheet with the income statement and displays the yield generated from earning assets and interest bearing deposits. 2ost banks provide this type of table in their annual reports. he following table represents the same bank as in the previous e.amples/

Figure 3/ Average "alance and #nterest &ates First of all, the balance sheet is an average balance for the line item, rather than the balance at the end of the period. Average balances provide a better analytical framework to help understand the bank's financial performance. 4otice that for each average balance item there is a corresponding interest5related income, or e.pense item, and the average yield for the time period. #t also demonstrates the impact a flattening yield curve can have on a bank's net interest income. he best place to start is with the net interest income line item. he bank e.perienced lower net interest income even though it had grown average balances. o help understand how this occurred, look at the yield achieved on total earning assets. For the current period, it is actually higher than the prior period. hen e.amine the yield on the interest5bearing assets. #t is substantially higher in the current period, causing higher 5

interest5generating e.penses. his discrepancy in the performance of the bank is due to the flattening of the yield curve. As the yield curve flattens, the interest rate the bank pays on shorter term deposits tends to increase faster than the rates it can earn from its loans. his causes the net interest income line to narrow, as shown above. 'ne way banks try to overcome the impact of the flattening of the yield curve is to increase the fees they charge for services. As these fees become a larger portion of the bank's income, it becomes less dependent on net interest income to drive earnings. (hanges in the general level of interest rates may affect the volume of certain types of banking activities that generate fee5related income. For e.ample, the volume of residential mortgage loan originations typically declines as interest rates rise, resulting in lower originating fees. #n contrast, mortgage servicing pools often face slower prepayments when rates are rising, since borrowers are less likely to refinance. As a result, fee income and associated economic value arising from mortgage servicing5 related businesses may increase or remain stable in periods of moderately rising interest rates. +hen analyzing a bank you should also consider how interest rate risk may act 0ointly with other risks facing the bank. For e.ample, in a rising rate environment, loan customers may not be able to meet interest payments because of the increase in the size of the payment or a reduction in earnings. he result will be a higher level of problem loans. An increase in interest rates e.poses a bank with a significant concentration in ad0ustable rate loans to credit risk. For a bank that is predominately funded with short5 term liabilities, a rise in rates may decrease net interest income at the same time credit quality problems are on the increase. Credit Risk (redit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. +hen this happens, the bank will e.perience a loss of some or all of the credit it provided to its customer. o absorb these losses, banks maintain an allowance for loan and lease losses. #n essence, this allowance can be viewed as a pool of capital specifically set aside to absorb estimated loan losses. his allowance should be maintained at a level that is adequate to absorb the estimated amount of probable losses in the institution's loan portfolio. Actual losses are written off from the balance sheet account 6allowance6 for loan and lease losses. he allowance for loan and lease losses is replenished through the income statement line item 6provision6 for loan losses. Figure 7, below, shows how this calculation is performed for the bank being analyzed.

Figure 7/ 8oan 8osses here are a couple of points an investor should consider from Figure 7. First, the actual write5offs were more than the amount management included in the provision for loan losses. +hile this in itself isn't necessarily a problem, it is suspect because the flattening of the yield curve has likely caused a slow5down in the economy and put pressure on marginal borrowers. Arriving at the provision for loan losses involves a high degree of 0udgment, representing management's best evaluation of the appropriate loss to reserve. "ecause it is a management 0udgment, the provision for loan losses can be used to manage a bank's earnings. 8ooking at the income statement for this bank shows that it had lower net income due primarily to the higher interest paid on interest5bearing liabilities. he increase in the provision for loan losses was a ,.9: increase, while actual loan losses were significantly higher. ;ad the bank's management 0ust matched its actual losses, it would have had a net income that was <=93 less (or <,,>>-!. An investor should be concerned that this bank is not reserving sufficient capital to cover its future loan and lease losses. #t also seems that this bank is trying to manage its net income. %ubstantially higher loan and lease losses would decrease its loan and lease reserve account to the point where this bank would have to increase the future provision for loan losses on the income statement. his could cause the bank to report a loss in income. #n addition, regulators could place the bank on a watch list and possibly require that it take further corrective action, such as issuing additional capital. 4either of these situations benefits investors. Conclusion A careful review of a bank's financial statements can highlight the key factors that should be considered before making a trading or investing decision. #nvestors need to have a good understanding of the business cycle and the yield curve 5 both have a ma0or impact on the economic performance of banks. #nterest rate risk and credit risk are the primary factors to consider as a bank's financial performance follows the yield curve. +hen it flattens or becomes inverted a bank's net interest revenue is put under greater pressure. +hen the yield curve returns to a more traditional shape, a bank's net interest revenue usually improves. (redit risk can be the largest contributor to the negative performance of a bank, even causing it to lose money. #n addition, management of credit risk is a sub0ective process that can be manipulated in the short term. #nvestors in banks need to be aware of these factors before they commit their capital.

How Basel
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A!!ected Banks

"y Fadi #aher $Contact Author % Biogra&hy'

%hare Filed Under: "anking, ?conomics, Financial heory, Fore.

From ,=A) to ,=9, there were about eight bank failures (or bankruptcies! in the $nited %tates. "ank failures were particularly prominent during the '9*s, a time which is usually referred to as the 6savings and loan crisis.6 "anks throughout the world were lending e.tensively, while countries' e.ternal indebtedness was growing at an unsustainable rate. (For related reading, see Analy*in# A Ban%+s Financial Statements .!

