Chapter 5

Commercial banks and

other lending institutions
Off-Balance-Sheet Items
• Off-balance-sheet items are contingent assets and liabilities that
may affect a commercial bank’s balance sheet and/or income
statement
• Loan commitments
• up-front fees are charged for making funds available
• commitments fees are charged on unused portion of commitments
• Letters of credit
• commercial letters of credit
• standby letters of credit
• Loans sold
• loans can be sold with or without recourse
• Derivative contracts
• futures, forwards, swaps, and options

McGraw-Hill/Irwin 12-8
Income Statement

• Interest income – interest expense = net interest

income
• Noninterest income – noninterest expense = net
noninterest income
• Net interest income – provision for loan losses + net
noninterest income = income before taxes and
extraordinary items (EBTEI)
• EBTEI – income taxes – extraordinary items = net
income

McGraw-Hill/Irwin 12-9
Income Statement
• There is a direct relationship between the income
statement and the balance sheet of commercial banks
N M
NI   rn An  rm Lm  P  NII  NIE  T
n 1 m

NI = net income
An = dollar value of the bank’s nth asset
Lm = dollar value of the bank’s mth liability
rn = rate earned on the bank’s nth asset
rm = rate paid on the bank’s mth liability
P = provision for loan losses
NII = non-interest income earned, including income from OBS activities
NIE = non-interest expenses
T = taxes and extraordinary items
N = number of assets the bank holds
M = number of liabilities the bank holds

McGraw-Hill/Irwin 12-10
Finding the required dollar interest spread

• Suppose that a bank has equity of $200, interest expense of $90, P = $20, net
noninterest income of -$15 and a tax rate of 34%. What is the minimum total
interest revenue required to give a ROE of 15%?
• Required NI = NI/$200 = 0.15 or NI = $30
• NI = [Interest revenue– Interest expense – P + (NII – NIE)] X (1 – Tax rate) or
• $30 = [Interest revenue – $90 – $20 + –$15] (1 – 0.34)
• Required interest revenue = $170.45

9-11 McGraw-Hill/Irwin
Illustrative loan pricing

• If securities are $500 and are earning an average rate of return of 5%

and the bank has $1500 in loans, what must be the average loan rate
to generate interest revenue of $170.45?
• $170.45 = ($500 x 0.05) + ($1500 x Avg. Loan Rate)
• Avg. Loan Rate required = 9.7%

9-12 McGraw-Hill/Irwin
Financial Statement Analysis

• Financial statement analysis is based on accounting

ratios
• Time series analysis is the analysis of financial
statements over a period of time
• Cross-sectional analysis is the analysis of financial
statements comparing one firm with others
• the Uniform Bank Performance Report (UBPR) maintained
by the FFIEC allows banks to observe competitor financial
statements
• Most financial statement analyses is a combination of
time series analysis and cross-sectional analysis

McGraw-Hill/Irwin 12-13
 RETURN ON EQUITY AND ITS COMPONENTS
2007 Full Year Interest Expense
37.46%
Data Operating Income
Profit Margin
Net Income
Operating PLL
Income 6.95%
11.89% Operating Income
ROA
Net Income Noninterest
expense 38.20%
Total Assets Operating Income
0.93%
ROE Income Taxes
5.21%
Net Income Operating Income
Total Equity
Capital
9.13% Asset Utilization Interest Income
Operating Total Assets 5.47%
Income
Total Assets
Equity Multiplier 7.15% Noninterest
income 1.89%
Total Assets Total Assets
Total Equity Capital
9-14 9.65x McGraw-Hill/Irwin
Return on Equity (ROE) Framework

• Return on Equity (ROE) analysis begins with ROE and then

breaks it down into its components
• ROE measures the overall profitability of the bank per
dollar of equity
net income
ROE 
total equity capital
• ROE can be broken down into its components
net income total assets
ROE    ROA  EM
total assets total equity capital

McGraw-Hill/Irwin 12-15
Return on Equity (ROE) Framework

• Return on Assets (ROA) measures profit generated

relative the banks assets
• Equity Multiplier (EM) measures the extent to which
assets are funded with equity relative to debt (i.e., it is a
measure of leverage)
• ROA can also be broken down into its components

net income total operating income

ROA  
total operating income total assets
 PM  AU

McGraw-Hill/Irwin 12-16
Return on Equity (ROE) Framework

• Profit Margin (PM) measures the ability to pay expenses

and generate net income from interest and noninterest
income and is composed of
• interest expense ratio
• provision for loan loss ratio
• noninterest expense ratio
• tax ratio
• Asset Utilization (AU) measures the amount of interest
and noninterest income generated per dollar of total
assets and is composed of
• interest income ratio
• noninterest income ratio

McGraw-Hill/Irwin 12-17
Other Ratios

• The net interest margin (NIM) measures the net return on

a bank’s earning assets
net interest income interest income  interest expense
NIM  
earning assets investment securities  net loans and leases
• The spread measures the difference between the
average yield on earning assets and average cost on
interest-bearing liabilities
interest income interest expense
Spread  
earning assets interest - bearing liabilitie s

McGraw-Hill/Irwin 12-18
Other Ratios

• Overhead efficiency measures a bank’s ability to generate

noninterest income to cover noninterest expenses

noninteres t income
Overhead efficiency 
noninteres t expense
• Many additional ratios are commonly used to analyze
commercial banks by breaking down the components
of ROE even further (see Tables 12-6 and 12-7)

McGraw-Hill/Irwin 12-19
 Comparison of WFS and BOA
Interest Expense WFS = 38.40%
Operating Income BOA = 37.16%
Profit Margin
Net Income
Operating Income PLL WFS = 1.14%
WFS = 14.02% Operating Income BOA = 5.33%
ROA BOA = 18.18%
Net Income Noninterest expense WFS = 38.50%

Total Assets Operating Income BOA = 30.25%

WFS = 0.99%
ROE BOA = 1.43% Income Taxes WFS = 6.94%
Net Income Operating Income BOA = 9.15%
Total Equity Capital

WFS = 8.45% Asset Utilization Interest Income WFS = 5.95%

BOA = 13.36% Operating Income Total Assets BOA = 5.57%
Total Assets
Equity Multiplier WFS = 7.08% Noninterest income WFS = 1.13%
Total Assets BOA = 7.91% Total Assets BOA = 2.34%
Total Equity Capital
WFS = 8.51
9-20 BOA = 9.33 McGraw-Hill/Irwin