As a result, the potential for the bankruptcy of the ma0or international banks because grew as a result of low security. #n order to prevent this risk, the "asel (ommittee on "anking %upervision, comprised of central banks and supervisory authorities of ,* countries, met in ,=9> in "asel, %witzerland. he committee drafted a first document to set up an international 'minimum' amount of capital that banks should hold. his minimum is a percentage of the total capital of a bank, which is also called the minimum risk5based capital adequacy. #n ,=99, the "asel # (apital Accord (agreement! was created. he "asel ## (apital Accord follows as an e.tension of the former, and was implemented in -**>. #n this article, we'll take a look at "asel # and how it impacted the banking industry. (he )ur&ose o! Basel I #n ,=99, the "asel # (apital Accord was created. he general purpose was to/ ,. %trengthen the stability of international banking system. -. %et up a fair and a consistent international banking system in order to decrease competitive inequality among international banks. he basic achievement of "asel # has been to define bank capital and the so5called bank capital ratio. #n order to set up a minimum risk5based capital adequacy applying to all banks and governments in the world, a general definition of capital was required. #ndeed, before this international agreement, there was no single definition of bank capital. he first step of the agreement was thus to define it. (wo*(iered Ca&ital "asil # defines capital based on two tiers/ 8

,- Tier , .Core Capital// ier , capital includes stock issues (or share holders equity! and declared reserves, such as loan loss reserves set aside to cushion future losses or for smoothing out income variations. 0- Tier 0 .Supplementary Capital// ier - capital includes all other capital such as gains on investment assets, long5term debt with maturity greater than five years and hidden reserves (i.e. e.cess allowance for losses on loans and leases!. ;owever, short5term unsecured debts (or debts without guarantees!, are not included in the definition of capital. (redit &isk is defined as the risk weighted asset (&+A! of the bank, which are banks assets weighted in relation to their relative credit risk levels. According to "asel #, the total capital should represent at least 9: of the bank's credit risk (&+A!. #n addition, the "asel agreement identifies three types of credit risks/ he on5balance sheet risk (see Figure , for e.ample!. he trading off5balance sheet risk. hese are derivatives, namely interest rates, foreign e.change, equity derivatives and commodities. he non5trading off5balance sheet risk. hese include general guarantees, such as forward purchase of assets or transaction5related debt assets. 8et's take a look at some calculations related to &+A and capital requirement. Figure , displays predefined categories of on5balance sheet e.posures, such as vulnerability to loss from an une.pected event, weighted according to four relative risk categories.

Figure ,/ "asel's (lassification of risk weights of on5balance sheet assets As shown in Figure -, there is an unsecured loan of <,,*** to a non5bank, which requires a risk weight of ,**:. he &+A is therefore calculated as $WA12,3444 5 ,44612,3444. "y using Formula -, a minimum 9: capital requirement gives 76 5 $WA176 52,34441274. #n other words, the total capital holding of the firm must be <9* related to the unsecured loan of <,,***. (alculation under different risk weights for different types of assets are also presented in able -.

Figure -/ (alculation of &+A and capital requirement on5balance sheet assets 2arket risk includes general market risk and specific risk. he general market risk refers to changes in the market values due to large market movements. %pecific risk refers to changes in the value of an individual asset due to factors related to the issuer of the security. here are four types of economic variables that generate market risk. hese are interest rates, foreign e.changes, equities and commodities. he market risk can be calculated in two different manners/ either with the standardized "asel model or with internal value at risk (Ba&! models of the banks. hese internal models can only be used by the largest banks that satisfy qualitative and quantitative standards imposed by the "asel agreement. 2oreover, the ,==A revision also adds the possibility of a third tier for the total capital, which includes short5term unsecured debts. his is at the discretion of the central banks. (For related reading, see 8et To Know The Central Ban%s and What Are Central Ban%s9! )it!alls o! Basel I "asel # (apital Accord has been criticized on several grounds. he main criticisms include the following/ Limited di!!erentiation o! credit risk here are four broad risk weightings (*:, -*:, )*: and ,**:!, as shown in Figure,, based on an 9: minimum capital ratio. Static measure o! de!ault risk he assumption that a minimum 9: capital ratio is sufficient to protect banks from failure does not take into account the changing nature of default risk. +o recognition o! term*structure o! credit risk he capital charges are set at the same level regardless of the maturity of a credit e.posure. Sim&li!ied calculation o! &otential !uture counter&arty risk he current capital requirements ignore the different level of risks associated with different currencies and macroeconomic risk. #n other words, it assumes a common market to all actors, which is not true in reality. Lack o! recognition o! &ort!olio diversi!ication e!!ects #n reality, the sum of individual risk e.posures is not the same as the risk reduction through portfolio diversification. herefore, summing all risks might provide incorrect 0udgment of risk. A remedy would be to create an internal credit risk

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model 5 for e.ample, one similar to the model as developed by the bank to calculate market risk. his remark is also valid for all other weaknesses. hese listed criticisms have led to the creation of a new "asel (apital Accord, known as "asel ##, which added operational risk and also defined new calculations of credit risk. 'perational risk is the risk of loss arising from human error or management failure. "asel ## (apital Accord was implemented in -**>. Conclusion he "asel # (apital Accord aimed to assess capital in relation to credit risk, or the risk that a loss will occur if a party does not fulfill its obligations. #t launched the trend toward increasing risk modeling researchC however, its over5simplified calculations, and classifications have simultaneously called for its disappearance, paving the way for the "asel ## (apital Accord and further agreements as the symbol of the continuous refinement of risk and capital. 4evertheless, "asel #, as the first international instrument assessing the importance of risk in relation to capital, will remain a milestone in the finance and banking history.

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